L2, R25 Market Based Valuation Price and Enterprise Value Multiples Questions and Answers

L2, R25 Market Based Valuation Price and Enterprise Value Multiples Questions and Answers T/F: Enterprise multiples differ from price multiples because instead of using the market price in the numerator (equity price), EV uses the value of the company in the numerator (equity and debt) True Momentum indicators Relate either price or a fundamental value to a time series of its own past values or to its expected value T/F: The method of comparables is based on the law of one price True - method of comparables is based off of the law of one price which states that identical assets should sell at the same price Justified Price Multiple The estimated fair value of the price multiple, usually based on forecasted fundamentals or comparables. If justified price multiple actual multiple is sock: a) overvalued b) undervalued c) fairly valued A overvalud What are some drawbacks to using P/E? EPS can be negative or insignificantly small, can be difficult to distinguish the transient components of earnings from ongoing recurrent components, accounting policies can distort P/E Forward P/E Current market price / forecasted expected earnings. Preferred if firms business has changed significantly, and when earnings forecasts are available Trailing P/E Current market price/ last year EPS. Preferred if earnings are volatile and not readily predictable. Must consider the following items when calculating EPS for trailing P/E: - Dilution of EPS: recall diluted EPS is the EPS if all convertible securities were exercised - Nonrecurring items: analyst must focus only on earnings that are expected to continue into the future - Business Cycle Influences: for example due to cyclical effects most recent earnings may not accurately reflect the long-term earnings power of a company. Can mitigate this by using a normalized EPS: the level of earnings per share that the company could currently achieve under mid-cyclical conditions Justified P/E Is the P/E multiple that is considered sustainable over the long term derived from using the gordon growth model: Leading P/E: Po/E1=(D1/E1)/(r-g)=(1-b)/(r-g) Trailing P/E: Po/Eo=(Do(1+g)/Eo)/(r-g)=(1-b)(1+g)/(r-g) If the market P/E justified P/E, stock is: a) undervalued b) overvalued c) fairly valued A - stock is undervalued P/E based on cross sectional regression Develop a regression equation to estimate P/E such that P/E is the dependent variable and fundamentals such as growth rate, payout ratio, beta, etc are independent variables Ex: Predicted P/E = 12.12 + 2.25(dividend payout ratio) - 0.20Beta + 14.43*g Limitations to this method: predictive power of the regression for a different sample of stocks or for a different time period is not known, Relationships between P/E and fundamentals may change over time, method is prone to multicollinearity PEG ratio Price-Earnings Ratio/Earnings Growth Rate (%) is a ratio that represents a stocks P/E per percentage point of expected growth - the lower the value the more attractive - often look for a value 1 T/F the higher the PEG value the more attractive a stock False! The lower the PEG value Normalized EPS The EPS that a business could achieve currently under mid-cyclical conditions. Also called normal EPS. Can calculate using either: 1) Historical Average Method: Norm EPS = average EPS over most recent full cycle 2) Average ROE Method: Norm EPS = average full cycle ROE*Current BV/share When calculating P/B what is B? B is book value per share calculated as: (total assets - total liabilities) / common shares outstanding ** remember to subtract preferred shares if there are any! Which of the following ratios is an appropriate measure for valuing firms with liquid assets such as finance, investment, insurance and banking firms? A: P/E B: P/CF C: P/B C - P/B Which of the following ratios is an appropriate measure for valuing firms that are not expected to continue as a going concern? A: P/E B: P/CF C: P/B C - P/B Drawbacks to using P/B? Non-physical assets such as human capital, skills or reputation not reflected in an assets book value P/B can be misleading for companies with different levels of assets, for example firms that outsource a lot vs firms that don't Accounting policies may affect the usefulness of P/B such as the accounting treatment that intangible assets generated internally are not shown as assets on the balance sheet Book value is the historical cost minus depreciation, amortization, and impairment, thus does not reflect market value so can be difficult to compare assets of different ages Share repurchase can affect book value How do you calculate justified P/B? P/B = (ROE-g)/(r-g) When calculating P/S what is S? S is net sales per share net sales = total sales - returns and customer discouts T/F P/S uses net sales True! net sales = total sales - returns and customer discouts Are each of the following statements True of False regarding Price to Sales ratio? 