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Relative Valuation 1 Why relative valuation? “If you think I’m crazy, you should see the h lives across th h ll” guy who li the hall” Jerry Seinfeld talking about Kramer in a Seinfeld episode “ A little inaccuracy sometimes saves tons of explanation” H.H. Munro 2 What is relative valuation? • In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. • To do relative valuation then, – we need to identify comparable assets and obtain market values for these assets – convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price multiples. – compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or over valued 3 Standardizing Value • 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 and Relative PE) • Value/EBIT • Value/EBITDA • Value/Cash Flow – Book Value Multiples • Price/Book Value(of Equity) (PBV) • Value/ Book Value of Assets • Value/Replacement Cost (Tobin’s Q) – Revenues • Price/Sales per Share (PS) • Value/Sales – Industry Specific Variable (Price/kwh, Price per ton of steel ....) 4 The Four Steps to Understanding Multiples • Define the multiple – In use, the same multiple can be defined in different ways by different users. When comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated • Describe the multiple – Too many people who use a multiple have no idea what its cross sectional distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low. • Analyze the multiple – It is critical that we understand the fundamentals that drive each multiple, and the nature of the relationship between the multiple and each variable. • Apply the multiple – Defining the comparable universe and controlling for differences is far 5 more difficult in practice than it is in theory. Definitional Tests • Is the multiple consistently defined? – Proposition 1: Both the value (the numerator) and the p ( ) standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. • Is the multiple uniformally estimated? – The variables used in defining the multiple should be estimated uniformly across assets in the “comparable firm” list. – If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets. The same rule applies with book-value based multiples. 6 Descriptive Tests • What is the average and standard deviation for this multiple, across the universe (market)? • What is the median for this multiple? – The median for this multiple is often a more reliable comparison point. • How large are the outliers to the distribution, and how do we deal with the outliers? – Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate. • Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? • How has this multiple changed over time? 7 Analytical Tests • What are the fundamentals that determine and drive these multiples? – Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. – In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive 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. For example, if firm A has twice the g , g y growth rate of firm B, it will generally not trade at twice its PE ratio – Proposition 3: It is impossible to properly compare firms on a multiple, if we do not know the nature of the relationship between fundamentals and the multiple. 8 Application Tests • Given the firm that we are valuing, what is a “comparable” firm? – While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals. – Proposition 4: There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics. • Given the comparable firms, how do we adjust for differences across firms on the fundamentals? – Proposition 5: It is impossible to find an exactly identical firm to the one you are valuing. 9 Price Earnings Ratio: Definition 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: is usually the current price is sometimes the average price for the year • EPS: 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 10 PE Ratio: Descriptive Statistics Distribution of PE Ratios - September 2001 1200 1000 800 Current PE 600 Trailing PE Forward PE 400 200 0 0-4 4-6 6-8 8 - 10 10 - 15 15-20 20-25 25-30 30-35 35-40 40 - 45 45- 50 50 -75 75 - > 100 100 PE ratio 11 PE: Deciphering the Distribution Current PE Trailing PE Forward PE Mean 30.93 30 93 30.33 30 33 21 13 21.13 Standard Error 2.70 2.74 0.73 Median 15.27 15.20 13.71 Mode 10 0 14 Standard Devia 157.30 150.65 38.22 Kurtosis 795.82 1615.73 224.85 Skewness 26.28 36.04 12.97 Range 5370.00 7090.50 864.91 Maximum 5370.00 7090.50 865.00 Count 3387 3021 2737 12 PE Ratio: Understanding the Fundamentals • To understand the fundamentals, start with a model. basic equity discounted cash flow model • With the dividend discount model, DPS1 P0 r gn • Dividing both sides by the earnings per share, P0 Payout Ratio * (1 g n ) PE = EPS 0 r-gn • If this had been a FCFE Model, FCFE 1 P0 (FCFE/Earnings) * (1 g n ) P0 PE = r gn EPS0 r-g n 13 PE Ratio and Fundamentals • Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms. • Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms • Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.rates • Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rats. 14 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 50 45 40 35 30 g=25% g=20% 25 g=15% g=8% 20 15 10 5 0 0.75 1.00 1.25 1.50 1.75 2.00 Beta 15 PE: Emerging Markets 35 30 25 20 15 10 5 0 Mexico Malaysia Singapore Taiwan Hong Kong Venezuela Brazil Argentina Chile 16 Comparisons across countries • In July 2000, a market strategist is making the t th t B il d Venezuela th argument that Brazil and V l are cheap relative to Chile, because they have much lower PE ratios. Would you agree? Yes No • What are some of the factors that may cause one market’s PE ratios to be lower 17 than another market’s PE? Correlations and Regression of PE Ratios • Correlations g – Correlation between PE ratio and long term interest rates = - 0.733 – Correlation between PE ratio and yield spread = 0.706 • Regression Results PE Ratio = 42.62 - 3.61 (10’yr rate) + 8.47 (10-yr - 2 yr rate) R2 = 59% Input the interest rates as percent. For instance, the predicted PE ratio for Japan with this regression would be: PE: Japan = 42.62 - 3.61 (1.85) + 8.47 (1.27) = 46.70 At an actual PE ratio of 52.25, Japanese stocks are slightly overvalued. 