Equity Valuation Models

Estimated Value and Market Price

Intrinsic Buy or
Undervalued: value >
market price Don’t sell

Intrinsic
Fairly valued: value = Hold
market price
Intrinsic Sell or
Overvalued: value <
market price Don’t buy
 Valuation Models

Absolute • Discounted Cash Flow models

• Dividend discount models
Valuation • Free cash flow to equity
Models • Free cash flow to the firm

• Price ratios
• Price-to-earnings ratio
Relative • Price-to-book-value ratio
Valuation • Price-to-sales ratio
Models
• Enterprise value multiples
• Enterprise value to EBITDA
Misconceptions about Valuation

Myth 1: A valuation is an objective search for “true” value

◦ Truth 1: All valuations are biased. The only questions are “how much” and in
which direction.

Myth 2: A good valuation provides a precise estimate of value

◦ Truth 2: There are no precise valuations.

Myth 3: The more quantitative a model, the better the valuation

◦ Truth 3: Simpler valuation models do much better than complex ones.

◦ Source: Damodaran
DCF Valuation
The value of an asset is the present value of its expected cash flows

This requires estimates of:

◦ The stream of expected cash flows, and
◦ The required rate of return on the investment
 DCF or Present Value Models

Value of an investment = present value of

expected future benefits

Future benefits = Future benefits = free

dividends cash flow

 
Dt
V0  
FCFt
V0  
t 1 (1  r ) t 1 (1  r )
t t
The Dividend Discount Model (DDM)
The value of a share of common stock is the present value of all future
dividends
D1 D2 D3 D
V0     ... 
(1  r ) (1  r ) (1  r )
2 3
(1  r )
n
Dt

t 1 (1  r )
t

where:
V0 = value of common stock
Dt = dividend during time period t
r = required rate of return on stock
n = number of periods assumed to be infinite
Why dividends are used for valuation?
Investors receive cash returns only in the form of dividends
Constant Growth Dividend Model
(Gordon Model)
Cash dividends grow at some average rate g from one period to next forever.

Constant dividend growth is appropriate assumption for mature companies with

history of stable growth.
Constant Growth Dividend Model
Infinite Period Model (Constant Growth Model)
◦ Assumes a constant growth rate for estimating all of future dividends

D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
V0    ... 
(1  r ) (1  r ) 2
(1  r ) n

where:
V0 = value of stock
D0 = dividend payment in the current period
g = the constant growth rate of dividends
r = required rate of return on stock
n = the number of periods, which we assume to be infinite
Looks like a Geometric Progression
First Term is a and growth factor is m
Sum of GP series = a/(1-m)
First Term is D0 (1  g )
(1  r )

Growth factor is (1  g )
(1  r )
So what do we get?
Constant Growth Dividend Model
◦ It can be written as:

V0 
D1 D0 (1  g )
V0 
rg OR
rg
where:
V0 = value of stock
D1 = dividend payment in the year 1
g = the constant growth rate of dividends
r = required rate of return on stock j
It assumes that r > g
Constant Growth Example
Ramesh Engineering Ltd has just gave a dividend of Rs 2 per
share. The dividend is expected to grow at 6 percent per annum
infinitely. What should you pay for it if the risk free rate is 4%,
market risk premium is 8% and the beta of the stock is 1.25
Required rate is = 4 + (1.25x8) = 14%
2(1  0.06)
V0 
0.14  0.06
=Rs 26.5
Two-stage Dividend Discount Model
The model is based upon two stages of growth
◦ an extraordinary growth phase that lasts n years and
◦ a stable growth phase that lasts forever afterwards.

Extraordinary growth rate: gs each year for n years

Stable growth: gc forever

D0( 1  g s ) Dn( 1  g c )
t
n 1
V0   [ * ]
( 1  r) ( 1  r)
t n
t 1 r-gc
or
D0( 1  g s )
t
n Pn
V0   [ ]
( 1  r) ( 1  r)
t n
t 1

Dn( 1  g c )
where Pn 
r-g c
Example
Vertigo has just announced a dividend of Rs 2 per share. The dividends are
expected to grow at 20 percent for a period of 6 years initially. Thereafter the
growth will stabilize at 10 percent. Equity investors require a return of 15
percent.
What is the intrinsic value of the share.
First find the dividends for six years
Years 1 2 3 4 5 6
Dividends 2.400 2.880 3.456 4.147 4.977 5.972
Then find PV individually for each of them using 15%
2.4 2.88 3.456 4.147 4.977 5.972
+ + + + + =
(1.15)1 (1.15)2 (1.15)3 (1.15)4 (1.15)5 (1.15)6
= 2.09 + 2.18 + 2.27 + 2.37 + 2.47 +2.58 = 13.96
Or use PV of growing annuity formula:
𝐴 1+𝑔 𝑛 2.4 1+0.2 6
𝑃𝑉𝐺𝐴 = 1− = 1− = 13.96
𝑟−𝑔 1+𝑟 0.15−0.20 1+0.15
Then find the dividend in 7th year
= 5.972 (1.1) = 6.569
Then find the Terminal Value
6.569
= = 131.83
(0.15−0.10)
131.83
And then find PV of Terminal Value = = 56.80
(1.15)6
Lastly Add PVs of dividend in high growth years & PV of TV
= 13.96+56.80 = 70.76
 2( 1  0.20 ) Dn( 1  0.10 )
t
6 1
V0   { * }
( 1  0.15 ) 0.15-0.10 ( 1  0.15 )
t 6
t 1

