Lecture 2 Basic valuation and fin. statements: Method of Comparables Reading Ch.3 Penman. Papers: • Imam S., Barker R., and Clubb C. (2008). The Use of Valuation Models by UK Investment Analysts. European Accounting Review. Vol. 17. No.3, pp.503-535. • Demirakos E., Strong N., and Walker M. (2004). What Valuation Models Do Analysts Use? Accounting Horizons. Vol. 18. No.4, pp.221-240.
Transcript
1. Lecture 2Basic valuation and fin. statements: Method of
ComparablesReadingCh.3 Penman.Papers: Imam S., Barker R., and Clubb
C. (2008). The Use of Valuation Models by UK Investment Analysts.
European Accounting Review. Vol. 17. No.3, pp.503-535. Demirakos
E., Strong N., and Walker M. (2004). What Valuation Models Do
Analysts Use? Accounting Horizons. Vol. 18. No.4, pp.221-240.
2. Simple (single-period) valuation techniques1. Method of
Comparables2. Asset-Based Valuation no forecasting required only
little accounting info is needed cheap and quick to apply
3. 1. Method of Comparables Price multiple is the ratio of the
stock price to a particular financial statement number. E.g. P/E,
P/B, EV/EBITDA, P/S, EV/CF, (P- BV)/R&D. The price multiple is
a single number summary of the valuation relationship between a
stocks price and a value driver. It makes comparisons possible
among different stocks. It gives the price to purchase one unit of
value: e.g., P/S=2 means that it takes 2 to buy 1 of sales. The
economic rationale underlying the method is the law of one price:
two identical assets should sell at the same price.
4. How to apply this method:1. Identify comparable firms (same
sector, similar size, etc)2. Identify measures for the comparable
firms in their fin. statements (e.g. earnings, book value, sales,
cash flow) or use other important value drivers (e.g. sq. feet for
stores, oil/gas proven reserves, number of website clicks, number
of passengers)3. Make adjustments if necessary Unleveraging (the
higher the leverage, the higher is the cost of capital and the
lower is the cash/earnings available for ordinary shareholders.
=> downward biased multiple) dilute EPS Make adjustments for
accounting-induced differences4. calculate price multiples of those
measures for comparable firms (but exclude abnormal firms), and use
their mean or median5. Apply these price multiples to the
corresponding measures for the target firm to get that firms
value
5. The Method of Comparables Example:Dell, Hewlett Packard, and
Lenovo, 2008
6. Double-check your inputs and assumptions:Assess whether
differences between the actual and benchmark values of the multiple
are explained by differences in the fundamental determinants of the
price multiples. E.g.: If the subject stock has higher-than-average
expected earnings growth, a higher P/E than the benchmark P/E is
justified. If the subject stock has higher-than-average operating
or financial risk, a lower P/E than the benchmark P/E is
justified.Things to be careful about: What if the selected multiple
is inappropriate? What if the traded stock is an outlier or the
multiple is affected by factors other than mispricing (e.g., risk)?
What if the market remains mispriced for a long time? You may be
trading with someone who knows much more.
7. Most widely used valuation methods and multiples
8. Most commonly used multiples in different sectors: Industry
Most commonly used multiplesAutomobiles P/S; P/Cash EarningsBanks
P/BPaper, Chemicals, P/B; EV/EBITDA; EV/S; P/Cash Earnings;
P/Levered FreeMetals & Mining, Cash Flow; P/FCF; EV/EBITDA;
P/EConstructionBusiness Services EV/EBITDA; ROCE; P/Levered Free
Cash Flow; P/E; PEGEngineering, Defence P/E; EV/EBITDA; EV/SFood,
Drink & EV/EBITDA; P/E; PEG; EV/Cash Earnings;
ROCETobaccoHealthcare P/E; EV/EBITDAInsurance P/TALeisure
EV/EBITDAMedia P/E; EV/EBITDAOil & Gas P/E; EV/CEReal Estate
EV/EBITDARetail & Consumer P/E relative to market and sector;
EV/EBITDA; PEG; EV/STechnology P/ETelecoms EV/E to EBITDA growth;
EV/S; P/customerTransport EV/EBITDA; P/SUtilities P/E; P/Cash
earnings
9. Unlevered (or Enterprise) Multiples (that are Unaffected by
the Financing of Operations) Market Value of Equity + Net
DebtUnlevered Price/Sales Ratio = Sales Market Value of Equity +
Net DebtUnlevered Price/ebit = ebit Market Value of Equity + Net
DebtUnlevered Price/ebitda = ebitda Market Value of Equity + Net
DebtEnterprise P B = Book Value of Equity + Net Debt
10. Variations of the P/E Ratio Price per share Trailing P/E =
