FIN 468: Intermediate Corporate Finance

1. FIN 468: Intermediate Corporate Finance Topic 7–Price Multiples Larry Schrenk, Instructor

2. Topics • Relative Valuation • Price Multiples • P/E Ratio • Other Ratios

3. Relative Valuation

4. Relative Valuation • Value of an asset is compared to the values assessed by the market for similar or comparable assets. • To do relative valuation • Identify comparable assets and obtain market values • Convert these market values into standardized values • Absolute prices cannot be compared • Standardizing creates price multiples. • Compare the standardized values/multiples • Controlling for any differences that might affect the multiple • Judge whether the asset is under or over valued

5. Relative Valuation • Most valuations on Wall Street are relative valuations. • Almost 85% of equity research reports are based upon a multiple and comparables. • More than 50% of all acquisition valuations are based upon multiples • Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. • While there are more discounted cashflow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations. • The objective in many discounted cashflow valuations is to back into a number that has been obtained by using a multiple. • The terminal value in a significant number of discounted cashflow valuations is estimated using a multiple.

6. Four Steps • Define the multiple • Same multiple can be defined in different ways • Describe the multiple • Know what the cross sectional distribution • Analyze the multiple • Understand the fundamentals that drive each multiple • Apply the multiple • Define the comparable universe • Controlling for differences

7. Definitional Tests • Is the Multiple Consistently Defined? • Value (numerator) and the standardizing variable (denominator) should apply to the same claimholders in the firm. • E.g., the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or firm book value. • Is the Multiple Uniformly Estimated? • variables must be estimated uniformly across assets in the “comparable firm” list. • For earnings- or book-based multiples, the accounting rules must be applied consistently across assets.

8. Analytical Tests • What are the Fundamentals that Determine and Drive these Multiples? • Constitutive of every multiple are variables that drive cash flow valuation, e.g., growth, risk and cash flow patterns. • In theory, a simple discounted cash flow model should yield the fundamentals that drive a multiple • How Do Changes in these Fundamentals Change the Multiple? • Relationship between a fundamental (like growth) and a multiple (such as PE) typically non-linear. • Twice the growth rate doe not imply twice the PE ratio • Cannot use multiple, if we do not know relationship between fundamentals and multiple

9. Relative Value and Fundamentals: Equity Multiples • Gordon Growth Model: • Dividing both sides by the earnings, • Dividing both sides by the book value of equity, • If the return on equity is written in terms of the retention ratio and the expected growth rate • Dividing by the Sales per share,

10. Determinants of Multiples

11. PE For a High Growth Firm • The price-earnings ratio for a high growth firm can be related to fundamentals. • two-stage dividend discount model:: • For a firm that does not pay what it can afford to in dividends, substitute FCFE/Earnings for the payout ratio. • Dividing both sides by the earnings per share:

12. Application Tests • What is a ‘Comparable’ Firm? • Traditional Analysis: Firms in the same sector are comparable firms • Valuation Theory: Comparable firm is determined by similar fundamentals. • Firm can be compared with a firm in a very different business, if same risk, growth and cash flow characteristics. • How Do We Adjust for Differences across Firms on the Fundamentals? • Impossible to find two exactly identical firms

13. Price Multiples

14. Method of Comparables • Using a price multiple to evaluate whether an asset is in relation to a benchmark multiple value: • relatively fairly valued, • relatively undervalued, or • relatively overvalued. • Benchmark value of a multiple could be… • A closely matched individual stock • Average or median value of the multiple for the stock’s peer group of companies or industry.

15. Method of Comparables • Law of One Price • Two identical assets should sell at the same price. • Most widely used multiples approach for analysts • Assumption: Over/undervalued asset will under/outperform the comparison asset(s) on a relative basis. • If the comparison asset or assets themselves are efficiently priced

16. Profitability Assumptions Assumption 1: Markets are no perfectly efficient. Assumption 2: You have correctly identified a mispricing. Assumption 3: The market corrects this mispricing–within a ‘reasonable’ time.

17. P/E Ratios

18. Rationales for Use of P/E Ratios • Earning power chief driver of value. • Earnings per share (EPS) perhaps the chief focus of security analysts’ attention. • Differences in price/earnings ratios may be related to differences in long-run average returns, according to empirical research.

19. Drawbacks to P/E Ratios • EPS can be negative. • The P/E ratio does not make economic sense with a negative denominator. • Two components of earnings • On-going or recurrent are most important in • Volatile, transient components • Management distortion of earnings

20. Accounting Issues with P/E Ratios • Price easily obtained and unambiguous. • Earnings not as straightforward. • Two issues are • Time horizon over which earnings are measured • Adjustments to accounting earnings to make P/Es comparable across companies.

