FIN 468: Intermediate Corporate Finance Topic 7–Price Multiples Larry Schrenk, Instructor 1 (of 22) Topics Relative Valuation Price Multiples P/E Ratio Other Ratios Relative Valuation 3 (of 36) Relative Valuation Value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation Identify comparable assets and obtain market values Convert these market values into standardized values Absolute prices cannot be compared Standardizing creates price multiples. Compare the standardized values/multiples Controlling for any differences that might affect the multiple Judge whether the asset is under or over valued Relative Valuation Most valuations on Wall Street are relative valuations. Almost 85% of equity research reports are based upon a multiple and comparables. More than 50% of all acquisition valuations are based upon multiples Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. While there are more discounted cashflow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations. The objective in many discounted cashflow valuations is to back into a number that has been obtained by using a multiple. The terminal value in a significant number of discounted cashflow valuations is estimated using a multiple. Four Steps 1. Define the multiple 2. Describe the multiple 3. Know what the cross sectional distribution Analyze the multiple 4. Same multiple can be defined in different ways Understand the fundamentals that drive each multiple Apply the multiple Define the comparable universe Controlling for differences Definitional Tests Is the Multiple Consistently Defined? Value (numerator) and the standardizing variable (denominator) should apply to the same claimholders in the firm. E.g., the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or firm book value. Is the Multiple Uniformly Estimated? variables must be estimated uniformly across assets in the “comparable firm” list. For earnings- or book-based multiples, the accounting rules must be applied consistently across assets. Analytical Tests What are the Fundamentals that Determine and Drive these Multiples? Constitutive of every multiple are variables that drive cash flow valuation, e.g., growth, risk and cash flow patterns. In theory, a simple discounted cash flow model should yield the fundamentals that drive a multiple How Do Changes in these Fundamentals Change the Multiple? Relationship between a fundamental (like growth) and a multiple (such as PE) typically non-linear. Twice the growth rate doe not imply twice the PE ratio Cannot use multiple, if we do not know relationship between fundamentals and multiple Relative Value and Fundamentals: Equity Multiples DPS1 r - gn Gordon Growth Model: P0 = Dividing both sides by the earnings, P0 Payout Ratio *(1+ gn ) = PE = EPS0 r-g n Dividing both sides by the book value of equity, P0 ROE * Payout Ratio *(1+ gn ) = PBV = BV0 r-g n If the return on equity is written in terms of the retention ratio and the expected growth rate Dividing by the Sales per share, P0 ROE - gn = PBV = BV0 r-g n P0 Profit Margin * Payout Ratio *(1+ gn ) = PS = Sales0 r-g n Determinants of Multiples Value of Stock = DPS 1/(ke - g) PE=Payout Ratio (1+g)/(r-g) PE=f (g, payout, risk) PEG=Payout ratio (1+g)/g(r-g) PBV=ROE (Payout ratio) (1+g)/(r-g) PEG=f (g, payout, risk) PBV=f(ROE,payout, g, risk) PS= Net Margin (Payout ratio) (1+g)/(r-g) PS=f(Net Mgn, payout, g, risk) Equity Multiple s Fir m Multiple s V/FCFF=f(g, WACC) Value/FCFF=(1+g)/ (WACC-g) V/EBIT(1-t)=f(g, RIR, WACC) Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g) V/EBIT=f (g, RIR, WACC, t) Value/EBIT=(1+g)(1RiR)/(1-t)(WACC-g) Value of Firm = FCFF1/(WACC -g) VS=f(Oper Mgn, RIR, g, WACC) VS= Oper Margin (1RIR) (1+g)/(WACC-g) PE For a High Growth Firm The price-earnings ratio for a high growth firm can be related to fundamentals. two-stage dividend discount model:: (1+ g)n EPS0 *Payout Ratio *(1+ g)* 1 (1+ r)n EPS0 *Payout Ration *(1+ g)n *(1+ gn ) P0 = + r -g (r - gn )(1+ r)n For a firm that does not pay what it can afford to in dividends, substitute FCFE/Earnings for the payout ratio. Dividing both sides by the earnings per share: (1+ g)n Payout Ratio *(1+ g)* 1 (1+ r)n Payout Ration *(1+ g)n *(1+ gn ) P0 = + EPS0 r -g (r - gn )(1+ r)n Application Tests What is a ‘Comparable’ Firm? Traditional Analysis: Firms in the same sector are comparable firms Valuation Theory: Comparable firm is determined by similar fundamentals. Firm can be compared with a firm in a very different business, if same risk, growth and cash flow characteristics. How