fnce203 l10%2611 relative valuation s22010

8/3/2019 FNCE203 L10%2611 Relative Valuation S22010

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FNCE203 Analysis of Equity Investments

Lecture 10 & 11: Relative Valuation

by

Dr Phoon Kok Fai

e-mail: [email protected]

Weeks starting 15 & 22 Mar 2010


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What is Valuation Using Price Multiples?

The idea behind price multiples is that we need to evaluate a stocks price in

relation to what it buys in terms of earnings, assets etc.

Analysts use price multiples in one of two ways:

The method of comparables (also called relative valuation).

The method based on forecasted fundamentals.


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In relative valuation, the value of an asset is compared to the values assessedby the market for similar or comparable assets.

How do you value the home that you are staying in?

To do relative valuation, we need to:

Identify comparable assets and obtain market values for these assets

Convert these market values into standardised values, thereby creating pricemultiples.

Compare the standardized values or multiple for the asset, controlling for anydifferences that might affect the multiple.

Judge where the asset being analysed relatively over- or under-valued againstsome benchmark.

Is relative valuation really valuation? What if everyone is wrong?

If you think I am crazy, you should see the guy who lives down the hall. Seinfeld

What is Relative Valuation?


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Most valuations on Wall Street are relative valuations.

Almost 85% of equity research reports are based on a multiple and comparables

More than 50% of all acquisition valuation are based on multiples

Rules of thumb based on multiples are not only common but are often the basis forfinal valuation judgments.

Discounted cash flow valuations in consulting and corporate finance can oftenbe relative valuations masquerading as discounted cash flow valuations:

The objective in many discounted cash flow valuations is to back into a numberthat has been obtained by using a multiple

The terminal value is a significant number of discounted cash flow valuations isestimated using a multiple.

Pervasiveness of Relative Valuation


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Even if you are a true believer in discounted cash flow valuation, presentingyour findings on a relative valuation basis can make it more likely that yourfindings / recommendations will reach a receptive audience.

Relative valuation can help find weak spots in discounted cash flow valuationsand fix them.

The problems with multiples is not in their use, but in their abuse. If we can findways to frame multiples right, we should be able to use them better.

The Case for Relative Valuation

We need to understand multiples better and how they are related tocompany fundamentals


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Cash flows are related to fundamentals, therefore, we can relate multiples tocompany fundamentals through a DCF model.

By doing so, analysts can:

Examine how differences in stock price multiples relate to fundamentals.

Justify a multiple based on the method of forecasted fundamentals.

State the justified DCF fair value in terms of a multiple which is sometimes morefamiliar.

Sometimes fair absolute values are translated into multiples

Method Based on Fundamentals


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Price multiples are ratios. In a ratio, the price is standardized by dividing by

various measures. You can standardize by dividing by the:

Earnings of the asset

Price/Earnings Ratio (PE) and variants (PEG)

Value/EBIT

Value/EBITDA Value/Cash Flow

Book value of the asset

Price/Book Value (of Equity) (PBV)

Value/ Book Value of Assets

Revenues generated by the asset

Price/Sales per Share (PS)

Value/Sales.

What are Price Multiples?


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Four Steps to Understanding Multiples

The 4 Steps: Define, Describe, Analyze & Apply

Define the Multiple

The same multiple can be defined in different ways by different users. Whencomparing and using multiples, estimated by someone else, it is critical that weunderstand how they have been estimated.

Describe the Multiple

Many users have no idea what the multiples X-sectional distribution is. It is thendifficult to pass judgement whether the estimated value is high or low.

Analyse the Multiple

We must understand the fundamentals driving each multiple and the nature of therelationship between multiple and each fundamental variable.

Apply the Multiple

Defining the comparable universe and controlling for differences is difficult inpractice.


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Definitional Tests

Is the multiple consistently defined?

Both the value (numerator) and the standardizing variable (denominator) should beto the same claimholders in the firm.

E.g., the value of equity should be divided by equity earnings or equity book value,and the firm value should be divided by firm earnings or book value.

Is the multiple uniformly estimated

The variables used in defining the multiple should be estimated uniformly acrossassets in the comparable firm list.

If earnings-based multiples are used, the accounting rules to measure earningsshould be applied consistently across assets. The same rule applies with book value

based multiples.

Estimation should be consistent to compare apples-to-apples


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Descriptive Tests

What is the average and standard deviation for the multiples, across the universe(market)?

What is the median for this multiple?

The median is often a more reliable comparison point.

How large are the outliers? How do we deal with them? Throwing out the outliers may seem like an obvious solution. But, if outliers all lie on

one side of the distribution, this can lead to biased estimates.

Are there cases where the multiple cannot be estimated? Will ignoring thesecases lead to a biased estimate of the multiple?

How has the multiple changed over-time?

We should understand the distribution of the multiple.


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Analytical Tests

What are the fundamentals that determine and drive the multiples?

Embedded in every multiple are all of the variables that drive discounted cash flowvaluation - growth, risk and cash flow patterns.

Using a simple DCF model and basic algebra should yield the fundamentals thatdrives a multiple.

How do changes in these fundamentals change the multiple?

The relationship between a fundamental (like growth) and a multiple (such as PE)is seldom linear.

E.g., if firm A has twice the growth rate of firm B, it will generally not trade at twicethe PE ratio.

It is impossible to properly compare firms on a multiple if we do not know thenature of the relationship between fundamentals and the multiple.

We must understand the relation between multiple & fundamentals.


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Application Tests

Given the firm that we are valuing, what is a comparable firm? While tradition analysis is built on the premise that firms in the same sector are

comparable firms, valuation theory suggests that a comparable firm is one which issimilar in fundamentals.

There is no reason why a firm cannot be compared with a firm in a differentbusiness, if the two firms have the same risk, growth and cash flow characteristics.

Given the comparable firms, how do we adjust for differences across the firmson fundamentals?

It is impossible to find an exactly identical firm to the one that you are valuing.

Comparable firms should be identical in fundamentals.