18 Predicted PE Ratios Country Actual PE Predicted PE Under or Over V UK 22.02 20.83 5.71% Germany 26.33 25.62 2.76% France 29.04 25.98 11.80% Switzerland 19.6 30.58 -35.90% Belgium 14.74 26.71 -44.81% Italy 28.23 25.69 9.89% Sweden 32.39 28.63 13.12% Netherlands 21.1 21 1 26.01 26 01 18 88% -18.88% Australia 21.69 19.73 9.96% Japan 52.25 46.70 11.89% United States 25.14 19.81 26.88% Canada 26.14 22.39 16.75% 19 An Example with Emerging Markets: June 2000 Country PE Ratio Interest GDP Real Country Rates Growth Risk Argentina 14 18.00% 2.50% 45 Brazil 21 14.00% 4.80% 35 Chile 25 9.50% 5.50% 15 Hong Kong 20 8.00% 6.00% 15 India 17 11.48% 4.20% 25 Indonesia 15 21.00% 4.00% 50 Malaysia 14 5.67% 3.00% 40 Mexico 19 11.50% 5.50% 30 Pakistan 14 19.00% 3.00% 45 Peru 15 18.00% 4.90% 50 Phillipines 15 17.00% 3.80% 45 Singapore 24 6.50% 5.20% 5 South Korea 21 10.00% 4.80% 25 Thailand 21 12.75% 5.50% 25 Turkey 12 25.00% 2.00% 35 Venezuela 20 15.00% 3.50% 45 20 Regression Results • The regression of PE ratios on these i bl id the following variables provides th f ll i – PE = 16.16 - 7.94 Interest Rates + 154.40 Growth in GDP - 0.1116 Country Risk R Squared = 73% 21 Predicted PE Ratios Country PE Ratio Interest GDP Real Country Predicted PE Rates Growth Risk Argentina 14 18.00% 2.50% 45 13.57 Brazil 21 14.00% 4.80% 35 18.55 Chile 25 9.50% 5.50% 15 22.22 Hong Kong 20 8.00% 6.00% 15 23.11 India 17 11.48% 4.20% 25 18.94 Indonesia 15 21.00% 4.00% 50 15.09 Malaysia 14 5.67% 3.00% 40 15.87 Mexico 19 11.50% 5.50% 30 20.39 Pakistan 14 19.00% 3.00% 45 14.26 Peru 15 18.00% 4.90% 50 16.71 Phillipines 15 17.00% 3.80% 45 15.65 Singapore 24 6.50% 5.20% 5 23.11 South Korea 21 10.00% 4.80% 25 19.98 Thailand 21 12.75% 5.50% 25 20.85 Turkey 12 25.00% 2.00% 35 13.35 Venezuela 20 15.00% 3.50% 45 15.35 22 Comparisons of PE across time: PE Ratio for the S&P 500 PE Ratio: 1960-2000 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 23 Is low (high) PE cheap (expensive)? • A market strategist argues that stocks are i d because th PE ratio t d i over priced b the ti today is too high relative to the average PE ratio across time. Do you agree? Yes No • If you do not agree, what factors might explain the higer PE ratio today? 24 E/P Ratios , T.Bond Rates and Term Structure 16.00% 14.00% 14 00% 12.00% 10.00% 8.00% Earnings Yield T.Bond Rate Bond-Bill 6.00% 4.00% 4 00% 2.00% 0.00% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 -2.00% 25 Comparing PE ratios across firms Company Name Trailing PE Expected Growth Standard Dev Coca-Cola Bottling 29.18 9.50% 20.58% Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% Anheuser Busch Anheuser-Busch 24.31 24 31 11 00% 11.00% 22 92% 22.92% Corby Distilleries Ltd. 16.24 7.50% 23.66% Chalone Wine Group Ltd. 21.76 14.00% 24.08% Andres Wines Ltd. '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% Boston Beer 'A' 10.59 17.13% 39.58% Whitman Corp. 25.19 11.50% 44.26% Mondavi (Robert) 'A' 16.47 14.00% 45.84% Coca-Cola Enterprises 37.14 27.00% 51.34% Hansen Natural Corp 9.70 17.00% 62.45% 26 A Question You are reading an equity research report this t d the l t l i that on thi sector, and th analyst claims th t Andres Wine and Hansen Natural are under valued because they have low PE ratios. Would you agree? Yes No • Why or why not? 27 Comparing PE Ratios across a Sector Company Name PE Growth PT Indosat ADR 7.8 0.06 Telebras ADR 8.9 0.075 Telecom Corporation of New Zealand ADR p 11.2 0.11 Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08 Hellenic Telecommunication Organization SA ADR 12.8 0.12 Telecomunicaciones de Chile ADR 16.6 0.08 Swisscom AG ADR 18.3 0.11 Asia Satellite Telecom Holdings ADR 19.6 0.16 Portugal Telecom SA ADR 20.8 0.13 Telefonos de Mexico ADR L 21.1 0.14 Matav RT ADR 21.5 0.22 Telstra ADR 21.7 0.12 Gilat Communications 22.7 0.31 Deutsche Telekom AG ADR 24.6 0.11 British Telecommunications PLC ADR 25.7 0.07 Tele Danmark AS ADR 27 0.09 Telekomunikasi Indonesia ADR 28.4 0.32 Cable & Wireless PLC ADR 29.8 0.14 APT Satellite Holdings ADR 31 0.33 Telefonica SA ADR 32.5 0.18 Royal KPN NV ADR 35.7 0.13 Telecom Italia SPA ADR 42.2 0.14 Nippon Telegraph & Telephone ADR 44.3 0.2 France Telecom SA ADR 45.2 0.19 Korea Telecom ADR 71.3 0.44 28 PE, Growth and Risk Dependent variable is: PE R squared = 66.2% R squared (adjusted) = 63.1% Variable Coefficient SE t-ratio prob Constant 13.1151 3.471 3.78 0.0010 Growth rate 121.223 19.27 6.29 ≤ 0.0001 Emerging Market -13.8531 3.606 -3.84 0.0009 Emerging Market is a dummy: 1 if emerging market 0 if not 29 Is Telebras under valued? • Predicted PE = 13.12 + 121.22 (.075) - 13.85 8.35 13 85 (1) = 8 35 • At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued. 30 Using comparable firms- Pros and Cons • The most common approach to estimating the PE ratio for a firm is g p p – 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 valued and the comparable firms. • Problems with this approach. – The definition of a 'comparable' firm is essentially a subjective one. – The use of other firms in the industry as the control group is often not a solution because firms within the same industry can have very different business mixes and risk and growth profiles. – There is also plenty of potential for bias. – Even when a legitimate group of comparable firms can be constructed, differences will continue to persist in fundamentals31 between the firm being valued and this group. Using the entire crosssection: A regression approach • In contrast to the 'comparable firm' h the information i th entire approach, th i f ti in the ti cross-section of firms can be used to predict PE ratios. • The simplest way of summarizing this information is with a multiple regression, with the PE ratio as the dependent variable, and proxies for risk, growth and payout forming the independent variables. 