Market Based Valuation Flashcards
Can justify price multiple using these two methods
Method of comparables
Method of forecasted fundamentals
What is a justified price multiple
What multiple should be it stock is fairly valued
Actual multiple > justified, overvalued
Actual multiple < justified, undervalued
What is economic rationale for method of comparables
Law of one price - similar assets sell at comparable price
What is economic rationale for method of forecasted fundamentals
Value used in numerator of justified price multiple is derived from DCF model based on value equaling PV of expected future cash flows
Advantages and disadvantages to price earnings multiple
Earnings power is determinant of investment value
Earnings can be negative (meaningless p/e)
Volatility decreases interpretation accuracy
Mgt has accounting discretion
Difference between leading and trailing basis
Trailing = last 12 months Leading = forecasted 12 months
Normalize EPS by…
Calculating:
Historical average EPS (most recent complete bus cycle)
Average ROE (over most recent complete bus cycle * BVPS)
Calc justified leading P/E
P0 (1-b)
— = —–
E1 r-g
b = retention rate
Calc justified trailing P/E
P0 (1-b)(1+g)
— = ———–
E0 r-g
b = retention rate
Calc PEG ratio
PEG ratio = P/E
—–
g
Lower PEG = undervalued
Justified Price-to-book ratio
Justif P/B = ROE-g
———
r - g
How to calc book value per share
Common shareholder’s equity = total assets - total liabilities - preferred shares
Advantages of P/B
- usually positive (even w/neg earnings)
- more stable than EPS
- appropriate measure of NAV
Disadvantages of P/B
- Misleading with significant firm size differences
- Influenced by accounting choices
- inflation and technology cause differences in book and market value
What are common adjustments to P/B
Exclusion of intangibles
Use trailing BV
Calc justified price to sales ratio
S0 * (r-g)
Advantages of justified P/S ratio
Meaningful for distressed firms
Not easily manipulated
Less volatile
Useful for valuing mature, cyclical, zero income firms
Disadvantages of justified price to sales ratio
High sales may not translate to profitability
Doesn’t capture cost structure differences
Revenue recognition can distort
Calc justified Price to Cash Flow
P/CF = P / (NI + dep + amort)
P/CFO = P / (CFO + net cash int outflow * (1-tax))
P/FCFE = P / (CFO - FCInv + net borrowing)
P/EBITDA
Advantages of price to cash flow ratios
Difficult to manipulate
More stable
Mitigates quality of earnings issues
Disadvantages of price to cash flow ratios
True cash flow from operations difficult to determine
FCFE better but more volatile
