33

Example3:PEratiosfortheS&P500overtime

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0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

PERatiosfortheS&P500:1969-2016

PEforS&P500 NormalizedPEforS&P500 CAPEforS&P500

PE NormalizedPE CAPE1969-2016 16.18 20.80 18.031986-2016 18.63 24.04 21.551996-2016 19.72 25.60 23.402006-2016 17.36 21.27 19.662009-2016 16.88 20.72 19.24Jan-17 20.57 25.00 23.91

34

Islow(high)PEcheap(expensive)?

¨ AmarketstrategistarguesthatstocksareexpensivebecausethePEratiotodayishighrelativetotheaveragePEratioacrosstime.Doyouagree?a. Yesb. No

¨ Ifyoudonotagree,whatfactorsmightexplainthehigherPEratiotoday?

¨ WouldyouresponddifferentlyifthemarketstrategisthasaNobelPrizeinEconomics?

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35

E/PRatios,T.BondRatesandTermStructure

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-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

EarningstoPriceversusInterestRates:S&P500

Bond-Bill

EarningsYield

T.BondRate

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RegressionResults

¨ Inthefollowingregression,using1960-2016data,weregressE/PratiosagainstthelevelofT.Bond ratesandatermstructurevariable(T.Bond - T.Bill rate)EPRatio=0.0351+0.5609T.Bond Rate- 0.1391(T.Bond Rate- T.Bill Rate)

(5.21) (6.39) (-0.67)Rsquared=42.31%

¨ Goingbackto2008,thisiswhattheregressionlookedlike:E/P=2.56%+0.7044T.Bond Rate– 0.3289(T.Bond Rate-T.Bill Rate)

(4.71) (7.10) (1.46)Rsquared=50.71%TheR-squaredhasdroppedandtheT.Bond rateandthedifferentialwiththeT.Billratehavenoth lostsignificance.Howwouldyoureadthisresult?

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Correlation between E?P and interest rates

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II.PEGRatio

¨ PEGRatio=PEratio/ExpectedGrowthRateinEPS¤ Forconsistency,youshouldmakesurethatyourearningsgrowth

reflectstheEPSthatyouuseinyourPEratiocomputation.¤ Thegrowthratesshouldpreferablybeoverthesametimeperiod.

¨ TounderstandthefundamentalsthatdeterminePEGratios,letusreturnagaintoa2-stageequitydiscountedcashflowmodel:

¨ DividingbothsidesoftheequationbytheearningsgivesustheequationforthePEratio.Dividingitagainbytheexpectedgrowth‘g:

P0 =EPS0*Payout Ratio*(1+g)* 1− (1+g)n

(1+r)n

"

#$

%

&'

r-g+ EPS0*Payout Ration*(1+g)n*(1+gn )

(r-gn )(1+r)n

PEG=Payout Ratio*(1+g)* 1− (1+g)n

(1+r)n

"

#$

%

&'

g(r-g)+ Payout Ration*(1+g)n*(1+gn )

g(r-gn )(1+r)n

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38

PEGRatiosandFundamentals

¨ Riskandpayout,whichaffectPEratios,continuetoaffectPEGratiosaswell.¤ Implication:WhencomparingPEGratiosacrosscompanies,wearemakingimplicitorexplicitassumptionsaboutthesevariables.

¨ DividingPEbyexpectedgrowthdoesnotneutralizetheeffectsofexpectedgrowth,sincetherelationshipbetweengrowthandvalueisnotlinearandfairlycomplex(evenina2-stagemodel)

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39

ASimpleExample

¨ AssumethatyouhavebeenaskedtoestimatethePEGratioforafirmwhichhasthefollowingcharacteristics:

Variable HighGrowthPhase StableGrowthPhaseExpectedGrowthRate 25% 8%PayoutRatio 20% 50%Beta 1.00 1.00¨ Riskfree rate=T.Bond Rate=6%¨ Requiredrateofreturn=6%+1(5.5%)=11.5%¨ ThePEGratioforthisfirmcanbeestimatedasfollows:

PEG =0.2 * (1.25) * 1− (1.25)5

(1.115)5

"

#$

%

&'

.25(.115 - .25)+ 0.5 * (1.25)5*(1.08)