32 PE versus Growth 120 100 80 60 40 20 0 -20 -20 0 20 40 60 80 100 Expected Growth in EPS: next 5 years 33 PE Ratio: Standard Regression Model Summary Adj t d R Adjusted Std. E f Std Error of Model R R Square Square the Estimate 1 .478 a .229 .227 803.9541 a. Predictors: (Constant), Expected Growth in EPS: next 5 y, PAYOUT1, Beta Coefficients a,b Standar Unstandardized dized Coefficients Coe c e ts Coe c e ts Coefficients Model B Std. Error Beta t Sig. 1 (Constant) 13.090 1.164 11.242 .000 Beta -3.392 .908 -.089 -3.737 .000 PAYOUT1 4.938 1.190 .098 4.150 .000 Expected Growth .880 .040 .527 22.115 .000 in EPS: next 5 y a. Dependent Variable: Current PE b. Weighted Least Squares Regression - Weighted by Market Cap 34 Second Thoughts? • Based on this regression, estimate the PE ratio for a firm with no growth, no payout and no risk. • Is there a problem with your prediction? 35 PE Regression- No Intercept Model Summary Adjusted R Std. Error of a Model R q R Square q Square the Estimate 1 .912 b .832 .832 833.0224 a. For regression through the origin (the no-intercept model), R Square measures the proportion of the variability in the dependent variable about the origin explained by regression. This CANNOT be compared to R Square for models which include an intercept. b. Predictors: Expected Growth in EPS: next 5 y, PAYOUT1, Beta Coefficients a,b,c Standar Unstandardized dized Coefficients Coefficients Model B Std. Error Beta t Sig. 1 Beta 4.389 .609 .188 7.212 .000 PAYOUT1 13.299 .962 .189 13.823 .000 Expected Growth 1.014 .039 .608 25.786 .000 in EPS: next 5 y a. Dependent Variable: Current PE b. Linear Regression through the Origin c. Weighted Least Squares Regression - Weighted by Market Cap 36 Problems with the regression methodology • The basic regression assumes a linear relationship between PE ratios and the financial proxies, and that might not be appropriate. • The basic relationship between PE ratios and financial variables itself might not be stable, and if it shifts from year to year, the predictions from the model may not be reliable. • The independent variables are correlated with each other. For example, high growth firms tend to have high risk. This multi-collinearity makes the coefficients of the regressions unreliable and may explain the large changes in these coefficients from period to period. 37 The Multicollinearity Problem Correlations Expected Growth in EPS: Current PE next 5 y Beta Payout Ratio Current PE Pearson Correlation 1.000 .342 ** .130 ** .009 Sig. (2-tailed) . .000 .000 .594 N 3303 2085 3027 3290 Expected Growth Pearson Correlation .342 ** 1.000 .397 ** -.078 ** in EPS: next 5 y Sig. (2-tailed) .000 . .000 .000 N 2085 2675 2393 2143 Beta Pearson Correlation .130 ** .397 ** 1.000 -.213 ** Sig (2-tailed) Sig. 000 .000 .000 000 . 000 .000 N 3027 2393 4534 3114 Payout Ratio Pearson Correlation .009 -.078 ** -.213 ** 1.000 Sig. (2-tailed) .594 .000 .000 . N 3290 2143 3114 3388 **. Correlation is significant at the 0.01 level (2-tailed). 38 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 1.40 and pays no dividends. Based upon the regression, estimate the predicted PE ratio for Dell. Predicted PE = (Work with absolute values in regression - 10 for 10% etc.) • Dell is actually trading at 18 times earnings. What does the predicted PE tell you? 39 Investment Strategies that compare PE to the 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 undervalued stocks. • Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify under and overvalued stocks. – In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. – In its more general form, the ratio of PE ratio to growth is used as a measure of relative value. 40 Problems with comparing PE ratios to expected growth • In its simple form, there is no basis for believing that a firm is undervalued just because it has a PE ratio less than expected growth. • This relationship may be consistent with a fairly valued or even an overvalued firm, if interest rates are high, or if a firm is high risk. • As interest rate decrease (increase), fewer (more) stocks approach. will emerge as undervalued using this approach 41 PE Ratio versus Growth - The Effect of Interest rates: Average Risk firm with 25% growth for 5 years; 8% thereafter Figure 14.2: PE Ratios and T.Bond Rates 45 40 35 30 25 20 15 10 5 0 5% 6% 7% 8% 9% 10% T.Bond Rate 42 PEG Ratio: 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 t ti t ? rate estimate? • No double counting: If the estimate of growth in earnings per share is from the current year, 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 ratio consistent with the growth rate estimate? (US analysts use the ADR EPS) 43 PEG Ratio: Distribution 400 300 200 100 Std Dev = 1 05 Std. D 1.05 Mean = 1.55 0 N = 2084.00 Price/ Expected Growth RAte 44 PEG Ratios: The Beverage Sector Company Name Trailing PE Growth Std Dev PEG Coca-Cola Bottling 29.18 9.50% 20.58% 3.07 Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82 Anheuser-Busch 24.31 11.00% 22.92% 2.21 Corby Distilleries Ltd. y 16.24 7.50% 23.66% 2.16 Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55 Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56 Todhunter Int'l 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 A 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% 1.18 Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38 Hansen Natural Corp 9.70 17.00% 62.45% 0.57 Average 22.66 0.13 0.33 2.00 45 PEG Ratio: Reading the Numbers • The average PEG ratio for the beverage t i 2.00. The lowest PEG ratio i th sector is 2 00 Th l t ti in the group belongs to Hansen Natural, which has a PEG ratio of 0.57. Using this measure of value, Hansen Natural is the most under valued stock in the group the most over valued stock in the group • What other explanation could there be for Hansen’s low PEG ratio? 