Equity Investments

Study Sessions 9, 10, & 11

Weighting 15–25%
Overview of Level II Equity

SS9: Equity Valuation

27. Equity Valuation: Applications and
Processes
Overview of Level
28. Return ConceptsII Corp Fin

SS10: Industry & Company Analysis

29. Industry and Company Analysis
30. Discounted Dividend Valuation

© Kaplan, Inc. 2
Overview of Level II Equity

SS11: Equity Investments: Valuation Models

31.
Free Cash Flow Valuation
32.
Market Based Valuation: Price &
Overview of Level
Enterprise II Multiples
Value Corp Fin
33. Residual Income Valuation
34. Private Company Valuation

© Kaplan, Inc. 3
Valuation Process
Valuation
Valuation == the
the estimation
estimation of
of an
an asset’s
asset’s value
value
Porter’s
Porter’s Competitive
Competitive
Absolute:
Absolute: Based
Based on
on variables
variables Relative:
Relative: Based
Based on
on comparisons
comparisons Strategy
Strategy
perceived
perceived toto be
be related
related to
to with
with similar
similar assets
assets (law
(law of
of one
one 1.
1. Cost
Cost leadership
leadership
future
future investment
investment returns
returns price)
price) Price
Price multiples
multiples 2.
2. Differentiation
Differentiation
(DDM,
(DDM, Free
Free cash
cash flow,
flow, RI)
RI) 3.
3. Focus
Focus
Porter’s
Porter’s Five
Five Forces
Forces
1.
1. New
New entrants
entrants Uses:
Uses:
Valuation
Valuation Process
Process ––
Overview
Overview 2.
2. Substitutes
Substitutes  Stock
Stock selection
selection
1.
1. Understand
Understand the the business
business 3.
3. Buyers
Buyers  Reading
Reading the
the market
market
2.
2. Forecast
Forecast business
business 4.
4. Suppliers
Suppliers  Projecting
Projecting the
the value
value of
of
performance
performance corporate
corporate actions
actions
5.
5. Rivalry
Rivalry
3.
3. Select
Select the
the relevant
relevant  Fairness
Fairness opinions
opinions
valuation
valuation model(s)
model(s)  Planning
Planning and
and consulting
consulting
4.
4. Convert
Convert forecasts
forecasts to
to aa Critical
Critical step
step that
that involves
involves  Communications
Communications with with
valuation
valuation financial
financial statement
statement analysis
analysis analysts
analysts and
and investors
investors
5. Make (including
(including quality
quality ofof earnings
earnings
5. Make thethe recommendation
recommendation  Valuation
Valuation of
of private
private
or analysis)
analysis) combined
combined with with an
an
or investment
investment decision
decision business
business
evaluation
evaluation of of industry
industry
 Portfolio
Portfolio construction
construction
prospects,
prospects, competitive
competitive position,
position,
and and
and management
management
© Kaplan, Inc. and corporate
corporate strategies.
strategies. 4
Valuation Process
Perceived Mispricing
 Any difference between the analyst’s estimate of
intrinsic value and the market price
IV – Price = (IVactual – Price) + (IVanalyst – IVactual)

Going-concern Assumption
 Assumes business will continue to operate
 Liquidation value is value of assets sold separately
 Ordered liquidation value if assets sold with enough
time to get better value

Model selected must be:

 Consistent with the characteristics of the company being valued
 Appropriate given the availability and quality of data
 Consistent with the purpose of valuation, including the analyst’s ownership
perspective (i.e., extent of the investor’s influence over the company)

© Kaplan, Inc. 5
Return Concepts
Different
Different Returns/Rates
Returns/Rates
 Holding
Holding Period
Period Return,
Return, Realized
Realized Return,
Return, Expected
Expected Return,
Return, Required
Required Return,
Return, Return
Return from
from
Price
Price Convergence,
Convergence, Discount
Discount Rate,
Rate, Internal
Internal Rate
Rate of
of Return
Return

Required
Required Return
Return == R
Rff ++ ERP
ERP Equity risk premium (ERP):
(broad
(broad market
market or
or average
average risk
risk security)
security) = (required return – Rf)

Ways
Ways of
of Measuring
Measuring the
the Required
Required Return
Return  Rf equal to the investor’s investor horizon:
CAPM – Single Factor Model  T bills for short horizon
 T bonds for longer horizon
E(R) = Rf + β (Rm – Rf)  Methods to estimate ERP:
1. Historical ERP
2. Forward looking ERP
“equity risk premium”
 Gordon Growth Model
 Macroeconomic model
E(R) (Ibbotson – Chen)
E(R) == D
D11/P
/P00 ++ gg == Y+
Y+ gg
3.Survey
ERP
ERP == E(R)
E(R) –– R Rff == Y+
Y+ gg –– R
Rff

ERP
ERP == Y
Y ++ [(1
[(1 ++ E
Einfl)(1 + g eps)(1
infl)(1 + geps )(1 ++ PEG)
PEG) –– 1]
1] –– R
Rff
© Kaplan, Inc. 6
Return Concepts
Ways
Ways of
of Measuring
Measuring the
the Required
Required Return
Return

