Multiple Based Valuation, I

1. Multiple Based Valuation, I Alexander Motola, CFA Alexander Motola, 2013

2. What is “Valuation”? • It is NOT the stock price • It is NOT the market capitalization • Is a $50 stock expensive? • What if it was $25 3 months ago? • Is a $1MM home expensive? • What if costs $5MM to build and is right on the beach in Maui? • Price ≠ Valuation • Price is an important COMPONENT of valuation, but you need more information Alexander Motola, 2013

3. What is “Valuation”? • Is a $50 stock expensive? • What if it was $25 3 months ago? • What if it’s worth $150? • To get to $150 from $25, it’s still got to go through $50, $75 (still a double!), etc. • Saying a stock is cheap because it went down, or expensive because it went up • Is uninformed • Is to focus on the irrelevant • Will end your analyst job interview Alexander Motola, 2013

4. What is “Valuation”? Major classifications of multiples • Price multiples – ratios of a stock’s market price to some measure of fundamental value per share • Enterprise value multiples – relate the total market value of allsources of a company’s capital to a measure of fundamental value for the entire company Alexander Motola, 2013

5. Valuation Framework • In relative valuation (i.e. the multiples approach), the objective is to value assets based on how similar assets are currently priced in the market. • This idea is widely used in the real estate market – price per square foot, price per acre, how much my neighbor’s house just sold for… • While multiples are easy to use and intuitive, they are also easy to misuse. • There are two components to relative valuation: • To value assets on a relative basis, prices have to be standardized, usually by converting prices into multiples of earnings, book values, or sales. • To find similar firms. This is difficult to do since no two firms are identical and firms in the same business can still differ on risk, growth potential, and cash flows. Alexander Motola, 2013

6. Valuation Framework • The strengths of relative valuation are also its weaknesses: • The ease with which a relative valuation can be put together, pulling together a multiple and a group of comparable firms, can also result in inconsistent estimates of value where key variables such as risk, growth, or cash flow potential are ignored. • The fact that multiples reflect the market mood also implies that using relative valuation to estimate the value of an asset can result in values that are too high when the market is overvaluing comparable firms, or too low when it is undervaluing these firms. • While there is scope for bias in any type of valuation, the lack of transparency regarding the underlying assumptions in relative valuations make them particularly vulnerable to manipulation. Alexander Motola, 2013

7. Valuation Framework • In absolute valuation (using multiples or discounted approach), the objective is to value assets based on how much investors have paid for the company in the past and handicapping it vis-à-vis it’s growth prospects • Some industries don’t easily lend themselves to finding “comps” • There are two components to this valuation approach: • Having a robust data set of historical multiples • Having an understanding about how the company is similar and different to its own past, and being able to correctly adjust the multiple for these Alexander Motola, 2013

8. Fridson & Alvarez, Ch 8- EBITDA “Net income was not, to the disappointment of analysts, a standard by which every company’s value and risk could be compared. Had they thought deeply about the problem, they might have hypothesized that no single measure could capture financial performance comprehensively enough to fulfill such a role. Instead, they set off in quest of the single correct measure of corporate profitability, believing in its existence as resolutely as the conquistadors who went in search of El Dorado.” Pg 161 Alexander Motola, 2013

9. Fridson & Alvarez, Ch 8- EBITDA • Net Income is just 1 measure of profitability, and thus the basis of just a few of the many possible methods of valuing a company • Choose the best tool for the job; one size does not fit all • To help get closer to our goal of valuing a company, we need to be able to compare what we pay to some measure of corporate performance, preferably one that is forward looking Alexander Motola, 2013

10. Fridson & Alvarez, Ch 8- EBITDA • Page 162 – Exhibit 8.1 • 2 companies, $28.6mm and $33.0mm in Net Income but equal Operating Income • Different Capital Structures, leads to different NI; in this case, interest expense (and thus taxes) are the difference • EBIT is ALMOST the same as OI • EBITDA is used as a proxy for cash flow (and is often thus seen as “conservative” even though that is misleading) Alexander Motola, 2013

11. Fridson & Alvarez, Ch 8- EBITDA • EBITDA is a pro-forma NI/SCF # that is most often used to create comparability across different capital structures • D & A (and Depletion) are “real” expenses, but they are usually paid at one time, and often not in the period being analyzed; the “E” in EBITDA is “EARNINGS” which means an accrual based number is the basis, not a cash based number Alexander Motola, 2013

12. Fridson & Alvarez, Ch 8- EBITDA • EBITDA is a pro-forma NI/SCF # that is most often used to create comparability across different capital structures • D & A (and Depletion) are “real” expenses, but they are usually paid at one time, and often not in the period being analyzed; the “E” in EBITDA is “EARNINGS” which means an accrual based number is the basis, not a cash based number Alexander Motola, 2013

