Reading 37 - Market Based Valuation : Price and Enterprise Value Multiples Flashcards
Explain the Method of Comparables approach to valuation….
values a stock based on the average price multiple of the stock of similar companies
Explain the Method of Forecasted Fundamentals approach to valuation….
values a stock based on the ratio of its value from a discounted cash flow (DCF) model to some fundamental variable
Define a justified p/e multiple….
is what the multiple should be if the stock is fairly valued
What are some reasons for using P/E in valuations?
- Earnings power, as measured by EPS is the primary determinant of investment value
- P/E ratio is popular in the investment community
- Emperical research shows that P/E differences are significantly related to long run average stock returns
What are some shortcomings from using P/E for valuation?
- Earnings can be negative, which produces a meaningless P/E ratio
- Volatility of earnings makes the interpretation of P/E’s difficult
- Management can distort EPS through accounting assumptions
How do you calculate a trailing P/E?
How do you calculate a leading P/E?
What are some advantages to using the P/B ratio for valuation?
- Book Value is a cumulative amount, usually positive, even when earnings are negative.
- Book Value is more stable than EPS, so it may be more useful than P/E when EPS is particularily high, low or volatile.
- Book Value is an appropriate measure of net asset value for firms that primarily hold liquid assets (finance, investment, insurance., etc)
- P/B can be useful for companies going out of business
What are some of the disadvantages for using P/B for valuation?
- P/B does not reflect the value of intangible assets, like human capital
- Different accounting conventions can obscure the true investments
How do you calculate the P/B ratio?
What is a common adjustment made to P/B value to make for more useful comparisons?
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.
What are some advantages in using the P/S ratio in valuation?
- P/S is meaningful even for distressed firms, since sales revenue is always +
- Sales revenue is not as easy to manipulate or distort as EPS and Book Value
- P/S ratio are not as volatile as P/E multiples
- P/S ratios are particularily appropriate for valuing stocks in mature or cyclical industryes
- Empirical research finds that differences in P/S are significantly related to differences in long run average stock returns
What are some disadvantages in using the P/S ratio in valuation?
- High growth in sales does not necessarily indicates high operating profits are measured by earnings and cash flows
- P/S ratios do not capture differences in cost structures across companies
- Revenue recognition practices can still distort sales forecasts
How do you calculate the P/S ratio?
What are some advantages of using the P/CF ratio in valuation?
- 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
What are some disadvantages of using the P/CF ratio in valuation?
- Noncash revenue and net changes in working capital are ignored
- from a theoretical perspective, FCFE is prefereable to operating cash flow. The FCFE is more volatile than operating cash flow
What are some advantages of using the Dividend Yield ratio in valuation?
- Dividend yield contributes to total investment return
- Dividends are not as risky as the capital appreciation component of total return
What are some disadvantages of using the Dividend Yield ratio in valuation?
- the focus on dividend yield is incomplete because it ignores capital appreciation
- 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
How do you calculate the trailing Dividend Yield?
How do you calculate the leading Dividend Yield?
Define underlying earnings….
(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
What is the Molodovsky Effect?
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
What are the two methods used to normalize earnings, which adjusts P/Es for cyclicality?
- Method of historical average EPS - EPS is estimated as the average EPS over some recent period, often the most recent business cycle
- 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.
How do you calculate the ‘justified’ trailing P/E ratio?
How do you calculate the ‘justified’ leading P/E ratio?
By examining the Justified (leading and trailing) P/E ratio, we can conclude these two things….
- It is positively related to the growth rate of expected cash flows, whether defined as dividends or free cash flow
- It is inversly related to the stock’s required rate of return
How do you calculate the Justified P/B multiple?
What are two useful conclusions we can draw from the Justified P/B formula?
- P/B increases as ROE increases
- The larger the spread between ROE and R, the higher the P/B ratio.
How do you calculate the Justified P/S multiple?
How can you calculate the Justified P/S when given trailing P/E?
= net profit margin * justified trailing P/E
What is a predicted P/E?
a P/E estimated from linear regression of historical P/Es on its fundamental variables, including expected growth and risk
What are the 3 limitations of a predicted P/E?
- The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain
- The relationships between P/E and the fundamentals variables examined may change over time
- Multicollinearity is often a problem in time series regressions, which makes it difficult to interpret results
What is the PEG ratio and how do you calculate it?
as P/E per unit of growth. It “standardizes” the P/E ratio for stocks with different expected growth rates
What are the drawbacks to using the PEG ratio?
- The relationship between P/E and g is not linear, which makes comparisons difficult
- PEG ratio does not account for risk
- PEG ratio doesn’t reflect the duration of the high growth period for a multistage valuation model
How do you calculate earnings plus noncash charges?
= net income + depreciation + amortization
How do you calculate adjusted cash flow?
= CFO + [net cash interest outflow * (1-tax rate)]
How do you calculate FCFE ?
= CFO - FCInv + net borrowing
How do you calculate Enterprise Value (EV)?
= market value of common stock + market value of preffered equity + market value of debt + minority interest - cash and investments
When can EV/EBITDA be useful ?
- 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
What are some drawbacks from using EV/EBITDA?
- 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.
How do you calculate the standardized unexpected earnings (SUE) measure?
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?
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
How do you calculate the growth in earnings and dividends if it is not given?
= ROE * (1 - Payout Ratio)
How do you calculate the P/S multiple?
= [Profit Margin * Payout Ratio * (1+g)] / (r-g)
What is the equation for the Fed Model?
= Earnings Yield (E/P) on the S&P500 compared against the yield on the 10 yr US Treasury bonds
How do you calculate the justified P/E for the S&P 500 using the Fed Model?
How do you calculate the Justified Dividend Yield?
