MARKET-BASED

VALUATION:
PRICE AND ENTERPRISE
VALUE MULTIPLES

Presenter
Venue
Date
VALUATION INDICATORS

Enterprise
Price
Value
Multiples
Multiples

Momentum
Indicators
 METHODS FOR PRICE & ENTERPRISE VALUE
MULTIPLES

1) Method of Comparables
Economic rationale is the law of one price

2) Method Based on Forecasted Fundamentals

Reflects firm fundamentals and future cash flows

Justified Price Multiples

Can be determined using either method
 PRICE-TO-EARNINGS MULTIPLE
RATIONALES & DRAWBACKS

Rationales Drawbacks
Zero, negative, or very
EPS is driver of value
small earnings

Permanent vs.
Widely used
transitory earnings

Related to stock Management

returns discretion for earnings
 PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS

Trailing Forward
P/E P/E
Preferred Preferred
Uses last when Uses next when trailing
years forecasted years earnings are
earnings earnings are earnings not reflective
not available of future
 EXAMPLE: FORWARD P/E

Stock price $20 .00

2011:Q1 EPS $0 .18
2011:Q2 EPS $0 .25
2011:Q3 EPS $0 .32
2011:Q4 EPS $0 .35
2011 Fiscal year forecast $1 .10

2012:Q1 EPS $0 .43

2012:Q2 EPS $0 .48
2012:Q3 EPS $0 .50
2012:Q4 EPS $0 .59
2012 Fiscal year forecast $2 .00
 EXAMPLE: FORWARD P/E

1) Forward P/E based on EPS for the next 4 quarters:

EPS for the next 4 quarters = $0.35 $0.43 $0.48 $0.50 $1.76
Forward P/E based on EPS for the next 4 quarters $20 $1.76 11.4

2) Forward P/E based on EPS for the NTM (next 12 months):

EPS for the NTM 1 $1.10 11 $2.00 $1.925
12 12
Forward P/E based on EPS for the NTM $20 $1.925 10.4
 EXAMPLE: FORWARD P/E

3) Forward P/E based on the current fiscal year's EPS:

EPS for the current fiscal year $1.10
Forward P/E based on EPS for the current fiscal year $20 $1.10 18.2

4) Forward P/E based on the next fiscal year's EPS:

EPS for the next fiscal year $2.00
Forward P/E based on EPS for the next fiscal year $20 $2.00 10.0
ISSUES IN CALCULATING EPS

Underlying
EPS Dilution
Earnings

Differences
Normalized
in Accounting
Earnings
Methods
 EXAMPLE: UNDERLYING EARNINGS

Reported EPS from previous four quarters $4.00

Restructuring charges $0.10

Amortization of intangibles $0.15

Impairment charge $0.20

Stock price $50.00

 EXAMPLE: UNDERLYING EARNINGS

P/E based on reported earnings $50 $4.00 12.5

Reported core earnings $4.00 $0.10 $0.15 $0.20 $4.45

P/E based on reported core earnings $50 $4.45 11.2

Underlying earnings $4.00 $0.20 $4.20

P/E based on underlying earnings $50 $4.20 11.9
 EXAMPLE: NORMALIZED EARNINGS
Year EPS BVPS ROE
2010 $0.66 $4.11 16.1%
2009 $0.55 $3.67 15.0%
2008 $0.81 $2.98 27.2%
2007 $0.73 $2.12 34.4%
2006 $0.34 $1.61 21.1%

2011 stock price $24.00

 EXAMPLE: NORMALIZED EARNINGS

1) Method of historical average EPS

($0.66 $0.55 $0.81 $0.73 $0.34)

Average (normalized) EPS $0.618
5

P/E $24.00 $0.618 38.8

 EXAMPLE: NORMALIZED EARNINGS

2) Method of average ROE

(16.1% 15.0% 27.2% 34.4% 21.1%)

Average ROE 22.8%
5

Average (normalized) EPS Average ROE Current equity book value per share
Average (normalized) EPS 22.8% $4.11 $0.937

P E $24.00 $0.937 25.6

JUSTIFIED FORWARD P/E FROM
FUNDAMENTALS

D1
V0
r g
P0 D1 E1

E1 r g
P0 1 b

E1 r g
JUSTIFIED TRAILING P/E FROM
FUNDAMENTALS

D 0 (1 g )
V0
rg
P0 D 0 (1 g ) E0

E0 rg
P0 (1 b)(1 g )

