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Valuation at Best

Valuation at Best

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Published by harish

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Published by: harish on Mar 22, 2010
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11/05/2012

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Highlights
In this report, we update our basis for company financial valuation andanalysis. We continue to refine our systematic approach to maintainingconsistency in a global context – what we call
iQ
method 
SM 
, part of our suite of
iQ
analytics
SM 
offerings. The key features of
iQ
method 
are:
-
 
A consistently structured, detailed, and transparent methodology, with
data sourced directly from our analysts
models.
-
 
Guidelines to maximize the effectiveness of the comparative valuationprocess, and to identify some common pitfalls.
The
iQ
method 
framework focuses on standard measures under three broadheadings:
-
 
Business Performance
 – 
judging management effectiveness.
-
 
Quality of Earnings
 – 
assessing the sustainability of businessperformance, and the attendant risks.
-
 
Valuation
 – 
making the connection between business performance andmarket value. We look at the common metrics in fine detail to maximizeconsistency and highlight possible false signals.
Our global
iQ
database
SM 
facilitates this analysis:
-
 
The
 
iQ
database
is designed to provide both breadth and depth of data;and to effectively obtain, organize, and present consistent, detailed, andexplicit financial information, in a manner most useful to investorinvestment priorities.
-
 
More than 100 detailed line items for each of the 2,500+ stocks in ourglobal equity research coverage universe are available.
A suite of products is available to access and manipulate the rich content ofthe
iQ
analytics
platform. These include:
-
 
The
iQ
toolkit 
SM 
, which presents sector and regional analysis via ourMLX web portal, Bloomberg, and coming soon, Reuters Knowledge forInvestment Management platforms, leveraging the power of thedatabase, including the metrics presented in this work.
-
 
iQ
works
SM 
software, which further exploits the power of the
iQ
database
,enabling us to create custom reports and charts including user-definedratios and calculations based on the detailed data in the
iQ
database
.
GLOBAL
May 2005
iQ
method 
 
Our Approach to Global Equity Valuation, Accounting,and Quality of Earnings 
RC#60413801
Global Valuation andAnalytics Research
Karl Debenhamkarl_debenham@ml.com(44) 20 7996 2368Michael Schiffmanmichael_schiffman@ml.com(1) 212 449 7271Bryan Allworthybryan_allworthy@ml.com(44) 20 7996 2078David Evansdavid_evans@ml.com(61) 2 9226 5751Prepared with the assistance ofJon Duchac, Ph.D., Merrill LynchProfessor of Accounting at WakeForest University.
For educational purposesonly. Not to be used as thesole basis for any investmentdecisions.
Global Securities Research & Economics GroupGlobal Valuation and Analytics Research
SM 
 
iQ
method 
SM 
May 20052
Quick Reference
We summarize below the definitions of our standard measures under three broad headings: Business Performance, Quality of Earnings, and Valuation. A more detailed explanation of how these metrics can be used (and misused) is given in the body of this report.
Business Performance
These measures essentially provide a checklist to judge management; Return on Capital Employed tests the effectivedeployment of resources across the enterprise in general, Return on Equity considers the rate of return to equity in particular.The Operating Margin indicates pricing power, while EPS Growth and Free Cash Flow give a feel for future value.
Table 1: Business Performance
Standard MeasureNumeratorDenominatorUnitsPage
Return on Capital EmployedNOPAT = (EBIT + Interest Income) * (1 - Tax Rate) +Goodwill AmortizationTotal Assets – Current Liabilities + ST Debt +Accumulated Goodwill Amortization%5Return on EquityNet IncomeShareholdersEquity%11Operating MarginOperating ProfitSales%11EPS GrowthExpected 5-Year CAGR From Latest ActualN/A%12Free Cash FlowCash Flow From Operations Total CapexN/AMn15
Source: Merrill Lynch
Quality of Earnings
Not all earnings are equal!
High-quality
earnings should be viewed with greater confidence and, by implication, others treatedwith more caution. These metrics are intended to test the underlying security of the business performance.
Table 2: Quality of Earnings
Standard MeasureNumeratorDenominatorUnitsPage
Cash Realization RatioCash Flow From OperationsNet IncomeX17Asset Replacement RatioCapexDepreciationX18Tax RateTax ChargePre-Tax Income%19Net Debt/Equity RatioNet Debt = Total Debt, Less Cash & EquivalentsTotal Equity%20Interest CoverEBITInterest ExpenseX22
Source: Merrill Lynch
Valuation
These measures connect the economic performance of the business to its market value in various ways. The Price/EarningsRatio is a payback indicator; the Price/Book Ratio reflects the valuation of the company
s equity. The Dividend Yield and FreeCash Flow Yield reflect tangible and potential monetary rates of return, respectively. Enterprise Value/EBITDA is a general
structure-neutral
cash-generation multiple, and Enterprise Value/Sales indicates
volume leverage.
Table 3: Valuation
Standard MeasureNumeratorDenominatorUnitsPage
Price/Earnings RatioCurrent Share PriceDiluted Earnings Per Share (Basis As Specified)X23Price/Book ValueCurrent Share Price
Shareholders
Equity/Current Actual SharesX31Dividend YieldAnnualized Declared Cash Dividend per ShareCurrent Share Price%31Free Cash Flow YieldFree Cash FlowMarket Cap. = Current Share Price * Current ActualShares%33Enterprise Value/EBITDAEnterprise Value = Market Capitalization +Minority Equity + Net Debt + Other LT Liabilities
1
EBIT + Depreciation + AmortizationX34Enterprise Value/SalesEnterprise ValueSalesX35
1
 
Pension liabilities, deferred taxes, capitalized lease, and other post-retirement benefits are explicitly included in other non-current liabilities. However, this item is not limited to thesefactors, as new and inventive forms of funding are always emerging and need to be captured.Source: Merrill Lynch
 
iQ
method 
SM 
 
 
May 20053
CONTENTS
n
SectionPage
Quick Reference
Standard Measure Definitions
At a Glance
2
1.Steps in Measuring the Investment Process
Business PerformanceQuality of EarningsValuation
4
2.A Checklist for Management
Return on Capital EmployedReturn on EquityOperating MarginEPS GrowthFree Cash Flow
5
3.Measures to Test Resilience of Business Performance
Cash Realization RatioAsset Replacement RatioTax RateNet Debt/Equity RatioInterest Cover
17
4.Connecting Market Value With Business Performance
Price/Earnings RatioPrice/Book ValueDividend YieldFree Cash Flow YieldEnterprise Value/EBITDAEnterprise Value/Sales
23
5.A Best Practice Guide to Discounted Cash Flow and Its Limitations
What (and How) to DiscountDifferent Approaches to the Residual
36
The
iQ
database
Global Template44

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