21. Trailing and Leading P/E’s • Trailing P/E (Current P/E): • Current market price of the stock divided by the most recent four quarters’ earnings per share. • EPS in such calculations are sometimes referred to as trailing twelve months (TTM) EPS. • Trailing P/E is the price–earnings ratio published in stock listings of financial newspapers. • Leading P/E (Forward P/E, Prospective P/E) • Current market price of the stock divided by next year’s expected earnings. • Other • First Call/Thomson Financial reports as the “current P/E” market price divided by the last reported annual earnings per share. • Value Line reports as the “P/E” market price divided by the sum of the preceding two quarters’ trailing earnings and the next two quarters’ expected earnings.

22. Issues with Trailing P/E’s EPS issues include • Transitory, nonrecurring components of earnings that are company-specific; • Transitory components of earnings due to cyclicality (business or industry cyclicality); • Differences in accounting methods; and • Potential dilution of earnings per share.

23. Normalized P/E’s • Nomalized EPS can be used to create a normalized P/E. Two methods for nomalizingEPS: • The Method of Historical Average EPS: Normal EPS is calculated as average EPS over the most recent full cycle. • The Method of Average ROE: Normal EPS is calculated as the average return on equity from the most recent full cycle, multiplied by current book value per share. • Which method is preferred? • The first method is approach to cyclical earnings, but does not account for changes in the business’s size. • The second method reflects more accurately the effect growth or shrinkage in the company’s size. • The method of average ROE is sometimes preferred.

24. Justified P/E in a DCF Model • DCF valuation models can be used to develop an estimate of the justified P/E for a stock. • In the Gordon growth form of the dividend discount model, the P/E is calculated using these two expressions. • The leading P/E is: • The trailing P/E is: • Both expressions state P/E as a function of two fundamentals: the stock’s required rate of return, r, reflecting its risk, and the expected (stable) dividend growth rate, g. The dividend payout ratio, 1 – b, also enters into the expression. The stock’s justified P/E based on forecasted fundamentals.

25. Justified P/E Example For FPL Group, Inc. (FPL), a utility analyst, forecasts a long-term payout rate of 50 percent, a long-term growth rate of 5 percent, and a required rate of return of 9 percent. Based upon these forecasts of fundamentals, what is FPL’s justified leading P/E and trailing P/E? Leading Justified P/E: Trailing Justified P/E:

26. Benchmark P/E’s • The choices for the benchmark value of the P/E: • The P/E of the most closely matched individual stock. • The average or median value of the P/E for the company’s peer group of companies within an industry. • The average or median value of the P/E for the company’s industry or sector. • The P/E for a representative equity index • An average past value of the P/E for the stock. • Valuation errors are probably less likely when we use an equity index or a group of stocks than when we use a single stock, because the former choices involve an averaging.

27. Other Ratios

28. PEG Ratios • P/E to growth (PEG) ratio addresses the impact of earnings growth on P/E ratios is P/E to growth (PEG) ratio. • Stock’s P/E divided by the expected earnings growth rate. • Stock’s P/E per unit of expected growth. • Stocks with lower PEGs are more attractive • Cautions: • Assumes a linear relationship between P/E ratios and growth. • The model for P/E in terms of DDM shows that in theory the relationship is not linear. • Does not factor in differences in risk • Does not account for differences in the duration of growth. • For example, dividing P/E ratios by short-term (5 year) growth forecasts may not capture differences in growth in long-term growth prospects.

29. Price to Book (P/B) Ratio • Book value per share, the measure of value in the P/B ratio, is a stock or level variable coming from the balance sheet. • Contrast EPS, a flow variable from the income statement • Intuitively, book value per share represents the investment that common shareholders have made in the company, on a per-share basis.

30. Rationales for Use of P/B Ratio • Book value is generally positive even when EPS is negative. • We can generally use P/B when EPS is negative, whereas P/E based on a negative EPS is not meaningful. • Book value per share is more stable than EPS • P/B may be more meaningful than P/E when EPS are abnormally high or low, or are highly variable. • Book value per share appropriate for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions. • For such companies, book values of assets may approximate market values. • Book value used to valuation companies not expected to continue as a going concern. • Differences in P/B ratios may be related to differences in long-run average returns, according to empirical research.

31. Possible Drawbacks to P/B Ratios • Other assets besides those recognized in accounting may be critical operating factors. • For example, in many service companies human is more important than physical capital as an operating factor. • P/B can be misleading as a valuation indicator when there are significant differences among the level of assets employed by companies. • Accounting effects on book value may compromise book value as a measure of shareholders’ investment in the company. • As one example, book value can understate shareholders’ investment as a result of the expensing of investment in research and development (R&D). Such expenditures often positively affect income over many periods and in principle create assets. • Book value largely reflects the historical purchase costs of assets, as well as accumulated accounting depreciation expenses. • Inflation as well as technological change eventually drive a wedge between the book value and the market value of assets. • Book value per share often poorly reflects the value of shareholders’ investments.