E0 rg
 EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS

Retention ratio 0 .36

Dividend growth rate 4.0%

Required return on stock 10.0%

EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS

P0 1 b
=
E1 rg
P0 1 0.36
= =10.7
E1 0.10 0.04
 EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS

Predicted P/E
11.5 2.2 DPR + 0.03 Beta + 16.2 EGR
Values for subject firm

Dividend payout ratio 0.40

Beta 1 .20
Earnings growth rate 6.00%
Actual P/E 15 .0
 EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS

Predicted P/E

11.5 2.2 DPR 0.03 Beta 16.2 EGR

11.5 2.2 0.4 + 0.03 1.2 16.2 0.06

13.3
 METHOD OF COMPARABLES

Benchmark Value of the

Multiple Choices

Industry Broad Firms

Industry
or sector market historical
peers
index index values
 METHOD OF COMPARABLES
USING PEER COMPANY MULTIPLES

Law of one price

Risk and earnings growth adjustments
PEG limitations:
Assumes linear relationship
Does not account for risk
Does not account for growth duration
 EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG

Values for subject firm

Five-year EPS growth rate 8.0%
Consensus EPS forecast $4.50
Current stock price $28.00

Values for peer group

Median P/E 9 .00
Median PEG 1 .60
 EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG

P/E $28.00 $4.50 6.2

PEG 6.2 8.0 0.78

Intrinsic value 9.0 $4.50 $40.50

 METHOD OF COMPARABLES
USING INDUSTRY AND MARKET MULTIPLES

Industry or Sector Index

Mean vs. median
Check industry valuation against market

Broad Market Index

Adjust for differences in fundamentals & size
Use relative values on a historical basis
 METHOD OF COMPARABLES
VALUING THE MARKET

Fed Model: Earnings Yield vs. T-Bond Yield

Does not account for inflation correctly
Relationship between earnings yield &
interest rates is nonlinear
Small rate s large s in P/E

Yardeni Model
 METHOD OF COMPARABLES
USING OWN HISTORICAL MULTIPLES
Rationale: Regression to the Mean
Approaches:
Average of four middle values over past 10 years
Five-year average trailing P/E
Potential Problems from Changes in
Firm business
Firm financial leverage
Interest rate environment
Economic fundamentals
Inflationary environment
USING P/ES FOR TERMINAL VALUE

P/E Based on
Justified P/E
Comparables

P/E = Grounded in market

(D/E)/(r g) data

If comp is mispriced,
Sensitive to required
terminal value will
inputs
be mispriced
EXAMPLE: USING P/ES FOR TERMINAL VALUE

Values for subject firm

Required rate of return 11.0%
EPS forecast for year 3 $2.50

Values for peer group

Mean dividend payout ratio 0 .40
Mean ROE 8.0%
Median P/E 9 .00
EXAMPLE: USING P/ES FOR TERMINAL VALUE
USING GORDON GROWTH MODEL

D3 EPS3 Dividend payout ratio

D3 $2.50 0.40 $1.00

Retention ratio 1 Dividend payout ratio

Retention ratio 1 0.40 0.60

g Retention ratio ROE

g 0.60 8% 4.8%

D3 1 g $1.00 1 0.048
V3 $16.90
rg 0.11 0.048
EXAMPLE: USING P/ES FOR TERMINAL VALUE
USING COMPARABLES

V3 P/E EPS3

9.0 $2.50 $22.50

 PRICE-TO-BOOK VALUE MULTIPLE
RATIONALES

Book Value Is Usually Positive

More Stable than EPS

Appropriate for Financial Firms

Appropriate for Firms that Will Terminate

Can explain stock returns

 PRICE-TO-BOOK VALUE MULTIPLE
DRAWBACKS

Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Due to Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