Answer: 70.76
 Three-Stage Model
Assumes three distinct growth stages:
• First stage of growth
• Second stage of growth
• Stable-growth phase
 Three-Stage Model
Assumes three distinct growth stages:
• First stage of growth
• Second stage of growth
• Stable-growth phase
3 stage example
IM Ltd currently pays a dividend of Rs 1.60 per year. The current required return
is 12%. If dividends will grow at 14% for next 2 years, 12% for the following 5
years and 10.2% thereafter. Estimate its value.
 Dividends Growth PV
0 1.6
1 1.824 0.14 1.628571
2 2.07936 0.14 1.657653
3 2.328883 0.12 1.657653
4 2.608349 0.12 1.657653
5 2.921351 0.12 1.657653
6 3.271913 0.12 1.657653
7 3.664543 0.12 1.657653
8 4.038326 0.102 101.4852
Price 113.0597
Free Cash Flows
Free Cash Flow to the Firm (FCFF): What cash is available
before any financing considerations

Free Cash Flow to Equity (FCFE): What could shareholders

be paid
Free Cash Flows
Free Cash Flow to the Firm (FCFF): What cash is available
before any financing considerations

Free Cash Flow to Equity (FCFE): What could shareholders

be paid
 Free Cash Flow

Free Cash Flow to the Firm Free Cash Flow to Equity

= Cash flow available to = Cash flow available to

Equity shareholders Equity shareholders

Debtholders

Preference shareholders
FCFF is the cash flow available to the company’s suppliers of capital after all
operating expenses (including taxes) have been paid and necessary investments
in working capital (e.g., inventory) and fixed capital (e.g., equipment) have been
made.

FCFE is the cash flow available to the company’s equity shareholders after all
operating expenses, interest, and principal payments have been made and
necessary investments in working and fixed capital have been made
 Free Cash Flows
Not freely available data like dividends, need to be calculated
Used when
◦ The company does not pay dividends
◦ Company pays dividends much different than its capacity to pay
Calculating FCFE from Net Profit

FCFE =NP + Dep - Cap Exp – WCInv + New Debt Issues - Principal Debt
Repayments

FCFE =NP - (Cap Exp – Dep) - WCInv + (New Debt Issues - Debt Repayments)

FCFE =NP - (Net Cap Exp ) - WCInv + Net Borrowing

NP = Net Profit;
Dep = depreciation; it may include other non cash charges such as amortization
Cap Exp = Fixed Capital investments or Capital Expenditure;
WCInv = Non Cash Working Capital Investment (Current assets excluding cash – current liabilities)
Increase in WC is subtracted and decrease is added
Calculating FCFF From Net Profit
FCFF = NP + Int (1 – Tax rate) + Dep – Cap Exp – WCInv
FCFF = NP + Int (1 – Tax rate) – Net Cap Exp – WCInv

NP = Net Profit;
Dep = depreciation; it may include other non cash charges such as amortization
Cap Exp = Fixed Capital investments or Capital Expenditure;
WCInv = Non Cash Working Capital Investment (Current assets excluding cash – current liabilities)
Increase in WC is subtracted and decrease is added
Other formulas
FCFF from Cash Flow from Operations
FCFF = CFO + Int(1 – Tax rate) – Cap Exp

FCFF from EBIT

FCFF = EBIT(1 – Tax rate) + Dep – Cap Exp – WCInv

FCFE from Cash Flow from Operations

FCFE = CFO – Cap Exp + Net borrowing

CFO = Cash flow from operations

Calculate:
FCFF from NP; FCFE from NP

Net Profit Rs 315 cr

Depreciation expense Rs 400 cr
Interest expense Rs 150 cr
Tax rate 30%
Purchases of fixed assets Rs 500 cr
Investment in working capital Rs 50 cr
Net borrowing Rs 80 cr
Equity dividends Rs 200 cr
 Calculating FCFF from Net Profit

FCFF = NP + Int (1 – Tax rate) + Dep – Cap Exp - WCInv

FCFF = 315 + 150(1 - 0.3) + 400 – 500 – 50

= 270
 Calculating FCFE from Net Profit
FCFE from Net Profit
FCFE =NP + Dep - Cap Exp – WCInv + Net Borrowing