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1. Price Earnings RatioDefinition

PE = Market Price per Share / Earnings Per Share

There are a number of variants on the basic PE ratio in use. They are based onhow the price and the earnings are defined.

Price: is usually the current price per share

is sometimes the average price for the year

Earnings: earnings per share in most recent financial year

earnings per share in trailing 12 months (Trailing PE)

forecasted earnings per share next year (Forward PE)

forecasted earnings per share in future year

primary or diluted

before or after extraordinary

There are several variants to the PE ratio


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Price Earnings RatioHow is it used in the Real World?

People typically look for low PEs (both absolute and relative)

Related to looking at the PEs, investors also tend to look at EPSgrowth momentum.

Look for low PEs relative and absolute

Look for EPS growth momentum


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Price Earnings Ratio (1)Rationale & Drawbacks

Rationale for using PER

Earnings is a chief driver of investment value

Widely recognized and used by investors (it is simple)

Drawbacks

EPS can be negative

Earnings may be volatile

Earnings between companies may not be comparable because of somemanagerial discretion in accounting

PE is well understood by investment community


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Price Earnings Ratio (2)Looking at the distribution - 2005


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Price Earnings Ratio (2)Looking at the distribution - 2009


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Price Earnings Ratio (2)PE: Deciphering the Distribution

Current PE Trailing PE Forward PE

Mean 48.12 42.86 28.53

Standard Error 3.69 3.39 0.98

Median 23.21 20.65 19.21

Kurtosis 1214.98 1428.36 157.28

Skewness 31.75 32.86 10.85Minimum 1.15 1.31 1.40

Maximum 10081.26 9713 1017.00

Number of firms 4072 3637 2402.00

Largest(500) 58.90 44.72 29.31

Smallest(500) 12.65 11.11 14.54

Note: Number of firms decreases when using forward P/Eas not all firms are tracked by analysts

Price Earnings Ratio (2)


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Comparing PE Ratios: US, Europe, Japan and Emerging Markets

Median PE

Japan = 23.45

US = 23.21

Europe = 18.79

Em. Mkts = 16.18



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Comparing PE Ratios: US, Europe, Japan and Emerging Markets


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Price Earnings Ratio (3)Understanding the Fundamentals

To understand the fundamentals, start with a basic equity DCF model.

With the dividend discount model,

Dividing both sides by earnings per share,

If this has been a FCFE Model,

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PE Ratio and Fundamentals

Proposition:

Other things held equal, higher growth firms will have higher PE ratios.

Proposition:

Other things held equal, higher risk firms will have lower PE ratios

Proposition:

Other thing held equal, firms with lower reinvestment needs will have higherPE ratios.

Of course, other things are difficult to hold equal since high growth firms tend tohave higher risk and high reinvestment rates.

It is hard to hold other things equal.

U i th F d t l M d l t E ti t PE


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Using the Fundamental Model to Estimate PEHigh Growth Firm

The price-earnings ratio for a high growth firm can be related to fundamentals.In the special case of the two stage dividend discount model, the relation is asfollows:

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:

n

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rgr

ggRatioPayoutEPS

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U i th F d t l M d l t E ti t PE


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Using the Fundamental Model to Estimate PEHigh Growth Firm - Workings

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(1) (4) gives the present value ofdividends during the high growthperiod.


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A Simple Example

The PE ratio for a high growth firm is a function of growth, risk and payout, exactly the

same variables that it was a function of for the stable growth model. The only difference is that these inputs have to be estimated for two phases - the high

growth phase and the stable growth phase.

Extending to more than two growth phases, say the 3-stage model, will mean that risk,growth and cash flow patterns must be estimated for each phase.

Example: Estimate the PE ratio of a firm with the following characteristics

Variable High Growth (5 years) Stable Growth Phase

Expected Growth Rate 25% 8%

Payout Ratio 20% 50%

Beta 1.00 1.00

Riskfree rate = T-bond rate = 6%

Required rate of return = 6% + 1 x 5.5% = 11.5%

75.285)115.1()08.115(.

)08.1()25.1(5.0

)25.115(.

)115.1(

)25.1(1)25.1(2.0

PE55

5



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g ( )Sensitivity Analysis

Higher PE if higher growth rate (during high growth period)

Also change is greatest if r is low

PE and Growth: Firm grows at x% for 5 years, 8% thereafter



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Price Earnings Ratio (5)Sensitivity Analysis

Higher PE if longer duration of high growth

PE Ratios and Length of High Growth: 25% growth for n years;

8% thereafter



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Lower PE if beta or leverage is higher

PE and Risk: Effects of Changing Betas on PE Ratio:

Firm with x% growth for 5 years; 8% thereafter

PE Ratios and Beta: Growth Scenarios

0

5

10

15

20

25

30

35

40

45

50

0.75 1.00 1.25 1.50 1.75 2.00

Beta

g=25%

g=20%

g=15%

g=8%



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Note: If growth is held constant, increase in payout is possibleonly if ROE increases. G = (1 payout ratio) x ROE

PE and Payout Ratio


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2. Using Comparable Firms

The most common approach to estimating the PE ratio for a firm is: To choose a group of comparable firms

To calculate the average PE ratio for this group, and

To subjectively adjust this average for differences between the firm being valuedand the comparable firms

Problem with this approach:

The definition of a comparable firm is a subjective one

Use of other firms in the industry as the control group is often not a solution asfirms within an industry can have very different business mixes, risk and growthprofiles

There is plenty of potential for bias Even when a legitimate group of comparable firms can be constructed, differences

will still persist in fundamentals between the firm being valued.

Choosing comparable firms provides potential for bias

Using the Entire X-Section of Firms:


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Using the Entire X-Section of Firms:A Regression Approach

In contrast to the comparable firm approach, the information in the entire

cross-section of firms can be used to predict PE ratios

The simplest way of summarising this information is with a multiple regression,with the PE ratio as the dependent variable, and proxies for risk, growth andpayout forming the independent variables.

Should intercept be positive, negative or zero?