 ADJUSTMENTS TO BOOK VALUE

Intangible Inventory
Assets Accounting

Off-Balance-
Fair Value
Sheet Items
 JUSTIFIED P/B

P0 ROE g

B0 r g

P0 PV Expected future residual earnings

1
B0 B0
 PRICE-TO-SALES
MULTIPLE RATIONALES

Sales Less Easily Manipulated

Sales Are Always Positive

P/S Appropriate For Mature, Cyclical, & Distressed Firms

P/S More Stable Than P/E

Can Explain Stock Returns

 PRICE-TO-SALES
MULTIPLE DRAWBACKS

Sales Earnings & Cash Flow

Numerator & Denominator Not Consistent

P/S Does Not Reflect Cost Differences

P/S Can Be Misleading Due to Accounting

Practices
 JUSTIFIED P/S

P0 (E0 / S0 )(1 b)(1 g )

S0 rg

g b ROE

Sales Total assets

g b PM0
Total assets Shareholders equity
EXAMPLE: CALCULATING THE ACTUAL & JUSTIFIED
P/E, P/B, & P/S

Stock price $50 .00

EPS $2 .00
Dividends per share $1 .20
Book value of equity per share $6 .25
Sales per share $15 .00
ROE 22.5%
Required return on stock 12.0%
EXAMPLE: CALCULATING THE ACTUAL
P/E, P/B, & P/S
P0 $50
Actual 25.0
E0 $2

P0 $50
Actual 8.0
B0 $6.25

P0 $50
Actual 3.3
S0 $15
EXAMPLE: CALCULATING THE INPUTS FOR
THE JUSTIFIED
P/E, P/B, & P/S

Dividend payout ratio $1.20 $2.00 0.60

Retention ratio (b) 1 0.60 0.40

Growth rate in dividends (g ) 0.40 22.5% 9.0%

 EXAMPLE: CALCULATING THE JUSTIFIED
P/E, P/B, & P/S

P0 (1 b)(1 g ) (1 0.60)(1 0.09)

21.8
E0 rg 0.12 0.09

P0 ROE g 0.225 0.09

4.5
B0 rg 0.12 0.09

P0 (E0 S0 )(1 b)(1 g ) ($2 $15)(0.6)(1.09)

2.9
S0 rg 0.12 0.09
 PRICE-TO-CASH-FLOW
MULTIPLE RATIONALES

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E

Ratio Can Explain Stock Returns

PRICE-TO-CASH-FLOW
MULTIPLE DRAWBACKS

Cash Flow Can Be

Distorted

FCFE More Volatile

and More Frequently
Negative

Cash Flow Increasingly

Managed by Firms
 DEFINITIONS OF CASH FLOW

Earnings + Depreciation +
CF Amortization + Depletion

CFO From statement of cash flows

FCFE Most valid but volatile

Best used with enterprise

EBITDA value
JUSTIFIED PRICE-TO-CASH-FLOW RATIO

FCFE 0 (1 g )
V0
rg
 DIVIDEND YIELD
RATIONALES & DRAWBACKS

Rationales Drawbacks
Only one component of
Component of return return

Dividends may displace

future earnings
Dividends less risky
than future capital Market may not favor
gains dividends
JUSTIFIED DIVIDEND YIELD

D0 rg

P0 1 g
 INVERSE PRICE RATIOS

Price Ratio Inverse Price Ratio

Price-to-earnings (P/E) Earnings yield (E/P)

Price-to-book (P/B) Book-to-market (B/P)

Price-to-sales (P/S) Sales-to-price (S/P)

Price-to-cash-flow (P/CF) Cash flow yield (C/P)

Price-to-dividends (P/D) Dividend yield (D/P)

 ENTERPRISE VALUE/EBITDA MULTIPLE
RATIONALES & DRAWBACKS

Rationales Drawbacks
Useful for comparing firms
of different leverage Exaggerates cash flow

Useful for comparing firms

of different capital utilization
FCFF more strongly
Usually positive grounded
 ISSUES IN USING ENTERPRISE VALUE
MULTIPLES

EV = Market Value of Stock + Debt Cash Investments

Justified EV/EBITDA
Positively related to FCFF growth
Positively related to ROIC
Negatively related to WACC
Comparables May Utilize TIC

Other EV Multiples
EV/FCFF
EV/EBITA
EV/EBIT
EV/S
 CROSS-COUNTRY COMPARISONS

US GAAP Net income higher under IFRS

Shareholder's equity lower under IFRS
vs. IFRS ROE higher under IFRS

Valuation P/CFO & P/FCFE most comparable

P/B, P/E, & EBITDA multiples least
Multiples comparable

Higher inflation Lower justified price

multiples
Inflation Higher pass-through rates Higher justified
price multiples
 MOMENTUM INDICATORS:
EARNINGS SURPRISES