32. Computation of Book Value • Calculation of Book Value: Shareholders’ Equity – Senior Equity Claims = Common Shareholders’ Equity Common Shareholder Equity/Common Stock Shares Outstanding = Book Value per Share • Possible Senior Claims • value of preferred stock • dividends in arrears on preferred stock

33. Adjustments to Book Value • Tangible book value per share • Subtracting reported intangible assets from the balance sheet from common shareholders’ equity • Following financial theory, the general exclusion of intangibles is not warranted • Significant off-balance sheet assets and liabilities • Internationally, accounting methods currently report some assets/liabilities at historical cost (with some adjustments) and others at fair value. • For example, assets such as land or equipment are reported at their historical acquisitions cost, and in the case of equipment are being depreciated over their useful lives. • Other assets such as investments in marketable securities are reported at fair market value. • Adjustments for comparability • One company may be using FIFO and a peer company may be using LIFO

34. Justified P/B Ratio • Fundamental forecasts to estimate a stock’s justified P/B ratio. For example, using Gordon growth model and sustainable growth rate (g= bROE), the expression for the justified P/B ratio based on the most recent book value (B0) is • For example, if a business’s ROE is 12 percent, its required rate of return is 10 percent, and its expected growth rate is 7 percent, then its justified P/B based on fundamentals is (0.12  0.07)/(0.10  0.07) = 1.7. • Further insight into the P/B ratio comes from the residual income model. The expression for the justified P/B ratio based on the residual income valuation is

35. Rationales for Price/Sales Ratios • Sales less subject to distortion or manipulation than other fundamentals such as EPS or book value. • Total sales, as the top line in the income statement, is prior to any expenses. • Sales are positive even when EPS is negative. • Therefore, we can use P/S when EPS is negative, whereas P/E based on a negative EPS is not meaningful. • Sales are generally more stable than EPS • EPS reflects operating and financial leverage • P/S is generally more stable than P/E • P/S may be more meaningful than P/E when EPS is abnormally high or low. • P/S appropriate for valuing the stock of mature, cyclical, and zero income companies. • Differences in P/S ratios may relate to differences in long-run average returns

36. Drawbacks to P/S Ratios • High growth in sales not imply operating profitably as judged by earnings and cash flow from operations. • To have value as a going concern, a business must ultimately generate earnings and cash. • P/S ratio does not reflect differences in cost structures across companies. • Manipulation potential through revenue recognition practices

37. Justified P/S Ratio • Like other multiples, the P/S multiple can be linked to DCF models. • In terms of the Gordon growth model, we can state P/S as

38. Rationales for Price/Cash Flow Ratios • Cash flow less manipulation by management than earnings. • Cash flow manipulated only through ‘real’ activities, such as the sale of receivables. • Cash flow is generally more stable than earnings • Price-to-cash flow is generally more stable than P/E. • Avoids issue of differences in accounting conservatism between companies (differences in the quality of earnings). • Differences in price to cash flow may be related to differences in long-run average returns

39. Drawbacks to Price/Cash Flow Ratios • Non-cash revenue and net changes in working capital are ignored. • Free cash flow rather than cash flow as the appropriate variable for valuation. • We can use P/FCFE ratios but FCFE • More volatile than CF for many businesses, and • More frequently negative than CF.

40. Common Cash Flow Measures • In practice, use simple approximations to cash flow from operations: • Earnings-plus-Non-Cash Charges (CF): approximation specifies cash flow per share as EPS plus per-share depreciation, amortization, and depletion. • Cash Flow from Operations (CFO) • Free Cash Flow to Equity (FCFE), and • EBITDA, an Estimate of Pre-interest, Pre-tax Operating Cash Flow. • Most frequently, trailing price-to-cash flow ratios are reported. • Current market price divided by the sum of the most recent four quarters’ cash flow per share.

41. Enterprise Value/EBITDA • A P/EBITDA multiple is flawed • EBITDA is a flow to both debt and equity. • Enterprise value to EBITDA is better. • Enterprise value (EV) • Total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments. • EV/EBITDA is a valuation indicator for the overall company rather than common stock.

42. Rationales for EV/EBITDA • Comparing companies with different financial leverage • EBITDA is a pre-interest earnings figure, • EPS, which is post-interest. • By adding back depreciation and amortization, EBITDA controls for differences in depreciation and amortization across businesses. • EV/EBITDA is frequently used in the valuation of capital-intensive businesses (for example, cable companies and steel companies). • EBITDA is frequently positive when EPS is negative.

43. Possible Drawbacks to EV/EBITDA • EBITDA will overestimate cash flow from operations if working capital is growing. • EBITDA also ignores the effects of differences in revenue recognition policy on cash flow from operations. • Free cash flow to the firm, which directly reflects the amount of required capital expenditures, has a stronger link to valuation theory than EBITDA. • Only if depreciation expenses match capital expenditures do we expect EBITDA to reflect differences in businesses’ capital programs.