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Using the Entire X Section of Firms:A Regression Approach

PE Ratio: Standard Regression for US stocks - January 2005



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Using the Entire X Section of Firms:A Regression Approach

PE Ratio: Standard Regression for US stocks - January 2009


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Using the PE Ratio Regression

Assume that you were given the following information for Dell. The firm has an

expected growth rate of 10%, a beta of 1.20 and pays no dividends. Based onthe regression, estimate the predicted PE ratio of Dell.

If Dell is actually trading at 22 times earnings, what does the predicted PE tellyou?

Should you buy or sell or do nothing?


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Problems with Regression Methodology

The basic regression assumes a linear relationship between PE ratios and thefinancial proxies, and this may not be appropriate

The basic relationship between PE ratios and financial variables might not bestable, and if it shifts from year to year, the predictions from the model may notbe reliable

The independent variables are correlated with each other. For example, highgrowth firms have high risk. This multi-collinearity makes the coefficients of theregression unreliable and may explain the large changes in these coefficientsfrom period to period.

Choosing comparable firms provides potential for bias


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PE versus Growth

Expected Growth in EPS: next 5 years

100806040200-20

300

200

100

0

-100 Rsq = 0.1500


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The Value of Growth

Time Period PE Value of extra 1% of growth Equity Risk Premium

January 2009 0.780 6.43%

January 2008 1.427 4.37%

January 2007 1.178 4.16%

January 2006 1.131 4.07%

January 2005 0.914 3.65%

January 2004 0.812 3.69%July 2003 1.228 3.88%

January 2003 2.621 4.10%

July 2002 0.859 4.35%

January 2002 1.003 3.62%

July 2001 1.251 3.05%

January 2001 1.457 2.75%July 2000 1.761 2.20%

January 2000 2.105 2.05%

The value of growth is in terms of additional PE

Fundamentals hold in every market: PE regressions


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across markets

Coefficients do differ

Region RegressionJanuary 2009 R2

Europe PE = 10.075.23 Beta + 7.78 Payout +

27.51 Expected growth rate53.8%

Japan PE = 9.28

4.50 Beta + 42.29 Payout +62.22 Expected growth rate

48.3%

Emerging

Markets

PE = 5.63 + 062 Beta + 9.65 Payout + 13.05

Expected growth rate27.4%

3. Investment Strategies


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Comparing PE to Expected Growth Rate

If we assume that all firms within a sector have similar growth rates and risk, a

strategy of picking the lowest PE ratio stock in each sector will yield under-valued stocks.

Portfolio managers and analysts sometimes compare PE ratios to the expectedgrowth rate to identify over- and under-valued stocks.

In the simplest form of this approach, firms with PE ratios less than their expected

growth rates are viewed as undervalued.

Problem 1: there is no basis to believe that a firm is under-valued just because itsPE ratio is less than its expected growth rate.

Problem 2: Relationship may be consistent with fairly valued or even an over-valued firm if interest rates are high, or if a firm is high risk.

Problem 3: As interest rate decrease (increase), fewer (more) stocks will

emerge under-valued using this approach.

In its more general form, the ratio of PE ratio to growth is used as measure ofrelative value.

PE / Expected Growth < 1 is not a good criteria

PEG Ratio (1)


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Definition

The PEG ratio is the ratio of price earnings to expected growth in earnings per

share

PEG = PE / Expected Growth Rate in Earnings

Definitional Tests:

Is the growth rate used to compute the PEG ratio

on the same base? (base year EPS) over the same period (2 years, 5 years)

from the same source? (analyst projections, consensus estimates)

Is the earnings used to compute the PE ratio consistent with the growth rateestimates?

No double counting: If the estimate of growth in EPS is from the currentyear, it would be a mistake to use forward EPS in computing PE.

If looking at foreign stocks or ADRs, is the earnings used for the PE ratioconsistent with the growth rate estimates? (US analysts use the ADR EPS)

The first step is to check for definitional consistency

PEG Ratio (2)


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Example: Beverage Sector

Company Name Trailing PE Growth Std Dev PEG

Coca-Cola Bottling 29.18 9.50% 20.58% 3.07Molson Inc Ltd A 42.65 15.50% 21.88% 2.82

Anheuser-Busch 24.31 11.00% 22.92% 2.21

Corby Distilleries Ltd 16.24 7.50% 23.66% 2.16

Chalone Wine Group Ltd 21.76 14.00% 24.08% 1.55

Andres Wine Ltd A 8.96 3.50% 24.70% 2.56

Todhunter Intl 8.94 3.00% 25.74% 2.98

Brown-Forman B 10.07 11.50% 29.43% 0.88

Coors (Adolph) B 23.02 10.00% 29.52% 2.30

PepsiCo, Inc. 33.00 10.50% 31.35% 3.14

Coca-Cola 44.33 19.00% 35.51% 2.33

Boston Beer A 10.59 17.13% 39.58% 0.62

Whitman Corp. 25.19 11.50% 44.26% 2.19

Mondavi (Robert) A 16.47 14.00% 45.84% 1.18Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38

Hansen Natural Corp. 9.70 17.005 62.45% 0.57

Average 22.66 0.13 0.33 2.00

PEG Ratio (3)


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Analysis

To understand the fundamentals that determine the PEG ratio, let us return tothe 2-stage equity discounted cash flow model:

Dividing both sides of the equation by the earnings gives us the equation for thePE ratio. Dividing it again by the expected growth g gives the PEG ratio:

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PEG Ratio and Fundamentals


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PEG Ratio and Fundamentals

Risk and payout, which affect the PE ratio, continue to affect the PEG ratio:

Implication: When comparing PEG ratios across companies, we are making theimplicit or explicit assumption about these variables.

Dividing PE by expected growth does not neutralise the effects of expectedgrowth, since the relationship between growth and value is not linear and fairlycomplex (even in a 2-stage model)

Dividing PE by the growth rate does not neutralise the effects of growth.

