Reading 37 - Market Based Valuation : Price and Enterprise Value Multiples

Question 1

Explain the Method of Comparables approach to valuation….

Answer 1

values a stock based on the average price multiple of the stock of similar companies

Question 2

Explain the Method of Forecasted Fundamentals approach to valuation….

Answer 2

values a stock based on the ratio of its value from a discounted cash flow (DCF) model to some fundamental variable

Question 3

Define a justified p/e multiple….

Answer 3

is what the multiple should be if the stock is fairly valued

Question 4

What are some reasons for using P/E in valuations?

Answer 4

1. Earnings power, as measured by EPS is the primary determinant of investment value
2. P/E ratio is popular in the investment community
3. Emperical research shows that P/E differences are significantly related to long run average stock returns

Question 5

What are some shortcomings from using P/E for valuation?

Answer 5

1. Earnings can be negative, which produces a meaningless P/E ratio
2. Volatility of earnings makes the interpretation of P/E’s difficult
3. Management can distort EPS through accounting assumptions

Question 6

How do you calculate a trailing P/E?

Answer 6

Question 7

How do you calculate a leading P/E?

Answer 7

Question 8

What are some advantages to using the P/B ratio for valuation?

Answer 8

1. Book Value is a cumulative amount, usually positive, even when earnings are negative.
2. Book Value is more stable than EPS, so it may be more useful than P/E when EPS is particularily high, low or volatile.
3. Book Value is an appropriate measure of net asset value for firms that primarily hold liquid assets (finance, investment, insurance., etc)
4. P/B can be useful for companies going out of business

Question 9

What are some of the disadvantages for using P/B for valuation?

Answer 9

1. P/B does not reflect the value of intangible assets, like human capital
2. Different accounting conventions can obscure the true investments

Question 10

How do you calculate the P/B ratio?

Answer 10

Question 11

What is a common adjustment made to P/B value to make for more useful comparisons?

Answer 11

Using tangible book value instead of book value. Tangible book value is equity to book value of equity - intagible assets. Intangible assets include goodwill from acquisitions and patents.

Question 12

What are some advantages in using the P/S ratio in valuation?

Answer 12

1. P/S is meaningful even for distressed firms, since sales revenue is always +
2. Sales revenue is not as easy to manipulate or distort as EPS and Book Value
3. P/S ratio are not as volatile as P/E multiples
4. P/S ratios are particularily appropriate for valuing stocks in mature or cyclical industryes
5. Empirical research finds that differences in P/S are significantly related to differences in long run average stock returns

Question 13

What are some disadvantages in using the P/S ratio in valuation?

Answer 13

1. High growth in sales does not necessarily indicates high operating profits are measured by earnings and cash flows
2. P/S ratios do not capture differences in cost structures across companies
3. Revenue recognition practices can still distort sales forecasts

Question 14

How do you calculate the P/S ratio?

Answer 14

Question 15

What are some advantages of using the P/CF ratio in valuation?

Answer 15

• cash flow is harder for managers to manipulate than earnings
• price to cash flow is more stable than price to earnings
• reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings

Question 16

What are some disadvantages of using the P/CF ratio in valuation?

Answer 16

1. Noncash revenue and net changes in working capital are ignored
2. from a theoretical perspective, FCFE is prefereable to operating cash flow. The FCFE is more volatile than operating cash flow

Question 17

What are some advantages of using the Dividend Yield ratio in valuation?

Answer 17

1. Dividend yield contributes to total investment return
2. Dividends are not as risky as the capital appreciation component of total return

Question 18

What are some disadvantages of using the Dividend Yield ratio in valuation?

Answer 18

1. the focus on dividend yield is incomplete because it ignores capital appreciation
2. the dividend displacement of earnings concept argues that dividends paid now displace future earnings, which implies a trade-off between current and future cash flows

Question 19

How do you calculate the trailing Dividend Yield?

Answer 19

Question 20

How do you calculate the leading Dividend Yield?

Answer 20

Question 21

Define underlying earnings….

Answer 21

(aka persistent, continuing, or core earnings)…, which are earnings that exclude nonrecurring components, such as gains and losses from asset sales, asset-write downs, provisions for future losses, and changes in accounting estimates

Question 22

What is the Molodovsky Effect?

Answer 22

The countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle and low P/Es due to high EPS at the top of the cycle

Question 23

What are the two methods used to normalize earnings, which adjusts P/Es for cyclicality?