Multifactor Models
Required Return = Rf + (factor sensitivity)i*(factor risk premium)i + ….
…. + (factor sensitivity)n*(factor risk premium)n

Fama-French Model:
Required return on stock j = Rf + bmkt*(Rmkt – Rf) + bSMB,j*(RSMALL – RBIG) + bHML,j*(RHBM – RLBM)
Rmkt – Rf = return on a value-weighted market index minus risk-free rate
RSMALL– RBIG = small cap return premium
RHBM – RLBM = value return premium

Pastor-Stambaugh Model: Arbitrage Pricing Model (BIRR version):

Builds on the Fama French Model Uses economic variables believed to affect
by adding a liquidity factor cash flows as factors within the model (e.g.,
Burmeister, Roll and Ross Model) uses:
 Confidence
 Time Horizon
 Inflation
 Business Cycle
 Market Timing
© Kaplan, Inc. 7
Return Concepts
Ways of Measuring the Required Return

Build-Up Method
Required return = Rf + equity risk premium + size premium + specific company premium

Bond Yield Plus Risk Premium

Required return = YTM on long-term debt + risk premium

Country Spread Model and Country Risk Rating Model

Calculates premium to be added to required return when investing in emerging markets

WACC
 Weighted-average cost of capital using target
market weights of debt and equity
 Appropriate for valuing a total firm
 To value equity subtract the MV of long-term debt
© Kaplan, Inc. 8
Return Concepts
Estimating Beta
Public Companies:

Use regression of company stock returns against the market:

Rcompany = α + β (Rmarket) + ε
Adjust for beta drift by using adjusted beta β Influenced by:
Adjusted beta = (2/3) × regression beta + (1/3) × 1 • Index choice: Broad market index
• Risk free choice: Long-term
government bond yields
Thinly traded/non-public companies:
• Interval: Typical 5-year monthly
Unlevered beta of similar quoted company returns
= Beta of similar company × 1/[1 + (debt of similar co / equity of similar co)]

Estimated beta for ABC

= unlevered beta of similar quoted company × (1 + (debt of ABC / equity of ABC))