UEt EPSt E EPSt

EPSt E EPSt UEt

SUEt
EPSt E EPSt UEt
MOMENTUM INDICATORS:
RELATIVE STRENGTH

Past Performance

Relative to an Index

Inherently Self-
Destructing
VALUATION INDICATORS IN PRACTICE:
AVERAGING MULTIPLES

Arithmetic
Mean & Overestimate of index P/E
Weighted Mean

Closer to index P/E but is

Harmonic Mean
influenced by small outliers

Weighted
Harmonic Mean
Equal to index P/E
 VALUATION INDICATORS IN PRACTICE:
STOCK SCREENS

Database Limitations
Variables are predetermined
Does not contain qualitative data
Look-Ahead Bias
Assumes investor has info not yet available

Sector Rotation
 SUMMARY

Price & Enterprise Value Multiples

Method of comparables
Method based on forecasted fundamentals

Price-to-Earnings Rationales & Drawbacks

Rationales: EPS Driver of value; widely used;

related to stock returns
Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion for
earnings
Trailing and forward P/Es
 SUMMARY

Issues in Calculating EPS

EPS dilution
Underlying earnings
Normalized earnings
Differences in accounting methods

Method of Comparables

Industry peers
Industry or sector index
Broad market index
Own historical values
 SUMMARY

Price-to-Book Rationales & Drawbacks

Rationales: Book value usually > 0, more stable than EPS,

appropriate for financial firms & firms that will terminate,
explains stock returns
Drawbacks: Doesnt recognize nonphysical assets, misleading
if asset levels vary or differ from accounting practices, less
useful when asset age differs, can be distorted by repurchases

Issues in Calculating Book Value

Intangible assets
Inventory accounting
Off-balance-sheet items
Fair value
 SUMMARY

Price-to-Sales Rationales & Drawbacks

Rationales: Sales less easily distorted, sales always positive,
P/S more stable than P/E, appropriate for many firms,
explains stock returns
Drawbacks: Sales Earnings & Cash flow, numerator &
denominator not consistent, does not reflect cost differences,
can be distorted

Price-to-Cash-Flow Rationales & Drawbacks

Rationales: CF less easily manipulated, more stable than

P/E, addresses quality of earnings issue, explains stock
returns
Drawbacks: can be distorted, FCFE more volatile and more
frequently negative, increasingly managed by firms
 SUMMARY

Measures of Cash Flow

CF: Earnings + Depreciation + Amortization + Depletion
CFO: From statement of cash flows
FCFE: Most valid but volatile
EBITDA: Best used with enterprise value

Dividend Yield Rationales & Drawbacks

Rationales: A component of return, dividends less risky
than future capital gains
Drawbacks: Only one component of return, dividends
may displace future earnings, market may not favor
dividends
 SUMMARY
Inverse Price Ratios

Useful when denominators are small, low, or negative

(e.g., earnings)
Earnings yield, book-to-market, sales-to-price, cash
flow yield, and dividend yield

Enterprise Value Multiples

EV = Market value of stock + Debt Cash

Investments
Rationales: Useful for comparing firms of different
leverage & capital utilization, usually positive
Drawbacks: Exaggerates cash flow, FCFF more
strongly grounded
 SUMMARY

Justified Multiples

P/E: + related to g, related to r

P/B: + related to ROE, related to r
P/S: + related to g & PM, related to r
P/CF: + related to g, related to r
D/P: - related to g, + related to r
EV/EBITDA: + related to g and PM,
related to WACC
 SUMMARY

Cross-Country Comparisons

IFRS ROE higher than GAAP ROE

P/CFO & P/FCFE most comparable
P/B, P/E, & EBITDA multiples least
comparable
Higher inflation Lower justified price
multiples
Higher pass-through rates Higher
justified price multiples
 SUMMARY

Momentum Indicators

Unexpected earnings (UE)

Standardized unexpected earnings (SUE)
Relative strength

Stock Screens

Database limitations
Potential look-ahead bias
Used in sector rotation