46 PEG Ratios and Fundamentals • Risk and payout, which affect PE ratios, ti to ff t ti ll continue t affect PEG ratios as well. – Implication: When comparing PEG ratios across companies, we are making implicit or explicit assumptions about these variables. • Dividing PE by expected growth does not neutralize the effects of expected growth, since the relationship between growth and value is not linear and fairly complex (even in a 2-stage model) 47 PEG Ratios and Risk PEG Ratios and Beta: Different Growth Rates 3 2.5 2 g =25% g=20% 1.5 g=15% g=8% 1 0.5 0 0.75 1.00 1.25 1.50 1.75 2.00 Beta 48 PEG Ratios and Quality of Growth PEG Ratios and Retention Ratios 1.4 1.2 1 0.8 PEG 0.6 0.4 0.2 0 1 0.8 0.6 0.4 0.2 0 Retention Ratio 49 PE Ratios and Expected Growth PEG Ratios, Expected Growth and Interest Rates 2.50 2.00 1.50 r=6% r=8% r=10% 1.00 0.50 0.00 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Expected Growth Rate 50 PEG Ratios and Fundamentals: Propositions • Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate. – Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector • Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently. – Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns. • Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks. – Corollary 3: PEG ratios do not neutralize the growth effect. 51 PE, PEG Ratios and Risk 45 2.5 40 2 35 30 1.5 25 PE PEG Ratio 20 1 15 10 0.5 5 0 0 Lowest 2 3 4 Highest 52 PEG Ratio: Returning to the Beverage Sector Company Name Trailing PE Growth Std Dev PEG Coca-Cola Bottling 29.18 9.50% 20.58% 3.07 Molson Inc. Ltd. 'A' 43.65 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 Ltd. 21.76 21 76 14 00% 14.00% 24 08% 24.08% 1 55 1.55 Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56 Todhunter Int'l 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 Corp. Whitman Corp 25.19 25 19 11.50% 11 50% 44.26% 44 26% 2 19 2.19 Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18 Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38 Hansen Natural Corp 9.70 17.00% 62.45% 0.57 Average 22.66 0.13 0.33 2.00 53 Analyzing PE/Growth • Given that the PEG ratio is still determined by the expected growth rates, risk and cash flow patterns, it is necessary that we control for differences in these variables. • Regressing PEG against risk and a measure of the growth dispersion, we get: PEG = 3.61 - 2.86 (Expected Growth) - 3.75 (Std Deviation in Prices) R Squared = 44.75% • In other words, – PEG ratios will be lower for high growth companies – PEG ratios will be lower for high risk companies • We also ran the regression using the deviation of the actual growth rate from the industry-average growth rate as the independent variable, with mixed results. 54 Estimating the PEG Ratio for Hansen • Applying this regression to Hansen, the predicted PEG ratio for the firm can be estimated using Hansen’s measures for the independent variables: – Expected Growth Rate = 17.00% – Standard Deviation in Stock Prices = 62.45% • Plugging in, Expected PEG Ratio for Hansen = 3.61 - 2.86 (.17) - 3.75 (.6245) = 0.78 0 57 undervalued, • With its actual PEG ratio of 0.57, Hansen looks undervalued notwithstanding its high risk. 55 Extending the Comparables • This analysis, which is restricted to firms in the ft t b d dt th software sector, can be expanded to include all firms in the firm, as long as we control for differences in risk, growth and payout. • To look at the cross sectional relationship, we first plotted PEG ratios against expected growth rates. 56 A Variant on PEG Ratio: The PEGY ratio • The PEG ratio is biased against low growth firms because the relationship between value and growth is non-linear. One variant that has been devised to consolidate the growth rate and the expected dividend yield: PEGY = PE / (Expected Growth Rate + Dividend Yield) • As an example, Con Ed has a PE ratio of 16, an expected growth rate of 5% in earnings and a dividend yield of 4.5%. – PEG = 16/ 5 = 3.2 – PEGY = 16/(5+4.5) = 1.7 57 Relative PE: Definition • The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market. Relative PE = PE of Firm / PE of Market • While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market. time. Thus, • Relative PE ratios are usually compared over time Thus a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7. 58 Relative PE and Relative Risk Relative PE and Relative Risk: Stable Beta Scenarios 4.5 4 3.5 3 2.5 Beta stays at current level Beta drops to 1 in stable phase 2 15 1.5 1 0.5 0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 59 Relative PE: Summary of Determinants • The relative PE ratio of a firm is determined by two variables. In particular, it will – increase as the firm’s growth rate relative to the market increases. The rate of change in the relative PE will itself be a function of the market growth rate, with much greater changes when the market growth rate is higher. In other words, a firm or sector with a growth rate twice that of the market will have a much higher relative PE when the market growth rate is 10% than when it is 5%. – decrease as the f firm’s risk relative to the market increases. The extent of the decrease depends upon how long the firm is expected to stay at this level of relative risk. If the different is permanent, the effect is much greater. • Relative PE ratios seem to be unaffected by the level of rates, which might give them a decided advantage over PE ratios. 60 Relative PE Ratios: The Auto Sector Relative PE Ratios: Auto Stocks 1.20 1.00 0.80 Ford 0.60 Chrysler GM 0.40 0 40 0.20 0.00 1993 1994 1995 1996 1997 1998 1999 2000 61 Relative PEs: Why do they change? • Historically, GM has traded at the highest l ti ti f the three auto relative PE ratio of th th t companies, and Chrysler has traded at the lowest. In the last two or three years, this historical relationship has been upended with Ford and Chrysler now trading at the higher ratios than GM. Analyst projections for earnings growth at the three companies are about the same. How would you explain the shift? 