= 315 + 400 - 500 – 50 + 80

=245
FCFE from FCFF
FCFE =FCFF – Int (1 – Tax rate) + Net Borrowing

FCFE = 270 – 150(1 – 0.3) + 80

= 245
Financial
Statements for Pitts
Corporation (in
Millions, except for
Per-Share Data
1. Calculate FCFF starting with the net profit income figure.
2. Calculate FCFE starting with the net profit figure.
1.
FCFF = NP + Dep + Int(1 − Tax rate) − Cap Exp − WCInv
= 240 + 300 + 60 − 400 − 45
= $155 million
Capital spending is $400 million, which is the increase in gross fixed assets shown on the balance
sheet and in capital expenditures shown as an investing activity in the statement of cash flows.
The increase in working capital is $45 million, which is the increase in accounts receivable of $40
million ($600 million − $560 million) plus the increase in inventories of $30 million ($440 million
− $410 million) minus the increase in accounts payable of $15 million ($300 million − $285
million) minus the increase in accrued taxes and expenses of $10 million ($150 million − $140
million).
When finding the increase in working capital, we ignore cash because the change in cash is what
we are calculating.
We also ignore short-term debt, such as notes payable, because such debt is part of the capital
provided to the company and is not considered an operating item.
The after-tax interest cost is the interest expense times (1 − Tax rate): $100 million × (1 − 0.40) =
$60 million.
2.
FCFE = NP + Dep − Cap exp − WCInv + Net borrowing
= 240 + 300 − 400 − 45 + 75
= $170 million
Because notes payable increased by $50 million ($250 million − $200 million)
and long-term debt increased by $25 million ($890 million − $865 million), net
borrowing is $75 million.
FCFF vs. FCFE Approaches to
Equity Valuation
FCFF
◦ Forecast FCFFs
◦ Using WACC find PV of all FCFFs : You get firm value
◦ Firm Value – Debt Value = Equity Value
FCFE
◦ Forecast FCFEs
◦ Using Cost of Equity find PV of all FCFEs : You get Equity Value
 FCFF vs. FCFE Approaches to
Equity Valuation
Using FCFF Using FCFE

FCFFt
Firm value   
t 1  t FCFEt
1  WACC Equity value  
t 1 1  r 
t
Equity value  Firm value  Debt value
Assumptions about growth in FCFE and FCFF
Constant growth model
Two stage growth model
Three stage growth model
Constant Growth Free Cash Flow Models
Using FCFF
FCFF1
Firm value 
WACC  g
Equity value  Firm value  Debt value
Using FCFE
FCFE1
Equity value 
rg
Example: Constant Growth FCFF Model
Current FCFF Rs 6,000,000
Target debt to capital ratio 0.25
Market value of debt Rs 30,000,000
Shares outstanding 2,900,000
Required return on equity 12%
Cost of debt 7%
Long-term growth in FCFF 5%
Tax rate 30%

Find the value of stock using FCFF

 Example: Constant Growth FCFF Model

 MV(Debt)    MV(Equity)  
WACC     rd  (1  Tax rate)     r
 MV(Equity)  MV(Debt)    MV(Equity)  MV(Debt)  

WACC  0.25  7%  (1  0.30)  0.75 12%  10.23%

 Example: FCFF Model
6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 (1.05)
Firm value = = 120.57 million
(0.1023−0.05)

Equity value = 120.57 million – 30 million = 90.57

million

90.57 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Equity value per share = = Rs 31.23
2.9 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Two stage FCFF and FCFE
Using FCFF

Equity Value = Firm Value – Debt Value

Using FCFE
Forecasting FCFE
Forecast the components of FCFE:
Forecast Sales
Find NP using the historical average of Net Profit Margin adjusting
for current and expected economic environment
Capital needs can be forecasted based on historical relation between
increase in sales and increase in investments for net capital
expenditure and working capital
Forecasting FCFEs
When forecasting FCFE, analysts often make an assumption that the financing of
the company involves a target debt ratio.
A specified percentage of the sum of net capital expenditure and increase in
working capital is assumed to be financed based on a target debt ratio.
This assumption leads to a simplification of FCFE calculations.
 Valuation using forecasted FCFE

Henschel is doing a valuation of TechnoSchaft on the basis of the following

information:
Year 0 sales per share = Rs 25.
Sales growth rate = 20 percent annually for three years and 6 percent annually
thereafter.
Net profit margin = 10 percent forever.
Net investment in Capital Expenditure (net of depreciation) = 50 percent of the sales
increase.
Annual increase in working capital = 20 percent of the sales increase.
Debt financing = 40 percent of the net investments in capital equipment and working
capital.
TechnoSchaft beta is 1.20; the risk-free rate of return is 7 percent; the equity risk
premium is 4.5 percent.
Find the intrinsic value per share.
The required rate of return for equity is
= 7% + 1.2(4.5%) = 12.4%
Find Sales per share over the years