Do We Adjust for Differences across Firms on the Fundamentals? Impossible to find two exactly identical firms Price Multiples Method of Comparables Using a price multiple to evaluate whether an asset is in relation to a benchmark multiple value: relatively fairly valued, relatively undervalued, or relatively overvalued. Benchmark value of a multiple could be… A closely matched individual stock Average or median value of the multiple for the stock’s peer group of companies or industry. Method of Comparables Law of One Price Two identical assets should sell at the same price. Most widely used multiples approach for analysts Assumption: Over/undervalued asset will under/outperform the comparison asset(s) on a relative basis. If the comparison asset or assets themselves are efficiently priced Profitability Assumptions Assumption 1: Markets are no perfectly efficient. Assumption 2: You have correctly identified a mispricing. Assumption 3: The market corrects this mispricing–within a ‘reasonable’ time. 16 (of 70) P/E Ratios 17 (of 36) Rationales for Use of P/E Ratios Earning power chief driver of value. Earnings per share (EPS) perhaps the chief focus of security analysts’ attention. Differences in price/earnings ratios may be related to differences in long-run average returns, according to empirical research. Drawbacks to P/E Ratios EPS can be negative. Two components of earnings The P/E ratio does not make economic sense with a negative denominator. On-going or recurrent are most important in Volatile, transient components Management distortion of earnings Accounting Issues with P/E Ratios Price easily obtained and unambiguous. Earnings not as straightforward. Two issues are Time horizon over which earnings are measured Adjustments to accounting earnings to make P/Es comparable across companies. Trailing and Leading P/E’s Trailing P/E (Current P/E): Leading P/E (Forward P/E, Prospective P/E) Current market price of the stock divided by the most recent four quarters’ earnings per share. EPS in such calculations are sometimes referred to as trailing twelve months (TTM) EPS. Trailing P/E is the price–earnings ratio published in stock listings of financial newspapers. Current market price of the stock divided by next year’s expected earnings. Other First Call/Thomson Financial reports as the “current P/E” market price divided by the last reported annual earnings per share. Value Line reports as the “P/E” market price divided by the sum of the preceding two quarters’ trailing earnings and the next two quarters’ expected earnings. Issues with Trailing P/E’s EPS issues include Transitory, nonrecurring components of earnings that are company-specific; Transitory components of earnings due to cyclicality (business or industry cyclicality); Differences in accounting methods; and Potential dilution of earnings per share. Normalized P/E’s Nomalized EPS can be used to create a normalized P/E. Two methods for nomalizing EPS: The Method of Historical Average EPS: Normal EPS is calculated as average EPS over the most recent full cycle. The Method of Average ROE: Normal EPS is calculated as the average return on equity from the most recent full cycle, multiplied by current book value per share. Which method is preferred? The first method is approach to cyclical earnings, but does not account for changes in the business’s size. The second method reflects more accurately the effect growth or shrinkage in the company’s size. The method of average ROE is sometimes preferred. Justified P/E in a DCF Model DCF valuation models can be used to develop an estimate of the justified P/E for a stock. In the Gordon growth form of the dividend discount model, the P/E is calculated using these two expressions. The leading P/E is: P0 D1 / E1 1 b E1 rg rg The trailing P/E is: P0 D0(1+g)/E0 (1-b)(1+g) = = E0 r -g r -g Both expressions state P/E as a function of two fundamentals: the stock’s required rate of return, r, reflecting its risk, and the expected (stable) dividend growth rate, g. The dividend payout ratio, 1 – b, also enters into the expression. The stock’s justified P/E based on forecasted fundamentals. Justified P/E Example For FPL Group, Inc. (FPL), a utility analyst, forecasts a long-term payout rate of 50 percent, a long-term growth rate of 5 percent, and a required rate of return of 9 percent. Based upon these forecasts of fundamentals, what is FPL’s justified leading P/E and trailing P/E? Leading Justified P/E: P0 1-b 1- 0.50 = = =12.5 E1 r - g 0.09- 0.05 Trailing