Answer 23

1. Method of historical average EPS - EPS is estimated as the average EPS over some recent period, often the most recent business cycle
2. Method of average return on equity (ROE) - EPS is estimated as the average ROE multiplied by the current book value per share.

***Since the method of historical average EPS ignores size effects, the method of average ROE is preferred.

Question 24

How do you calculate the ‘justified’ trailing P/E ratio?

Answer 24

Question 25

How do you calculate the ‘justified’ leading P/E ratio?

Answer 25

Question 26

By examining the Justified (leading and trailing) P/E ratio, we can conclude these two things….

Answer 26

1. It is positively related to the growth rate of expected cash flows, whether defined as dividends or free cash flow
2. It is inversly related to the stock’s required rate of return

Question 27

How do you calculate the Justified P/B multiple?

Answer 27

Question 28

What are two useful conclusions we can draw from the Justified P/B formula?

Answer 28

1. P/B increases as ROE increases
2. The larger the spread between ROE and R, the higher the P/B ratio.

Question 29

How do you calculate the Justified P/S multiple?

Answer 29

Question 30

How can you calculate the Justified P/S when given trailing P/E?

Answer 30

= net profit margin * justified trailing P/E

Question 31

What is a predicted P/E?

Answer 31

a P/E estimated from linear regression of historical P/Es on its fundamental variables, including expected growth and risk

Question 32

What are the 3 limitations of a predicted P/E?

Answer 32

1. The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain
2. The relationships between P/E and the fundamentals variables examined may change over time
3. Multicollinearity is often a problem in time series regressions, which makes it difficult to interpret results

Question 33

What is the PEG ratio and how do you calculate it?

Answer 33

as P/E per unit of growth. It “standardizes” the P/E ratio for stocks with different expected growth rates

Question 34

What are the drawbacks to using the PEG ratio?

Answer 34

1. The relationship between P/E and g is not linear, which makes comparisons difficult
2. PEG ratio does not account for risk
3. PEG ratio doesn’t reflect the duration of the high growth period for a multistage valuation model

Question 35

How do you calculate earnings plus noncash charges?

Answer 35

= net income + depreciation + amortization

Question 36

How do you calculate adjusted cash flow?

Answer 36

= CFO + [net cash interest outflow * (1-tax rate)]

Question 37

How do you calculate FCFE ?

Answer 37

= CFO - FCInv + net borrowing

Question 38

How do you calculate Enterprise Value (EV)?

Answer 38

= market value of common stock + market value of preffered equity + market value of debt + minority interest - cash and investments

Question 39

When can EV/EBITDA be useful ?

Answer 39

• may be more useful than P/E when comparing firms with different amounts of leverage
• EBITDA is useful for capital intensive businesses with high levels of depreciation and amortization
• EBITDA is usually positive when EPS is not

Question 40

What are some drawbacks from using EV/EBITDA?

Answer 40

• if working capital is growing, EBITDA will overstate CFO
• because FCFF captures the amount of capital expenditures, it is more strongly linked with valuation theory than EBITDA.

Question 41

How do you calculate the standardized unexpected earnings (SUE) measure?

Answer 41

Question 42

The Lewis Corp. had revenue per share of $300 in 2001, earnings per share of $4.50, and paid out 60% of its earnings as dividends. If the return on equity (ROE) and required rate of return of Lewis are 20% and 13% respectively, what is the appropriate price/sales (P/S) multiple for Lewis?

Answer 42

STEP1 : Realize we need to calculate Profit Margin & Payout ratio which will be used in the P/S calc

STEP2: Profit Margin = EPS/Sales -> 4.5/300 = 1.5%

STEP3: Payout ratio, already given as 60%

STEP4: Since the growth rate of earnings and dividends wasn’t given we need to calculate it… g = ROE * (1-payout ratio) = 8%

STEP5: Plug into the P/S formula

1.5% * 0.60*1.08

0.13-0.08

= 0.1944

Question 43

How do you calculate the growth in earnings and dividends if it is not given?

Answer 43

= ROE * (1 - Payout Ratio)

Question 44

How do you calculate the P/S multiple?

Answer 44

= [Profit Margin * Payout Ratio * (1+g)] / (r-g)

Question 45

What is the equation for the Fed Model?

Answer 45

= Earnings Yield (E/P) on the S&P500 compared against the yield on the 10 yr US Treasury bonds

Question 46

How do you calculate the justified P/E for the S&P 500 using the Fed Model?

Answer 46

Question 47

How do you calculate the Justified Dividend Yield?

Answer 47