Finance Club Thursday, February 2, 2012

1. Finance ClubThursday, February 2, 2012

2. Primer on Equity Valuation and Financial Ratios

3. Robert Shiller • In 1981 he wrote a paper on market volatility. • He determined if a stock price is the estimate of “something,” • (say the discounted cash flows from a corporation), • …then market prices are too volatile in relation to tangible manifestations of that “something.” • (he used dividends as proxy). • He concluded markets are not as efficient as established by financial theory.

4. The ability to benefit from identifying a mispriced security depends on the market price converging to the estimated intrinsic value.

5. Categories of Equity Valuation Models • Present Value Models • Dividend Discount Model • Free Cash Flow to Equity Models • Asset Based Valuation Models • Estimate intrinsic value of a share. • Multiplier Models

6. Market Multiple Models • Based on share price or enterprise value multiples. • Examples • (price to earnings) • (price to sales) • (price to book) • (price to cash flow)

7. Major advantage of using price multiples is that they allow fast relative comparisons, both cross-sectional and in time series. • Note of caution: Difference in accounting practices can make these ratios less meaningful. • Be wary of ratios for companies whose operations are driven by economic cycles.

8. Equity Securities and Company Value • What is one goal of a company’s management? • Increase book value and maximize market value of its equity. • Book value • Shareholders’ equity on balance sheet. • Management can directly affect. • Market value

9. A Company’s Market Value • Reflects the collective and differing expectations of investors. • Rarely will book value and market value be equal.

10. Return on Equity • This is the primary measure that equity investors use to determine effectiveness and efficiency.

11. So is an increase in ROE always good? • It depends. • What if NI decreases slower than BVE? • What if a company issues debt and repurchases shares? • This will increase leverage and make company risker. • It is important to examine cause of change. (DuPont)

12. Price-to-Book • Provides an indication of investors’ expectations about future cash flows. • Important to compare companies in the same industry.

13. Example • GSK has the highest P/B. This suggests investors’ expect higher growth opportunities in GSK. But… • Clearly GSK is using higher financial leverage to do so.

14. Valuation Based on Price Multiple