.25(.115-.08) (1.115)5 = 115 or 1.15

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40

PEGRatiosandRisk

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PEGRatiosandQualityofGrowth

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PERatiosandExpectedGrowth

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PEGRatiosandFundamentals:Propositions

¨ Proposition1:HighriskcompanieswilltradeatmuchlowerPEGratiosthanlowriskcompanieswiththesameexpectedgrowthrate.¤ Corollary1:ThecompanythatlooksmostundervaluedonaPEGratio

basisinasectormaybetheriskiestfirminthesector¨ Proposition2:Companiesthatcanattaingrowthmoreefficiently

byinvestinglessinbetterreturnprojectswillhavehigherPEGratiosthancompaniesthatgrowatthesameratelessefficiently.¤ Corollary2:CompaniesthatlookcheaponaPEGratiobasismaybe

companieswithhighreinvestmentratesandpoorprojectreturns.¨ Proposition3:Companieswithveryloworveryhighgrowthrates

willtendtohavehigherPEGratiosthanfirmswithaveragegrowthrates.Thisbiasisworseforlowgrowthstocks.¤ Corollary3:PEGratiosdonotneutralizethegrowtheffect.

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44

III.PricetoBookRatio

¨ Goingbacktoasimpledividenddiscountmodel,

¨ Definingthereturnonequity(ROE)=EPS0/BookValueofEquity,thevalueofequitycanbewrittenas:

¨ Ifthereturnonequityisbaseduponexpectedearningsinthenexttimeperiod,thiscanbesimplifiedto,

P0 =DPS1r −gn

P0 = BV0*ROE*Payout Ratio*(1+gn )r-gn

P0

BV0

= PBV= ROE*Payout Ratio*(1+gn )r-gn

P0

BV0

= PBV= ROE*Payout Ratior-gnAswath Damodaran

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45

PriceBookValueRatio:StableGrowthFirmAnotherPresentation

¨ Thisformulationcanbesimplifiedevenfurtherbyrelatinggrowthtothereturnonequity:

g=(1- Payoutratio)*ROE¨ SubstitutingbackintotheP/BVequation,

¨ Theprice-bookvalueratioofastablefirmisdeterminedbythedifferentialbetweenthereturnonequityandtherequiredrateofreturnonitsprojects.

¨ Buildingonthisequation,acompanythatisexpectedtogenerateaROEhigher(lowerthan,equalto)itscostofequityshouldtradeatapricetobookratiohigher(lessthan,equalto)one.

P0

BV0

= PBV= ROE - gn

r-gn

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46

NowchangingtoanEnterprisevaluemultipleEV/BookCapital

¨ Toseethedeterminantsofthevalue/bookratio,considerthesimplefreecashflowtothefirmmodel:

¨ Dividingbothsidesbythebookvalue,weget:

¨ Ifwereplace,FCFF=EBIT(1-t)- (g/ROC)EBIT(1-t),weget:

V0 = FCFF1 WACC - g

V0

BV= FCFF1/BV

WACC-g

V0

BV= ROC - g

WACC-g

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47

IV.EVtoEBITDA- Determinants

¨ Thevalueoftheoperatingassetsofafirmcanbewrittenas:

¨ Nowthevalueofthefirmcanberewrittenas

¨ DividingbothsidesoftheequationbyEBITDA,

¨ ThedeterminantsofEV/EBITDAare:¤ Thecostofcapital¤ Expectedgrowthrate¤ Taxrate¤ Reinvestmentrate(orROC)

€

EV0 = FCFF1 WACC - g

€

EV = EBITDA (1- t) + Depr (t) - Cex - Δ Working Capital

WACC - g

€

EVEBITDA

= (1- t)

WACC - g +

Depr (t)/EBITDAWACC - g

- CEx/EBITDA

WACC - g -

Δ Working Capital/EBITDAWACC - g

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48

ASimpleExample

¨ Considerafirmwiththefollowingcharacteristics:¤ TaxRate=36%¤ CapitalExpenditures/EBITDA=30%¤ Depreciation/EBITDA=20%¤ CostofCapital=10%¤ Thefirmhasnoworkingcapitalrequirements¤ Thefirmisinstablegrowthandisexpectedtogrow5%ayearforever.