PEG Ratio and FundamentalsR l ti hi


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Relationships

High risk companies will trade at much lower PEG ratios than low risk

companies with the same expected growth rates. The company that looks most under valued on a PEG ratio basis in a sector may

be the riskiest firm in the sector

Companies that can attain growth more efficiently by investing less in betterreturn projects will have higher PEG ratios than companies that grow at the

same rate less efficiently. Companies that look cheap on a PEG ratio basis may be companies with high

reinvestment rates and poor project returns.

Companies with very low or very high growth rates will tend to have higher PEGratios than firms with average growth rates. This bias is worse for low growthstocks.

PEG ratios do not neutralise the growth effect

We can generally explain differences in PEG ratios using fundamentals.

Analysing PE and Growth


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Analysing PE and Growth

Given that the PEG ratio is determined by the expected growth rates, risk and

cash flow patterns, it is necessary that we control for differences in thesevariables.

For the beverage companies, if we regress PEG against risk and a measure ofgrowth dispersion, we get:

PEG = 3.61 - 2.86 x Expected Growth - 3.75 x Std Dev in Prices

R2 = 44.75%

In other words,

PEG ratios will be lower for high growth companies

PEG ratios will be lower for high risk companies

Applying this regression to Hansen, the predicted PEG ratio for Hansen was 0.78.

With the actual PEG ratio of 0.57, Hansen looks under-valued not with standing its high risk.

Simplistic Rules Almost Always Break Down:

The PEG < 1 = Cheap Test?


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The PEG < 1 = Cheap Test?

4. Price-Book Value Ratio (1)Definition


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Definition

The price-book value ratio is the ratio of the market value of equity to the book

value of equity, i.e., the measure of shareholders equity in the balance sheet.

Consistency Test:

If the market value of equity refers to the market value of equity of common stockoutstanding, the book value of common equity should be used in the denominator

If there is more than one class of common stock outstanding, the market values ofall classes (even the non-traded classes) needs to be factored in.

EquityofValueBook

EquityofValueMarketValuePrice/Book

Price / Book Value Ratio (2)How is the PBV used?


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How is the PBV used?

Particularly relevant for financial institutions

Look for low PBV, preferably at or below 1

PBV versus growth rate

But why did DBS pay more than 3x book value for Dao Heng Bank?

Price / Book Value Ratio (3)Rationale & Drawbacks


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Rationale & Drawbacks

Rationale for using PBV

Generally positive even if EPS is negative

More stable than EPS

Useful for valuing companies chiefly composed of liquid assets

Useful for liquidation cases

Drawbacks

Human capital not recognized

Significant different assets and business models

Accounting effects on book value, e.g. R&D, brand name, historical cost, write-offs, pooling vs. purchase acquisition accounting (subject to manipulation andunreliable)

Other reasons cited simple, margin of safety &indicator of value creation.

Price / Book Value Ratio (4)Computing Book Value


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Computing Book Value

Book Value

= Shareholders equity senior equity claims

Adjustments

Tangible book value

exclude intangibles like goodwill

Off-balance sheet items

Adjustments for different accounting methods

E.g., depreciation LIFO versus FIFO

Some adjustments may be made

Price-Book Value Ratio (5)Stable Growth Firm


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Stable Growth Firm

Go back to the simple dividend discount model:

Defining ROE = EPS / BV of Equity, the value of equity can be written as:

If ROE is based on expected earnings next period, this can be simplified:

Or, since g = (1-payout ratio) x ROE,

g-rP 1

0DPS

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For a stable firm, P/BV isdetermined by differentialbetween ROE and r

Price Book Value Ratio (6)High Growth Firms


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High Growth Firms

The Price-book ratio for a high-growth firm can be estimated beginning with a 2-stage DCF model:

Dividing both sides by BV of equity:

where ROE = return on equity during high-growth period

ROEn

= return on equity during stable-growth period

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Strong linkage between PBV and ROE

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Price Book Value Ratio (7)PBV and ROE is the Key


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y

PBV and ROE: Different Risk

0

0.5

1

1.5

2

2.5

3

3.5

4

10%

15%

20%

25%

30%

ROE

Price/Book

ValueRatio Beta increasing

Example: PBV/ROE European Banks


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Bank Symbol PBV ROE

Banca di Roma SpA BAHQE 0.60 4.15%

Commerzbank AG COHSO 0.74 5.49%

Bayerische Hypo und Vereinsbank AG BAXWW 0.82 5.39%

Intesa Bci SpA BAEWF 1.12 7.81%

Natexis Banques Populaires NABQE 1.12 7.38%Almanij NV Algemene Mij voor Nijver ALPK 1.17 8.78%

Credit Industriel et Commercial CIECM 1.20 9.46%

Credit Lyonnais SA CREV 1.20 6.86%

BNL Banca Nazionale del Lavoro SpA BAEXC 1.22 12.43%

Banca Monte dei Paschi di Siena SpA MOGG 1.34 10.86%

Deutsche Bank AG DEMX 1.36 17.33%

Skandinaviska Enskilda Banken SKHS 1.39 16.33%

Nordea Bank AB NORDEA 1.40 13.69%

DNB Holding ASA DNHLD 1.42 16.78%

ForeningsSparbanken AB FOLG 1.61 18.69%

Danske Bank AS DANKAS 1.66 19.09%

Credit Suisse Group CRGAL 1.68 14.34%

KBC Bankverzekeringsholding KBCBA 1.69 30.85%

Societe Generale SODI 1.73 17.55%

Santander Central Hispano SA BAZAB 1.83 11.01%

National Bank of Greece SA NAGT 1.87 26.19%

San Paolo IMI SpA SAOEL 1.88 16.57%

BNP Paribas BNPRB 2.00 18.68%

Svenska Handelsbanken AB SVKE 2.12 21.82%UBS AG UBQH 2.15 16.64%

Banco Bilbao Vizcaya Argentaria SA BBFUG 2.18 22.94%

ABN Amro Holding NV ABTS 2.21 24.21%

UniCredito Italiano SpA UNCZA 2.25 15.90%

Rolo Banca 1473 SpA ROGMBA 2.37 16.67%

Dexia DECCT 2.76 14.99%

Average 1.60 14.96%

PBV versus ROE Regression


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g

Regressing PBV ratios against ROE for banksyields the following regression:

PBV = 0.81 + 5.32 (ROE) R2 = 46%

For every 1% increase in ROE, the PBV ratioshould increase by 0.0532.