13. Fridson & Alvarez, Ch 14- P/E Ratio (pages 313-323) • Pg 314: P/E ratio = (stock price)/ (Earnings per Share) • Wolfe Food • Stock Price $50 • Net Income: $45mm • Shares Out: 10MM • EPS: $4.50 ($45MM/10MM) or (Net Income divided by Shares Out) • $50/$4.50 = 11.1X (Stock Price divided by Earnings per Share) Alexander Motola, 2013

14. Price Earnings Ratio • Earnings easily manipulated by management (extensively covered in prior lectures) • Earnings generally serve as a proxy for cash flow; most sophisticated market participants prefer P/CF to P/E ratios • For a lot of reasons, it is easier to forecast “E” than “CF” • P/E does not distinguish between accounting choices or financing options • Over long periods (10 years), the market p/e tends to mean reversion – “the P/E ratio was negatively correlated with subsequent stock price growth but uncorrelated with subsequent earnings growth.” (Campbell and Shiller, 1998) • A low p/e strategy works much better for large capitalization stocks than for low capitalization stocks (low relative to the market & peers; low relative to its growth potential; low relative to its own history) – see the point above Alexander Motola, 2013

15. Price Earnings Ratio • The “P” is obvious • Which “E” do you use? • For companies with no/low growth or for greater certainty, using trailing earnings makes sense (actual earnings) • For companies that are growing, the current year or “the out year” makes sense • For some companies, you might be willing to go further out, but you also need to “handicap” the multiple you’d be willing to pay • How much do you adjust the “E”? Alexander Motola, 2013

16. Price Earnings Ratio • Rationales for using the P/E • Earnings drive stock prices • It is widely recognized and used by investors, both retail and professional • There is an intuitive basis for this (P is P, and earnings should be profits available to common shareholders) • It should be RELATIVELY comparable to other methods unless there is an anomaly • Assuming no growth, a P/E represents the # of years of earnings (not cash) payback to an investor; this can also be expressed as an Earnings Yield: E/P Alexander Motola, 2013

17. Price Earnings Ratio • Drawbacks • EPS can be zero, negative, or insignificantly small relative to price, and P/E does not make economic sense under these circumstances • Your “E” is materially impacted by financial leverage • The ongoing or recurring components of earnings that are most important in determining intrinsic value can be practically difficult to distinguish from transient components • Differences in accounting standards adopted by firms may affect the comparability of P/Es among companies • Fundamental factors that could explain differences in P/Es • Growth in EPS: companies with a higher growth rate are expected to have higher P/Es • Risk (measured by beta or leverage): companies with lower risk can have higher P/Es Alexander Motola, 2013

18. Price Earnings Growth Ratio • Comparing the P/E to the Earnings Growth Rate would appear to address one of P/E’s shortcomings • For Example, Wolfe, with a P/E of 11.1 X (see example), is growing EPS @ 15% • 11.1 / 15 = 74% • 74% is a discount to its growth rate – that “should” be a bargain • This over simplifies the process of analyzing valuation; now you have to a pick the right “E” and the right “G”; it also assumes that a 1:1 ratio is “fair value”, and that remains true at the extremes Alexander Motola, 2013

19. Price Earnings Growth Ratio PEG • A good tool for evaluating the “research worthiness” of potential research, but a poor valuation technique for individual securities • Supplemental tests indicate that analysts appear to value and recommend stocks based on heuristics such as the PEG ratio – versus using a cash flow or residual income based approach • “given the lack of any meaningful statistical correlation between P/E ratios and EPS growth rates, the use of P/E to growth rate as a valuation tool appears to offer no real benefit to the investor” - (Networking Industry Report, “Does Valuation Matter?”, Johnson and Silverstein, Robertson Stephens & Company, June 16, 1997) Profit Margins • “History shows using high profit margins as the only determinant in buying a stock will lead to disappointing results.” WWOWS Alexander Motola, 2013

20. Valuation and Earnings Growth • “Notwithstanding the fascination of Wall Street with EPS growth rates, there is neither a statistical relationship nor a common sensible relationship between EPS growth rates and stock prices” (Paul Johnson, “Does Valuation Matter?”, Robertson Stephens & Company, June 16, 1997 • “There is a widespread belief among market participants that future earnings growth is highly predictable” – Chan, Karceski, Lakonishok, but “there is essentially no persistence or predictability in growth of earnings across all firms.” • When comparing estimates to realized results, “median forecast exceed median realized growth rates, with the most pronounced bias [coming from the companies with the highest estimated growth rates].”

