T UTORIAL 4

Q UEEN ’ S U NIVERSITY B ELFAST

Q UEEN ’ S M ANAGEMENT S CHOOL

Capital Markets (FIN3013)

Week 6
Question 1
You plan to use P/E and the method of comparables as a basis for recommending
purchasing shares of one of two peer-group companies in the business of manufac-
turing personal digital assistance. Neither company has been profitable to date, and
neither is expected to have positive EPS over the next year. Data on the companies’
prices, trailing EPS, and expected growth rates in sales (five-year compounded rates)
are given in the following table:
Expected
Company Price Trailing EPS P/E Growth (Sales)
Hand 22 -2.20 NM 45%
Somersault 10 -1.25 NM 40%
Because the earnings for both companies have been negative, their P/Es are not
meaningful.
1. Discuss how you could carry out a relative valuation in this case.
2. Which stock is relatively more attractive.

Solution Question 1
1)
• An analyst can rank the two stocks by earnings yield (E/P).
• Whether EPS is positive or negative, a lower E/P reflects a higher valuation,
and a ranking from high to low E/P has a meaningful interpretation.
• In some cases, an analyst might handle negative EPS by using normalized EPS
in its place. However, neither business has a history of profitability.
• When year-ahead EPS is expected to be positive, forward P/E is positive. Thus,
the use of forward P/Es sometimes addresses the problem of trailing negative
EPS.
• Forward P/E is not meaningful in this case, because next year’s earnings are
expected to be negative.

2)
• Hand has an E/P of -0.100, and Somersault has an E/P of -0.125.
• A higher earnings yield has an interpretation that is similar to that of a lower
P/E, so Hand appears to be relatively undervalued.
• The difference in earnings yield cannot be explained by differences in sales
growth forecasts. In fact, Hand has a higher expected sales growth than Som-
ersault.
• An analyst should recommend Hand.

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Question 2
Measure Hoppelli Foods Telli Foods Drisket Co. Whiteline Foods
Stock price 25.70 11.77 23.65 24.61
Shares outstanding (thousands) 138,923 220,662 108,170 103,803
Market cap ($ millions) 3,570 2,597 2,558 2,555
Enterprise value ($ millions) 3,779 4,056 3,846 4,258
Sales ($ millions) 4,124 10,751 17,388 6,354
Operating income ($ millions) 285 135 186 396
Operating profit margin 6.91% 1.26% 1.07% 6.23%
Net income ($ million) 182 88 122 252
TTM EPS 1.30 0.40 1.14 2.43
Return on equity 19.20% 4.10% 6.40% 23.00%
Net profit margin 4.41% 0.82% 0.70% 3.97%

On the basis of the data given, answer the following questions.

1. Calculate the trailing P/E and EV/Sales for each company.

2. Explain on the basis of fundamentals, why these stocks have different EV/S
multiples.

Solution to Question 2
1)

The P/Es are:

Hoppelli 25.70/1.30 = 19.8

Telli 11.77/0.40 =29.4
Drisket 23.65/1.14 =20.7
Whiteline 24.61/2.43 =10.1

The EV/S multiples are:

Hoppelli 3,779/4,124 =0.916

Telli 4,056/10,751 =0.377
Drisket 3,846/17,388 =0.221
Whiteline 4,258/6,354 =0.670

2)

The data for the problem includes measures of profitability, such as operating profit
margin, ROE, and net profit margin. Because EV includes the market values of both
debt and equity, logically the ranking based on EV/S should be compared with a
pre-interest measure of profitability, namely, operating profit margin. The ranking
of the stocks by EV/S from highest to lowest and the companies’ operating margins
are:

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 Operating Profit Margin
Company EV/S (%)
Hoppelli 0.916 6.91
Whiteline 0.670 6.23
Telli 0.377 1.26
Drisket 0.221 1.07

The differences in EV/S appear to be explained, at least in part, by differences in

cost structure as measured by operating profit margin.

Question 3
Giantin Growing AG (GG) is currently selling for 38.50, with TTM EPS, and div-
idends per share of 1.36 and 0.91, respectively. The company’s P/E is 28.3, P/B
is 7.1, and P/S is 2.9. The ROE is 27.0 percent, and the profit margin on sales is
10.24 percent. The Treasury bond rate is 4.9 percent, the equity risk premium is 5.5
percent, and GG’s beta is 1.2.

1. What is GG’s required rate of return, based on the capital asset pricing model
(CAPM)?

2. Assume that the dividend and earnings growth rates are 9 percent. What trail-
ing P/E, P/B, and P/S multiples would be justified in light of the required
rate of return and current values of the dividend payout ratio, ROE, and profit
margin?

3. Given that the assumptions and constant growth model are appropriate, state
and justify whether GG, based on fundamentals, appears to be fairly valued,
overvalued or undervalued.