Under or Over Valued Banks?Bank Actual Predicted nder or Over


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Banca di Roma SpA 0.60 1.03 -41.33%

Commerzbank AG 0.74 1.10 -32.86%

Bayerische Hypo und Vereinsbank AG 0.82 1.09 -24.92%

Intesa Bci SpA 1.12 1.22 -8.51%

Natexis Banques Populaires 1.12 1.20 -6.30%

Almanij NV Algemene Mij voor Nijver 1.17 1.27 -7.82%

Credit Industriel et Commercial 1.20 1.31 -8.30%

Credit Lyonnais SA 1.20 1.17 2.61%

BNL Banca Nazionale del Lavoro SpA 1.22 1.47 -16.71%

Banca Monte dei Paschi di Siena SpA 1.34 1.39 -3.38%

Deutsche Bank AG 1.36 1.73 -21.40%

Skandinaviska Enskilda Banken 1.39 1.68 -17.32%

Nordea Bank AB 1.40 1.54 -9.02%

DNB Holding ASA 1.42 1.70 -16.72%

ForeningsSparbanken AB 1.61 1.80 -10.66%

Danske Bank AS 1.66 1.82 -9.01%

Credit Suisse Group 1.68 1.57 7.20%

KBC Bankverzekeringsholding 1.69 2.45 -30.89%

Societe Generale 1.73 1.74 -0.42%

Santander Central Hispano SA 1.83 1.39 31.37%

National Bank of Greece SA 1.87 2.20 -15.06%

San Paolo IMI SpA 1.88 1.69 11.15%

BNP Paribas 2.00 1.80 11.07%Svenska Handelsbanken AB 2.12 1.97 7.70%

UBS AG 2.15 1.69 27.17%

Banco Bilbao Vizcaya Argentaria SA 2.18 2.03 7.66%

ABN Amro Holding NV 2.21 2.10 5.23%

UniCredito Italiano SpA 2.25 1.65 36.23%

Rolo Banca 1473 SpA 2.37 1.69 39.74%

Dexia 2.76 1.61 72.04%

Looking for Undervalued SecuritiesPBV Ratios and ROE


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Given the relation between PBV and ROE, it is not surprising to see firms with

high ROE selling for well above book value DBS takeover example Firms that should draw attention are those which provide mismatches of PBV

ratios and ROE.

Low ROE

High MV/BV

Overvalued

High ROELow MV/BV

Undervalued

ROE - r

MV/BV

Valuation Matrix

Price to Book versus ROELargest Market Cap Firms in US: Jan 2005

18


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806040200

18

16

14

12

10

8

6

4

2

0

BUD

PBR

BADOW

NSANY

FRE

RICY

YHOO

UNH

WYE

D

MDT

VIA/B

UL

FNM

MRK

EBAY

AMGN

TWX

EDP

KO

DELL

RD

GSK

PG

IBM

PBR = Petrobas

FRE = Freddie Mac

IBM: The Rise and Fall and Rise Again


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0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

19 83 19 84 19 85 1986 1987 1988 1989 19 90 19 91 19 92 19 93 19 94 1995 1996 1997 19 98 19 99 20 00

Year

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

R e t u r n o n E q u i t y

PBV ROE

Price-Book Value Ratio (8)Relation to Residual Income Analysis


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Go back to the simple dividend discount model:

We can rewrite this as:

Hence,

If PV of expect future residual earnings is zero, justified PBV = 1

0

0

0

0 )(

)(

1g-r

)()(

BV

gr

rROEBV

grrROE

BV

P

00

0)(

1BV

earningsresidualfutureExpectedPV

BV

P

g-r

1

0

0 gROE

BV

P

PV of expected future residual earnings is negative, justified PBV


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The price/sales ratio is the ratio of the market value of equity to sales

Consistency Test:

The price/sales ratio is internally inconsistent, since the market value of equity isdivided by the total revenues of the firm.

Assume that you are comparing price/sales ratio across firms in a sector, and thatthere are differences in financial leverage across firms. What type of firms willemerge with the lowest price/sales ratios?

RevenueTotal

EquityofValueMarketsPrice/Sale

The Price/Sales ratio is internally inconsistent.

Price / Sales Ratio (2)Rationale and Drawbacks


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Rationale for using PS

Generally subject to less distortions and manipulations

Positive even when EPS is negative

More stable

Useful for valuing mature, cyclical and zero income companies

Drawbacks

High growth but no earnings or cash little relation to value

Cost structure not reflected

Revenue recognition is still subjected to abuse

We actually have significant problems with revenue recognition

Price / Sales Ratio (3)Determinants


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The price/sales ratio of a stable growth firm can be estimated as follows:

Dividing both sides by the sales per share, we get:

For a 2-stage model, we have:

g-rP 10 DPS

g-r

)g(1RatioPayoutMarginProfitNet

0

0

Sales

P

n

n

n

n

r

gr

g

Sales

P

)1()g-(r

1(g)(1ratioPayoutmarginNet

g-r

)1(

)1(1g)(1ratioPayoutmarginNet

n

n

nn

0

0

Net margin n = net margin during stable growth

Key determinant of Price/Sales ratio is the profit margin

Price / Sales Ratio (4)Profit Margins


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A decline in profit margin has a two-fold effect:

Reduction in profit margin reduces the price-sales ratio directly.

A lower profit margin can lead to lower the sustainable growth rate and hence,lower PS ratios.