21. Price to Book Ratio • Price to Book • “Book” is “Book Value Per Share”; this is Shareholder’s Equity, or “What’s Left” if you remember the Balance Sheet lecture • Book equity easily manipulated. Assets are not marked to market value but cost. Asset impairments and other charges can have a material effect on Book value. • Impairments, write downs, buybacks, dividends all impact BV • BV can be adjusted by the analyst, but there are many unknowns • Low P/B tends to outperform the general stock universe, but has a lot of volatility (standard deviation of returns) (WWOWS) • Book Value was popularized by the Buffet/Graham school of investing, during a period when it was possible to buy many firms at an extreme discount to BV; Buffet regularly discusses Book Value Growth in his Shareholder Letters

22. Price to Book Ratio • Most useful for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions • Rationales for using the P/B • Because book value is a cumulative balance sheet amount, book value is generally positive even when EPS is zero or negative • Book value per share is more stable than EPS. May be more meaningful than P/E when EPS is abnormally high or low or is highly variable

23. Price to Book Ratio • Drawbacks • Some assets (e.g., human capital, company reputation) are not reflected on the balance sheet • P/B may be misleading when the levels of assets used by the companies under examination differ significantly. Such differences may reflect differences in business models. • Accounting effects on book value may compromise how useful book value is as a measure of the shareholders’ investment in the company • e.g. Intangible assets that are acquired are shown on the books; those that are generated internally are not (R&D, advertising, marketing are expensed not capitalized) • Book value largely reflects the historical purchase cost of assets, net of accumulated depreciation. Significant differences in the average age of assets among companies being compared may weaken the comparability of P/Bs among companies • Share repurchases or issuances may distort historical comparisons

24. Price to Sales • The ratio of the market value to annual net sales • Useful for certain stocks: cyclicals, supercyclicals, and contrarian investments • Most useful for valuing certain types of privately held companies, including investment management companies and many types of companies in partnership form • Appropriate for valuing the stocks of mature, cyclical, and zero-income companies • Rationales for using the P/S • Sales are generally less subject to distortion or manipulation than are other fundamentals, such as EPS or book value • Sales are positive even when EPS is negative • P/S is generally more stable than P/E • Can be used to “normalize” margins for cyclical companies • Most effective SINGLE valuation factor (WWOWS)

25. Price to Sales • Drawbacks • A business may show high growth in sales even when it is not operating profitably as judged by earnings and cash flows from operations • Sales is a pre-financing income measure while share price reflects the effect of debt financing • P/S does not reflect differences in cost structures among different companies • Although P/S is relatively robust with respect to manipulation, revenue recognition practices have the potential to distort P/S • Relationship of P/S to P/E • If you assume a given net margin for a company (5%, for example), you can convert P/S to P/E, and vice-versa • If the P/S is 4, and the net margin is 5%, the equivalent P/E would be 80 (4 * (100%/5%)) • If the P/E is 20, and net margin is 10%, then P/S = 2; (10%/100%) * 20

26. Enterprise Value to EBITDA • The ratio of the enterprise value to EBITDA • EV = MV of Equity + MV of Debt + MV of Pref Shares – Cash and M/S • EV is the total value of the firm if the capital structure were to be “flattened” • EBITDA = Net income + Interest expense + Taxes + Depreciation + Amortization • Alternative denominators: EBITA, EBIT • Frequently used in the valuation of capital intensive businesses such as cable companies and steel companies • Rationales for using the EV/EBITDA • EV/EBITDA is usually more appropriate than P/E alone for comparing companies with different levels of debt. EBITDA is a pre-interest earnings figure; EPS is post-interest • EBITDA controls for differences in depreciation and amortization among business, in contrast to net income. • EBITDA is frequently positive when EPS is negative

27. Enterprise Value to EBITDA • Drawbacks • EBITDA will overestimate cash flow from operations if working capital is growing. • Free cash flow to the firm (FCFF), which directly reflects the amount of the company’s required capital expenditures, has a stronger link to valuation theory than does EBITDA • Fundamental factors that could explain differences in EV/EBITDA • Return on Capital • Growth in FCFF • Risk (as measured by WACC)

28. Other Approaches Enterprise Value to Sales (EV/Sales) • The ratio of the enterprise value to sales • Alternative sales-based ratio that is particularly useful when comparing companies with diverse capital structures • Dividend Discount Model • P= D / (r-g); P = price, D = next annual dividend, r = WACE, g = perpetual growth in dividends • Theoretically perfect (a stock’s value ideally would be the discount value of all future dividend payments), but only P and probably D are really known, the other 2 numbers are estimates, and the model is very sensitive to them • “Trading on Yield” • A very market based approach based on the trade off between stocks and the fixed income market • Only useful for companies who enjoy perceived safety and consistency of dividend payments