62 Value/Earnings and Value/Cashflow Ratios • 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 f th fi l ti to ti of the firm relative t operating earnings. V l t cash fl i Value to ti dif h flow ratios modify the earnings number to make it a cash flow number. • The form of value to cash flow ratios that has the closest parallels in DCF valuation is the value to Free Cash Flow to the Firm, which is defined as: Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash) EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC • Consistency Tests: used – If the numerator is net of cash (or if net debt is used, then the interest income from the cash should not be in denominator – The interest expenses added back to get to EBIT should correspond to the debt in the numerator. If only long term debt is considered, only long term interest should be added back. 63 Value/FCFF Distribution 800 600 400 200 Std. 21.77 Std Dev = 21 77 Mean = 20.6 0 N = 3063.00 Enterprise Value/FCFF 64 Alternatives to FCFF - EBIT and EBITDA • Most analysts find FCFF to complex or messy to use in multiples (partly because capital expenditures and working capital have to be estimated). They use modified versions 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, where any non-operating expenses and income is removed from the EBIT – EBITDA, which is earnings before interest, taxes, depreciation and amortization. 65 Reasons for Increased Use of Value/EBITDA 1. The multiple can be computed even for firms that are reporting net losses, since earnings before interest, taxes and depreciation are usually positive. 2. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio. 3. In leveraged buyouts, where the key factor is cash generated by the firm prior to all discretionary expenditures, the EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term. 4. By looking at cashflows prior to capital expenditures, it may provide a better estimate of “optimal value”, especially if the capital expenditures are unwise or earn substandard returns. 5. By looking at the value of the firm and cashflows to the firm it allows for comparisons across firms with different financial leverage. 66 Value/EBITDA Multiple • The Classic Definition Value Market Value of Equity + Market Value of Debt EBITDA Earnings before Interest, Taxes and Depreciation • The No-Cash Version Enterprise 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. 67 The Determinants of Value/EBITDA Multiples: Linkage to DCF Valuation • Firm value can be written as: FCFF1 V0 = WACC - g • The numerator can be written as follows: FCFF = EBIT (1-t) - (Cex - Depr) - Working Capital = (EBITDA - Depr) (1-t) - (Cex - Depr) - Working Capital = EBITDA ( ) + Depr ( ) - C - Working C (1-t) (t) Cex Capital 68 From Firm Value to EBITDA Multiples • Now the Value of the firm can be rewritten as, EBITDA (1 - t) + Depr (t) - Cex - Working Capital Value = WACC - g f • Dividing both sides of the equation by EBITDA, Value (1- t) Depr (t)/EBITDA CEx/EBITDA Working Capital/EBITDA = + - - EBITDA WACC - g WACC -g WACC - g WACC - g 69 A Simple Example • Consider a firm with the following h t i ti characteristics: – Tax Rate = 36% – Capital Expenditures/EBITDA = 30% – Depreciation/EBITDA = 20% – Cost of Capital = 10% – The firm has no working capital requirements – The firm is in stable growth and is expected to grow 5% a year forever. 70 Calculating Value/EBITDA Multiple • In this case, the Value/EBITDA multiple for this fi b ti t d follows: thi firm can be estimated as f ll Value (1 - .36) (0.2)(.36) 0.3 0 = + - - = 8.24 EBITDA .10 - .05 .10 - .05 .10 - .05 .10 - .05 71 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 Yellow Corp. $ 931.47 $ 292.82 3.18 Roadway 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 3.78 Trimac 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 56.92 $ 8 79 8.79 6 47 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 Swift Transportation $ 835.58 $ 121.34 6.89 Landair Services $ 212.95 $ 30.38 7.01 CNF Transportation $ 2,700.69 $ 366.99 7.36 Budget 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 Average 5.61 72 A Test on EBITDA • Ryder System looks very cheap on a Value/EBITDA lti l basis, l ti to V l /EBITDA multiple b i relative t the rest of the sector. What explanation (other than misvaluation) might there be for this difference? 73 Analyzing the Value/EBITDA Multiple • While low value/EBITDA multiples may be a symptom of undervaluation, a few questions need to be answered: – Is the operating income next year expected to be significantly lower than the EBITDA for the most recent period? (Price may have dropped) – Does the firm have significant capital expenditures coming up? (In the trucking business, the life of the 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? 74 Value/EBITDA Multiples: Market • The multiple of value to EBITDA varies widely across firms in the market, depending upon: – how capital intensive the firm is (high capital intensity firms will tend to have lower value/EBITDA ratios), and how much reinvestment is needed to keep the business going and create growth – how high or low the cost of capital is (higher costs of capital will lead to lower Value/EBITDA multiples) – how high or low expected growth is in the sector (high growth sectors will tend to have higher Value/EBITDA multiples) 75 Price-Book Value Ratio: 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. • Price/Book Value = Market Value of Equity Book Value of Equity • Consistency Tests: – If the market value of equity refers to the market value of equity of common stock outstanding, the book value of common equity should be used in the denominator. – If there is more that one class of common stock outstanding, the market values of all classes (even the non-traded classes) needs to be factored in. 76 Price to Book Value: Distribution 1000 800 600 400 200 Std. Dev = 2.36 Mean = 2.39 0 N = 4866.00 PBV Ratio 77 Price Book Value Ratio: Stable Growth Firm • Going back to a simple dividend discount model, DPS1 P0 r gn • Defining the return on equity (ROE) = EPS0 / Book Value of Equity, the value of equity can be written as: BV 0 * ROE * Payout Ratio * (1 gn ) P0 r-gn P0 ROE * Payout Ratio * (1 g n ) PBV = BV 0 r-g n • If the return on equity is based upon expected earnings in the next time period, this can be simplified to, P0 ROE * Payout Ratio PBV = BV 0 r-g n 78 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 • Substituting back into the P/BV equation, P0 ROE - gn PBV = BV 0 r-g n • price-book The price book value ratio of a stable firm is determined by the differential between the return on equity and the required rate of return on its projects. 