### relative_valuation_edhec

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P.V. VISWANATH
PREPARED FOR EDHEC
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 Involves utilizing existing valuations of
'comparable' assets to price a given asset by
working with a common variable such as
earnings, cash flows, book value or revenues.
 Measures relative values and not intrinsic
values.
 Assumptions tend to be implicit because we
take existing valuations of comparables as
“correct.”
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 PE ratio (Price per share/Earnings per share)
 Current PE ratio: based on current earnings per
share
 Forward PE: based on forecasts of next year’s
earnings.
 Price/EBITDA
 Value of the firm as a multiple of the operating
income or the earnings before interest, taxes,
depreciation and amortization.
 Works like a sort of payback ratio
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 P0 = DPS1/(k-g), where k is the cost of equity and g is the
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growth rate of dividends
P0/E0 = (DPS1/E0)/(k-g)
= (DPS0/E0)(1+g)/(k-g)
= (Payout Ratio)(1+g)/(k-g)
The higher the growth rate, the higher the PE ratio
Keeping the growth rate constant, the higher the payout
ratio, the higher the PE ratio
Obviously, keeping the same growth rate but raising the
payout ratio is only possible if the assets are used more
efficiently, i.e if return on assets is higher. This causes a
higher valuation.
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 Markets provide asset values through market prices
 Accountants provide asset values through accounting
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rules and conventions.
The relationship between market value and book
value varies from industry to industry and depends on
various factors.
For example, during a time of inflation, book values
will be much higher than market values. The extent of
this undervaluation will depend on the firms assets’
exposure to inflation.
Thus, if output prices in an industry move less (more)
with general inflation, the undervaluation will be less
(more) in that industry.
Measured as mkt value of firm/ book value of all
assets.
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 P0 = DPS1/(k-g), where k is the cost of equity
and g is the growth rate of dividends
 Divide both sides by BV of assets and noting
that DPS1/BV0 = (DPS1/EPS1)x(EPS1/BV0), we
get
 P0/BV0 = (DPS1/EPS1)x(EPS1/BV0)/(k-g),
= (Payout ratio)(1+g)(ROE)/(k-g)
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 Payout Ratio – the higher the payout ratio, the
higher the multiple
 Growth Rate: the higher the growth rate in
earnings, the higher the multiple.
 ROE: the higher the ROE, the higher the
multiple.
 Cost of equity: the lower the cost of equity, the
lower the multiple.
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 Earnings and book values are subject to
accounting rules; revenue determinations are
less so.
 Comparisons can be made even if accounting
rules for comparables vary.
 Can be measured as
share price/sales per share or
 Firm value/sales
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 Varies across sectors
 Depends on profit margins
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 P0 = DPS1/(k-g), where k is the cost of equity
and g is the growth rate of dividends
 Using similar identities as before, we get
 P0/Sales = (Profit Margin)(Payout Ratio)(1+g)/(k-g)
 The higher the profit margin and the higher the
growth rate, the higher the P/Sales ratio.
 Again, we can conclude a higher payout ratio
implies a higher P/Sales ratio only if we assume
that the growth rate will not be negatively
affected. This will only happen if the ROA is
higher.
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 Dupont Analysis tells us that firms have to choose
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between a high margin/low volume and a low
margin/high volume strategy.
Clearly, the first strategy will yield a higher
Price/Revenue ratio.
This can be used to value a brand name.
Thus the value of the brand equals
[(P/Sales)brand - (P/Sales)nobrand]xSalesbrand
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 Higher Profit Margins imply higher Price/Sales
ratios, ceteris paribus
 Hence in using industry Price/Sales ratios, we
need to adjust for differences in profit margins.
 Porter Analysis could be used to predict
differences in margins, although this may
simply be a difference in marketing strategy, as
well.
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 We have seen that PE ratios depend on growth rates,
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payout ratios and cost of equity
So if it’s possible to find comparables with the same
growth rates, payout ratios and cost of equity, the
average PE ratio of the comparables could be used to
value the target firm.
What if the factors are not exactly the same?
How about regressing PE ratio on growth rate, payout
ratio, ROE and beta?
Can we use this relationship to estimate the PE ratio for
the target firm?
Maybe, but we have to keep in mind that the true
underlying relationship may not be linear!
Similarly, we could think of regressing P/Sales on profit
margins.
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 This is the ratio of the PE to the growth rate; if the PE
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is 15 and the growth rate is 7.5%, the PEG is 2.
The belief is that stocks with a PEG>1 are overvalued
and PEG<1 are undervalued.
Since this is an equity multiple, the growth rate
should be the growth in EPS, not op inc.
If the growth rate used is the forecasted growth over
the next year, then the PE ratio should be based on
current earnings.
When comparing across firms, the growth rate
estimate for all firms should be over the same time
period, e.g. forecasted 5-year growth rates.
interpretation of the PEG.
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 EV/EBITDA = (MV Equity + MV Debt –
Cash)/EBITDA
 EBITDA is Earnings before Interest
income as well as interest paid, before
taxes, depreciation and amortization.
 This is a firm-level multiple, which is why
 Interest income is subtracted out because
the idea is to look at operating income –
interest income may not be part of the
firm’s core operations.
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 Once we exclude interest income, we also
exclude cash and cash equivalents from
the numerator. Once the enterprise value
is computed, we add back cash and cash
equivalents to get a value of the entire
firm.
 If a firm has minority holdings, the ratio
may be overstated because income from
these holdings is not included in the
operating income of the firm, while the
value of the equity interest is included in
the numerator.
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 FCFF = EBIT(1-t) – (Capex - DA
+DNoncash WC)
= (EBITDA-DA)(1-t) – Reinvestment
= EBITDA(1-t) – DA(1-t) – Reinv
 Reinvestment = Capex - DA
+DNoncash WC
 Since V0 = FCFF1/(WACC–g), we get:
EBIT
Reinvestme nt
(1  t)

