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Intrinsic Value (PowerPoint download)

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					BM409 Investment Management Academy




         Valuation 7:
    Relative Value Models
                Objectives

 A. Understand how we apply relative value
  models




                      2
          Relative Value Models

 We have developed a framework for valuation that
  includes key models and metrics. Key valuation models
  fall under four main types. They are:
   • 1. Intrinsic Value models
   • 2. Relative Value models
   • 3. Acquisition/Breakup models
   • 4. Technical models
   • 5. Quantitative/other models
 The first three classes are fundamental models. Within
  each of these models, there are many different types of
  models that can and are being used. We will explain the
  models we use in this class.                              3
          Relative Value Models

 We currently use three relative value models in
  our research
 1. Relative value versus the S&P 500
   • You will compare your company versus the
     S&P500
      • How has it traded historically versus the S&P?
      • You set the Buy and Sell range for where you
        would buy and sell security
         • Your buy and sell range will give you a
           target buy and sell price
                                                         4
    Relative Value Models (continued)

 2. Relative value versus the S&P 500 Industry
  Sector
   • You will comparing the relative value of your
     company versus the S&P500 industry sector
     benchmark
      • How has it traded historically versus the sector?
      • You set the Buy and Sell range for where you
        would buy and sell security
         • Your buy and sell range will give you a
           target buy and sell price

                                                            5
    Relative Value Models (continued)

 3. Relative value versus select peers
   • You will compare the relative value of your
     company to a portfolio of peer companies that you
     choose
      • We use ten different metrics:
          • PTNI, PTB, PTGP PTS, PTEBITDA,
            EVTNI, EVTB, EVTGP, EVTS, and
            EVTEBITDA
      • We then calculate these metrics for up to 10
        companies of your choice.
          • Based on averages for the companies, you
            can calculate the price of your company      6

            based on the average metrics of the peers
        Relative Valuation Models

 What are relative valuation models?
   • Models which provide information about how the
     market is currently valuing stocks at several levels:
      • The market level
      • The industry level, and
      • Comparative stocks in the same industry space
         • These are often called “comps” or
           “comparables” of similar companies or
           industries


                                                             7
         Relative Valuation (continued)

 What is relative value?
  • It is the value of the company relative to other
    stocks, or stocks in the same market or industry
 Which relative valuation methods are used most often?
  • Generally, the most used in the industry is Price
    Earnings. However, PTNI, PTB, PTGP PTS,
    PTEBITDA, EVTNI, EVTB, EVTGP, EVTS, and
    EVTEBITDA are also used




                                                          8
          Relative Valuation (continued)

 How do you use relative valuation methods?
   • You compare your company’s valuation ratio to the
      market, industry, its history, or other companies
   • If you notice a change in relative valuation, i.e. it is
      cheaper (expensive) than it has been historically, it
      may signal it may be a buy (sell) assuming no other
      major changes in the company and industry
 In the Apple case, we used PE relative to the market.
  Can we use price earnings relative to the industry?
   • Yes, although it is harder to find good forecast data
      on the industry, as most industry indices do not
      have forecasts.                                           9
       Relative Valuation (continued)

 How do I determine my buy and sell range?
  • This is one of the most difficult challenges of being
    an analyst. Here is where the art comes in!
     • Look to company history
         • If the company has traditionally traded in a
           tight range, the likelihood is that it will
           continue
         • If your company is volatile, it will be more
           difficult
             • You will need to make the best decision
                you can
                                                            10
  Relative Valuation (continued)

• I always recommend using wisdom and
  judgment
    • Determine whether you think it’s a buy, sell
      or hold, then set your relative value
      consistent with that view
        • Make sure you have other factors
          supporting your decision




                                                     11
  1. Relative Value versus S&P 500

 What is the process for relative value?
   • The process is the same, whether you calculate
     relative value versus the S&P 500 Index or versus
     the S&P Industry Indices
 What is that process?
   • It is a seven-step process
   • 1. Calculate your PE for your company historically
     and for your forecast period
       • You do this in your Financials Tab, Exhibit 4
         Section 2: Price/Earnings
       • This calculates your company PE for both the
                                                          12
         historical and forecast periods
Relative PE Versus the S&P 500 (continued)

  2. Calculate your PE for the S&P 500 index
   historically and for the forecast period
       • You do this in your Financials Tab, Exhibit 4
         Section 18: S&P500 Market Price/Earnings
           • This is why you added this data
       • You have already calculated your S&P 500 PE
         for both the historical and forecast periods




                                                         13
Relative PE Versus the S&P 500 (continued)

  3. Calculate the relative PE (i.e. the company
   PE / market PE) for all periods
    • You do this in your Financials Tab, Exhibit 4
      Section 3: Relative PE Versus the S&P500 Market
      PE
       • You have already calculated your company PE
         for both the historical and forecast periods and
         the S&P 500 PE for both the historical and
         forecast periods
           • Now just divide them
    • This gives how your company has performed (on a
      PE basis) versus the S&P 500 Index                    14
Relative PE Versus the S&P 500 (continued)

  4. Look at the trend for the relative PE
    • Has it historically traded at a discount (relative PE <
      1.0) or premium (relative PE . 1.0) to the market
    • What does it look like in the forecast period?
       • Is it still in that same range




                                                                15
Relative PE Versus the S&P 500 (continued)

  5. Determine your sell differential over your
   buy
    • What is the range, relative to the S&P 500 Index,
      that you would sell the stock
        • It is in percentage or relative terms
             • Your price to sell divided by your price to
               buy gives you your potential gains in the
               stock
                 • The tighter this range, the lower your
                   potential upside

                                                             16
Relative PE Versus the S&P 500 (continued)

  6. Based on that trend, determine what you
   consider to be a fair relative PE range
    • This tells at what relative PE would you buy the
      stock, and at what relative PE would you sell the
      stock
        • This is a critical decision
  7. Calculate your relative buy and sell ranges
       • The formula is:
           • Relative PE range * market PE * firm EPS =
             Future Price
       • We actually take the average of the buy prices   17
         for each of the forecast years
2. Relative PE Versus the Industry Index

 This type of relative value model follows the
  exact format as the Relative Value versus the
  S&P 500 Index
   • The process is the same
   • The framework is the same
   • The only difference is that instead of using the S&P
     500 Index, you are using your Industry Index




                                                            18
    Limitations of Relative Valuation
                 Models
 When is it most appropriate to use RVM?
  • When you have a good set of comparables, i.e.
    industries/companies in terms of size and risk
  • When the aggregate market is not at a valuation
    extreme, i.e. it is neither over or undervalued
 When are they inappropriate?
  • When you have poor comparables
  • The current market level is at extremes.
      • If you compare the value of a company to the
        very overvalued market, you might believe it is
        cheap. However, you may be wrong as company
                                                          19
        may be fully valued and the benchmark, the
        market, is overvalued.
         Review of Objectives
 A. Do you understand the importance of relative
  valuation models?




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posted:3/10/2012
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