© Kaplan, Inc. 9
Industry and Company Analysis
Top
Top Down
Down Bottom
Bottom Up
Up Segmental
Segmental Disclosure:
Disclosure:
1.
1. Economy
Economy Most 1.
1. Product
Product lines
lines •• Geographical
Geographical
(GDP)
(GDP) common 2.
2. Aggregate
Aggregate for
for firm
firm •• Divisions
Divisions ≥≥ 10%
10% sales
sales or
or operating
operating
2.
2. Sector
Sector = Techniques:
Techniques: profits
profits or
or use
use of
of assets
assets
3.
3. Industry
Industry hybrid •• Time
Time series
series
4.
4. Products
Products •• Return
Return on
on capital
capital Disclosure
Disclosure forfor Each
Each Segment:
Segment:
•• Capacity
Capacity based
based
•• Revenue
Revenue (external
(external andand internal)
internal)
•• Segment
Segment result
result (operating
(operating profit)
profit)
Revenue
Revenue Forecasting:
Forecasting: •• Carrying
Carrying amount
amount of of segment
segment assets
assets
1.
1. Growth
Growth relative
relative to
to GDP
GDP growth:
growth: •• Segment
Segment liabilities
liabilities (not
(not U.S.
U.S. GAAP)
GAAP)
GDP
GDP growth
growth (1(1 ++ x%)
x%) •• Cost
Cost of
of PP&E
PP&E andand Intangibles
Intangibles acquired
acquired
2.
2. Market
Market growth
growth and
and market
market share:
share: •• Depreciation
Depreciation and
and Amortization
Amortization expense
expense
Industry
Industry sales
sales forecast
forecast ×× market
market share
share •• Other
Other noncash
noncash expenses
expenses
•• Share
Share of
of NI
NI from
from equity
equity accounted
accounted
Operating
Operating Cost
Cost Forecasting:
Forecasting: investments
investments
1.
1. Top
Top Down
Down
Inflation
Inflation Economies
Economies of of Scale:
Scale:
Industry Fixed vs. Variable Costs:
Industry specific
specific costs
costs 
 Volumes
Volumes   Average
Average cost
cost
Company
Company assumptions
assumptions Investment in PP&E Larger
Larger companies
companies have
have higher
higher
2.
2. Bottom
Bottom UpUp gross
gross margins
margins
Segmental
Segmental margins
margins +ve
+ve correlation
correlation between
between sales
sales
Historical
Historical cost
cost growth
growth % of revenue growth and margins
growth and margins
Specific
Specific costs
© Kaplan, Inc. costs 10
Industry and Company Analysis
COGS
COGS Forecasting:
Forecasting: Bottom
Bottom Up
Up Analysis
Analysis of
of Margins:
Margins:
Related
Related to
to sales
sales •• Segmental
Segmental
1.
1. Forecast
Forecast revenue
revenue ×× (historical
(historical COGS/revenue)
COGS/revenue) •• Product
Product category
category
2.
2. Forecast
Forecast revenue
revenue ×× (1
(1 –– gross
gross margin)
margin) •• Price
Price and
and volume
volume
•• Trends
Trends
Sales,
Sales, General,
General, and and Admin
Admin (SGA):
(SGA):
•• Less-variable
Less-variable costs
costs Cross
Cross check
check with
with Consider:
Consider:
•• Costs
Costs tend
tend to
to increase
increase slowly
slowly competitor
competitor firms
firms •• Hedging
Hedging activity
activity
over
over time
time with
with firm
firm size
size •• Ability
Ability to
to pass
pass cost
cost increase
increase to
to
•• Use
Use historical
historical relationships
relationships customer
customer (flow
(flow through)
through)
•• Use
Use segmental
segmental analysis
analysis ifif
available
available Nonoperating
Nonoperating Costs:
Costs: Taxes:
•• Normalize •• Interest
Interest
Normalize Statutory rate
•• Taxes
Taxes
•• Minority Effective rate
Interest: Minority interest
interest
•• Income Cash rate
Function of capital structure and Income from
from affiliates
affiliates
interest rates
••Gross
Gross expense/avg.
expense/avg. gross
gross debt
debt
Footnotes: Information on Function of:
maturity and interest rates ••Net
Net expense/avg.
expense/avg. net
net debt
debt
Overseas operations
• Gross interest rate ••Interest
Interest income/avg.
income/avg. cash
cash and
and
ST securities
ST securities
Disallowable expenses
• Net interest rate Tax credits
net
net debt
debt == gross
gross debt
debt –– cash,
cash, cash
cash
• Yield on avg. cash balance equivalents, and ST securities
equivalents, and ST securities Deferred tax
© Kaplan, Inc. 11
Industry and Company Analysis
Balance
Balance Sheet
Sheet Forecasting:
Forecasting: PPE:
PPE:
Items
Items related
related toto income
income statement:
statement: •• Capex
Capex
•• Retained
Retained earnings
earnings •• Depreciation
Depreciation
•• Accounts
Accounts receivable
receivable Use Method
Method 11
•• Ending
Ending inventory
inventory efficiency PPE
PPE == forecast
forecast revenue
revenue ×× (PP&E/revenue)
(PP&E/revenue)
•• Accounts
Accounts payable
payable ratios Method
Method 22
Items
Items not
not related
related to to income
income statement:
statement: Consider
Consider firms
firms future
future plans
plans
•• PP&E
PP&E •• Capex
Capex for
for growth
growth
•• Intangibles
Intangibles •• Capex
Capex for
for maintenance
maintenance
•• Investments
Investments in in group
group companies
companies (depreciation
(depreciation ×× inflation)
inflation)
•• Capital
Capital structure
structure
•• Pension
Pension liabilities
liabilities Capital
Capital Structure:
Structure:
•• Leases
Leases Historic
Historic precedents
precedents
MD&A
MD&A
Forecast
Forecast statements
statements should
should be
be subject
subject to
to Capital
Capital requirements
requirements
sensitivity
sensitivity and
and scenario
scenario analysis
analysis •• D/(D
D/(D ++ E)
E)
•• D/E
D/E
Return
Return onon Invested
Invested Capital:
Capital: •• D/EBITDA
D/EBITDA
Preleverage
Preleverage measure
measure
ROIC
ROIC == NOPLAT
NOPLAT // ICIC
NOPLAT
NOPLAT == EBIT(1
EBIT(1 –– T)
T) Return
Return on
on Capital
Capital Employed:
Employed:
IC
IC == operating
operating assets
assets –– operating
operating liabilities
liabilities Useful
Useful for
for firm
firm comparison
comparison in
in differing
differing tax
tax
Compare
Compare with
with competitors:
competitors: Measure
Measure of of regimes
regimes
competitive
©competitive advantage
Kaplan, Inc. advantage ROCE
ROCE == EBIT
EBIT // (D
(D ++ E)
E) 12
Industry and Company Analysis
Input
Input Cost
Cost Impact
Impact onon Margins:
Margins: Technological Developments:
•• By
By product
product category
category • Decrease production costs
•• By
By geographical
geographical region
region • Increase supply and sales
•• Temporary
Temporary vs. vs. permanent
permanent increases
increases Substitute Development:
Firms
Firms Ability
Ability toto Maintain
Maintain Margins
Margins via:
via: • Potential market and industry
•• Hedging
Hedging commodity
commodity cost
cost disruption
•• Vertical
Vertical integration
integration with
with suppliers
suppliers • Cannibalization factor = % of existing
•• Passing products market taken by new products
Passing on on cost
cost to
to customer
customer (elasticity
(elasticity of
of
demand
demand key)key) • Higher for consumers
• Lower for business customers
Impact
Impact of
of Competition:
Competition: • Scenario analysis
Use
Use Porter’s
Porter’s Five
Five Forces
Forces
•• Revenues Explicit
Explicit Forecast
Forecast Horizon:
Horizon:
Revenues
•• Margins •• Buy
Buy side:
side:
Margins Inflection
Inflection Points:
Points:
•• Capex •• Match
Match forecast
forecast to to expected
expected
Capex Past
Past no
no longer
longer aa holding period
holding period
guide
guide to
to the
the future
future •• Highly
Highly cyclical
cyclical firms:
firms:
Beyond
Beyond the
the Short
Short Term:
Term: Change
Change in:
in: •• Normalize
Normalize the the business
business
Forecast
Forecast CFs
CFs ++ Terminal
Terminal •• Economic
Economic cycle
cycle
Value
Value (TV)
(TV) environment
environment •• Mid-market
Mid-market earnings
earnings
TV
TV approaches:
approaches: •• Business
Business cycle
cycle •• M&A
M&A activity:
activity:
•• Gordon
Gordon growth
growth model
model •• Gov’t
Gov’t policy
policy
•• Technology •• Ensure
Ensure horizon
horizon is is long
long
•• Multiples
Multiples Technology enough
enough to capture benefits
to capture benefits
© Kaplan, Inc. of
of M&A
M&A 13
DCF