Justified P/E: P0 (1- b)(1+ g) (1- 0.5)(1+ 0.05) = = =13.125 E0 r -g 0.09 - 0.05 Benchmark P/E’s The choices for the benchmark value of the P/E: The P/E of the most closely matched individual stock. The average or median value of the P/E for the company’s peer group of companies within an industry. The average or median value of the P/E for the company’s industry or sector. The P/E for a representative equity index An average past value of the P/E for the stock. Valuation errors are probably less likely when we use an equity index or a group of stocks than when we use a single stock, because the former choices involve an averaging. Other Ratios 27 (of 36) PEG Ratios P/E to growth (PEG) ratio addresses the impact of earnings growth on P/E ratios is P/E to growth (PEG) ratio. Stock’s P/E divided by the expected earnings growth rate. Stock’s P/E per unit of expected growth. Stocks with lower PEGs are more attractive Cautions: Assumes a linear relationship between P/E ratios and growth. The model for P/E in terms of DDM shows that in theory the relationship is not linear. Does not factor in differences in risk Does not account for differences in the duration of growth. For example, dividing P/E ratios by short-term (5 year) growth forecasts may not capture differences in growth in long-term growth prospects. Price to Book (P/B) Ratio Book value per share, the measure of value in the P/B ratio, is a stock or level variable coming from the balance sheet. Contrast EPS, a flow variable from the income statement Intuitively, book value per share represents the investment that common shareholders have made in the company, on a per-share basis. Rationales for Use of P/B Ratio Book value is generally positive even when EPS is negative. Book value per share is more stable than EPS P/B may be more meaningful than P/E when EPS are abnormally high or low, or are highly variable. Book value per share appropriate for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions. We can generally use P/B when EPS is negative, whereas P/E based on a negative EPS is not meaningful. For such companies, book values of assets may approximate market values. Book value used to valuation companies not expected to continue as a going concern. Differences in P/B ratios may be related to differences in long-run average returns, according to empirical research. Possible Drawbacks to P/B Ratios Other assets besides those recognized in accounting may be critical operating factors. P/B can be misleading as a valuation indicator when there are significant differences among the level of assets employed by companies. Accounting effects on book value may compromise book value as a measure of shareholders’ investment in the company. For example, in many service companies human is more important than physical capital as an operating factor. As one example, book value can understate shareholders’ investment as a result of the expensing of investment in research and development (R&D). Such expenditures often positively affect income over many periods and in principle create assets. Book value largely reflects the historical purchase costs of assets, as well as accumulated accounting depreciation expenses. Inflation as well as technological change eventually drive a wedge between the book value and the market value of assets. Book value per share often poorly reflects the value of shareholders’ investments. Computation of Book Value Calculation of Book Value: Shareholders’ Equity – Senior Equity Claims = Common Shareholders’ Equity Common Shareholder Equity/Common Stock Shares Outstanding = Book Value per Share Possible Senior Claims value of preferred stock dividends in arrears on preferred stock Adjustments to Book Value Tangible book value per share Significant off-balance sheet assets and liabilities Internationally, accounting methods currently report some assets/liabilities at historical cost (with some adjustments) and others at fair value. Subtracting reported intangible assets from the balance sheet from common shareholders’ equity Following financial theory, the general exclusion of intangibles is not warranted For example, assets such as land or equipment are reported at their historical acquisitions cost, and in the case of equipment are being depreciated over their useful lives. Other assets such as investments in marketable securities are reported at fair market value. Adjustments for comparability One company may be using FIFO and a peer company may be using LIFO Justified P/B Ratio Fundamental