Finance ClubThursday, February 2, 2012

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Primer on Equity Valuation and Financial Ratios

Robert Shiller

• In 1981 he wrote a paper on market volatility.– He determined if a stock price is the estimate of

“something,” • (say the discounted cash flows from a corporation),

– …then market prices are too volatile in relation to tangible manifestations of that “something.”

• (he used dividends as proxy).

• He concluded markets are not as efficient as established by financial theory.

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• The ability to benefit from identifying a mispriced security depends on the market price converging to the estimated intrinsic value.

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Categories of Equity Valuation Models

• Present Value Models– Dividend Discount Model– Free Cash Flow to Equity Models

• Asset Based Valuation Models– Estimate intrinsic value of a share.

• Multiplier Models

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Market Multiple Models

• Based on share price or enterprise value multiples.

• Examples• (price to earnings)• (price to sales)• (price to book)• (price to cash flow)

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• Major advantage of using price multiples is that they allow fast relative comparisons, both cross-sectional and in time series.

• Note of caution: Difference in accounting practices can make these ratios less meaningful.

• Be wary of ratios for companies whose operations are driven by economic cycles.

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Equity Securities and Company Value

• What is one goal of a company’s management?

• Increase book value and maximize market value of its equity.

• Book value – Shareholders’ equity on balance sheet.– Management can directly affect.

• Market value

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A Company’s Market Value

• Reflects the collective and differing expectations of investors.

• Rarely will book value and market value be equal.

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Return on Equity

• This is the primary measure that equity investors use to determine effectiveness and efficiency.

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So is an increase in ROE always good?

• It depends.• What if NI decreases slower than BVE?• What if a company issues debt and

repurchases shares?– This will increase leverage and make company

risker.

• It is important to examine cause of change. (DuPont)

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Price-to-Book

• Provides an indication of investors’ expectations about future cash flows.

• Important to compare companies in the same industry.

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ExamplePfizer Novartis GlaxoSmithKline

Price $21.11 $55.66 $44.40

BVPS $11.71 $27.39 $4.67

P/B 1.80 2.03 9.51

• GSK has the highest P/B. This suggests investors’ expect higher growth opportunities in GSK. But…

Pfizer Novartis GlaxoSmithKline

Gross Margin 77.35% 67.59% 72.28

Debt/Equity 0.46 0.31 2.03

ROE 11.39% 14.11% 38.48%

• Clearly GSK is using higher financial leverage to do so.

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Valuation Based on Price MultipleApple Inc. 2012E 2011 2010 2009

Sales (billion) $155.4 $108.6 $65.1 $36.3

NI (billion) $39.6 $25.9 $14.0 $5.7

EPS $42.12 $27.68 $15.15 $6.29

P/E 12 13.8 18.7 20.4

Price $505.44 $381.98 $283.31 $128.32