HOW FINANCIAL STATEMENTS ARE USED IN VALUATION

Preface

Valuation models: Multiple Analysis (The method of Comparables &

Screening)

Asset-Based Valuation Fundamental Analysis The Architecture of Fundamental Analysis

Multiple Analysis

Methods of Comparables Screening on Multiples

Technical Screens Fundamental Screen

Price-To-Book Ratio - P/B Ratio

A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.

Also known as the "price-equity ratio".

P/B = Stock Price (Total assets – Intangible Assets and Liabilities)/

No. of Shares outstanding

Price-to-Book Ratio

Perhaps the least valuable ratio is the Price-to-Book Ratio. Conceived in a time when world was made up mainly of industrial companies that had actual hard assets like factories to back up their stock, its utility has diminished in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. The fact that Microsoft doesn't have very much in the way of book value doesn't mean the company is overvalued -- it just means that the company does not need a lot of land and factories to make a very high-margin product.

Price-to-Book Ratio

Traditional book value is simply the shareholders' equity divided by the number of shares of stock outstanding. In order to look at the company as a whole, you can use the aggregate market capitalization of the company divided by the current shareholders' equity.

A valuation ratio of a company's current share price compared to its per-share earnings.

P/E = Market Value per ShareEarnings per Share (EPS)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters. Also sometimes known as "price multiple" or "earnings multiple". 

Price-Earnings Ratio - P/E Ratio

Explanation of P/E Ratio

Price –earning ratio compares current price with earning.

P/E = Future Earnings

Current Earnings

Price the numerator is the market anticipated price is the market anticipation of value to be added from sales in future, that is the future earnings. The denominator is current earning , value added from current sales. So P/E ratio compares forecasted future earnings to current earning. If one considered more future earnings than current earnings, the P/E ratio should be high and vice versa.

To be more concise P/E ratio reflects anticipated earning growth.

Forward Price To Earnings - Forward P/E

Price-To-Sales Ratio - Price/Sales

A ratio for valuing a stock relative to its own past performance, other companies or the market itself. Price to sales is calculated by dividing a stock's current price by its revenue per share for the trailing 12 months:

PSR = Share PriceRevenue Per Share

The ratio can also be referred to as a stock's "PSR".

The price-to-sales ratio can vary substantially across industries; therefore, it's useful mainly when comparing similar companies. Because it doesn't take any expenses or debt into account, the ratio is somewhat limited in the story it

tells.

Price-To-Cash-Flow from operations Ratio

A measure of the market's expectations of a firm's future financial health. Because this measure deals with cash flow from operations, the effects of depreciation and other non-cash factors are removed. Similar to the price-earnings ratio, this measures provides an indication of relative value.

P/CFO = Share Price

Cash Flow from Operations per share

Because accounting laws on depreciation vary across jurisdictions, the price-to-cash-flow ratio can allow investors to assess foreign companies from the same industry (ex. mining

industry) with a bit more ease.

Relative/Comparable Valuation

Digital Lightwave

TeleComm Equipment Industry

Market

Price/Sales 2.78 1.56 1.28

Price/Earnings - - 64.74

Price/Book 2.06 2.90 2.53

Price/Cashflow 24.35 (23.28) 15.30

Company Sales

Earning Before

Extraordinary

Items

Book Value

market Value

P/S P/E P/B

Hewlett-Packard Co. 45,226 624 13,953 32,963 0.73 52.80 2.40

Gateway Inc. 6,080 (1,290) 1,565 1,944 0.32 (1.51) 1.20

Dell Computers Corp. 31,168 1,246 4,694 - - -

Avearge Multiple

for Comparabl

es

Dell's Numbers

Dell's Numbers

Sales 0.53 x 31,168 = 16,519

Earning 52.80 x 1,246 = 65,789

Book value 1.80 x 4,694 = 8,449

Average valuations x = 30,252

Pricing Multiples for Comparables Firms to Dell Computers

Enterprise Value

The enterprise value (EV) to shareholders' equity (SE)

EV/SE = (Shares Outstanding x Price) + Debt-Cash)

Shareholders' equity This number will get you a simple multiple, much like

the price/earnings ratio or the price/sales ratio. If it is below 1, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will avoid any companies that trade above 2 times book value or more

Enterprise Value

Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed.

Advantages of Relative/Comparable Valuation

Relative valuation is much more likely to reflect market perceptions. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO).

Relative valuation generally requires less information than discounted cash flow valuation.

Easy to measure but chances of fallacy is relatively high. Relative Valuation / Comparables Methods are used where similar

companies are available in the business.

(An initial public offering (IPO), referred to simply as an "offering" or "flotation", is when a company (called the issuer) issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately owned companies looking to become publicly traded.)

Disadvantages of Relative/Comparable Valuation

Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

(

Unlevered (or Enterprise) Multiples

Leverage involves borrowing. A given set of assets can be financed by equity or by debt (borrowing). Hence, the balance sheet equation, Assets = Liabilities (Debt) + Shareholders’ Equity. Some items in the financial statements have nothing to do with the amount of debt relative to equity (the amount of leverage). So the price multiple for this item should not reflect the leverage. What is the price that is not affected by leverage (the unlevered price)?  