1 2 3 4 5 6
Sales growth rate 20% 20% 20% 6% 6% 6%
Sales per share 25.00 30.00 36.00 43.20 45.792 48.5395 51.45189

Find EPS
1 2 3 4 5 6
NP Margin 10% 10% 10% 10% 10% 10%
EPS 3.00 3.60 4.32 4.5792 4.85395 5.145189
 1 2 3 4 5 6
Sales per share 25 30 36 43.20 45.792 48.5395 51.45189
Change in Sales 5.00 6.00 7.20 2.592 2.7475 2.91237

Find Net Cap Exp per share

Net investment in Capital Expenditure (net of depreciation) = 50 percent of the sales increase

1 2 3 4 5 6

Net Cap Exp per share 2.50 3.00 3.60 1.296 1.37376 1.456186

Find WCInv per share

Investment in WC = 20 percent of the sales increase

1 2 3 4 5 6
WCInv per share 1.00 1.20 1.44 0.5184 0.5495 0.582474
Find debt financing per share

1 2 3 4 5 6
Debt financing per
share 1.40 1.68 2.016 0.72576 0.7693 0.815464
Find FCFE per share

1 2 3 4 5 6
FCFE per share 0.90 1.08 1.296 3.49056 3.6999 3.92199

Find the growth rates in FCFE

1 2 3 4 5 6
Growth rate of FCFE 20% 20% 169% 6% 6%
Beyond year 4 the growth rate can be taken as 6%
Find PV of FCFE
The stock value is the present value of the first four years’ FCFE plus the present
value of the terminal value of the FCFE from years 5 and beyond.
0.90 1.08 1.296 3.49056
+ + +
(1.124)1 (1.124)2 (1.124)3 (1.124)4
= .800712 + .854852 + .912654 + 2.1869
= 4.7551
3.69999
The terminal value is = = 57.8124 ;
(0.124−0.06)
57.81
PV of Terminal Value = 4 = 36.2206
(1.124)
PV= 4.7551+ 36.2206
= 40.9757 or 40.98
Three-Stage FCF Models
Current FCFF in millions $100

Shares outstanding in millions 300

Long-term debt value in millions $400
FCFF growth for years 1 to 3 30%
FCFF growth for year 4 24%
FCFF growth for year 5 12%
FCFF growth for year 6 and thereafter 5%
WACC 10%
 Year
1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 12% 5%

FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4
PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5
 FCFFn 1 1
Terminal value 
 WACC  g  (1  WACC)n

$320.4 1
Terminal value   $3979
 0.10  0.05 (1  0.10) 5
 n
FCFFt FCFFn 1

1
Firm value  +
t =1 1  WACC t  WACC  g  (1  WACC)n

Firm value  $118.2  $139.7  $165.1  $186.1  $189.5  $3979  $4777

Equity value  Firm value  Debt value

Equity value  $4777  $400  $4377

Equity value per share  $4377/300  $14.59

FCFF better than FCFE for:
◦ Companies having negative FCFE
◦ Companies with changing capital structure
Sensitivity Analysis of a FCFE Valuation
Steve Bono is valuing the equity of Petroleo Brasileiro (NYSE: PBR), commonly
known as Petrobras, in early 2013 by using the single-stage (constant-growth)
FCFE model.
FCFE for 2012 is 1.05 Brazilian reals (BRL).
Bono’s estimates of input values for the analysis are as follows:
• The FCFE growth rate is expected to be 6.0 percent.
• The risk-free rate is 5.2 percent.
• The equity risk premium is 5.5 percent.
• Beta is 1.2.
Using the capital asset pricing model (CAPM), Bono estimates that the required rate of return
for Petrobras is:
5.2% + 1.2 (5.5%) = 11.8%
The estimated value per share is:
What would be the value if estimates for cost of equity and growth change?
Cost of equity: 10.8%, 11.3%, 11.8%, 12.3%, 12.8%
FCFE growth: 7%, 6.5%, 6%, 5.5%, 5%
Cost of Equity
10.80% 11.30% 11.80% 12.30% 12.80%
FCFE growth 7.0% 29.57 26.13 23.41 21.20 19.37
6.5% 26.01 23.30 21.10 19.28 17.75
6.0% 23.19 21.00 19.19 17.67 16.37
5.5% 20.90 19.10 17.58 16.29 15.17
5.0% 19.01 17.50 16.21 15.10 14.13
Relative Valuation
The value of any asset can be estimated by looking at how the
market prices “similar” or ‘comparable” assets.

Why use it?

It is the opinion of some that
◦ The intrinsic value of an asset is impossible (or close to impossible) to
estimate. The value of an asset is whatever the market is willing to pay for it
(based upon its characteristics)
When relative valuation works best..

