Descriptive Tests. Aswath Damodaran

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Alvin Beasley
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1 Descriptive Tests 15 What is the average and standard deviation for this multiple, across the universe (market)? What is the median for this multiple? The median for this multiple is often a more reliable comparison point. How large are the outliers to the distribution, and how do we deal with the outliers? Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate. Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? How has this multiple changed over time? 15

2 16 1. Multiples have skewed distributions US company PE Ratios PE Ratios: US companies in January To 4 4 To 8 8 To To To To To To To To To To To and over Current Trailing Forward 16

3 2. Making statistics dicey 17 Current PE Trailing PE Forward PE Number of firms Number with PE 3,076. 3,081. 2,553. Average Median Minimum Maximum 134, , , Standard deviation Standard error Skewness th percentile th percentile US firms in January

4 3. Markets have a lot in common : Comparing Global PEs % PE Ratios by Region 20.00% <4 4 To 8 8 To To % 16 To To To % 28 To To To % 40 To To % US Europe Japan Emerging Markets Aus, NZ & Canada Global 75 To and over 18

5 3a. And the differences are sometimes revealing Price to Book Ratios across globe January

6 4. Simplistic rules almost always break down 6 times EBITDA was not cheap in

7 But it may be in 2017, unless you are in Japan.. 21 EV/EBITDA Multiples in January % 20.00% 15.00% 10.00% 5.00% 0.00% <2 2 To 4 4 To 6 6 To 8 8 To To To To To To To To To To To To 100 US Europe Japan Emerging Markets Aus, NZ & Canada Global >100 21

8 Analytical Tests 22 What are the fundamentals that determine and drive these multiples? Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. How do changes in these fundamentals change the multiple? The relationship between a fundamental (like growth) and a multiple (such as PE) is almost never linear. Proposition 3: It is impossible to properly compare firms on a multiple, if we do not know how fundamentals and the multiple move. 22

9 A Simple Analytical device 23 23

10 I. PE Ratios 24 To understand the fundamentals, start with a basic equity discounted cash flow model. With the dividend discount model, P 0 = DPS 1 r g n Dividing both sides by the current earnings per share, P 0 = PE= Payout Ratio*(1+ g n) EPS 0 r-g n If this had been a FCFE Model, P 0 = FCFE 1 r g n P 0 = PE= (FCFE/Earnings)*(1+ g n) EPS 0 r-g n 24

11 25 Using the Fundamental Model to Estimate PE For a High Growth Firm The price-earnings ratio for a high growth firm can also be related to fundamentals. In the special case of the two-stage dividend discount model, this relationship can be made explicit fairly simply: " % EPS 0 *Payout Ratio*(1+g)* $ 1 (1+g)n ' # (1+r) n & P 0 = r-g + EPS 0*Payout Ratio n *(1+g) n *(1+g n ) (r-g n )(1+r) n 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: P 0 EPS 0 = " (1 + g)n Payout Ratio * (1 + g) * $ % 1 # (1+ r) n ' & r - g + Payout Ratio n *(1+ g) n * (1 + g n ) (r - g n )(1+ r) n 25

12 A Simple Example 26 Assume that you have been asked to estimate the PE ratio for a firm which has the following characteristics: Variable High Growth Phase Stable Growth Phase Expected Growth Rate 25% 8% Payout Ratio 20% 50% Beta Number of years 5 years Forever after year 5 Riskfree rate = T.Bond Rate = 6% Required rate of return = 6% + 1(5.5%)= 11.5% ".20*(1.25)* $ 1 (1.25)5 P 0 # (1.115) 5 = EPS % ' & +.50*(1.25)5 *(1.08) ( )(1.115) 5 =

13 27 a. PE and Growth: Firm grows at x% for 5 years, 8% thereafter PE Ratios and Expected Growth: Interest Rate Scenarios PE Ratio r=4% r=6% r=8% r=10% % 10% 15% 20% 25% 30% 35% 40% 45% 50% Expected Growth Rate 27

14 b. PE and Risk: A Follow up Example 28 PE Ratios and Beta: Growth Scenarios PE Ratio g=25% g=20% g=15% g=8% Beta 28

15 29 Example 1: Comparing PE ratios across Emerging Markets- March 2014 (pre- Ukraine) Russia looks really cheap, right? 29

16 30 Example 2: An Old Example with Emerging Markets: June 2000 Country PE Ratio Interest Rates GDP Real Growth Country Risk Argentina % 2.50% 45 Brazil % 4.80% 35 Chile % 5.50% 15 Hong Kong % 6.00% 15 India % 4.20% 25 Indonesia % 4.00% 50 Malaysia % 3.00% 40 Mexico % 5.50% 30 Pakistan % 3.00% 45 Peru % 4.90% 50 Phillipines % 3.80% 45 Singapore % 5.20% 5 South Korea % 4.80% 25 Thailand % 5.50% 25 Turkey % 2.00% 35 Venezuela % 3.50% 45 30

17 Regression Results 31 The regression of PE ratios on these variables provides the following PE = R Squared = 73% Interest Rates Growth in GDP Country Risk 31

18 Predicted PE Ratios 32 Country PE Ratio Interest Rates GDP Real Growth Country Risk Predicted PE Argentina % 2.50% Brazil % 4.80% Chile % 5.50% Hong Kong % 6.00% India % 4.20% Indonesia % 4.00% Malaysia % 3.00% Mexico % 5.50% Pakistan % 3.00% Peru % 4.90% Phillipines % 3.80% Singapore % 5.20% South Korea % 4.80% Thailand % 5.50% Turkey % 2.00% Venezuela % 3.50%

1. Mul'ples have skewed distribu'ons

1. Mul'ples have skewed distribu'ons 14 PE Ra&os for US stocks: January 2015 700. 600. 500. 400. 300. Current Trailing Forward 200. 100. 0. 0.01 To 4 4 To 8 8 To 12 12 To 16 16 To 20 20 To 24 24 To 28