Value of the Firm = Value of Debt + Value of Equity  The unlevered value is the value of the firm – or the

value of the enterprise – that is, the value that is independent of the amount of debt relative to equity.

Unlevered (or Enterprise) Multiples

Below are some unlevered multiples. The multiple of sales, for example, must be an unlevered multiple. Sometime people calculate the P/S ratio as the price of the equity/sales. But sales are generated by the assets of the enterprise, not by the amount of equity. Sales are not affected by the degree to which the assets are financed by borrowing. So the appropriate price in the numerator is the price of the enterprise, that is, the price of the equity plus the price of the debt.

Unlevered Price to Sales, ebit & ebitda

Unlevered P/S Market Value of Equity + Debt

sales Unlevered P/ebit Market Value of Equity + Debt

ebit Unlevered P/ebitda Market Value of Equity +

Debt

ebitda

Price-to-ebitda Ratios

Some analysts use the ratio, price/ebitda, to value shares. Ebitda is earnings before interest, taxes, depreciation and amortization. The use of this multiple can lead to errors.

Taxes have to be paid (but excluded in ebitda), so you should pay less for a firm that has higher taxes. So taxes must be taken into account in the earnings you are buying. We all wish that we could ignore taxes, but we can’t unfortunately. And depreciation is a real cost, just like wages expense: plants rust and becomes obsolescent and have to be replaced. Amortization expense can be a real cost also: patents expire and goodwill can decline in value.

P/E Ratios and Dividends

P/E Ratios and Dividends  Trailing P/E ratios from rolling P/E and

leading (or forward) P/E ratios. It also indicates that, in calculating standard and rolling P/E ratios, price in the numerator should be adjusted for dividends that have been paid.

 

Percentile

P/BEnterpris

e P/BTrailing

P/EForward

P/EP/S

Unlevered P/S

P/CFOUnlevere

d P/ebitda

Unlevered

P/ebit

95.00 7.90 12.70 -ve Ern's49.20 8.90 8.10 -ve CF 30.10 -ve ebit

75.00 2.90 2.70 23.50 19.10 1.70 2.00 18.80 10.60 15.30

50.00 1.70 1.50 15.20 13.10 0.80 0.90 9.90 7.00 9.90

25.00 1.00 1.00 10.30 9.20 0.30 0.50 5.60 4.80 6.60

5.00 0.50 0.60 5.90 5.60 0.10 0.20 2.30 2.50 3.30

Percentile for Common Stock Multiples

Technical Analysis

Two major types of analysis for predicting the performance of a company’s stock Technical Analysis / Technical screening Fundamental Analysis / Fundamental Screening

Technical Analysis looks for peaks, bottoms, trends, patterns, and other

factors affecting a stock’s price movement makes a buy/sell decision based on those factors The world of technical analysis is huge Hundreds of different patterns and indicators investors

claim to be successful

What is Technical Analysis?

Method of evaluating securities by analyzing statistics generated by Market activity Past Prices Volume

It does not attempt to measure intrinsic value

Instead look for patterns and indicators on charts to determine future performance

What is Technical Analysis

Technicians believe that securities move in very predictable trends and patterns

Trends continue until something happens to change the trend

Until that change takes place, price levels are predictable

Most agree that technical analysis is much more effective when combined with fundamental analysis

The Bar Chart

The Bar Chart

Some of the most popular type of charts are bar charts

Advantage is that it show the high, low, open and close for each day

Technical Analysis / Technical Screening

Price Screening Buy stock whose price drop a lot, sell whose price have increase a lot

Small Stock ScreeningBuy stock with low market value and sell stock with high market value

Neglect Stock ScreeningBuy stock not followed by many analysis

Seasonal ScreeningBuy stock that are certain time of the year

Momentum ScreeningBuy stock that have had increase in stock price

Insider Trader ScreeningGet real data from SECP about the firm and then decided where to

invest

Fundamental Analysis / Fundamental Screening

Price to Earning (P/E)ScreeningBuy firm with low P/E ratio and sell firm with high P/E ratio

Price to Book Value (P/B) ScreeningBuy firm with low P/B ratio and sell firm with high P/B ratio

Price to Cash Flow (P/CFO) ScreeningBuy low price relative to cash from operations, sell high P/CFO

Price to dividend (P/D)ScreeningBuy low p/d & sell high p/d

The Bar Chart

10, 25, 50, 75 and 90 percentiles of price to sales (P/S) ratios for NASDAQ firms, 1963-1998

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tio

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Source: Calculated from Standard & Poor's COMPUSTAT data.1999 was excluded from the graph.

http://screen.yahoo.com/stocks.htmlSome engines rank firms on particular price ratios. For example, http://screen.morningstar.com/stocksearch/stockrank.htmlhttp://www.globalfindata.com