This approach is easiest to use when

◦ there are a large number of assets comparable to the one being valued
◦ these assets are priced in a market
◦ there exists some common variable that can be used to standardize the price
This approach tends to work best for investors
◦ who have relatively short time horizons
◦ can take actions that can take advantage of the relative mispricing;
◦ for instance, a hedge fund can buy the under valued and sell the over valued
assets
 How to conduct Relative Valuation
To do a relative valuation, you need
◦ an identical asset, or a group of comparable or similar assets
◦ a standardized measure of value which is obtained by
◦ dividing the price by a common variable, such as earnings or book value,
◦ dividing enterprise value by EBITDA
◦ if the assets are not perfectly comparable, we need to control for
the differences
◦ Examine Fundamentals
◦ Is there a reason your company should have lower/higher ratios than the
comparable companies
Given the firm that we are valuing, what is a “comparable” firm?
◦ Firms in the same sector are comparable firms
◦ A comparable firm is one which is similar to the one being analyzed in
terms of fundamentals.
When selecting the peer group, the following traits are among those considered:
Business Characteristics: Product/Service Mix, Customer Type, Stage in Lifecycle
Financials: Revenue Historical and Projected Growth, Operating Margin and EBITDA Margin
Risks: Industry Headwinds (e.g. Regulations, Disruption), Competitive Landscape
Prices can be standardized using a common variable such as
earnings, cash flows, book value or revenues.

Price/Earnings Ratio (PE) and PEG ratio

Price/Book Value(of Equity) (PBV)
Price/Sales per Share (PS)

Enterprise Value/EBITDA
P/E ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Leading PE (or forward P/E) uses next four quarters’ earnings per share

Trailing P/E (or current P/E) uses the most recent four quarters’ earnings per
share
Relative Valuation using P/E ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

The value of an equity share, using P/E ratio, is estimated as

follows:

Price = EPS1 x Justified PE ratio

EPS1 is the earnings per share for the next year

Justified PE ratio is the ratio justified based on the comparable firms, past ratios, and
fundamentals
Justified P/E multiple from Comparables
Select the benchmark

◦ Cross Sectional:
◦ The mean or median value of the P/E for the company’s peer group of
companies within an industry.
◦ The mean or median value of the P/E for the company’s industry or sector.

◦ Time Series:
◦ An average past value of the P/E for the stock.
Example: Valuing a firm using P/E ratios (using peer group average)

Our firm’s next year estimated EPS is Rs 2.10.

In an industry we identify 4 stocks which are similar to the stock we want to
evaluate.
Stock PE
A 14
B 18
C 24
D 21
The average PE = (14+18+24+21)/4=19.25
Price = 19.25 * 2.1 = Rs 40.43
We may use the median instead, which will be 19.5 and the price will be
19.5 * 2.1 = Rs 40.95
A Simple Peer-Group Comparison
As a telecommunications industry analyst at a brokerage firm, you are valuing
Verizon Communications, Inc. (NYSE: VZ), one of the world’s leading
telecommunications companies.
The valuation metric that you have selected is the trailing P/E
According to GICS, VZ is in the telecommunications services sector and, within it,
the integrated telecommunication services subindustry.
Exhibit presents the relevant data. (Note that although BCE Inc. is a Canadian
company, it is classified in this peer group.)
Trailing P/Es of Telecommunications Services Companies (as of 11 September 2013)
Based on the data, address the following:
1. Given the definition of the benchmark stated above, determine the most
appropriate benchmark value of the P/E for VZ.
2. State whether VZ is relatively fairly valued, relatively overvalued, or relatively
undervalued, assuming no differences in fundamentals among the peer group
companies. Justify your answer.
3. Identify the stocks in this group of telecommunication companies that appear
to be relatively undervalued when the median trailing P/E is used as a
benchmark. Explain what further analysis might be appropriate to confirm your
answer
Solution to 1:
Use of median values mitigates the effect of outliers on the valuation
conclusion.
In this instance, the P/E for EQIX is clearly an outlier. Therefore, the median
trailing P/E for the group, 36.91, is more appropriate than the mean trailing P/E
of 50.95 for use as the benchmark value of the P/E.
Note: When a group includes an odd number of companies, as here, the median
value will be the middle value when the values are ranked (in either ascending
or descending order). When the group includes an even number of companies,
the median value will be the average of the two middle values
Solution to 2:

If you assume no differences in fundamentals among the peer group companies,

VZ appears to be overvalued because its P/E is greater than the median P/E of
36.91
Solution to 3:
T, BCE, and CTL appear to be undervalued relative to their peers because their trailing
P/Es are lower than the median P/E.
WIN appears to be relatively fairly valued because its P/E equals the median P/E.
VZ, FTR, and EQIX appear to be overvalued.
To confirm this valuation conclusion, you should look at other metrics.
One issue for this particular industry is that earnings may differ significantly from cash
flow. These companies invest considerable amounts of money to build out their
networks—whether it be landlines or increasing bandwidth capacity for mobile users.
Because telecommunication service providers are frequently required to take large non-
cash charges on their infrastructure, reported earnings are typically very volatile and
frequently much lower than cash flow
Valuing a firm using P/E ratios: Own Historical P/E
As an alternative to comparing a stock’s valuation with that of other stocks, one
traditional approach uses past values of the stock’s own P/E as a basis for
comparison.
Underlying this approach is the idea that a stock’s P/E may regress to historical
average levels. An analyst can obtain a benchmark value in a variety of ways
with this approach.
The five-year average trailing P/E is a reasonable metric.
In general, trailing P/Es are more commonly used than forward P/Es in such
computations. In addition to “higher” and “lower” comparisons with this
benchmark, justified price based on this approach may be calculated as follows:
Justified price = (Benchmark value of own historical P/Es) x (Most recent EPS)
As of mid-September 2013, you are valuing Honda Motor Company (TSE: 7267; NYSE ADR:
HMC), among the market leaders in Japan’s auto manufacturing industry. You are applying the
method of comparables using HMC’s five-year average P/E as the benchmark value of the
multiple.
Historical P/Es for HMC
2012 2011 2010 2009 2008 Mean Median
15.8 23.1 10.0 19.8 35.8 20.9 19.8
1. State a benchmark value for Honda’s P/E.
2. Given EPS for fiscal year 2013 (ended 31 March) of ¥203.71, calculate and interpret a justified
price for Honda.
3. Compare the justified price with the stock’s recent price of ¥3,815
Solution to 1:
The benchmark value based on the median P/E value is 19.8 and based on the mean P/E value is 20.9.
Solution to 2:
The calculation is 19.8 × ¥203.71 = ¥4,033 when the median-based benchmark P/E is used and 20.9 ×
¥203.71 = ¥4,258 when the mean-based benchmark P/E is used.
Solution to 3:
The stock’s recent price is 5.4 percent (calculated as 3,815/4,033 – 1) less than the justified price of the
stock based on median historical P/E but 10.4 percent (calculated as 3,815/4,258 – 1) less than the
justified price of the stock based on mean historical P/Es.
The stock may be undervalued, but mis-valuation, if present, appears slight. Reaching a conclusion from
these results is complicated by the fact that the time period of the analysis reflects the effects of the
financial crisis of 2007–2009.
Prior to the crisis, the P/E for HMC was much lower than the mean and median values used in this
analysis. In particular, history suggests that the P/E ratio of 35.8 in 2008 should be considered an outlier.
Advantages of Relative Valuation

Relative valuation is much more likely to reflect market perceptions

and moods than discounted cash flow valuation.

Relative valuation generally requires less information than

discounted cash flow valuation
 Disadvantages of Relative Valuation

Stocks which are under valued on a relative basis may still be overvalued
◦ It is just less overvalued than other securities in the market.

Relative valuation may require less information maybe because of implicit

assumptions made about other variables
◦ To the extent that these implicit assumptions are wrong the relative valuation will also
be wrong.

Even within an industry, companies are rarely perfectly comparable.

There is no way to know for sure what the “correct” price multiple is.
Drawbacks to P/E ratios
EPS can be negative. The P/E ratio does not make economic sense
with a negative denominator.

Earnings often have volatile, transient components, non recurring

items making the analyst’s task difficult.
Article on understanding PE ratio
https://www.morningstar.in/posts/59882/3-step-guide-understanding-pe-
ratio.aspx?utm_campaign=yahoocmpg&utm_medium=onlinecmpg&utm_source=yahoo
In practice, analysts often find that the stock being valued has some significant differences from
the median or mean fundamental characteristics of the comparison assets.
In applying the method of comparables, analysts usually attempt to judge whether differences
from the benchmark value of the multiple can be explained by differences in the fundamental
factors believed to influence the multiple.
The following relationships for P/E hold, all else being equal:
• If the subject stock has higher-than-average (or higher-than-median) expected earnings
growth, a higher P/E than the benchmark P/E is justified.
• If the subject stock has higher-than-average (or higher-than-median) risk (operating or
financial), a lower P/E than the benchmark P/E is justified.
For a group of stocks with comparable relative valuations, the stock with the greatest expected
growth rate (or the lowest risk) is, all else being equal, the most attractively valued.
 PEG ratios

The PEG ratio:

P/E ÷ Expected earnings growth rate.

Stocks with lower PEGs are more attractive than stocks with higher PEGs, all
else equal.