1: Sales are less subject to manipulation compared to EPS and BV 2: Sales are positive when EPS is negative 3: Sales are less stable than EPS 4: Does not reflect differences in cost structure between companies 5: impacted by the level of debt 1 true 2 true 3 false 4 true 5 false How are P/S and P/E related? P/S = P/E * net profit margin P/S = P/E * E/S How do you calculate justified P/S? recall P/S = P/E * E/S, thus: P/S= (Eo/So)*(1-b)(1+g)/(r-g) T/F: P/CF is less prone to manipulation than earnings True T/F: P/CF does a better job taking care of differences in accounting practices than P/E True What is the difference between the dividend yield and the dividend payout ratio The dividend yield compares the amount of the dividend paid to the share price of the company's stock. The dividend payout ratio instead compares the dividend amount to the company's earnings per share. T/F : dividend yield is much more common that P/D True How do you calculate Enterprise Value EV is designed to measure the net price an acquirer would pay for the company as a whole, cash and investments are subtracted because the net price paid reduces by the amount of liquid assets as the acquirer gets access to the cash on an acquisition It is a sum of claims by all claimants: creditors and shareholders Market Value of Equity + Debt + Preferred Stock + Minority Interest - Cash T/F: Depreciation and Amorization accounting differences do not matter when using EV/EBITDA True because EBITDA adds back non cash charges thus accounting differences for those terms do not matter Which of the following should you use when comparing companies with different levels of leverage? a) P/E b) EV/EBITDA b is correct - this is because EBITDA is a pre-interest figure unlike Earnings Is EV/Sales or P/Sales preferred when comparing companies with different capital structures? EV/Sales is preferred over P/S. As P/S represents the stock price of the company whereas sales indicates the funds available to all capital providers. Because some of the proceeds from the sales would be to service debt, EV/S is a more appropriate ratio for comparing companies with different capital structures Describe the following Momentum Indicators: a - Earnings Surprise b - Scaled Earnings surprise c - standardized unexpected earnings (SUE) d - relative strength 1 - Earnings Surprise: aka Unexpected earnings, is the difference between reported earnings and expected earnings: UEt=EPSt-E(EPST) 2 - Scaled Earnings Surprise: Earnings surprise scaled by the variability in analyst estimates. Measured by dividing unexpected earnings by std dev of analysts forecasts Scaled Earnings Surprise=UEt/std(forecasts) 3 - Standardized Unexpected Earnings (SUE): scales the earnings surprise relative to past earnings surprise. For instance if a stock has an earnings surprise of .1 and std deviation of past surprises is .4, then earnings surprise is relatively small to past forecast errors. Measured as current earnings surprise divided by standard deviation of past earning surprise: SUE=UEt/std (UEn) 4 - Relative Strength: is a technical indicator that compares a stocks performance during a period either with its own past performance or with the performance of some group of stocks. RSI is based on the premise that patterns of persistence or reversal may exist in stock returns Earnings Surprise Earnings Surprise: aka Unexpected earnings, is the difference between reported earnings and expected earnings: UEt=EPSt-E(EPST) Scaled earnings surprise Unexpected earnings divided by the standard deviation of analysts' earnings forecasts. Standardized Unexpected Earnings (SUE) Earnings Surprise / σ of Earnings surprise Relative Strength Index (RSI) Ratio of total price increases to decreases over a set amount of time; Over 70 is overbought; Under 30 is oversold; Oscillator Based on the premise that patterns of persistence or reversal may exist in stock returns Harmonic Mean T/F: the fed model considers the overall stock market to be overvalued when the markets current earnings yield ratio is less than the 10 year treasury bond yield True ** Recall the lower the earnings yield , the higher the P/E meaning that you pay more per dollar of earnings! T/F: the yardini model addresses a concern of the fed model by including the expected growth rate in analyis True Difference between P/E and P/B? denominator in P/E came from the income statement, where the denominator in P/B (the book value per share) comes from the balance sheet Book value is generally positive even when EPS is zero or negative Book value is more stable than EPS Historical Average Method to calculate Normalized EPS Normalized EPS = average EPS over most recent full cycle Average ROE method to calculate Normalized EPS Normalized EPS = average full cycle ROE * current BV/Share ** USE CURRENT BV/S!! For given: EPS : $1.45 $0.23 $2.13 $2.55 