¨ Inthiscase,theValue/EBITDAmultipleforthisfirmcanbeestimatedasfollows:

ValueEBITDA

= (1- .36) .10 -.05

+ (0.2)(.36).10 -.05

- 0.3.10 - .05

- 0.10 - .05

= 8.24

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49

TheDeterminantsofEV/EBITDA

¨TaxRates Reinvestment

Needs

ExcessReturns

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50

V.EV/SalesRatio

¨ Ifpre-taxoperatingmarginsareused,theappropriatevalueestimateisthatofthefirm.Inparticular,ifonemakesthereplacestheFCFFwiththeexpandedversion:¤ FreeCashFlowtotheFirm=EBIT(1- taxrate)(1- ReinvestmentRate)

¨ ThentheValueoftheFirmcanbewrittenasafunctionoftheafter-taxoperatingmargin=(EBIT(1-t)/Sales

g=Growthrateinafter-taxoperatingincomeforthefirstnyearsgn=Growthrateinafter-taxoperatingincomeafternyearsforever(Stablegrowthrate)RIRGrowth,Stable=ReinvestmentrateinhighgrowthandstableperiodsWACC=Weightedaveragecostofcapital

Value Sales0

=After-tax Oper. Margin*(1-RIRgrowth )(1+g)* 1− (1+g)n

(1+WACC)n

"

#$

%

&'

WACC-g+ (1-RIRstable )(1+g)n*(1+gn )

(WACC-gn )(1+WACC)n

(

)

****

+

,

----

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51

Thevalueofabrandname

¨ Oneofthecritiquesoftraditionalvaluationisthatisfailstoconsiderthevalueofbrandnamesandotherintangibles.

¨ Theapproachesusedbyanalyststovaluebrandnamesareoftenad-hocandmaysignificantlyoverstateorunderstatetheirvalue.

¨ Oneofthebenefitsofhavingawell-knownandrespectedbrandnameisthatfirmscanchargehigherpricesforthesameproducts,leadingtohigherprofitmarginsandhencetohigherprice-salesratiosandfirmvalue.Thelargerthepricepremiumthatafirmcancharge,thegreateristhevalueofthebrandname.

¨ Ingeneral,thevalueofabrandnamecanbewrittenas:¤ Valueofbrandname={(V/S)b-(V/S)g }*Sales¤ (V/S)b =ValueofFirm/Salesratiowiththebenefitofthebrandname¤ (V/S)g =ValueofFirm/Salesratioofthefirmwiththegenericproduct

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52

ValuingBrandName

CocaCola WithCott MarginsCurrentRevenues= $21,962.00 $21,962.00Lengthofhigh-growthperiod 10 10ReinvestmentRate= 50% 50%OperatingMargin(after-tax) 15.57% 5.28%Sales/Capital(Turnoverratio) 1.34 1.34Returnoncapital(after-tax) 20.84% 7.06%Growthrateduringperiod(g)= 10.42% 3.53%CostofCapitalduringperiod= 7.65% 7.65%StableGrowthPeriodGrowthrateinsteadystate= 4.00% 4.00%Returnoncapital= 7.65% 7.65%ReinvestmentRate= 52.28% 52.28%CostofCapital= 7.65% 7.65%ValueofFirm= $79,611.25 $15,371.24

Valueofbrandname=$79,611-$15,371=$64,240million

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53

TheDeterminantsofMultiples…

Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio (1+g)/(r-g)

PEG=Payout ratio (1+g)/g(r-g)

PBV=ROE (Payout ratio) (1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF 1/(WACC -g)

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

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54

ApplicationTests

¨ Giventhefirmthatwearevaluing,whatisa“comparable” firm?¤ Whiletraditionalanalysisisbuiltonthepremisethatfirmsinthesamesectorarecomparablefirms,valuationtheorywouldsuggestthatacomparablefirmisonewhichissimilartotheonebeinganalyzedintermsoffundamentals.

¤ Proposition4:Thereisnoreasonwhyafirmcannotbecomparedwithanotherfirminaverydifferentbusiness,ifthetwofirmshavethesamerisk,growthandcashflowcharacteristics.