Thumb rule: PEG less than 1: undervalued

 Applying the PEG Ratio

An analyst is asked to determine whether BAS or CPX is more attractive as an

acquisition target. Both firms provide engineering, construction, and specialty
services to the oil, gas, refinery, and petrochemical industries.
BES and CPX have projected annual earnings per share growth rates of 15 percent
and 9 percent, respectively. BES’ and CPX’ current earnings per share are Rs 2.05 and
Rs 3.15, respectively. The current share prices as of June 25, 2016 for BAS is Rs 31.48
and for CPX is Rs 26.
The industry average price-to-earnings ratio and growth rate are 12.4 and 11%,
respectively.
Based on this information, which firm is a more attractive takeover target as of the
point in time the firms are being compared?
BES PE = 31.48/2.05 = 15.36
BES PEG = 15.35/15 = 1.02
CPX PE = 26/3.15 = 8.25
PEG = 8.25/9 = 0.92

Industry PEG = 12.4/11 = 1.13

Both have PEG lesser than industry average.
Relatively, CPX is more undervalued than BES
Book Value
Book value (BV) is equal to the shareholder's equity
= share capital + reserves and surplus

Book value per share:

= BV ÷ the number of outstanding shares
The Price-Book Value Ratio
Book value can be a reasonable measure of value for firms that have consistent
accounting practice (for example, firms in the same industry).
Book value is generally positive even when EPS is zero or negative
Fama and French (1992) study indicated inverse relationship between P/BV
ratios and excess return for a cross section of stocks
Book value per share has been viewed as appropriate for valuing banking
institutions. For banks, book values of assets may approximate market values.
For assets measured at net historical cost, inflation and technological change can
eventually result in significant divergence between the book value and the
market value of assets.
As a result, book value per share often does not accurately reflect the value of
shareholders’ investments.
Value using P/B ratio

Price = Justified P/B ratio x Book Value per share

If P/B less than 1, is it a buy?
A P/B ratio of less than one could be an indicator of an undervalued company
that the market has misunderstood.
It represents an attractive buying opportunity at a bargain price. That's the way
value investors think.
Value investors search for opportunities where they believe the market has
wrongly valued or priced a stock.
Or
The market's low opinion and valuation of the company may be correct.
It is perceived as a losing proposition.
P/B Comparables Approach
You are working on a project to value an independent securities brokerage firm.
You know the industry had a significant decline in valuations during the
2007−2009 financial crisis.
You decide to perform a time series analysis on three firms: E*TRADE Financial
Corp. (NASDAQ: ETFC), The Charles Schwab Corporation (NASDAQ: SCHW), and
TD Ameritrade Holding Corp. (NYSE: AMTD). Exhibit presents information on
these firms.
Question
Based only on the information in Exhibit, discuss the relative valuation of ETFC
relative to the other two companies.
Solution
ETFC is currently selling at a P/B that is less than 30 percent of the P/B for either
SCHW and AMTD.
It is also selling at a P/B that is less than 60 percent of its average P/B for the
time period noted in the exhibit.
The likely explanation for ETFC’s low P/B is that its growth forecasts for book
value and revenues are lower and its beta higher than for those for SCH and
AMTD.
In deciding whether ETFC is overvalued or undervalued, an analyst would likely
decide how his or her growth forecast and the uncertainty surrounding that
forecast compare to the market consensus
The Price-Sales Ratio
Sales growth drives all subsequent earnings and cash flow
If you are concerned with accounting manipulation, sales is one of the purest
numbers available.
◦ Sales is subject to less manipulation than other financial data
Relative comparisons using P/S ratio should be between firms in similar
industries
Sales are positive even when EPS is negative
P/S has been viewed as appropriate for valuing the stocks of mature, cyclical,
and zero-income companies (Martin 1998).
Stora Enso Oyj (Helsinki Stock Exchange: STERV) is an integrated paper, packaging, and forest
products company headquartered in Finland. In its fiscal year ended 31 December 2012, Stora
Enso reported net sales of €10,814.8 million and had 788.6 million shares outstanding.
Calculate the P/S for Stora Enso based on a closing price of €6.72 on 16 September 2013.
Solution:
Sales per share
= €10,814.8 million/788.6 million shares
= €13.71.
So, P/S
= €6.72/€13.71 = 0.490.
P/S
The price to sales ratio is calculated by dividing the market price (of the stock) by
the current sales per share.
It can also be calculated by dividing the market capitalization of the company by
the annual sales.
Price = Justified P/S ratio x Sales per share
P/S Comparables Approach
As a health care analyst, you are valuing the stocks of a Swedish medical equipment manufacturer
Getinge AB (Stockholm: GETI). You have compiled the information on GETI and peer companies Smith
& Nephew plc (London: SN) and CR Bard Inc. (NYSE: BCR) given in Exhibit.
P/S Comparables (as of 4 October 2013)