ROE : 8.9% 1.6% 16.3% 21.8% With beginning of 2019 share price of $57.98, and BV/S of $19.20 what is the normalized EPS and P/E under: a) Historical Average Method B) Average ROE Method A) Averaging EPS over the 2015-18 period, we find that ($2.55 + $2.13 + $0.23 + $1.45)/4 = $1.59. According to the method of historical average EPS, the normalized EPS is $1.59. The P/E based on this estimate is $57.98/$1.59 = 36.5. B) Averaging ROE over the 2015-18 period, we find that (0.218 + 0.163 + 0.016 + 0.089)/4 = 0.1215. For current BV per share, you would use the estimated value of $19.20 for year end 2019. According to the method of average ROE, 0.1215 × $19.20 = $2.33 is the normalized EPS. The P/E based on this estimate is $57.98/$2.33 = 24.9 The earnings for two companies have been negative, and thus their P/Es are not meaningful. Discuss how the analyst might make a relative valuation in this case? The analyst can rank the two stocks by earnings yield (E/P). Whether EPS is positive or negative, a ranking from high to low E/P has a meaningful interpretation. The higher the earnings yield the cheaper in terms of earnings per one unit of currency The earnings for two companies have been negative, and thus their P/Es are not meaningful. An analyst decides to measure the companies earnings yield (E/P) instead and gets the following: Company A: E/P of -0.100 Company B: E/P of -0.125 Which stock should the analyst recommend? The analyst should recommend Company A because a higher E/P reflects more earnings per unit of currency, or in this case less losses per unit of currency A higher P/E and lower E/P represents: a) a higher valuation b) a lower valuation A a higher valuation - investors are willing to pay more than a lower valuation stock Given the following information, calculate the trailing and leading justified P/E for year 1: Year 0: E/S = .714 , D/S = .214 Year 1: E/S = .952, D/S = .286 required rate of return = .14 industry average growth rate = .13 Recall justified P/E is the P/E calculated using the gordon growth model: Leading P/E = Po/E1 = (D1/E1)/(r-g) = (1-b)/(r-g) = (.952/.286) / (.14-.13) = 30 Trailing P/E = Po/Eo = (Do(1+g)/Eo)/(r-g) =(1-b)(1+g)/(r-g) = (.714/.214)*(1+.13) / (.14-.13) = 33.9 Identify, within the context of the constant dividend growth model, how each of the following fundamental factors would affect the P/E: 1: an increase in stock Beta 2: an increase in the estimated growth rate of the stocks earnings and dividends 3: The equity risk premium increases 1 and 3 affect the required return of equity found by CAPM, recall: re = RFR + B(ERP) Which in turn affects justified P/E in terms of re, recall: P/E = (D1/E)/(re-g) Thus: 1: as beta increases re increases which causes P/E to decrease 2: from P/E equation above we see g is proportionally related to P/E thus an increase in g causes an increase in P/E 3: an increase in ERP causes an increase in re, and since re is inversely related to P/E, causes a decreases in P/E You are valuing a stock and feel confident explicitly projecting earnings and dividends to three years (to t = 3). Other information and estimates are as follows: ● Required rate of return = 0.09. ● Average dividend payout rate for mature companies in the market = 0.45. ● Industry average ROE = 0.10. ● E3 = $3.00. ● Industry average P/E = 12. Compare terminal value (V3) found using comparables approach and gordon growth model approach a - V3 using comparables approach: V3 = P/E*E3 = 12 x 3 = $36 b - V3 using gordon growth approach V3 = D4/r-g step 1: compute growth rate = ROE(1-D/E) = .10(1-.45) = .055 = 5.5% step 2: find D4 = D3(1+g) = .45(3)(1+.055) = 1.424 step 3: solve for V3 = 1.424/(.09-.055) = $40.69 Discuss three types of stocks or investment situations for which an analyst could appropriately use P/B in valuation. The company is composed mainly of liquid assets, which is the case for finance, investment, insurance, and banking institutions. The company's EPS is highly variable or negative The company is no longer considered a going concern When a company is not expected to continue as a going concern, and is likely to be liquidated, which of the following multiples is most likely to be used? a) P/B b) P/E c) P/CF a) P/B : recall book value of equity is the difference between total assets and total liabilities. In a liquidation the book value of equity is of upmost importance When a company is composed mainly of liquid assets, which is the case for finance, investment, insurance, and banking institutions. Which is the most appropriate multiple used to measure the firms value? a) P/B b) P/E c) P/CF a) P/B T/F : it is a good idea to use the P/B multiple when the company's EPS is highly variable or negative True! P/B is a good alternative in this scenario Given the following information, which of the two companies has a more attractive valuation based on P/S? Company A: Price/Share = $10 Shares Outstanding = 20 mm