Solution to Question 3
1)
Based on the CAPM, the required rate of return is

• 4.9% + 1.2 × 5.5% = 11.5%

2)
The dividend payout ratio is

• 0.91/1.36 = 0.669

The justified valued for the three valuation ratios are

P0 (1 − b)(1 + g) 0.669 × 1.09 0.7293

= = = = 29.2
E0 r −g 0.115 − 0.09 0.025

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 P0 ROE − g 0.27 − 0.09 0.18
= = = = 7.2
B0 r −g 0.115 − 0.09 0.025

P0 PM(1 − b)(1 + g) 0.1024 × 0.669 × 1.09

= = = 3.0
S0 r −g 0.115 − 0.09

3)
• The justified trailing P/E is higher than the trailing P/E (29.2 vs 28.3).
• The justified P/B is higher than the actual P/B (7.2 vs 7.1).
• The justified P/S is higher than the actual P/S (3.0 vs 2.9).

Based on these three measures, GG appears to be slightly undervalued.

Question 4
Consider the relative valuation of two companies in the aerospace/defense industry,
NCI Heavy Industries (NCI) and Relay Group International (RGI).

Company RGI NCI

Price per share 150 100
Shares outstanding 5 million 2 million
Market value of debt 50 100
Book value of debt 52 112
Cash and investments 5 2
Net income 49.5 12
Net income from continuing operations 49.5 8
Interest expense 3 5
Depreciation and amortization 8 4
Taxes 2 3

Using the information in the table, answer the following questions:

1. Calculate P/EBITDA for NCI and RGI.
2. Calculate EV/EBITDA for NCI and RGI.
3. Which company appears to be undervalued? Justify the selection.

Solution to Question 4
1)
EBITDA = Net income (from continuing operations) + Interest expense + Taxes +
Depreciation + Amortization

P/EBITDA for RGI:

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 • EBITDA for RGI: 49.5 million + 3 million + 2 million + 8 million = 62.5
million

• Per-share EBITDA: (62.5 million)/(5 million shares) = 12.5

• P/EBITDA: 150/12.5 = 12

P/EBITDA for NCI:

• EBITDA for NCI: 8 million + 5 million + 3 million + 4 million = 20 million

• Per-share EBITDA: (20 million)/(2 million shares) = 10

• P/EBITDA: 100/10= 10

2)
For RGI:

• Market value of equity: 150 × 5 million = 750 million

• Market value of debt: 50 million

• Total market value: 750 million + 50 million = 800 million

• EV: 800 million - 5 million (cash and investments) = 795 million

• EV/EBITDA: (795 million)/(62.5 million) = 12.72

For NCI:

• Market value of equity: 100 × 2 million = 200 million

• Market value of debt: 100 million

• Total market value: 200 million + 100 million = 300 million

• EV: 300 million - 2 million (cash and investments) = 298 million

• EV/EBITDA: (298 million)/(20 million) = 14.9

3)
RGI is relatively undervalued.

NCI appears to be relatively undervalued because it has a lower P/EBITDA multiple:

• P/EBITDA: 12 for RGI

• P/EBITDA: 10 for NCI

However, RGI is relatively undervalued on the basis of EV/EBITDA.

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 • EV/EBITDA: (795 million)/(62.5 million) = 12.7 for RGI

• EV/EBITDA: (298 million)/(20 million) = 14.9 for NCI

EBITDA is a pre-interest flow, therefore it is a flow to both debt and equity and as
such the EV/EBITDA multiple is more appropriate than the P/EBITDA multiple.

An analyst would rely on EV/EBITDA to reach a decision if the two ratios conflicted.

P/EBITDA does not take into account difference in the use of financial leverage.
Substantial differences in leverage exist in this case (NCI uses a lot more debt), so
the preference for using EV/EBITDA rather than P/EBITDA is supported.

Question 5
Consider data on two pharmaceutical industry, DriveMed and MAT Technology, are
given in the following table. For both companies, expenditures on fixed capital and
working capital during the previous year reflect anticipated average expenditures
over the foreseeable future.

Measure DriveMed MAT Technology

Current price 46.00 78.00
Trailing CF per share 3.60 6.00
P/CF 12.8 13.0
Trailing FCFE per share 1.00 5.00
P/FCFE 46.0 15.6
Consensus five-year growth forecast 15% 20%
Beta 1.25 1.25

Discuss the valuation of MAT Technology relative to DriveMed. Justify your conclu-
sion.

Solution to Question 5
• MAT Technology is relatively undervalued compared with DriveMed on the
basis of P/FCFE.

• MAT Tech’s P/FCFE multiple is 34 percent the size of DriveMed’s FCFE multiple
(15.6/46.0 = 0.34).

• The only comparison slightly in favour, or approximately equal for both com-
panies, is the comparison based on P/CF (12.8 (DriveMed) vs 13.0 (MAT Tech-
nology).

• FCFE is more strongly grounded in valuation theory than P/CF.

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• The fact that DriveMed’s and MAT Technology’s expenditures for fixed capital
and working capital during the previous year reflected anticipated average ex-
penditures over the foreseeable horizon, provides additional support for the
P/FCFE comparison.