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Chapter 14Chapter 14
Valuation:Valuation: Market - Based Market - Based
ApproachesApproaches
Chapter: 14 2
Market MultiplesUsed as
An analytical toolA valuation tool
Caution advised:Market multiples are shortcut valuation tools.They use just one or two accounting numbers.They are relatively simple ratios of Market
value to Summary accounting measures.
Chapter: 14 3
Market Multiples (Contd.)Capture relative valuation per dollar of
book value or earnings.To be applied and interpreted after
considering firm’s expected future in terms of:ProfitabilityRiskGrowth
Chapter: 14 4
Market Multiples (Contd.)Firm’s fundamental characteristics are
necessary for comparison with other firms and industry averages.
Chapter: 14 5
Market-to-Book (MB) Ratio
Reflects what the market value is, and not what should be.
Useful for comparison with Value-to-Book Ratio.
Market value of common shareholders’ equity Book value of common shareholders’ equity
MB Ratio =
Chapter: 14 6
Value-to-Book (VB) Ratio
Residual income valuation model used to compute shareholder’s equity value.
Can be compared with Market-to-Book ratio to evaluate share price.
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Chapter: 14 7
Value-to-Book (VB) Ratio – Continuing Value Model
Finite Horizon Earnings Forecasts and Continuing Value Computation.
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Chapter: 14 8
VB Ratio: Insights into ValuationIn equilibrium, firms maintain shareholder
wealth and thus valued at book value.Firm Value > Book Value of common
equity, if the firm generates return greater than cost of capital.
Growth adds value only when additional residual income is created for common equity shareholders.
Chapter: 14 9
VB Ratio: Insights into Valuation (Contd.)Increase in risk decreases Firm Value.Firm’s VB Ratio differs from industry due
to differences in their ROCE, RE and/or book value growth.
Change current expectations about ROCE, RE and/or book value growth if VB ratio of firm changes over time.
Chapter: 14 10
MB and VB Ratios differ from ‘1’Economic reasons:
ROCE > RE (firm has competitive advantage)
ROCE < RE (firm has unprofitable projects)
Accounting reasons:Firms may invest in projects for which
accounting methods and principles cause ROCE to differ from RE.
Chapter: 14 11
Empirical properties of MB RatioFirms with assets appearing at book value
on balance sheet have MB ratio closer to ‘1’Firms having off-balance sheet assets and
shareholders’ equity have relatively high MB ratios.
Predictive power of MB ratiosFirms with higher MB ratios have higher ROCEsDiminishes as the horizon of study lengthens
Chapter: 14 12
Value-Earnings (VE) Ratio
Common equity value is determined as a function of expected future earnings and residual income model.
Future earnings is measured as expected future comprehensive income.
Value of Common Equity Earnings for a single period
VE Ratio =
In theory, VE Ratio calculated as:Value of Common Equity
Expected Comprehensive IncomeVE Ratio =
Chapter: 14 13
Price-Earnings (PE) Ratio
Ratio projects firm value from permanent earnings.
Advantages:Quick and efficient way to value a firm.Can be readily observed for most of the firms.
Current share priceReported EPS for most recent prior fiscal Year
PE Ratio =
Chapter: 14 14
Price-Earnings (PE) Ratio (Contd.)Disadvantages:
Logical misalignment as historical earnings divided into share price, which reflects present value of future earnings.Historical earnings used may include unusual items
and need to be normalized.Forward PE ratio is more logical as it uses a forecast
of future EPS as against historical EPS.
Chapter: 14 15
PE Ratio CautionsFactors causing PE ratios to differ across
firms:Risk and the Cost of capitalGrowth and ProfitabilityAccounting differencesAccounting measures earnings in annual
periodsGrowth
Chapter: 14 16
PE Ratios and Earnings GrowthApproaches:Perpetuity-With-Growth approach
Assumes firms current period earnings grow at a constant rate “g”.
Firm is valued as the present value of a permanent stream of future earnings.
1(RE − g)
PE Ratio =
Chapter: 14 17
PE Ratios and Earnings Growth (Contd.)Price-Earnings-Growth approach
Used as a rule of thumb to assess share price relative to earnings and expected future earnings growth.
PE RatioExpected Earnings Growth rate
PEG Ratio =
Chapter: 14 18
Value-Earnings-Growth (VEG) RatioPEG model implies the following value
model for the VEG ratio:
Assumptions of the model:Earnings have a perpetual growth.Earnings generate an ROCE equivalent to RE.
VE RatioExpected Earnings Growth rate
VEG Ratio =
Chapter: 14 19
Value-Earnings-Growth (VEG) Ratio (Contd.)
Reinvested earnings generate an ROCE equivalent to RE.
Chapter: 14 20
PE Ratio Measurement IssuesGrowth
Ratio does not consider firm-specific differences in long-term earnings growth.
Transitory earningsPast earnings used in computation of ratio are
not indicative of future earnings.Past earnings may contain non-recurring
elements.
Chapter: 14 21
PE Ratios: Empirical PropertiesPredictors of future earnings growth
A low percentage increase (decrease) in earnings is followed by a High percentage earnings increase for the high PE portfolios, vice versa for the low PE portfolios.
Articulation of MB and PE RatiosFuture residual income is higher for high MB firms
than for low MB firms.Current period residual income is much lower than
future residual income for high PE firms.
Chapter: 14 22
Price DifferentialsPrice Differentials offer an approach to
evaluate market’s pricing of risk.
WherePDIFF = Price differentialRNV = Risk-neutral Value (calculated by
substituting risk free rate for cost of capital in Residual Income Model).
RNV0 per share − Price per share0PDIFF0 =
Chapter: 14 23
Price Differentials (Contd.)Used to evaluate the extent to which
market is discounting share prices for risk:If PDIFF > Risk of firm, shares are over-
discounted or under-valued.If PDIFF < Risk of firm, shares are under-
discounted or over-valued.
Chapter: 14 24
Reverse EngineeringVariables in Valuation Process
ValueExpected future profitabilityExpected long-run future growth Expected risk-adjusted discount rates
Assumes market price equals value and solves for assumptions about other variables.
Chapter: 14 25
Academic ResearchWhether academic research models and
empirical evidences are relevant in making buy/sell or hold recommendations?Research in accounting provides insights into
relations between accounting numbers and capital market variables.
Empirical evidence available on relative degree of market efficiency with respect to earnings.
Chapter: 14 26
Academic Research (Contd.)Capital Market Efficiency
The degree to which market prices react completely and quickly to available accounting information.
Positions taken in securities after study of accounting information drive prices to efficient levels.Analysts are driving forces involved in identifying
and correcting security mispricing.
Chapter: 14 27
Academic Research (Contd.)Market efficiency and Earnings
The Bernard and Thomas studies (1989 – 90’) reveal market is highly, but not completely, efficient with respect to quarterly earnings.
There are returns to be earned by being good at forecasting and reacting to earnings.
Insightful financial statement analysis lead to better-than-average returns by identifying stocks that are temporarily mispriced.
Chapter: 14 28
Academic Research (Contd.)Use of Valuation models to form portfolios
The Frankel and Lee studies implement a 3-year forecast horizon version of the residual income model to compute fundamental share value of firms.
Portfolios are formed with highest V/P ratios and lowest V/P ratios
