R.31 Market-based Valuations

Question 1

Price to Sales

• advantages/disadvantages
• calculation
• calculate justified ratio
• fundamental influences
• growth driver

Answer 1

Advantages

• Meaningful for distressed firms.
• Sales rev not easily manipulated.
• Not as volatile as P/E ratios.
• Useful for mature, cyclical, and zero-income (start-up) firms.

Disadvantages

• High sales do not necessarily mean high profits or cash flows.
• Doesn’t capture cost structure differences b/w firms.
• Rev recognition practices still distort sales.

Calc

• ​See slide. Note: E/S = profit margin, so we can also calculate (P₀ / S₀ ) = profit margin x justified trailing P/E

Question 4

Pricing multiples overall

• What are price multiples vs justified price multiples?
• What are the two methods for justifiying a price multuiple? (define each)

Answer 4

Price multiples: Price multiples are ratios of a common stock’s market price to some fundamental variable.

Justified price multiples: what the multiple should be if the stock is fairly valued.

• Actual multiple > Justified price multiple means stock overvalued (vice-versa)
• Two methods:
  
  1. ​​Method of comparables is an average multiple of similar stocks in the same peer group. The economic rationale for the method of comparables is the Law of One Price, which asserts that two similar assets should sell at comparable prices
  2. Forecasted fundamentals: Ratio of DCF valuation (numberator) to fundamental variable (e.g. EPS).

Question 5

P/B ratio

• advantages/disadvantages
• calculate justified ratio
• fundamental influences
  
  • growth driver

Answer 5

Question 6

Price-to-CashFlow

• advantages/disadvantages
• calculation
• calculate justified ratio
• fundamental influences
• growth driver

Justified Dividend Yield

• advantages/disadvantages
• calculation

Answer 6

Calcs:

• P/CF: CF = NI + depreciation + amortization.
• P/CFO = NI + Dep + Other NCC - (Use of Cash: increase A / decrease L) + (source of cash: decrease A or increase L)
• Price-to-adjusted CFO (P/CFO)
  
  • adjusted CFO = CFO + [(net cash interest outflow) × (1 – tax rate)].
• Price-to-FCFE:
  
  • FCFE = CFO – FCInv + net borrowing.
• Price-to-EBITDA: EBITDA = earnings before interest, taxes, depreciation, and amortization.

Theoretically, FCFE is the preferred way to define cash flow. However, FCFE is also more volatile than traditional cash flow. EBITDA is a measure of cash flow to all providers of capital (i.e., both debt and equity). Hence, it may be better suited to valuing the entire firm rather than just the equity stake. Analysts typically use trailing cash flows when calculating price-to-cash-flow ratios.

Question 7

PEG Ratio (very testable)

• calc
• implications
• drawbacks

Answer 7

PEG = ^(P/E) / _{g (<strong><em><u>whole number!</u></em></strong> not decimal!)}

Implications - calculates a stock’s P/E per unit of expected growth, so:

• Low PEG ( < 1 )is desirable, indicates undervalued
• High PEG less attractive, indicates overvalued

Drawbacks

• differences in firm risk attributes
• differences in duration of growth
• linear relationship assumed b/w P/E and g, but this may actually be nonlinear
• calc uses g as WHOLE #!!!

Question 8

Price to Earnings

Answer 8

Question 9

Fed model

Yardeni model

Answer 9

Question 10

Enterprise Value Multiples

1. Enterprise Value to EBITDA
2. Determining Enterprise Value
3. Valuation Based on:

• Forecasted Fundamentals
• Comparables

1. Other Enterprise Value Multiples

Answer 10

1. Enterprise Value to EBITDA

​​Rationale to use EV/EBITDA:

+ Good for comparing companies with differing leverage.

+ EBITDA controls for differences in depreciation and amortization.

+ EBITDA is usually positive even if EPS negative.

Drawbacks

• EBITDA overestimates cash flow from operations if the working capital is growing.
• Free cash flow to the firm (FCFF) is more consistent with valuation theory.
  1. Determining Enterprise Value

EV = Debt + Common equity + Preferred equity − Cash and short-term inv

• Enterprise value is the total company value on a market value basis less cash and short-term investments. The cash is subtracted because enterprise value represents the price an acquirer would pay for the whole company.​*
  1. Valuation Based on:
• Forecasted Fundamentals

The justified EV/EBITDA multiple is

• positively related to expected growth rate in free cash flow
• positively related to ROIC
• negatively related to WACC
• Comparables: Lower EV/EBITDA value indicates a company is undervalued.

1. Other Enterprise Value Multiples
   
   • EV/EBITDA most popular
   • EV/FCFF, EV/EBITA, and EV/EBIT also used
     
     • All of the measures listed for the denominator add interest back to net income. That means the cash flows are for both debt and equity providers of capital. Occasionally nonfinancial measures are used in the denominator for enterprise value multiples. For example, subscribers could be used for a cable company.
   • EV/Sales: common alternativeto P/S b/c EV/S more useful for companies with different capital structures

Question 11

Harmonic mean and weighted harmonic mean

Answer 11

Question 12

Momentum Indicators

Answer 12