Expected growth rate = Retention ratio x Return on Equity

= Retention ratio x (Net Profit/Sales) x (Sales/BV)

= Retention ratio x Profit Margin x Sales/BV

Note: Dupont Analysis:

ROE = Net Profit / Sales x Sales / Assets x Assets / BV

A lower profit margin produces a lower sustainable growth rate so long assales does not increase proportionately

Price / Sales Ratio (5)Current vs Predicted Margins


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We should not focus solely on current margins as stock are priced base on

expected margins. For most firms, current margins and predicted margins are highly correlated

and hence using current margins are still relevant.

For firms where current margins have little or no correlation with expectedmargins, regressions of price to sales ratios against current margins will not

provide much explanatory power. In such cases, it makes more sense to run a regression using either predicted

margins or some proxy for predicted margins.

We will carry out a case study on internet stocks.

Internet Stocks


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0

20

40

60

80

100

120

140

160

-20.0 -15.0 -10.0 -5.0 0.0 5.0

Net Margin

Pr

ice/Sales

Regression:

PS = 27.89 - 1.29 Net Margin

(0.49)

R2

= 0.02

Not surprising. Firms are priced on expected margins

Price / Sales Ratio (6)Using Proxies for Survival & Growth


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Hypothesizing that firms with higher revenue growth and higher cash balances

should have a greater chance of surviving and becoming profitable, we ran aregression:

PS = 30.61 - 2.77 x (ln(Rev)) + 6.42 x (Rev growth) + 5.11 x (Cash/Rev)

(0.66) (2.63) (3.49)

R2 = 31.8%

Predicted PS (for Amazon) = 30.42

Actual PS = 25.63

Stock is undervalued using PS measure to other internet stocks.

Solution 1: Using Proxies

Price / Sales Ratio (7)Using Forward Multiples


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You can always estimate price (or value) as a multiple of revenues, earnings orbook value in a future year. These multiples are called forward multiples.

For young, evolving firms, the values of fundamentals in future years mayprovide a much better picture of the true value potential of the firm.

There are two ways to look at multiples:

Look at value today as a multiple of revenues or earnings in the future (say 5 yearsfrom now) for all firms in the comparable firm list. Use the average of this multiplein conjunction with your firms earnings or revenues to estimate the value of yourfirm today.

Estimate value as a multiple of current revenues and earnings for more maturefirms in the group and apply this multiple to the forward earnings or revenues foryour firm. This will yield the expected value of your firm in the forward year.Discount back to get current value.

Solution 2: Using forward multiples

6. Value/Earnings & Value/CF Ratios


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While Price earnings ratios look at the market value of equity relative to

earnings to equity investors, Value earnings ratios look at the market value ofthe firm relative to operating earnings.

Value to cash flow ratios modify the earnings number to make it a cash flownumber.

The form of a value to cash flow ratio that has the closest parallel in DCF

valuation is Value/FCFF which is defined as:

Consistency Tests:

If the numerator is net of cash (or if net debt is used, then the interest income from cash

should not be in the denominator The interest expenses added back to get EBIT should correspond to the debt in the

numerator. If only long-term debt is considered, only long-term interest should be added back

in WCChg-on)Depreciati-(Capex-t)-(1EBIT

Cash-DebtofValueMarketEquityofValueMarket

FCFF

Value

Value of Firm/FCFFAnalysis


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Reverting to a 2-stage FCFF DCF model:

where

V0 = Value of the firm (today)

FCFF0 = Free cash flow to the firm in the current year

g = Expected growth rate in FCFF in high growth period (n-years)

WACC = Weighted average cost of capital

gn = Expected growth rate in FCFF in stable growth period (after n-years)

Dividing both sides by FCFF gives:

n

n

n

nn

n

WACCgWACC

ggFCFF

gWACC

WACCggFCFF

V)1()(

)1()1(

)(

)1()1(1)1(

0

0

0

n

n

n

nn

n

WACCgWACCgg

gWACCWACC

gg

FCFFV

)1()()1()1(

)()1(

)1(1)1(

0

0

V/FCFF is a function of WACC and the expected growth

Alternatives to FCFFEBIT & EBITDA


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Most analysts find FCFF too complex or messy to use in multiples (partly

because capex and working capital have to be estimated). They use a modified version of the multiple with the following alternative

denominator:

after-tax operating income or EBIT(1-t)

pre-tax operating income or EBIT

net operating income (NOI), a slightly modified version of operating income, whereany non-operating expenses and income is removed from EBIT

EBITDA, which is earnings before interest, taxes, depreciation and amortisation.

Some short-cut measures to Value of firm / FCFF

Illustration: Using Value/FCFF Approaches to value afirm: MCI Communications


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MCI Communications has earnings before interest and taxes of $3356 million in

1994 (its net income after taxes was $855 million). It had capital expenditures of $2500 million in 1994 and depreciation of $1100

million; working capital increased by $250 million.

It expects free cash flows to the firm to grow 15% a year for the next five yearsand 5% a year after that.

The cost of capital is 10.50% for the next five years and 10% after that.

The company faces a tax rate of 36%.

The solution is:

V0

FCFF 0=

(1.15) 1 -(1.15)

5

(1.105)5

.105 - .15+

(1.15)5

(1.05)

(.10 - .05)(1.105)5

= 31.28

Multiple Magic

In this case of MCI there is a big difference between the FCFF and short


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Multiple gets lower. Do such low ratio give illusion that the firm is cheap?

In this case of MCI there is a big difference between the FCFF and shortcut measures. For instance the following table illustrates the appropriatemultiple using short cut measures, and the amount you would overpay by ifyou used the FCFF multiple.

Free Cash Flow to the Firm

= EBIT (1-t) - Net Cap Ex - Change in Working Capital

= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million

$ Value Correct Multiple

FCFF $498 31.28382355

EBIT (1-t) $2,148 7.251163362

EBIT $ 3,356 4.640744552

EBITDA $4,456 3.49513885

7. Value of Firm / EBITDAReasons for Its Increased Use


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The multiple can be computed even for firms that are reporting net losses, since EBITDA

are usually positive. For firms in certain industries, e.g. cellular, which require a substantial investment in

infrastructure and long gestation periods, this multiple seems to be more appropriatethan the PE ratio.