79 PBV/ROE: Oil Companies Company Name Ticker Symbol PBV ROE Crown Cent. Petr.'A' CNPA 0.29 -14.60% Giant Industries GI 0.54 7.47% Harken Energy Corp. HEC 0.64 -5.83% Getty Petroleum Mktg. GPM 0.95 6.26% Pennzoil-Quaker State PZL 0.95 3.99% Ashland Inc. ASH 1.13 10.27% Shell Transport SC 1.45 1 45 13.41% 13 41% USX-Marathon Group MRO 1.59 13.42% Lakehead Pipe Line LHP 1.72 13.28% Amerada Hess AHC 1.77 16.69% Tosco Corp. TOS 1.95 15.44% Occidental Petroleum OXY 2.15 16.68% Royal Dutch Petr. RD 2.33 13.41% Murphy Oil Corp. MUR 2.40 14.49% Texaco Inc. TX 2.44 13.77% Phillips Petroleum P 2.64 2 64 17 92% 17.92% Chevron Corp. CHV 3.03 15.69% Repsol-YPF ADR REP 3.24 13.43% Unocal Corp. UCL 3.53 10.67% Kerr-McGee Corp. KMG 3.59 28.88% Exxon Mobil Corp. XOM 4.22 11.20% BP Amoco ADR BPA 4.66 14.34% Clayton Williams Energy CWEI 5.57 31.02% 80 Average 2.30 12.23% PBV versus ROE regression • Regressing PBV ratios against ROE for oil i i ld the following companies yields th f ll i regression: i PBV = 1.04 + 10.24 (ROE) R2 = 49% • For every 1% increase in ROE, the PBV ratio should increase by 0.1024. 81 Valuing Pemex • Assume that you have been asked to l f th M i value a PEMEX for the Mexican Government; All you know is that it has earned a return on equity of 10% last year. The appropriate P/BV ratio can be estimated P/BV Ratio (based upon regression) = 1.04 + 10.24 * 0.1 = 2.06 82 Looking for undervalued securities - PBV Ratios and • ROE Given the relationship between price-book value ratios and returns on equity, it is not surprising to see firms which have high returns on equity selling for well above book value and firms which have low returns on equity selling at or below book value. • The firms which should draw attention from investors are those which provide mismatches of price-book value ratios and returns on equity - low P/BV ratios and high ROE or high P/BV ratios and low ROE. 83 The Valuation Matrix MV/BV Overvalued Low ROE High ROE High MV/BV High MV/BV ROE-r Undervalued Low ROE High ROE Low MV/BV Low MV/BV 84 Value/Book Value Ratio: Definition • While the price to book ratio is a equity multiple, both the market value and the book value can be stated in terms of the firm. • Value/Book Value = Market Value of Equity + Market Value of Debt Book Value of Equity + Book Value of Debt 85 Price Sales Ratio: Definition • The price/sales ratio is the ratio of the market value of equity to the sales. • Price/ Sales= Market Value of Equity Total Revenues • Consistency Tests – The price/sales ratio is internally inconsistent, since the market value of equity is divided by the total revenues of the firm. 86 PS Ratios: The Inconsistency Test • Assume that you are comparing i / l ti firms i a sector, price/sales ratios across fi in t and that there are differences in financial leverage across firms. What type of firms will emerge with the lowest price/sales ratios? Low Leverage Firms Average Leverage Firms High Leverage Firms 87 Price/Sales Ratio: Cross Sectional Distribution 1400 1200 1000 800 600 400 Std. Dev = 2.55 200 Mean = 1.87 0 N = 4634.00 PS RATIO 88 Price Sales Ratios and Profit Margins • The 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 price- sales ratio directly. – Second, the lower profit margin can lead to lower growth and hence lower price-sales ratios. E t d th t Retention ti Expected growth rate = R t ti ratio * R t Equity Return on E it = Retention Ratio *(Net Profit / Sales) * ( Sales / BV of Equity) = Retention Ratio * Profit Margin * Sales/BV of Equity 89 Effect of Margin Changes Price/Sales Ratios and Net Margins 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 2% 4% 6% 8% 10% 12% 14% 16% Net Margin 90 PS/Margins: Greek Retailers Company PS Net Margin SPAKIANAKIS SA 0.25 2.88% KOTSOVOLOS SA 0.48 1.91% SANYO HELLAS 1.12 5.07% IMAGE-SOV2VD SA 1.31 2.86% GERMAN0S 1.49 6.94% ELEKTRONIKI 1.61 6.29% JUMBO 1.68 6.08% PHiLIPPOS NAKAS 1 71 1.71 5 04% 5.04% GOODY'S 2.24 6.77% HELLENIC DUTY 5.60 19.49% AS COMPANY 7.02 8.23% FOLLI-FOLLIE 10.82 29.08% 91 Regression Results: PS Ratios and Margins • Regressing PS ratios against net margins, PS = -.10 + 36 29 (N t M i ) 10 36.29 (Net Margin) R2 = 78% • Thus, a 1% increase in the margin results in an increase of 0.36 in the price sales ratios. • The regression also allows us to get predicted PS ratios for these firms 92 Predicted PS Ratios Symbol Company PS Predicted PS Under or Over V SFA SPAKIANAKIS 0.25 0.94 73.28% -73.28% KOTSV KOTSOVOLOS 0.48 0.59 -18.47% SANYO SANYO HELLA 1.12 1.74 -35.37% IKONA IMAGE-SOV2V 1.31 0.94 39.82% GERM GERMAN0S 1.49 2.42 -38.41% ELATH ELEKTRONIKI 1.61 2.18 -26.47% BABY JUMBO 1.68 2.11 -20.39% NAKAS PHXLXPPOS N 1 71 1.71 1.73 1 73 -1 38% -1.38% GOODY GOODY'S 2.24 2.36 -5.01% HDF HELLENIC DUT 5.60 6.97 -19.72% ASCO AS COMPANY 7.02 2.89 143.07% FOLLI FOLLX-FOLLXE 10.82 10.45 3.51% 93 Current versus Predicted Margins • One of the limitations of the analysis we did in these last few pages is the focus on current margins. Stocks are priced based upon expected margins rather than current margins. • For most firms, current margins and predicted margins are highly correlated, making the analysis still relevant. • For firms where current margins have little or no correlation with expected margins, regressions of price to sales ratios against current margins (or price to book against current return on equity) will not provide much explanatory power. • In these cases, it makes more sense to run the regression using either predicted margins or some proxy for predicted margins. 