29. Other Approaches Discounted Cash Flow (DCF) • Net Present Value (NPV, or the “current value”) is equal to the sum of all future projected cash flows, which have been discounted • Similar to the DDM, and also very, very sensitive to the inputs used, especially the selection of the discount rate • Often used academically • It is very easy to “reverse engineer” the target price you are looking for • Not a relative measure of value, but one that focuses on intrinsic value • It is difficult to project cash flows, particularly the timing of big events • The longer your intended investment horizon, the better a DCF works

30. How do we use multiples? • Compare with a firm’s historical multiples • Compare with sector multiples • Compare as a ratio to the S&P multiple • Compare to the company’s history • Adjust/handicap for circumstances • Valuation • Sum-of-the-parts valuation

31. How do we use multiples? • Once you have selected the best approach to value your company, you will want to compare its valuation on that basis with the market, with its competitors/industry peers, and its own history • You will definitely want to use more than 1 measure of valuation, but there should be a “primary” approach that is used to calculate your target price

32. How do we use multiples? • Like any other part of investment analysis, we bring our own thoughts to the table, and rely on what makes sense to us • Management cannot do much (in the short run) about the numerator, so • They focus on the denominator • If they can convince analysts/investors to use a more favorable calculation for earnings, ebitda, etc. then their stock either looks cheap or can support a higher multiple • This is also why the focus on convincing the market of their “growth prospects” • When someone says “XYZ Corp is trading at 20 times”, they are almost always referring to the P/E ratio, and most likely forward earnings

33. Calculating Your Target Price • Let’s suppose you think XYZ should trade at 15x FORWARD earnings • You’ve modeled their EPS to be, starting with this year: • $1.00 CFY, $1.16 NFY, $1.32 NFY+1 • You have 3 “forward earnings” numbers • You should be more confident in your projections the closer they are to today • I would use 15 (multiple) * $1.32 (NFY+1 EPS Projection) = $19.80, and hope the stock could get there in 1-1.5 years

34. Calculating Your Target Price • If [($19.80 / current price) – 1] is not greater than the expected market return over my holding period, than I definitely am not interested in buying • If my stock pays a dividend, and I expected to receive one or more payments over my holding period, then I can add that to my target price • The riskier my stock is or the more uncertain my earnings estimates are, the higher my return needs to be • If the market averages 9% a year, and my holding period is 1.5 years, then my base hurdle rate should be 13.8% = [(1+.09)^1.5] • The market return has a beta of 1. My stock has a market risk of its beta (relative to the market) PLUS specific equity risk.

35. TRACKING Your Target Price • XYZ EPS est: $1.00 CFY, $1.16 NFY, $1.32 NFY+1 • What if XYZ finishes the CFY with EPS of $1.05? • If the factors that drive your model are doing better, you might (or the next analyst on your stock) need to revise your future estimates (and thus TP) higher • If something else is causing better than expected EPS, you need to examine the sustainability and impact (ONNN: buybacks, deleveraging) • What if they do $0.97? • Since the P/E (or most multiples) contemplates the growth rate among other factors, do these events also change what you are willing to pay? Multiples go up when thing are BTE, and down when they are Worse Than Expected, so it’s a “Double Whammy”

36. Surprise! Higher Dividends = Higher Earnings Growth • Companies with higher dividend payout ratios have generated higher earnings growth rates over subsequent ten-year periods. • Companies with lower payout ratios (in the bottom quartile) actually generated negative real earnings growth over the next ten years. • The data was robust and consistent for all ten-year periods dating from 1871 to 2001. Source: Robert D. Arnott and Clifford S. Asness, Financial Analysts Journal January / February 2003

37. Valuation Tools / “Alpha Factors” Value Growth Low P/E Price to Book Price to Sales Dividend Yield Price to Cash Flow Earnings Growth Momentum Capital Returns (ROE, ROIC) Profit Margins PEG Ratio

38. Valuation as an Explanatory Factor • Results of Merrill Lynch study • (Examining the Effectiveness of Valuation Metrics, Milunovich, 9/24/02) • Valuation metrics explained only a small percentage of stock price variations • The valuation ratios explained more price variation over 12 than 3 months (and presumably more and more the further you go out) • The valuation metrics were least effective in North America • No valuation metric worked consistently at market bottoms • “In the short run, the market is a voting machine but in the long run it is a weighing machine.” – Ben Graham