Last annual Eps Price per shareRolling P/E = Sum of Eps for most
recent four quarters Price per share Forward P/E = Forecast of next
years Eps Dividend-Adjusted P/E Rationale: Dividend affects prices
but not earnings
12. Test your understanding: P/B P/E P/S Unlev P/CF Unlev Share
Equity BV ER Sales CF debt ered ered Price (in Market P/S P/CF
pence) value (in millions)M&S 344 5662.7 2081.9 398.8 8302 285
1578Morrison 204.8 5442.3 2046 333.9 4944 534.6 96.4Tesco 316.8
24434 9773.6 1163.5 30814 2279 8061Sainsbury 272.3 4629 4583.2 348
17141 731.3 1908mean value of ratios:Iceland * actual 94.25 323.8
281.6 28.9 5152 119 242Valuationbased on: mean P/B mean P/E mean
P/S mean P/CF Average value:
13. Problems with Method of Comparables:Conceptual problems:
Circular reasoning: Price is ascertained from price (of the comps)
Violates the tenet: When calculating value to challenge price, dont
let price enter the calculation If the market is efficient for the
comparable companies....Why is it not for the target company
?Implementation problems: Finding the comparables that match
precisely Different accounting methods for comps and target
Different prices from different multiples What about negative
denominators?Applications: IPOs; firms that are not traded (to
approximate price, not value)
14. P/E pros and consPros: Earnings is a chief driver of
investment value and the chief focus of security analysts
attention. P/E is widely recognized and used by investorsCons:
Earnings can be negative => P/E does not make sense The ongoing
or recurring components of earnings are the most important in
determining intrinsic value. Earnings often have volatile,
transient components, which make the analysis difficult Management
can manipulate earnings. Distortions can affect the comparability
of P/Es across firms.
15. P/B pros and consPros: P/B is only slightly less popular
than P/E, but sectors matter BV is generally positive and more
stable than earnings, => P/B more meaningful when earnings are
abnormal or highly volatile. BV is appropriate for firms composed
of liquid assets or natural resources (e.g., financials, mining,
oil & gas). BV is a better proxy for valuing firms that are not
a going concern.Drawbacks: Other unrecorded assets may be critical
valuation factors. E.g., skills, knowledge, know-how, reputation,
customer loyalty. P/B Accounting treatment of shareholders
investment in the company. E.g., BV understates shareholders
investment as a result of the expensing of investment in R&D,
advertising, etc. Yet R&D or advertising may create value in
the long term BV largely reflects the historical costs of assets,
as well as accumulated accounting depreciation. Inflation and
technological change (time effect) distorts the BV from the market
value of assets. The accounting treatment of both inventories and
long-term contracts is also a suspect.
16. P/S pros and consPros: Sales less subject to distortion or
accounting manipulations, as it is prior to any expenses. But
revenue recognition practices must be examined. Sales are always
positive => P/S can be used when P/E or P/B is negative. Sales
are more stable than earnings, which reflect operating and
financial leverage. => P/S more stable than P/E. May be more
appropriate for shares of mature and/or cyclical firms.Cons: High
growth in sales is not a sign of high growth in earnings or
profitability. Earnings and growth in earnings is what creates
value. Unlevered P/S is affected by capital structure. P/S ignores
differences in cost structure among different firms. P/S normal
levels vary sharply across sectors.
17. Stock screening & use of price multiples Technical
screens: identify positions based on trading indicators: Price
screens Small stock screens Neglected stocks screens Seasonal
screens Momentum screens Insider trading screens Fundamental
screens: based on price multiples: Price/Earnings (P/E) ratios
Market/Book Value (P/B) ratios Price/Cash Flow (P/C) ratios
Price/Dividend (P/d) ratios Any combination of these methods is
possible Try Googles stock screener: http://
www.google.com/finance/stockscreener
18. Stock screening using price multiples1. Identify a multiple
on which to screen stocks.2. Rank stocks on that multiple, from
highest to lowest.3. Buy stocks with the lowest multiples and
(short) sell stocks with the highest multiples.What are the implied
assumptions?