94 A Case Study: The Internet Stocks 30 PKSI LCOS SPYG 20 INTM MMXI SCNT MQST FFIV ATHM A CNET DCLK d j RAMP INTW P 10 CSGP CBIS NTPA S NETO SONE APNT CLKS PCLN PSIX EDGR ATHY AMZN SPLN BIDS ALOY ACOM EGRP BIZZ IIXL ITRA ANET ONEM FATB ABTL INFO TMNT GEEK RMII -0 TURF PPOD BUYX ELTX GSVI ROWE -0.8 -0.6 -0.4 -0.2 AdjMargin 95 PS Ratios and Margins are not highly correlated • Regressing PS ratios against current margins yields the following PS = 81.36 - 7.54(Net Margin) ( g ) R2 = 0.04 (0.49) • This is not surprising. These firms are priced based upon expected margins, rather than current margins. 96 Solution 1: Use proxies for survival and growth: Amazon in early 2000 • Hypothesizing that firms with higher revenue growth and higher cash balances should have a greater chance of surviving and becoming profitable, we ran the following regression: (The level of revenues was used to control for size) PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev) (0.66) (2.63) (3.49) R squared = 31.8% Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) = 30.42 Actual PS = 25.63 Stock is undervalued, relative to other internet stocks. 97 Solution 2: Use forward multiples • You can always estimate price (or value) as a multiple of revenues, earnings or book value in a future year. These multiples are called multiples. forward multiples • For young and evolving firms, the values of fundamentals in future years may provide a much better picture of the true value potential of the firm. There are two ways in which you can use forward multiples: – Look at value today as a multiple of revenues or earnings in the future (say 5 years from now) for all firms in the comparable firm list. Use the average of this multiple in conjunction with your firm’s i to ti t the l f fi ’ earnings or revenues t estimate th value of your firm fi today. – Estimate value as a multiple of current revenues or earnings for more mature firms in the group and apply this multiple to the forward earnings or revenues to the forward earnings for your firm. This will yield the expected value for your firm in the forward year and will have to be discounted back to the present to get 98 current value. An Example of Forward Multiples: Amazon in early 2000 • Amazon.com lost $0.63 per share in 2000 but is expected to earn $ 1.50 per share in 2005. At its current price of $ 49 per share, this would translate into 32.67. a price/future earnings per share of 32 67 • In the first approach, this multiple of earnings can be compared to the price/future earnings ratios of comparable firms. If you define comparable firms to be e-tailers, Amazon looks reasonably attractive since the average price/future earnings per share of e-tailers is 65. If, on the other hand, you compared Amazon’s price to future earnings per share to the average price to future earnings per share (in 2004) of specialty retailers, the picture is bleaker. The average price to future earnings for these firms is 12, which would lead to a conclusion that Amazon is over valued. • approach, In the second approach the current price to earnings ratio for specialty retailers, which is estimated to be 20.31 to the earnings per share of Amazon in 2004 (which is estimated to be $1.50). This would yield a target price of $30.46. Discounting this price back to the present using Amazon’s cost of equity of 12.94% results in a value per share: Value per share = Target price in five years/ (1 + Cost of equity)5 = $30.46/1.12945 = $16.58. 99 PS Regression Model Summary Adjusted R Std. Error of Model R R Square Square the Estimate 1 .851 a .723 .723 88.1869 a. Predictors: (Constant), Beta, MARGIN, PAYOUT, Expected Growth in EPS: next 5 y Coefficients a,b,c Standar Unstandardized dized Coefficients Coefficients Model B Std. Error Beta t Sig. 1 Expected Growth 4.392E-02 .005 .199 9.210 .000 in EPS: next 5 y PAYOUT .807 .115 .087 7.007 .000 MARGIN 23.747 .466 .876 50.955 .000 Beta -.607 .085 -.187 -7.110 .000 a. Dependent Variable: PS RATIO b. Linear Regression through the Origin c. Weighted Least Squares Regression - Weighted by Market Cap 100 Value/Sales Ratio: Definition • The value/sales ratio is the ratio of the market value of the firm to the sales. • Value/ Sales= Market Value of Equity + Market Value of Debt-Cas Total Revenues 101 Value/Sales Ratio: Cross Sectional Distribution 1400 1200 1000 800 600 400 Std. 2.48 Std Dev = 2 48 200 Mean = 2.01 0 N = 4644.00 EV/SALES 102 Brand Name Premiums in Valuation • You have been hired to value Coca Cola for an analyst reports and you have valued the firm at 6.10 times revenues, using the model described in the last few pages. Another analyst is arguing that there should be a premium added on to reflect the value of the brand name. Do you agree? Yes No • Explain. 