Generic DCF Model Consider using dividends for CF when:

  There is a dividend record to analyze
CFt
V0 =   The dividend policy established by the board
1+ r 
t
t=1
where: bears an understandable and consistent
V0  value of the asset today (t  0) relationship to the company’s profitability
CFt  expected cash flow at time t  The investor takes a noncontrol perspective
r  required rate of return

Using DCF for Valuation

 Calculate intrinsic value using cash flows
being considered
 Compare to current market value
 If model intrinsic value is greater than market
value, then the stock is undervalued
 This can be applied to DCF and Residual
Income valuation techniques

© Kaplan, Inc. 14
Dividend Discount Models
Generic DDM Single Holding Period Holding Period of n Years

Dt D1  P1
V0   V0  V0 
D1

D2
 ... 
Dn  Pn
1  r  1  r 
t 1
1  r  1  r  1  r 
1 2 n
t 1
where: where:
V0  value of the share today (t  0) Pt  share price at time t
Dt  expected dividend at time t
r  required return on equity
Two-Stage DDM
Expected HPR
Gordon Growth Model P1  P0  D1 n
Dt Vn
r
D0 1  g P0 V0   
1  r  1  r 
t n
D1 t 1
V0  
rg rg
H-Model
D0 1  gL  D0  H  gS  gL 

No Growth Model r  gL r  gL
D (or E)
V0  H = half the number of years for
r anticipated decline in growth

Present Value of Growth Opportunities (PVGO)

= market value per share – no growth value per share
© Kaplan, Inc. 15
DCF Commentary
Gordon Growth Model
Strengths:
 Suitable for stable, mature,
dividend paying firms
 Easily applied to indices
 Easily communicated and
explained
 Can be used to determine growth
rates, rates of return, and PVGO
 Supplements other methods
Limitations:
 Very sensitive to inputs
 Not easily applied to nondividend
paying stocks
 Unpredictable growth patterns
makes using the model difficult
Spreadsheet Approach
Used when even the three-stage DDM is too simple for a real-life application
© Kaplan, Inc.
Problem With Two-Stage Model With
Constant Growth in Both Stages
Assumption that a firm’s high growth rate will
suddenly drop to a lower level overnight is
highly unrealistic.
Improvement Built Into H-Model
Over a set time, the high initial growth will
decline in a linear fashion to the sustainable
long-term growth rate
Rationale for Three-Stage Model
 With a good product, some companies may
sustain a high growth rate in the short-term
 The business is most likely to go through a
growth phase, transitional phase, then mature
phase
16
Further Aspects

Multi-Stage Models SGR: g = b × ROE

Strengths: where: b = retention rate
 Flexibility
ROE = expected return on equity
 Can calculate implied growth rates or
required returns
 Can incorporate the impact of
different assumptions into the model
Sustainable Growth Rate
 Relatively easy to construct using
spreadsheet software Rate at which earnings (and dividends) can
Limitations: continue to grow indefinitely, assuming that the
firm’s leverage is unchanged and no new external
 Estimates are only as good as the
equity is issued.
inputs used
 Model must be fully understood to
arrive at accurate estimates
 Estimates are very sensitive to Estimating Return on Equity (ROE)
assumptions regarding growth and Net Income Use opening
ROE  balance sheet values
the required return Equity
 Formula and data input can lead to Net Income EBT EBIT Sales Assets
errors that are difficult to identify     
EBT EBIT Sales Assets Equity

© Kaplan, Inc. 17
FCF Models
 FCFs are not published but need to be computed from published financial statements
 Free means after fulfilling all obligations and without impacting on the future growth
plans of the company

Free Cash Flows to Equity (FCFE) Free Cash Flows to the Firm (FCFF)
= net income = net income
± noncash items in income ± noncash items in income
statement statement
– investment in working + interest expense × (1 – tax
capital rate)
– investment in fixed assets – investment in working
+ net increase in debt capital
– investment in fixed assets
or
= CFO*
or
– investment in fixed assets
= CFO
+ net increase in debt
+ interest expense × (1 – tax
* Assuming interest received or paid and rate)
dividends received have been – investment in fixed assets
classified as operating cash flows as
or
NCC: dep
required by/amort, impairments, provisions, change in DTL (if not expected to
U.S. GAAP
= retirement,
reverse), gains and losses on asset and debt FCFE DB pension expense
+ debt and
WCI : Δ (CA – cash and investments) – (CL – ST interest expense
dividends × (1 – tax
payable)
© Kaplan, Inc. NV rate) 18
FCF Models (continued)
FCInv: Net Capex
1. Given in statement of cash flows (CFI)
2. From Balance sheet:
FCInv = Ending net PPE – Beg net PPE + Depreciation – gain (loss) on sale of PPE

