Relative vs. fundamental valuation

Transcription

1 Relative Valuation Relative vs. fundamental valuation The DCF model is a method of fundamental valuation. Value of equity is the present value of future cash flows. Ignores the current level of the stock market. Appropriate for comparing investments across different asset classes - i.e. stocks vs bonds vs real estate etc. In the long run, fundamental valuation is the theoretically correct method of valuing any asset. 9/28/ /28/ Relative vs. fundamental valuation Relative valuation is based on P/E ratios and a host of other multiples Extremely popular with the press, CNBC pundits, stock brokers, Used to value one stock against another. Cannot compare values across different asset classes (i.e. bonds, real estate etc) Cannot answer the question Is the market over valued today? Can answer the question I want to buy a tech stock, which one should I buy? Which one of these overpriced IPOs is the best buy? Relative valuation Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues. Earnings Multiples Price/Earnings Ratio (PE) and variants (PEG) Value/EBIT Value/EBITDA Value/Cash Flow Enterprise value/ebitda Book Value Multiples Price/Book Value(of Equity) (PBV) Revenues Price/Sales per Share (PS) Industry Specific Variable (Price/kwh, Price per ton of steel, Price per click) 9/28/ /28/

2 Multiples Relative valuation relies on the use of multiples and a little algebra. For example: house prices.. House Price Sq ft. Price/sq ft A $ 110,000 1,700 $ B $ 120,000 1,725 $ C $ 96,000 1,500 $ D $ 99,000 1,550 $ E $ 105,000 1,605 $ Average $ What is the price of a 1,650 sq ft house? Price Earnings Ratios PE Market Price per Share / Earnings per Share There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: current price or average price for the year EPS: most recent financial year trailing 12 months (Trailing PE) forecasted eps (Forward PE) 9/28/ /28/ PE Ratio: Understanding the Fundamentals To understand the fundamentals, start with a basic equity discounted cash flow model. With the dividend discount model, P0 DIV 1 k s g n Dividing both sides by the earnings per share, P0 Payout Ratio * (1 + g) PE EPS 0 k s -g PE Ratio: Understanding the Fundamentals Holding all else equal: higher growth firms will have higher PE ratios than lower growth firms. higher risk firms will have lower PE ratios than lower risk firms firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates. Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates. 9/28/ /28/

3 PE Ratios over time PE Ratio for US stocks over time Example: Valuing a firm using P/E ratios In an industry we identify 4 stocks that are similar to the stock we wish to value. Stock A PE14 Stock B PE18 Stock C PE24 Stock D PE21 PE Ratio /28/ /28/ Value/Cashflow P/E is from the equity holder s point of view, this ratio looks at the whole firm. Value MV Equity + MV Debt FCFF FCFF For US firms, in 1999, the mean value to FCFF ratio was about 24. Value/FCFF For a firm with constant growth: V 0 FCFF 0 (1+g) wacc - g V 0 /FCFF FCFF 0 (1+g)/(wacc-g) FCFF 0 (1+g) wacc-g Therefore, the value/fcff multiple is a function of the cost of capital the expected growth 9/28/ /28/

4 Example: Value using value/fcff Industry average is 20. Firm has FCFF of $2,500 Shares outstanding of 450 MV of debt $30,000 Alternatives to FCFF - EBIT and EBITDA Most analysts find FCFF too complex or messy to use in multiples. They use modified versions after-tax operating income or EBIT(1-t) pre-tax operating income or EBIT EBITDA, which is earnings before interest, taxes, depreciation and amortization. Value MV Equity + MV EBITDA EBITDA Debt 9/28/ /28/ Value/FCFF and the Alternatives Assume that you have computed the value of a firm, using discounted cash flow models. Rank the following multiples in the order of magnitude from lowest to highest? A. Value/EBIT B. Value/EBIT(1-t) C. Value/FCFF D. Value/EBITDA What assumption(s) would you need to make for the Value/EBIT(1-t) ratio to be equal to the Value/FCFF multiple? But can we get away with using some of these other measures, instead of FCFF? Multiple Magic In this case of MCI there is a big difference between the FCFF and short cut measures. Free Cash Flow to the Firm EBIT (1-t) - Net Cap Ex - Change in Working Capital 3356 (1-0.36) $ 498 million $ Value Correct Multiple FCFF $ EBIT (1-t) $2, EBIT $3, EBITDA $4, /28/ /28/

5 Value/EBITDA Multiple The No-Cash Version Value Market Value of Equity + Market Value of Debt - Cash EBITDA Earnings before Interest, Taxes and Depreciation When cash and marketable securities are netted out of value, none of the income from the cash and securities should be reflected in the denominator. The no-cash version is also called Enterprise Value Enterprise value EV Market value of equity+debt-cash and marketable securities Many firms that have just conducted IPOs have huge amounts of cash - a war chest. EV excludes this cash from the value of the firm Cash + MV of non-cash assets MV debt + MV Equity > MV non-cash assets MV debt + MV equity - cash. For example Nasdaq:AWRE (did IPO in 1996): 1996: Cash $31.1 million, Total Assets $40.1 million, Debt 0 > EV $9 million 9/28/ /28/ Price to Book Value Ratio Ratio of the market value of equity to the book value of equity, i.e., the measure of shareholders equity in the balance sheet. P B Market Value of Book Value of Equity Equity In 1999 the average Price/book for US firms was about 3. Price Sales Ratio The price/sales ratio is the ratio of the market value of equity to the sales. P MV Equity S Total Revenues What is the fundamental problem of this ratio? The price/sales ratio is internally inconsistent. Average P/S for US firms is about /28/ /28/

6 Price/Sales Ratio: Determinants The price/sales ratio of a stable growth firm can be estimated beginning with a 2-stage equity valuation model: DIV 1 P 0 k s g Dividing both sides by the sales per share: P Net Profit Margin* Payout Ratio* (1 PS Sales0 k -g 0 + s g) Price Sales Ratios and Profit Margins The key determinant of price-sales ratios is the profit margin. A decline in profit margins has a two-fold effect. First, the reduction in profit margins reduces the pricesales ratio directly. Second, the lower profit margin can lead to lower growth and hence lower price-sales ratios. Expected growth rate Retention ratio * Return on Equity Retention Ratio *(Net Profit / Sales) * ( Sales / BV of Equity) Retention Ratio * Profit Margin * Sales/BV of Equity 9/28/ /28/ Choosing Between the Multiples There are dozens of multiples. There are three choices: Use a simple average of the valuations obtained using a number of different multiples Use a weighted average of the valuations obtained using a number of different multiples Choose one of the multiples and base your valuation on that multiple 9/28/