¨ Giventhecomparablefirms,howdoweadjustfordifferencesacrossfirmsonthefundamentals?¤ Proposition5:Itisimpossibletofindanexactlyidenticalfirmtotheoneyouarevaluing.

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55

Valuingonecompanyrelativetoothers…Relativevaluationwithcomparables

¨ Ideally,youwouldliketofindlotsofpubliclytradedfirmsthatlookjustlikeyourfirm,intermsoffundamentals,andcomparethepricingofyourfirmtothepricingoftheseotherpubliclytradedfirms.Since,theyarealljustlikeyourfirm,therewillbenoneedtocontrolfordifferences.

¨ Inpractice,itisverydifficult(andperhapsimpossible)tofindfirmsthatsharethesamerisk,growthandcashflowcharacteristicsofyourfirm.Evenifyouareabletofindsuchfirms,theywillveryfewinnumber.Thetradeoffthenbecomes:

Small sample of firms that are “just like” your firm

Large sample of firms that are similar in some dimensions but different on others

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56

Techniquesforcomparingacrossfirms

1. Directcomparisons:Ifthecomparablefirmsare“justlike” yourfirm,youcancomparemultiplesdirectlyacrossthefirmsandconcludethatyourfirmisexpensive(cheap)ifittradesatamultiplehigher(lower)thantheotherfirms.

2. Storytelling:Ifthereisakeydimensiononwhichthefirmsvary,youcantellastorybaseduponyourunderstandingofhowvaluevariesonthatdimension.Anexample:Thiscompanytradesat12timesearnings,whereastherestofthesectortradesat10timesearnings,butIthinkitischeapbecauseithasamuchhighergrowthratethantherestofthesector.

3. Modifiedmultiple:Youcanmodifythemultipletoincorporatethedimensiononwhichtherearedifferencesacrossfirms.

4. Statisticaltechniques:Ifyourfirmsvaryonmorethanonedimension,youcantryusingmultipleregressions(orvariantsthereof)toarriveata“controlled” estimateforyourfirm.

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57

Example1:Let’strysomestorytellingComparingPEratiosacrossfirmsinasector

CompanyName TrailingPE ExpectedGrowth StandardDeviationCoca-ColaBottling 29.18 9.50% 20.58%MolsonInc.Ltd.'A' 43.65 15.50% 21.88%Anheuser-Busch 24.31 11.00% 22.92%CorbyDistilleriesLtd. 16.24 7.50% 23.66%Chalone WineGroup 21.76 14.00% 24.08%AndresWinesLtd.'A'8.96 3.50% 24.70%Todhunter Int'l 8.94 3.00% 25.74%Brown-Forman'B'10.07 11.50% 29.43%Coors(Adolph)'B' 23.02 10.00% 29.52%PepsiCo,Inc. 33.00 10.50% 31.35%Coca-Cola 44.33 19.00% 35.51%BostonBeer'A' 10.59 17.13% 39.58%WhitmanCorp. 25.19 11.50% 44.26%Mondavi (Robert)'A'16.47 14.00% 45.84%Coca-ColaEnterprises37.14 27.00% 51.34%HansenNaturalCorp9.70 17.00% 62.45%

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58

AQuestion

¨ Youarereadinganequityresearchreportonthissector,andtheanalystclaimsthatAndresWineandHansenNaturalareundervaluedbecausetheyhavelowPEratios.Wouldyouagree?a. Yesb. No

¨ Whyorwhynot?

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59

Example2:Fact-basedstorytellingComparingPERatiosacrossaSector:PE

Company Name PE GrowthPT Indosat ADR 7.8 0.06Telebras ADR 8.9 0.075Telecom Corporation of New Zealand ADR 11.2 0.11Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08Hellenic Telecommunication Organization SA ADR 12.8 0.12Telecomunicaciones de Chile ADR 16.6 0.08Swisscom AG ADR 18.3 0.11Asia Satellite Telecom Holdings ADR 19.6 0.16Portugal Telecom SA ADR 20.8 0.13Telefonos de Mexico ADR L 21.1 0.14Matav RT ADR 21.5 0.22Telstra ADR 21.7 0.12Gilat Communications 22.7 0.31Deutsche Telekom AG ADR 24.6 0.11British Telecommunications PLC ADR 25.7 0.07Tele Danmark AS ADR 27 0.09Telekomunikasi Indonesia ADR 28.4 0.32Cable & Wireless PLC ADR 29.8 0.14APT Satellite Holdings ADR 31 0.33Telefonica SA ADR 32.5 0.18Royal KPN NV ADR 35.7 0.13Telecom Italia SPA ADR 42.2 0.14Nippon Telegraph & Telephone ADR 44.3 0.2France Telecom SA ADR 45.2 0.19Korea Telecom ADR 71.3 0.44

