Relative vs. fundamental valuation

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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. 2/17/25 1 2/17/25 2 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 vs. fundamental valuation You are investing for your retirement. You are planning to take a buy and hold strategy which involves picking some fairly priced stocks and holding them for several years. Which valuation approach should you use? Relative valuation Fundamental valuation 2/17/25 3 2/17/25 4 1

2 Relative vs fundamental valuation You are a short term investor. You trade several times a week on your E-trade account, and rarely hold a stock more than 1 month. Which valuation approach should you use. Relative valuation Fundamental valuation Relative vs. fundamental valuation You are trying to decide how to invest for your retirement. You can either use a buy and hold strategy based on fundamental valuation or you can use a short term strategy based on relative valuation. Which strategy is most likely to generate the greatest wealth when you retire? Why? Buy and hold Short term 2/17/25 5 2/17/25 6 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, PEGY) 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) 2/17/25 7 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 $ 11, 1,7 $ B $ 12, 1,725 $ C $ 96, 1,5 $ 64. D $ 99, 1,55 $ E $ 15, 1,65 $ Average $ What is the price of a 1,65 sq ft house? Answer: 65.51*1,65 $18,92 2/17/25 8 2

3 Multiples can be misleading To use a multiple intelligently you must: Know what the fundamentals are that determine the multiple. Know how changes in these fundamentals change the multiple. Know what the distribution of the multiple looks like. Ensure that both the denominator and numerator represents claims to the same group OK: P/E Price > Equityholders, EPS > Equityholders Not OK: P/EBIT Price >Equity, EBIT > all claimholders Ensure that the firms are comparable 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) 2/17/25 9 2/17/25 1 PE Ratio: Understanding the Fundamentals To understand the fundamentals, start with a basic equity discounted cash flow model. With the dividend discount model, D 1 P k g Dividing both sides by the earnings per share, P EPS Payout Ratio * (1 PE k -g + 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. 2/17/ /17/

4 PE Ratios over time PE Ratio for US stocks over time PE Ratio A Question You are reading an equity research report on Informix, and the analyst claims that the stock is under valued because it has a PE ratio of 9.77 which is much lower than the average for the sector., which is Would you agree? Yes No Why or why not? /17/ /17/25 14 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 Stock C Stock D The average P/E is ( )/ PE18 PE24 PE21 Our firm has EPS of $2.1 P/ > Price $2.1 * $4.425 Note do not include the stock to be valued in the average. Also do not include firms with negative PEs Value/EBIT and Value/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 Debt EBITDA EBITDA 2/17/ /17/

5 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/EBITDA 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 2/17/ /17/25 18 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 $4.1 million, Debt > EV $9 million Reasons for Increased Use of Value/EBITDA 1. The multiple can be computed even for firms that are reporting net losses, since EBITDA is usually positive. 2. More appropriate than the price/earnings ratio for high growth firms. 3 Allows for comparisons across firms with different financial leverage. For young firms it is common to use EV instead of Value 2/17/ /17/25 2 5

6 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 Book Value Ratio: Stable Growth Firm Going back to a simple dividend discount model, D k g 1 P Defining the return on equity (ROE) EPS / Book Value of Equity, the value of equity can be written as: BV * ROE * Payout Ratio * (1 + g) P k -g P ROE* Payout Ratio* (1+ g) PBV BV k-g If the return on equity is based upon expected earnings in the next time period, this can be simplified to, P ROE* Payout Ratio PBV BV k-g 2/17/ /17/25 22 Price Book Value Ratio: Stable Growth Firm Another Presentation This formulation can be simplified even further by relating growth to the return on equity: g (1 - Payout ratio) * ROE> payout ratio 1 - g/roe Substituting back into the P/BV equation, g ROE P 1 ROE PBV BV k - g ROE - g k-g The price-book value ratio of a stable firm is determined by the difference between the return on equity and the required rate of return on its projects. 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 /17/ /17/

7 Price/Sales Ratio: Determinants The price/sales ratio of a stable growth firm can be estimated beginning with a 2-stage equity valuation model: D 1 P k g Dividing both sides by the sales per share: P Net Profit Margin* Payout Ratio* (1 PS Sales k-g + g) Price Sales Ratios and Profit Margins A 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 2/17/ /17/25 26 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 Averaging Across Multiples This procedure involves valuing a firm using five or six or more multiples and then taking an average of the valuations across these multiples. This is completely inappropriate since it averages good estimates with poor ones equally. 2/17/ /17/

8 Weighted Averaging Across Multiples The estimates obtained from using different multiples are averaged, with weights on each based upon the precision of each estimate. The more precise estimates are weighted more and the less precise ones weighted less. This approach is more difficult to use when some of the estimates are subjective and some are based upon more quantitative techniques. Picking one Multiple Usually best way. best estimate value is obtained using one multiple. The multiple that is used can be chosen in one of two ways: Use the multiple that best fits your objective. Thus, if you want the company to be undervalued, you pick the multiple that yields the highest value. Use the multiple that seems to make the most sense for that sector, given how value is measured and created. 2/17/ /17/25 3 8