19. Fundamental Screening: Fundamental Screening: Returns to
P/E Screen Returns to P/B Screen Two-way Screening: P/E and
P/B
20. Technical Screening: Technical Screening: Returns to Size
Returns to Beta (is Beta dead?) Source: Fama and French
(1992)Average Monthly Returns and Estimated Betas from July 1963 to
December 1990 for Ten Size and Beta Groups
21. Returns to two fundamental screens Value GlamourSource:
Lakonishok, Shleifer, & Vishny, Contrarian Investment,
Extrapolation,and Risk, Journal of Finance, Vol. 49, No. 5. (Dec.,
1994), p 1554.
22. Year by Year Returns: Value Minus GlamourSource:
Lakonishok, Shleifer, & Vishny, Contrarian Investment,
Extrapolation,and Risk, Journal of Finance, Vol. 49, No. 5. (Dec.,
1994), p 1566.
23. P/B and P/V Ratios: The Dow Stocks during 1979-96Source:
Lee, Myers &Swaminathan, What is theIntrinsic Value of the
Dow,Journal of Finance, (Oct., 1999).
24. Problems with Screening You could be loading up on a risk
factor You need a risk model You are in danger of trading with
someone who knows more than you You need a model that anticipates
future payoffs A full-blown fundamental analysis supplies this
25. 2. Asset Based Valuation Values the firms assets and then
subtracts the value of debt: The balance sheet does this
calculation, but imperfectly: Shareholders Equity = Total Assets
-Total Liabilities Problems with this approach: Getting the value
of operating assets when there is not a market for them Identifying
value in use for a particular firm Getting the value of omitted
intangible assets (brand names, R&D, monopolistic position,
etc.) Getting the value of synergies of assets being used together
Applications: Asset-based firms such as oil and gas and mineral
products Calculating liquidation value
26. Investment decision: cost of capital vs. expected return
infoHewlett-Packard Company: Measuring (expected) returns for 1991
Required return (i.e. cost of capital) is 12%Price forecast at end
of 1991 $50.375 1991 dividend forecast .480Price at end of 1990
46.000 => Expected rate of return = ? Should we buy, hold or
sell this stock?
27. Investment decision: the no arbitrage condition P + d1 P0 =
1 If the price paid for a stock is (expected payoff discounted at
the required payoff per dollar, ), the stock is appropriately
priced: the market price is efficient Or, price is efficient if it
equals the expected return capitalized at the required
rate-of-return: P +d P P0 = 1 1 0 1 Or, todays price (P0) must be
such that the required rate-of-return, - 1, will equal the
(expected) rate-of-return: P + d1 P0 1 = 1 P0 Required Rate-of
Return = Expected Rate-of-Return
28. Investment decision: arbitrage trading strategies If no
arbitrage holds, the market is efficient for that stock: there is
no arbitrage opportunity Any discrepancy between expected and
required rate-of-return, is an arbitrage opportunity that, if
exploited, will profit the arbitrage trader. An arbitrage
opportunity arises if If P1 + d1 P0 > 1 then BUY P0 If P + d1 P0
1 < 1 then SELL P0The difference is called the expected abnormal
return and the rule can be restated as: BUY if the expected
abnormal return is positive, and SELL if negative. If it is zero,
do nothing (HOLD)
29. Investment decision: multiyear equity investments These
concepts apply to an investment for more than one period with two
modifications: The multiperiod rate-of-return will be the
compounded annual rate. Dividends for the intermediate years can be
reinvested at . For a T-year period and a flat term structure, the
required payoff is T For a changing term structure it would be: 1*
2* 3** T The accumulated value at year T of reinvested dividends is
called terminal value of dividends at T: T T t d t t =1 Adding the
selling price will get the cum dividend payoff or cum- dividend
terminal price: T PT + T t d1 t =1 And the T-period cum dividend
return will be: T PT + T t d t P0 t =1
30. Example: Hewlett Packard five-year Return 1990 1991 1992
1993 1994 1995 d91=0.24 d92=0.36 d93=0.45 d94=0.55 d95=0.70 0.70
0.55 x 1.12 0.62 0.45x 1.122 0.56 0.36 x 1.123 0.51 0.24 x 1.124
0.38 5 5 d t t E = 1.57 2.76x 1.12 -5 2.77 = d t =1 t 5t E t =1
(1990 value) (1995 value)Terminal value of dividends in 1995
2.77Price payoff in 1995 (PT) 84.00Total Payoff 86.77Purchase price
in 1990 (P0) 13.00Five-year Return 73.77Five-year rate-of-return
567.38%Normal rate-of-return (12% p.a.) 76.23%Abnormal
rate-of-return 491.15%