forecasts to estimate a stock’s justified P/B ratio. For example, using Gordon growth model and sustainable growth rate (g = b ROE), the expression for the justified P/B ratio based on the most recent book value (B0) is P0 ROE - g = B0 r -g For example, if a business’s ROE is 12 percent, its required rate of return is 10 percent, and its expected growth rate is 7 percent, then its justified P/B based on fundamentals is (0.12 0.07)/(0.10 0.07) = 1.7. Further insight into the P/B ratio comes from the residual income model. The expression for the justified P/B ratio based on the residual income valuation is P0 Present value of expected future residual earnings =1+ B0 B0 Rationales for Price/Sales Ratios Sales less subject to distortion or manipulation than other fundamentals such as EPS or book value. Sales are positive even when EPS is negative. Therefore, we can use P/S when EPS is negative, whereas P/E based on a negative EPS is not meaningful. Sales are generally more stable than EPS Total sales, as the top line in the income statement, is prior to any expenses. EPS reflects operating and financial leverage P/S is generally more stable than P/E P/S may be more meaningful than P/E when EPS is abnormally high or low. P/S appropriate for valuing the stock of mature, cyclical, and zero income companies. Differences in P/S ratios may relate to differences in long-run average returns Drawbacks to P/S Ratios High growth in sales not imply operating profitably as judged by earnings and cash flow from operations. To have value as a going concern, a business must ultimately generate earnings and cash. P/S ratio does not reflect differences in cost structures across companies. Manipulation potential through revenue recognition practices Justified P/S Ratio Like other multiples, the P/S multiple can be linked to DCF models. In terms of the Gordon growth model, we can state P/S as P0 (E0 / S0 )(1-b)(1+g) = S0 r -g Rationales for Price/Cash Flow Ratios Cash flow less manipulation by management than earnings. Cash flow is generally more stable than earnings Cash flow manipulated only through ‘real’ activities, such as the sale of receivables. Price-to-cash flow is generally more stable than P/E. Avoids issue of differences in accounting conservatism between companies (differences in the quality of earnings). Differences in price to cash flow may be related to differences in long-run average returns Drawbacks to Price/Cash Flow Ratios Non-cash revenue and net changes in working capital are ignored. Free cash flow rather than cash flow as the appropriate variable for valuation. We can use P/FCFE ratios but FCFE More volatile than CF for many businesses, and More frequently negative than CF. Common Cash Flow Measures In practice, use simple approximations to cash flow from operations: Earnings-plus-Non-Cash Charges (CF): approximation specifies cash flow per share as EPS plus per-share depreciation, amortization, and depletion. Cash Flow from Operations (CFO) Free Cash Flow to Equity (FCFE), and EBITDA, an Estimate of Pre-interest, Pre-tax Operating Cash Flow. Most frequently, trailing price-to-cash flow ratios are reported. Current market price divided by the sum of the most recent four quarters’ cash flow per share. Enterprise Value/EBITDA A P/EBITDA multiple is flawed EBITDA is a flow to both debt and equity. Enterprise value to EBITDA is better. Enterprise value (EV) Total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments. EV/EBITDA is a valuation indicator for the overall company rather than common stock. Rationales for EV/EBITDA Comparing companies with different financial leverage EBITDA is a pre-interest earnings figure, EPS, which is post-interest. By adding back depreciation and amortization, EBITDA controls for differences in depreciation and amortization across businesses. EV/EBITDA is frequently used in the valuation of capital-intensive businesses (for example, cable companies and steel companies). EBITDA is frequently positive when EPS is negative. Possible Drawbacks to EV/EBITDA EBITDA will overestimate cash flow from operations if working capital is growing. EBITDA also ignores the effects of differences in revenue recognition policy on cash flow from operations. Free cash flow to the firm, which directly reflects the amount of required capital expenditures, has a stronger link to valuation theory than EBITDA. Only if depreciation expenses match capital expenditures do we expect EBITDA to reflect differences in businesses’ capital programs.