Forecasting FCFE:
DR = debt / asset
FCFE = NI – [(1 –DR) × (FCInv – Dep’n)] – [(1 – DR) × WCInv)]

Calculating FCFF
 FCFF = NI + NCC + [Int(1 – t)] – WCInv – FCInv
 FCFF = CFO + [Int(1 – t)] – FCInv
 FCFF = [EBIT(1 – t)] + NCC – WCInv – FCInv
 FCFF = EBITDA(1 – t) + (NCC × t) – WCInv – FCInv

Calculating FCFE
 FCFE = NI + NCC – WCInv – FCInv + Net borrowings
 FCFE = CFO – FCInv + Net borrowings
 FCFE = EBIT(1 – t) – Int(1 – t) + NCC – WCInv – FCInv + Net borrowings
 FCFE = EBITDA(1 – t) – Int(1 – t) + NCC(t) – WCInv – FCInv + Net borrowings
 FCFE = FCFF – [Int(1 – t)] + Net borrowings

© Kaplan, Inc. 19
FCF Models

FCFFt
Firm value  
1  WACC
t

FCFEt t 1
Equity value  
1  r 
t
Equity t 1
Often referred to as “enterprise
value.” This represents the total
value of the firm’s operations
regardless of who is providing
Debt the capital.

Constant growth FCFE0 1  g FCFF0 1  g

models: Equity value  Firm value 
rg WACC  g
n
FCFt FCFn1 1
Generic two- V0   1 r 
  r  g 1  r n
t
stage model: t 1

Forecasting FCF: Apply a growth rate to most recent reported free cash flow or forecast
each component separately
Sensitivity Analysis: Often utilized to of
Calculation assess the
WACC is impact
covered of uncertain
in Corporate assumptions
Finance

© Kaplan, Inc. 20
FCF Further Aspects
Preferred to DDM when:
 Firm pays no dividends.
 Firm is paying dividends but dividends
differ significantly from the firm’s
capacity to pay dividends (i.e.,
dividends imperfectly signal the firm’s
long-run profitability).
 Free cash flows appear to be better
aligned with profitability over the
analyst’s forecast period.
 Investor takes a control perspective
since the firm is being analyzed as a
takeover target.
FCFE vs. FCFF Models
For firms with relatively stable leverage,
FCFE is more direct and easier to use.
Situations where the FCFF approach is
more useful include:
 Proposed purchase of entire firm (i.e.,
equity and debt capital) with a
subsequent reorganization of the capital
structure
 Firms where FCFE is negative
 Firms with history of leverage changes,
FCFF may be more meaningful than an
ever-changing growth pattern in FCFE

Free Cash Flow Proxies

Both net income and EBITDA are regarded as fairly poor proxies because:
 Both ignore the important distinction between profit and cash flow
 Both ignore the reinvestment of earnings needed for growth
 EBITDA ignores the tax that the firm needs to pay before any distribution to investors

© Kaplan, Inc. 21
Price Multiples
Overview
 Price multiples are ratios of a stock’s market price to some measure of value per share.
 Method of comparables involves comparing a stock’s price multiple to a benchmark
multiple to determine whether or not the stock is appropriately valued.
 Method based on forecasted fundamentals relates multiples to company fundamentals
using a discounted cash flow model.
 A justified price multiple is a multiple justified by an analyst based on either of the above
methods.

P/E Multiple
Rationales for Using P/E Drawbacks of Using P/E
 Earnings power is the primary driver of  Earnings may not exist or be negative
investment value  Need to adjust “book” earnings to
 P/E ratio is a popular measure with sustainable or recurring earnings
investors  Management discretion with
 Empirical research shows that P/Es accounting practices distort earnings
may be related to differences in long- and affect comparability of P/Es
run average stock returns across companies

© Kaplan, Inc. 22
Valuation Using P/E
Value = earnings × P/E ratio

Determining Earnings
P/E Ratio Based on Fundamentals
Analyst may adjust for:
 Company specific transitory,
D1
P0 E1 1 b
nonrecurring components* Leading P/E   
 Transitory components due to E1 rg rg
business or industry cyclicality
 D0  (1  g)
 Accounting method differences* P0  E  1  b 1  g
 Potential dilution (e.g., due to Trailing P/E    0

options and convertibles)
E0 r g r g

Methods used to find normalized P/E multiple increases if:

earnings for cyclical businesses:
 Growth rate increases
 Method of historical average EPS: Use
 Firm’s risk level decreases causing the
the average EPS over the most recent full
required return to decrease
cycle
 Interest rates decrease causing the
 Method of average return on equity: Use
required return to decrease
the average ROE (based on the most
recent full cycle) multiplied by the current  Payout ratio increases (although g will
book value per share also be negatively affected)

© Kaplan, Inc. 23
PEG Ratio
Steps for Valuation Using Comparables
1. Select and calculate the price multiple that will be used in the comparison.
2. Select the comparison asset or assets.
3. Calculate the benchmark value of the multiple (i.e., the mean or median value of the
multiple for the comparison assets).
4. Compare the stock’s actual multiple with the benchmark value.
5. If possible, assess whether differences in the fundamental determinants of the price
multiple explain any of the difference in Step 4 and modify conclusions accordingly.