In leveraged buyouts, where the key factor is cash generated by the firm prior to alldiscretionary expenditures, EBITDA is the measure of cash flows from operations that

can be used to support debt payment at least over the short-term. By looking at CF prior to capex, it may provide a better estimate of optimal value,

especially if capex are unwise or earn substandard returns.

By looking at the value of the firm and cash flows to the firm, it allows for comparisonacross firms with different financial leverage.

Allows cross-country comparison - higher in the income statement.

Closer to reflecting the economics of a business, relates tocash flows problems (same as PE)

Some like to use it for takeover valuation

Value of Firm / EBITDA MultipleDefinition


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The Classic Definition:

The Non-cash Version

When cash and marketable securities are netted out of value, none of theincome form the cash and securities should be reflected in the denominator.

onDepreciati&TaxesInterest,beforeEarnings

DebtofValueMarketEquityofValueMarket

EBITDA

Value

onDepreciati&TaxesInterest,beforeEarnings

Cash-DebtofValueMarketEquityofValueMarket

EBITDA

Value

Enterprise Value / EBITDA Distribution - US

EV Multiples: US firms in January 2005


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0

100

200

300

400

500

600

700

800

Number

offirms

100

EV Multiple

EV/EBITDA

EV/EBIT

About 1500 firms trade at less

than 7 times EBITDA

Value/EBITDA Multiple: Europe, Japan and EmergingMarkets in Jan 2005


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Is 6 times EBITDA Cheap?


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Value of Firm / EBITDA (2)Analysis


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Firm value can be written as:

The numerator can be written as:

FCFF = EBIT(1-t) - (Capex - Depr) - Working Capital

= (EBITDA-Depr)(1-t) - (Capex - Depr) - Working Capital

= EBITDA x (1-t) + Depr x t - Capex - Working Capital Hence, the value of the firm can be written as:

Dividing both sides by EBITDA gives:

g-WACCV10

FCFF

g-WACC

)()1(Value

WCCapextDeprtEBITDA

g-WACC

/

g-WACC

/

g-WACC

/)(

g-WACC

)1(Value EBITDAWCEBITDACapexEBITDAtDeprt

EBITDA

Linkage of Value/EBITDA to DCF Valuation

Example: Value/EBITDA Multiple: Trucking Companies

Company Name Value EBITDA Value/EBITDA

KLLM Trans. Svcs. 114.32$ 48.81$ 2.34

Ryder System 5,158.04$ 1,838.26$ 2.81

Rollins Truck Leasing 1,368.35$ 447.67$ 3.06

Cannon Express Inc. 83.57$ 27.05$ 3.09

Hunt (J.B.) 982.67$ 310.22$ 3.17


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( )

Yellow Corp. 931.47$ 292.82$ 3.18

Roadw ay Express 554.96$ 169.38$ 3.28

Marten Transport Ltd. 116.93$ 35.62$ 3.28

Kenan Transport Co. 67.66$ 19.44$ 3.48

M.S. Carriers 344.93$ 97.85$ 3.53

Old Dominion Freight 170.42$ 45.13$ 3.78Trimac Ltd 661.18$ 174.28$ 3.79

Matlack Systems 112.42$ 28.94$ 3.88

XTRA Corp. 1,708.57$ 427.30$ 4.00

Covenant Transport Inc 259.16$ 64.35$ 4.03

Builders Transport 221.09$ 51.44$ 4.30

Werner Enterprises 844.39$ 196.15$ 4.30

Landstar Sys. 422.79$ 95.20$ 4.44

AMERCO 1,632.30$ 345.78$ 4.72

USA Truck 141.77$ 29.93$ 4.74

Frozen Food Express 164.17$ 34.10$ 4.81

Arnold Inds. 472.27$ 96.88$ 4.87

Greyhound Lines Inc. 437.71$ 89.61$ 4.88

USFreightways 983.86$ 198.91$ 4.95

Golden Eagle Group Inc. 12.50$ 2.33$ 5.37

Arkansas Best 578.78$ 107.15$ 5.40

Airlease Ltd. 73.64$ 13.48$ 5.46

Celadon Group 182.30$ 32.72$ 5.57

Amer. Freightways 716.15$ 120.94$ 5.92

Transfinancial Holdings 56.92$ 8.79$ 6.47

Vitran Corp. 'A' 140.68$ 21.51$ 6.54

Interpool Inc. 1,002.20$ 151.18$ 6.63

Intrenet Inc. 70.23$ 10.38$ 6.77

Sw ift Transportation 835.58$ 121.34$ 6.89

Landair Services 212.95$ 30.38$ 7.01

CNF Transportation 2,700.69$ 366.99$ 7.36Budget Group Inc 1,247.30$ 166.71$ 7.48

Caliber System 2,514.99$ 333.13$ 7.55

Knight Transportation Inc 269.01$ 28.20$ 9.54

Heartland Express 727.50$ 64.62$ 11.26

Greyhound CDA Transn Corp 83.25$ 6.99$ 11.91

Mark VII 160.45$ 12.96$ 12.38

Coach USA Inc 678.38$ 51.76$ 13.11

US 1 Inds Inc. 5.60$ (0.17)$ NA

Ave rag e 5.61

Look at Ryder System


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Ryder System looks very cheap on a Value/EBITDA multiple basis, relative tothe rest of the sector. What explanation (other than mis-valuation) might therebe for this difference?

Value of Firm / EBITDA (3)Underlying factors


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The Value / EBITDA multiple varies widely across firms in the market dependingon:

How capital intensive the firm is (high capital intensity firms will tend to have lower V/EBITDAratios), and how much reinvestment is needed to keep the business going and create growth

How high or low the cost of capital is (higher cost of capital having lower EV/EBITDA ratios)

How high or low expected growth in the sector (high growth sectors tend to have higherEV/EBITDA ratios)

We also need to ask specific questions of companies that may seem to beundervalued:

Is operating income next year expected to be significantly lower than this years

Does the firm have significant capex coming up? (In the trucking business, the life cycle ofthe trucking fleet would be a good indicator)

Does the firm have a much higher cost of capital than other firms in the sector?