Use the data in Exhibit to address the following: 1. Based on the P/S but referring to no other
information, assess GETI’s relative valuation. 2. State whether GETI is more closely comparable to SN
or to BCR. Justify your answer.
Solution to 1:
Because the P/S for GETI, 2.14, is the lowest of the three P/S multiples, if no other information is
referenced, GETI appears to be relatively undervalued.
Solution to 2:
On the basis of the information given, GETI appears to be more closely matched to SN than BCR.
BCR’s P/S is significantly higher than the P/S for GETI and SN.
The profit margin and revenue growth are key fundamentals in the P/S approach, and despite BCR’s
higher P/S, its profit margin and revenue growth rate are both lower than those of GETI and SN.
The big difference between GETI and SN is that GETI relies much more on debt as a funding source.
Because of this, the enterprise value-to-revenue ratio arguably provides a more appropriate valuation
measure than does P/S.
Enterprise Value/EBITDA
Enterprise Value = Market value of debt + market value of equity – cash
and short term investments
Enterprise value is often viewed as the cost of a takeover: In the event of a
buyout, the acquiring company assumes the acquired company’s debt but
also receives its cash.
Why are debt and cash considered when valuing a firm?
◦ If the firm is sold to a new owner, the buyer has to pay the equity value and
must also repay the firm's debts.
◦ The buyer gets to keep the cash available with the firm, which is why cash
needs to be deducted.
Advantages of EBITDA
The pre-interest expenses & pre-tax measure EBIT removes the impact of different tax rates &
financial leverage. EBITDA further removes the impact of choices regarding depreciation &
amortization.
Comparing the firm’s performance based on net earning leads to a bias due to differences in
accounting policies and capital structures.
This is because some firms may charge depreciation on an accelerated basis, which leads to high
depreciation costs in the initial years.

In addition, some firms have a high debt in their capital structure leading to high interest costs.
Such depreciation and interest costs ultimately depress the net earnings.
EBITDA discards such difficulties due to varying depreciation policies and debt-equity mix
EBITDA is usually positive
Because EBITDA is a flow to both debt and equity, defining an EBITDA multiple
by using a measure of total company value in the numerator, such as EV, is
appropriate.
Enterprise value is total company value: the market value of debt, common
equity, and preferred equity) minus the value of cash
Thus, EV/EBITDA is a valuation indicator for the overall company rather than
solely its common stock.
Analysts have offered the following rationales for using EV/EBITDA:
• EV/EBITDA is usually more appropriate than P/E alone for comparing companies with different
financial leverage (debt), because EBITDA is a pre-interest earnings figure, in contrast to EPS,
which is post interest.
• By adding back depreciation and amortization, EBITDA controls for differences in depreciation
and amortization among businesses, in contrast to net income, which is post depreciation and
post amortization.
For this reason, EV/EBITDA is frequently used in the valuation of capital-intensive businesses (for
example, cable companies and steel companies). Such businesses typically have substantial
depreciation and amortization expenses.
• EBITDA is frequently positive when EPS is negative.
Investors use EV/EBITDA measure of relative takeover attractiveness of a company within
industry.
Western Digital Corporation (NYSE: WDC) manufactures hard disk drives.
The company has 238 million shares outstanding.
Long term debt is 2,013 million.
Total of cash and cash equivalents is $4,060 million.
The company’s share price as of 1 July 2013 was $63.06.
The trailing 12 month (TTM) EBITDA is $3,565 million.

Based on the above information, calculate EV/EBITDA.

Solution
For EV, we first calculate the total value of WDC’s equity: 238 million shares
outstanding times $63.06 price per share equals $15,008 million market
capitalization.
EV includes the value of long-term debt. Per WDC’s balance sheet, the amount
of long-term debt is $2,013 million
Per WDC’s balance sheet, the total of cash and cash equivalents is $4,060
million.
So, WDC’s EV is $15,008 million + 2,013 million − $4,060 million = $12,961
million
EV/EBITDA = ($12,961 million)/($3,565 million) = 3.6
Comparable Enterprise Value Multiples
Exhibit presents EV multiples for four companies in the data storage device industry: Western Digital
Corporation (NYSE: WDC), Net App (NASDAQ GS: NTAP), EMC Corporation (NYSE: EMC), and Seagate
Technology (NASDAQ GS: STX).
Enterprise Value Multiples for Industry Peers (amounts in $ million, except where indicated otherwise)
How does the valuation of WDC compare with that of the other three companies?
Solution
Based on its lower EV/EBITDA multiples of 4.3, WDC appears undervalued
relative to the other three companies.
However, these lower valuation ratios may be warranted given WDC’s low profit
margin and declining revenue growth.
Compared with STX, the enterprise value multiples of WDC are slightly lower,
which is consistent with its being less profitable than STX (profit margin of 12.81
percent).
The enterprise value multiples of NTAP are much higher than those of WDC,
probably reflecting NTAP’s recent relatively high revenue growth.
Similarly, the enterprise value ratios for WDC are lower than those for EMC due
also to differences in profitability and growth.
Example:
Companies with EV/EBITDA less than that of industry
(Jan 2014)
Which multiple to use?

Sector Multiple Used Rationale/Comments

Cyclical manufacturing PE

Big differences in growth across firms make it

High tech, high growth PEG difficult to compare PE ratios

High growth/negative earnings P/S Assume future margins will be positive.

Infrastructure EV/EBITDA Firms in sector have losses in early years

Financial services PBV

Retailing P/S
Source: Investment Valuation by Damodaran