P/E to Growth Ratio

 Step 5 above could involve calculating the P/E-to-g (PEG) ratio.
 A high P/E should be justified by high growth, so this ratio should be roughly
constant for all firms in a sector.
 A high ratio may indicate an overpriced share, a low ratio may indicate an under
priced share.
 Issues: linear relationship assumed between multiple and growth, differences in
risk, differences in the duration of growth.

© Kaplan, Inc. 24
P/B Ratios
Value = book value × P/B ratio

Book value of equity is: P/B multiple increases if:

 Net assets  Growth rate increases
 Shareholders’ funds  Firm’s risk level decreases causing the
required return to decrease
Fundamental P/B  Interest rates decrease causing the
P0 ROE  g required return to decrease
  ROE increases
B0 rg

Rationales for Using P/B Drawbacks of Using P/B

 Book value more stable than EPS
 Works with zero or negative earnings
 For some firms, book values of assets
may approximate market values
 Empirical evidence suggests differences
in P/Bs may be related to differences in
long-run average returns
© Kaplan, Inc.
 Relies on consistent application of
accounting standards
 Not good for firms with off-balance-sheet
human capital
 Depreciated historical cost of assets may
be different across similar firms due to
the age of the assets
25
P/S Ratios
Value = sales × P/S ratio

P/S multiple increases if:

Fundamental P/S  Growth rate increases
 Payout rate increases, but ….
 E0  1  b 1  g
 S0      Profit margin increases
P0
  Firm’s risk level decreases causing the
S0 rg required return to decrease
E/S = profit margin  Interest rates decrease causing the
required return to decrease

Rationales for Using P/S Drawbacks of Using P/S

 Meaningful even if EPS is negative  Fails to highlight cost control
 Sales figures less subject to manipulation issues within a firm
 Less volatile than P/E  Does not reflect differences
 Viewed as appropriate for valuing the stock of mature, in cost structures among
cyclical, and zero-income companies different companies
 Research suggests that differences in P/Ss may be
related to differences in long-run average returns
© Kaplan, Inc. 26
P/CF Ratios
Value = cash flow × P/CF ratio

Measures of cash flows that may be used:

Fundamental P/CF
CFO = cash flow from operations
P0 Value of equity from FCFE model FCFE = free cash flow to equity

CF0 Chosen cash flow measure CF = earnings ± noncash charges or
income
EBITDA = earnings before interest, tax,
depreciation, and amortization

Rationales for Using P/CF Drawbacks of Using P/CF

 Addresses the issue of differences in accounting  Certain cash flows are
conservatism between companies (quality of ignored if proxies are used
earnings) such as EPS plus non-cash
 Cash flows less subject to manipulation than earnings charges
 Less volatile than P/E since CF tends to be more  FCFE is superior for
stable than earnings valuation but introduces
 Research suggests that differences in P/CFs may be volatility problems and may
related to differences in long-run average returns also be negative at certain
times
© Kaplan, Inc. 27
Other Models
Enterprise Value/EBITDA
 EV = MV of all equity and debt
less cash and liquid investments
= NPV of firm’s earning activities
Trailing D/P 
 EV should be a predictable
multiple of EBITDA Leading D/P 
Rationales for Using EV/EBITDA
 Useful in comparing firms with different
financial leverage
 Eliminates accounting manipulation in
depreciation and amortization
 EBITDA more stable than other earnings
measures, and normally positive
Drawback of Using EV/EBITDA
 EBITDA ignores required capital and
working capital investments
© Kaplan, Inc.
Dividend Yield Model
Value = annualized dividend / dividend yield
Most recent quaterly dividend  4
Market price
Forecasted dividends over next four quarters
Market price
Rationales for Using Dividend Yield
 Dividend yield is a component of total return
 Dividends are not as risky as the capital
appreciation component of total return
Drawbacks of D/P Approach
 Focus on D/P is incomplete as it ignores
capital appreciation
 Dividends now would displace future
earnings, which implies a trade-off between
current and future cash flows
28
Residual Income Overview
Overview
 Residual income = accounting profit – charge for equity capital employed
 Residual income represents returns in excess of shareholder expectations, or
“economic income”

The General Model Forecasting Residual Income


RIt
V0  B0    This might use internal management forecasts
1  r 
t
t 1 for the next few years. Problem = bias.