Does the firm face a much higher tax rate than other firms in the sector?

Some important questions to ask of low EV/EBITDA firms

Value of Firm / EBITDA (3)Underlying factors


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The Value / EBITDA multiple varies widely across firms in the market dependingon:

How capital intensive the firm is (high capital intensity firms will tend to have lower V/EBITDAratios), and how much reinvestment is needed to keep the business going and create growth

How high or low the cost of capital is (higher cost of capital having lower EV/EBITDA ratios)

How high or low expected growth in the sector (high growth sectors tend to have higherEV/EBITDA ratios)

We also need to ask specific questions of companies that may seem to beundervalued:

Is operating income next year expected to be significantly lower than this years

Does the firm have significant capex coming up?

Does the firm face a much higher tax rate than other firms in the sector?

Some important questions to ask of low EV/EBITDA firms

8. Dividend YieldDefinition


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Trailing dividend yield is generally calculated as four times the most recent

quarterly per share dividend divided by the current market price per share.

Leading dividend yield is calculated as forecasted dividends per share over thenext year divided by the current market price per share.

Consistency Test:

Ensure the time period of computation.

Is it next financial year or next 4 quarters?

Dividend Yield (2)Rationale & Drawbacks


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Rationale for using Dividend Yield

A component of total return

Less volatile component of total return

Drawbacks

Not using all information is suboptimal

Trade-off between payout now and future (dividend displacement of earnings)

Relative safety of dividends a strong assumption

Is dividend relatively safer than price?

Dividend Yield (3)Determinants


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To see the determinants of dividend yield, consider:

Dividend yield is:

Negatively related to growth rate

Positively related to the stocks required rate of return

Value vs. growth choosing high dividend yield stocks is consistent with valueorientation.

g1D

0

0

gr

P

Choosing Between the Multiples

Th d f lti l th t t ti ll b d t l i di id l


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There are dozens of multiples that can potentially be used to value an individualfirm.

Relative valuation can be relative to a sector (or comparable firms) or to theentire market (using regressions for example).

Since there can only be one final estimate of value, there are three choices:

Use a simple average of the valuations obtained using a number of differentmultiples.

Use a weighted average of the valuations obtained using a number of differentmultiples.

Choose one of the multiples and base your valuation on that multiple.

If there is a clear rationale, we should choose one of the multiples.

Picking One Multiple


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This is usually the best way to approach this issue. While a range of values can

be obtained from a number of multiples, the best estimate is obtained usingone multiple.

The multiple that is used can be chosen in one of two ways:

Use a multiple that best fits your objective. Thus, if you want the company to beundervalued, pick the multiple that yields the highest value.

Use the multiple that has the highest R-squared in the sector, when regressedagainst fundamentals. Thus if you have tried PE, PBV, PS etc. and run regressionsof these multiples against the fundamentals, use the multiple that works best atexplaining differences across firms in that sector.

Use the multiple that makes the most sense for that sector, given how value ismeasured and created.

Use the multiple that makes the most sense.

Self Serving Choice of Multiple


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When a firm is valued using several multiples, some will yield really high values

and some really low ones. If there is a significant bias in the valuation towards high or low values, it is

tempting to pick the multiple that best reflects this bias. One the multiple thatworks best is picked, the other multiples can be abandoned and never broughtup.

This approach, while yielding very biased and often absurd valuations, mayserve other purposes very well.

As a user of valuation, you should ask the following questions:

Why was this multiple chosen?

What would be the value if a different multiple was used?

Always ask why a multiple was chosen!

Problems with the Statistical Approach


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One of the advantages of running regressions of multiples againstfundamentals across firms in a sector is that you get R-squared values (thatprovide information on how well fundamentals explain differences acrossmultiples in that sector).

As a rule, it is dangerous to use multiples where valuation fundamentals (cashflows, risk and growth) do not explain a significant portion of the differences

across firms in the sector. As a caveat, it is not necessarily true that the multiple that has the highest R-

squared provides the best estimate of value for firms in a sector.

High R-squared is no guarantee

Intuitive Approach


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As a general rule of thumb, the following provides a way of picking a multiple fora sector:

Check that the rationale have not changed

Sector Multiple Used Rationale

Cyclical Manufacturing PE, Relative PE Often with normalized earnings

High Tech, High Growth PEG Big differences in growth across firms

High Growth/No Earnings PS, VS Assume future margins will be good

Heavy Infrastructure VEBITDA Firms in sector have losses in earlyyears and reported earnings can varydepending on depreciation method

REITs P/CF Generally no capex investments fromequity earnings

Financial Services PBV Book value often marked to market

Retailing PS If leverage is similar across firms

VS If leverage is different

Sector or Market Multiples


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The conventional approach to using multiples is to look at the sector orcomparable firms.

Whether sector or market based multiples make the most sense depends onhow you think mistakes are made in valuation:

If mistakes are at the individual firm level, but tends to be right on average at thesector level, then you should use sector-based valuation only

If mistakes are made on entire sectors, but right at the overall market level, youshould use market-based valuation

It is usually a good idea to approach valuation at two levels:

Check if firm is under or over-valued at the sector level

Check if the under or over valuation persists after you have corrected for sectorunder or over-valuation.

Check if the mistake is at the firm or sector level

A Possible Situation


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You have valued Pacific Internet, an ISP relative to other internet companiesusing PS ratios and found it to be under-valued almost 50%. When you value itrelative to the market, using a market regression, you find it to be overvalued byalmost 50%. How would you reconcile the two findings?

One of the two valuations must be wrong. A stock cannot be under andover valued at the same time

It is possible that both valuations are right.

What has to be true about valuation in the sector for the second statement to becorrect?

You can be over and under-valued at the same time

fnce203 l10%2611 relative valuation s22010

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