V0
EBITDA
EBITDA

EBITDA
WACC  g
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 A low marginal tax rate: A smaller tax bite
 Higher EBIT as a proportion of EBITDA:
the EBIT portion of EBITDA obviously has
greater value.
 Lower reinvestment needs as a percentage
of EBITDA: implies higher ROA
 Lower cost of capital: lower discount rate
 Higher expected growth: higher future
FCFF
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 Used for firms in industries with high
depreciation, where EBITDA is a better measure
of operating cashflow than EBIT or Net Income.
 When the firms being compared have different
depreciation methods, using an EBITDA
multiple keeps them comparable as opposed to
an income multiple.
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 In general, firm value multiples depend
positively on ROA, while stock value multiples
depend positively on ROE.
 The factors affecting a firm’s ability to have a
higher ROA/ROE can be seen from Porter’s
Five Forces model:
Barriers to entry
 Weak Sellers
 Low Threat of substitutes
 Market power relative to competitors
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 A firm with a high (low) ROA/ROE and a low
Price/Book ratio is likely to be undervalued
(overvalued).
 Thus, if we regress P/B on ROE, firms with very
high residuals may be overvalued, while those
with very negative residuals are likely to be
undervalued.
 This could be used as a screening device.
 Of course, the ROE used in this analysis should
be forward looking, else the results may be
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 We are implicitly keeping everything else
constant; thus it’s better to do this analysis
on firms in the same industry.
 Else we might be mistaking riskier firms
for undervalued firms.
 Fama and French find evidence that a high
P/B ratio is a proxy for risk.
 They find that high P/B stocks earn
consistently more than low P/B stocks.
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 Sometimes there are clear drivers in a given
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industry.
In this case, specific multiples may be used in
that industry.
For example, in subscription-based firms,
value per subscriber could be used.
For retailers, value per customer may be used.
For internet portals, value per site visitor
could be used.
Airlines? Wireless cos? Home improvement
firms?
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