Et  rBt 1  Could use fundamental forecasts of earnings
 B0   growth and dividend policy.
1  r 
t
t 1


(ROE  r)  B t-1
 B0   Relationship With Other Models
1  r 
t
where: t 1
 RI, DDM, and FCF models = DCF models but
V0 = value of share today recognition of value is different in the RI
B0 = current per-share BV of equity model.
Bt = expected per-share BV at time t  The total PV produced by all models should
r = required rate of return on equity be consistent, in theory, as long as each uses
Et = expected EPS for period t fully consistent assumptions.
RIt = expected per-share RI
© Kaplan, Inc. 29
Residual Income Models
Drivers of RI and Link to P/B Multi-Stage RI Model – Continuing RI
Assuming a constant growth rate in  Continuing residual income is residual income
earnings, g, and a constant ROE after the forecast horizon.
and dividend payout, the residual  It is likely that residual income will decline in the
income valuation model simplifies to: long run until the firm is making a “normal” return
ROE  r (i.e., ROE = r → RI = 0).
V0  B0  B0  Possible continuing RI assumptions are:
rg
This formula is linked to:  RI continues indefinitely at a positive level
 RI is 0 from the terminal year forward
P0 ROE  g ROE  r  RI declines to 0 as ROE reverts to r over time
  1
B0 rg rg  RI reflects reversion of ROE to some mean

Applicable RI Model when RI Fades Over Time From Time T

w (fade rate) takes values from 0 to 1:

V0  B0  

T 1
Et  rBt 1 

ET  rBT 1 w = 0 → no expectation of any future RI
w = 1 → same level of RI continuing forever
    
t T 1
t 1 1  r 1  r   1  r
Terminal value of RI

© Kaplan, Inc. 30
RI Models – Further Aspects
Implied Growth Rate
Can be calculated given the P/B
ratio and the required rate of return
on equity by rearranging the
single-stage RI formula:
 B0 × ROE – r  
g= r– 
 V 0 – B 0   Large special items (e.g., nonrecurring items)
Justifying Continuing RI Persistence
Factors suggesting high ω:
 Low dividend payout ratios
 High historical industry persistence
Factors suggesting low ω:
 Very high rates of return (ROE)
 Large accounting accruals

Problems Applying RI Models

 Violations of clean surplus: Currency translation adjustments, pension remeasurements,
unrealized gains/losses on available-for-sale securities
 Off-balance-sheet items: Operating leases, LIFO inventory, goodwill, assets/liabilities not
at FMV
 Nonrecurring items: Extraordinary items, discontinued operations, accounting changes
 Differing international standards

© Kaplan, Inc. 31
31
Residual Income Models—Commentary
Strengths of RI Models
 Terminal value doesn’t dominate
estimate
 Uses available accounting data
 Useful even if firm doesn’t pay dividend,
and not distorted by irregular dividends
 Can be used with unpredictable cash
flows
 Models focus on economic profitability,
not just accounting profitability
Weaknesses of RI Models
 Easily manipulated by changing
accounting assumptions
 Ignore changes in reserves other than
income and dividends
 Many adjustments may need to be made
to accounting data to get comparable
figures

When to Use Residual Income Models

RI model is most appropriate when:
 Company does not pay dividends, or its dividends are not predictable
 Company’s expected FCFs are negative within the analyst’s forecast horizon
 Great uncertainty exists in forecasting TVs using an alternative PV approach
RI model is least appropriate when:
 There are significant departures from “clean surplus accounting”
 Determinants of RI are not predictable

© Kaplan, Inc. 32
Value-Based Metrics
Alternative Measures Accounting vs. Economic Profitability
RI (see earlier slide) Economic profitability reflects the dollar
EVA® = NOPAT – (WACC × IC) cost of debt and equity capital used to
generate cash flow.
MVA = Market value of firm – IC
Accounting profitability (ROE) only
includes an accounting accrual related to
interest expense.
One way of assessing relative economic
profitability is to compute an EVA spread:
EVA spread = ROC – WACC
where: ROC = NOPAT / Invested Capital

Methods of Increasing EVA®

 Increase revenues
 Reduce operating expenses
 Use less Invested Capital
 Take advantage of positive NPV projects
 Reduce WACC

© Kaplan, Inc. 33
Private Company Valuation
Firm Specific Factors in Valuation
 Lifecycle: Typically less mature
 Size: Less capital, fewer assets, etc.
 Quality and depth of management
 Management and shareholder overlap
 Investor’s time horizon: Private firm managers
tend to be long-term holders of significant
equity
 Quality of information: Less stringent
requirements
 Taxes: Private more concerned due to impact
of taxes on owner/managers
Transaction Related Valuations
 Firms in development stage to gain VC funding
 IPO: Investment bank often uses public firm as
benchmark
 Sale: Performed by buyer and seller
 Bankruptcy: Can help to decide whether to
liquidate or reorganize
 Performance based compensation: Accurate
valuation needed for accounting and taxes
© Kaplan, Inc.
Stock Specific Factors in Valuation
 Liquidity: Discount required in valuation
 Restrictions on marketability: Agreements
may prevent s/h from selling
 Concentration of control: Greater
perquisites for owners/managers at the
expense of minority shareholders
Compliance Related Valuations
 Financial reporting: Goodwill impairment
tests for units of a public firm
 Tax: Transfer pricing, property, corp.
restructuring at firm level. Individuals
estate and gift tax.
Litigation Related Valuations
For example:
 Shareholder suits
 Damage claims
 Lost profits
 Divorce settlements
34
Private Company Valuation
Definitions of Value Normalized Earnings
 Fair market value: Used in the United States for Firm earnings if the firm were acquired.
tax purposes Adjust for:
 Nonrecurring
 Fair value: Similar to FMV used in financial
 Discretionary expenses
reporting or litigation
 Nonmarket levels of compensation
 Market value: Real asset appraisals for a  Personal expenses
particular date (well informed parties)  Real estate expenses based on hist cost
 Investment value: Value to a particular buyer  Nonmarket lease rates
 For strategic buyers, include acquisition
 Intrinsic value: True value derived from
synergies
investment analysis