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60

PE,GrowthandRisk

Dependentvariableis: PERsquared=66.2%Rsquared(adjusted)=63.1%

Variable Coefficient SE t-ratio ProbabilityConstant 13.1151 3.471 3.78 0.0010Growthrate121.223 19.27 6.29 ≤0.0001EmergingMarket -13.8531 3.606 -3.84 0.0009

EmergingMarketisadummy: 1ifemergingmarket0ifnot

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61

IsTelebrasundervalued?

¨ PredictedPE=13.12+121.22(.075)- 13.85(1)=8.35

¨ Atanactualpricetoearningsratioof8.9,Telebrasisslightlyovervalued.

¨ Bottomline:JustbecauseacompanytradesatalowPEratiodoesnotmakeitcheap.

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Example3:AnEyeballingExercisewithP/BVRatiosEuropeanBanksin2010

Name PBV Ratio Return on Equity Standard DeviationBAYERISCHE HYPO-UND VEREINSB 0.80 -1.66% 49.06%COMMERZBANK AG 1.09 -6.72% 36.21%DEUTSCHE BANK AG -REG 1.23 1.32% 35.79%BANCA INTESA SPA 1.66 1.56% 34.14%BNP PARIBAS 1.72 12.46% 31.03%BANCO SANTANDER CENTRAL HISP 1.86 11.06% 28.36%SANPAOLO IMI SPA 1.96 8.55% 26.64%BANCO BILBAO VIZCAYA ARGENTA 1.98 11.17% 18.62%SOCIETE GENERALE 2.04 9.71% 22.55%ROYAL BANK OF SCOTLAND GROUP 2.09 20.22% 18.35%HBOS PLC 2.15 22.45% 21.95%BARCLAYS PLC 2.23 21.16% 20.73%UNICREDITO ITALIANO SPA 2.30 14.86% 13.79%KREDIETBANK SA LUXEMBOURGEOI 2.46 17.74% 12.38%ERSTE BANK DER OESTER SPARK 2.53 10.28% 21.91%STANDARD CHARTERED PLC 2.59 20.18% 19.93%HSBC HOLDINGS PLC 2.94 18.50% 19.66%LLOYDS TSB GROUP PLC 3.33 32.84% 18.66%Average 2.05 12.54% 24.99%Median 2.07 11.82% 21.93%

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63

Themediantest…

¨ Wearelookingforstocksthattradeatlowpricetobookratios,whilegeneratinghighreturnsonequity,withlowrisk.Butwhatisalowpricetobookratio?Orahighreturnonequity?Oralowrisk

¨ Onesimplemeasureofwhatisparforthesectorarethemedianvaluesforeachofthevariables.Asimplisticdecisionruleonunderandovervaluedstockswouldthereforebe:¤ Undervaluedstocks:Tradeatpricetobookratiosbelowthemedianfor

thesector,(2.07),generatereturnsonequityhigherthanthesectormedian(11.82%)andhavestandarddeviationslowerthanthemedian(21.93%).

¤ Overvaluedstocks:Tradeatpricetobookratiosabovethemedianforthesectorandgeneratereturnsonequitylowerthanthesectormedian.

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64

Howaboutthismechanism?

¨ Wearelookingforstocksthattradeatlowpricetobookratios,whilegeneratinghighreturnsonequity.Butwhatisalowpricetobookratio?Orahighreturnonequity?

¨ Takingthesampleof18banks,weranaregressionofPBVagainstROEandstandarddeviationinstockprices(asaproxyforrisk).

PBV= 2.27 + 3.63ROE - 2.68Std dev(5.56) (3.32) (2.33)

Rsquaredofregression=79%

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65

Andthesepredictions?

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66

AfollowuponUSBanks

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