103 The value of a brand name • One of the critiques of traditional valuation is that it fails to consider the value of brand names and other intangibles. • The approaches used by analysts to value brand names are often ad-hoc and may significantly overstate or understate their value. • One of the benefits of having a well-known and respected brand name is that firms can charge higher prices for the same products, leading to higher profit margins and hence to higher price-sales ratios and firm value. The larger the price premium that a firm can charge, the greater is the value of the brand name. • In general, the value of a brand name can be written as: Value of brand name ={(V/S)b-(V/S)g }* Sales (V/S)b = Value of Firm/Sales ratio with the benefit of the brand name (V/S)g = Value of Firm/Sales ratio of the firm with the generic product 104 Illustration: Valuing a brand name: Coca Cola Coca Cola Generic Cola Company O ti M AT Operating Margin i 18.56% 18 56% 7.50% 7 50% Sales/BV of Capital 1.67 1.67 ROC 31.02% 12.53% Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%) Expected Growth 20.16% 8.15% Length 10 years 10 yea Cost of Equity 12.33% 12.33% E/(D E) E/(D+E) 97.65% 97 65% 97.65% 97 65% AT Cost of Debt 4.16% 4.16% D/(D+E) 2.35% 2.35% Cost of Capital 12.13% 12.13% Value/Sales Ratio 6.10 0.69 105 Value of Coca Cola’s Brand Name • Value of Coke’s Brand Name = ( 6.10 - 0.69) ($18 868 million) = $102 billion ($18,868 • Value of Coke as a company = 6.10 ($18,868) million) = $ 115 Billion • Approximately 88.69% of the value of the company can be traced to brand name value 106 Choosing Between the Multiples • As presented in this section, there are dozens of multiples that can be potentially used to value an individual firm. • In addition, relative valuation can be relative to a sector (or comparable firms) or to the entire market (using the regressions, for instance) • Since there can be only one final estimate of value, there are three choices at this stage: – 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 107 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. • If some of the multiples are “sector based” and some are “market based”, this will also average across two valuation. different ways of thinking about relative valuation 108 Weighted Averaging Across Multiples • In this approach, 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. • The precision of each estimate can be estimated fairly simply for those estimated based upon regressions as follows: Precision of Estimate = 1 / Standard Error of Estimate where the standard error of the predicted value is used in the denominator. • This approach is more difficult to use when some of the estimates are subjective and some are based upon more quantitative techniques. 109 Picking one Multiple • 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” 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 has the highest R-squared in the sector when regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc. and run regressions of these multiples against fundamentals, use the multiple that works best at explaining differences across firms in that sector. – Use the multiple that seems to make the most sense for that sector, given how value is measured and created. 110 Self Serving Multiple Choice • 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. Once the multiple that works best is picked, the other multiples can be abandoned and never brought up. • This approach, while yielding very biased and often absurd valuations, may serve other purposes very well. • As a user of valuations, it is always important to look at the biases of the entity doing the valuation, and asking some questions: – Why was this multiple chosen? – What would the value be if a different multiple were used? (You pick the specific multiple that you want to see tried.) 111 The Statistical Approach • One of the advantages of running regressions of multiples against fundamentals across firms in a sector is that you get R-squared values on the regression (that provide information on how well fundamentals explain differences across multiples in that sector). • As a rule, it is dangerous to use multiples where valuation fundamentals (cash flows, risk and growth) do not explain a significant portion of the differences across firms in the sector. • As a caveat, however, 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. 112 A More Intuitive Approach • As a general rule of thumb, the following table provides a way of picking a multiple for a sector 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 early years and reported earnings can vary depending on depreciation method REITa P/CF Generally no cap ex investments from equity earnings Financial Services PBV Book value often marked to market Retailing R t ili PS l i i il firms If leverage is similar across fi VS If leverage is different 113 Sector or Market Multiples • The conventional approach to using multiples is to look at the sector or comparable firms. • Whether sector or market based multiples make the most sense depends upon how you think the market makes mistakes in valuation – If you think that markets make mistakes on individual firm valuations but that valuations tend to be right, on average, at the sector level, you will use sector-based valuation only, – If you think that markets make mistakes on entire sectors, but is generally right on the overall market level, you will use only market- based valuation • It is usually a good idea to approach the valuation at two levels: – At the sector level, use multiples to see if the firm is under or over valued at the sector level – At the market level, check to see if the under or over valuation persists once you correct for sector under or over valuation. 114 A Test • You have valued Earthlink Networks, an internet service provider, relative to other internet companies using Price/Sales ratios and find it to be under valued almost 50% .When you value it relative to the market, using the market regression, you find it to be overvalued by almost 50%. How would you reconcile the two findings? One of the two valuations must be wrong. A stock cannot be under and over valued at the same time. It is possible that both valuations are right. What has to be true about valuations in the sector for the second statement to be true? 115 Reviewing: The Four Steps to Understanding Multiples • Define the multiple – Check for consistency y – Make sure that they are estimated uniformally • Describe the multiple – Multiples have skewed distributions: The averages are seldom good indicators of typical multiples – Check for bias, if the multiple cannot be estimated • Analyze the multiple f – Identify the companion variable that drives the multiple – Examine the nature of the relationship • Apply the multiple 116