Valuation Methods Free Cash Flows

 Income approach: PV of future income, used in
high growth phase
 Market approach: Price multiples based on
recent sales of comparable assets, used in
mature phase
 Asset based approach: Assets minus liabilities,
most appropriate early in life cycle as cash
flows uncertain
 Estimates vary for controlling and
noncontrolling
 Several scenarios analyzed with
consideration given to life cycle stage
 Anticipate management bias
 FCFF used if there are to be capital
structure changes

© Kaplan, Inc. 35
Private Company Valuation
Income Approach
 FCF: Two-stage model using FCFs + terminal value
 Capitalized cash flow: Discount single flow using
capitalization rate
 Excess earnings: Value tangible and intangible
assets separately, useful for small firms and those
with intangibles

Estimating Discount Rate

Discount Rate Models
 Size premium: Small cap public firm rate  CAPM: Not appropriate as beta is
includes distress premium (may not be
estimated using public firms
applicable to the private firm)  Expanded CAPM: Add premium for
 Availability and cost of debt: Not as cheap
size and firm specific risk
or readily available as it is for a public  Build-up method: Market rate plus
company
industry risk and other risk premiums;
 Use WACC of target not acquirer
used when betas for comparable
 Projection risk: Projecting cash flows for
public firms not available
private firms is riskier
 Lifecycle: More difficult for early stage
firms

© Kaplan, Inc. 36
Private Company Valuation
Market Approach Advantages and Disadvantages
 Guideline Public Co. Method (GPCM): Price  GPCM: Numerous public
multiples of traded public company's adjusted for risk companies available but may not be
diffs. comparable. When estimating
 Guideline Transactions Method (GTM): Price control premium, consider
multiples from sale of whole public and private transaction type, industry
company's adjusted for risk diffs. conditions, type of consideration,
 Prior Transaction Method (PTM): Historical stock reasonableness
sales of the subject company  GTM: Consider transaction type,
contingent consideration, type of
Asset-Based Approach consideration, availability of data,
 Not usually for going concerns, more common for date of data
troubled firms  PTM: Best when using recent,
 May be used for finance firms, investment company’s arm’s length data of the same
firms with few intangibles, natural resource firms motivation

Discounts and Premiums

 Discount for lack of control (DLOC) when using valuations based on reported earnings
1 – [1/(1 + control premium)]
 Discount for lack of marketability (DLOM) can be estimated using restricted share vs. publicly
traded share prices, pre-IPO and post-IPO prices and put prices

© Kaplan, Inc. Total discount = 1 – [(1 – DLOC)(1 – DLOM)] 37

Example
Cherry Corp. Balance Sheet
$m Actual 20x6 Projected 20x7
Cash 64 73
A/R 27 47
Inventory 55 60
Gross PP&E 100 120
Accumulated dep. (30) (30)
Total assets 216 270
Footnote disclosure reveals Cherry disposed of PP&E that
had a carrying value of $5m at the date of disposal and DTL
not expected to reverse.
© Kaplan, Inc. 38
Example
Cherry Corp. Balance Sheet (cont.)
$m Actual 20x6 Projected 20x7
Accounts payable 70 50
Accrued taxes & exp. 4 14
Dividends payable 2 4
Deferred tax liability 6 8
Long-term debt 20 30
Common stock 80 80
Retained earnings 34 84
Liabilities & equity 216 270
© Kaplan, Inc. 39
Example

Cherry Corp. Income Statement

$m Actual 20x6 Projected 20x7

Sales 130 200
COGS 52 60
Gross profit 78 140
SG&A 11 34
Depreciation 3 5
Gain on disposal 0 5
EBIT 64 106

© Kaplan, Inc. 40
Solution

Cherry Corp. Income Statement (cont.)

$m Actual 20x6 Projected 20x7
EBIT 64 106
Interest expense 4 6
EBT 60 100
Income tax provision 24 40
Net Income 36 60

Footnote disclosure reveals Cherry Corp’s tax rate to be 40%

Review of the MD&A reveals the fixed asset base is
expected to expand for the foreseeable future
© Kaplan, Inc. 41
Solution

Cherry Corp: NCC and WCInv

WCInv = 43 – 8 = 35

NCC $m $m 20x6 20x7

Depreciation +5 A/R 27 47
Gain on asset -5 Inventory 55 60
disposal A/Payable (70) (50)
Change in DTL +2 Tax Payable (4) (14)
Total +2 Total 8 43

© Kaplan, Inc. 42-3

Solution
Cherry Corp: FCInv

$m 20x7 20x6
Gross cost 120 100
Acc. Dep. (30) (30)
Net PPE 90 70 From I/S = $5m

FCInv = end net PPE – beg net PPE + depreciation

+/– loss/(gain) on disposal = $90 – $70 + $5 – $5
= $20m
From I/S gain = $5m
© Kaplan, Inc. 43
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