Week 4 Flashcards
What is the equity valuation?
estimate a value for a firm or its security
Three primary equity valuation models:
Discount cash flow (DCF)
Cost
Comparable (or comparable approach)
What is the comparables approach?
entity’s value should bear some resemblance to other equities in a similar class (relative valuation approach)
Two primary comparables approach
First (most common) looks at market comparables for a firm and its peers
Second looks at market transactions where similar firms or divisions have been bought out or acquired by other rivals, private equity firms or other classes of large, deep-pocketed investors
What is a comparable company analysis (CCA)?
Calculate a company’s “implied value” (what it should be worth) based on what other, similar companies are worth
What are the steps for CCA?
- Select an appropriate set of comparable PUBLIC companies
- Determine the metrics and multiples you want to use
- Calculate the metrics and multiples for the companies
- Apply the median or 25th/75th percentile multiples from the set to your company to estimate its Implied Equity Value and Enterprise Value
How many companies should be in a set?
50 is too many to be useful, 1-2 does not have enough data
Formula for company value
Company value = cashflow / (discount rate - CF growth rate)
Where CF growth rates must be < discount rate
If one company has a higher expected growth rate, it _______ trade at higher multiples
Should
Calculate the company’s equity value and enterprise value based on…
current share price, shares outstanding, and balance sheet
What is law of one price?
- firms which generate identical cashflows will have the same value
- identical assets will have the same price regardless of where they are traded (firms which generate identical cashflows and the same growth rate prospects, no matter which industry)
What do analysts look for?
- Comparison firms that have similar future prospects
- No fundamental differences between firms
- Same growth rates
- Same cost of capital (discount rate)
- Industry (or comparison set) is correctly valued
Formula for P/E ratio
Share price / earnings
What does price / earnings ratio mean?
- Meaningless for a company with little to no earnings
- Does not take capital structure (risk) into consideration
What does price / book ratio mean?
- Measures how much an investor is willing to pay for each dollar of book value
- One would think that purchasing shares in a Company at less than book value (ie. Price/Book < 1) would be a good investment
- Advantages of using this metric are that book value is – - Commonly used for comparing financial firms as the assets and liabilities of a financial firm are well represented by book value
Disadvantages to price / book ratio
- Book value does not do a good job of capturing the value of non-physical assets (patents, trademarks, intellectual property, etc.)
- Book value becomes less relevant as physical assets age
- Accounting policies and share repurchases impact the relationship between market value and book value
- NOTE: metric is never used when analyzing technology-based firms
What does price / sales ratio mean?
- Measures what an investor is willing to pay for each dollar of sales a Company is able to generate
- Sales are always a positive number
- Very difficult for a Company to manipulate the reported sales figure (accounting perspective)
- Stable metric
- Commonly used to compare technology-based companies which have yet to mature to the point where earnings have become reliable and consistent
What does price / cash flow ratio mean?
- Measures what an investor is willing to pay for each dollar of Cash Flow a Company is able to generate
- Consistent with the idea that the value of any asset is equal to the present value of future cash flows
- Issue: determining the definition of cash flow (many variations)
- Must stay consistent to calculate the cash flow generated by all firms in the compset
Main issues associated with using price-based valuation metrics is that…
they fail to consider the Company’s capital structure (risk level associated)
What is enterprise value (EV)?
measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization
Formula for enterprise value
Market Value of Equity + Debt - Cash
Formula for debt
Long term debt + Current portion of LT Debt + Pension Obligations + Preferred Shares
What does EV / EBITDA ratio mean?
- Numerator in a valuation metric represents what an investor is paying while the denominator represents what the investor is getting in return
- EV/EBITDA metric can be interpreted as what is an investor paying for a dollar’s worth of cash flow (EBITDA is a rough estimate of cash flow)
Advantages and disadvantages of EV / EBITDA
- advantages of being appropriate for comparing firms with different levels of leverage
- Disadvantages with using this metric is there are better estimates of cash flow than EBITDA (academic perspective)
What does EV / revenue ratio mean?
- Metric is similar to Price/Sales with the exception that we are compensating for different capital structures
- Commonly used for companies that do not produce consistent cash flows or earnings