Sales = $1b Company B: Price/Share = $20 Shares Outstanding = 30 mm Sales = $1.6b P/S (A) = $10/ (1b/20mm) = 0.2 P/S (b) = $20/(1.6b/30mm) = 0.375 A has a more attractive valuation than B based on its lower P/S What is an advantage of P/S over P/E as a valuation tool? - sales are less subject to manipulation compared to EPS - sales are positive even when EPS are negative - sales are more stable than EPS - Useful for valuing mature, cyclical and zero-income companies What is the rational for using EV/S over P/E? ● more useful than P/E in valuing companies with negative earnings ● better than either P/E or P/B for comparing companies in different countries that are likely to use different accounting standards (a consequence of the multinational nature of the industry); ● less subject to manipulation than earnings (i.e., through aggressive accounting decisions by management, who may be more motivated to manage earnings when a company is in a cyclical low, rather than in a high, and thus likely to report losses). Given the following information, calculate P/EBITDA and EV/EBITDA: Price per share : 150 Shares outstanding: 5mm Market Value of debt: 50 Book value of debt 52 Cash and Investments: 5 Net income : 50 Net income from continuing operations: 49.5 Interest Expense: 3 Depreciation and Amortization: 8 Taxes: 2 1) P/EBITDA: step 1: calculate EBITDA : EBITDA = Net Income from continuing operations + Interest Expense + Depreciation and Amortization + Taxes = 49.5 + 3 + 8 + 2 = 62.5mm step 2: calculate EBITDA/share = 62.5mm / 5mm = 12.5/share step 3: calculate P/EBITDA = 150/12.5 = 12.5 2) EV/EBITDA: step 1: calculate EV = MV Equity + MV debt - Cash and investments = 150*5mm + 50 - 5 = 750mm + 50mm - 5mm = 795mm step 2: Divide EV/EBITDA = 795mm/62.5mm = 12.72 * use total EBITDA, not per share EBITDA * Would a recommendation based on high relative strength be consistent with a value oriented investment firm? No, Relative strength is based strictly on price movement (a technical indicator), High relative strength would be relevant for a portfolio managed with a growth/momentum investment style T/F: a stock screen that includes a maximum P/E should include criteria requiring positive earnings? True - otherwise, the screen could select companies with negative P/Es. A company makes a major acquisition during 2020. When calculating P/E at the beginning of 2021 is it more appropriate to use leading P/E or lagging P/E? Leading P/E, since a major change such as an acquisition or divestiture can affect results, the forward P/E, also known as the leading P/E or prospective P/E, is the most appropriate P/E to use. Earnings estimates for 2021 should incorporate the performance of the acquired company. For a company in a cyclical industry who was recently affected by a downturn in the economy, however is starting to recover, what valuation approach should you use? a) P/B B) P/E using trailing earnings C) P/E using normalized earnings C is correct - The use of normalized earnings should address the problem of cyclicality by estimating the level of earnings per share that the company could achieve currently under mid-cyclical conditions. The preference to use the P/E over the P/S is best supported by: A - Reason 1 Earnings are more stable than sales. B - Reason 2 Earnings are less easily manipulated than sales. C - Reason 3 The P/E reflects financial leverage, whereas the P/S does not. C is correct. The price to sales ratio (P/S) fails to consider differences in cost structures. Also, while share price reflects the effect of debt financing on profitability and risk, sales is a pre-financing income measure and does not incorporate the impact of debt in the firm's capital structure. Earnings reflect operating and financial leverage, and thus the price-to-earnings ratio (P/E) incorporates the impact of debt in the firm's capital structure. Which measure of central tendency are you most likely to recommend to mitigate the effect of large outliers but not the impact of small outliers when calculating a sector P/E? A median. B harmonic mean. C arithmetic mean. B is correct. The harmonic mean is sometimes used to reduce the impact of large outliers—which are typically the major concern in using the arithmetic mean multiple—but not the impact of small outliers (i.e., those close to zero). The harmonic mean may aggravate the impact of small outliers, but such outliers are bounded by zero on the downside T/F : when calculating P/BV, book value is total shareholders equity - value of preferred shares True - Price to book is calculated as the current market price per share divided by book value per share. Book value per share is common shareholders' equity divided by the number of common shares outstanding. Common shareholders' equity is calculated as total shareholders' equity minus the value of preferred stock. How do you calculate enterprise value? EV = Market value of common equity + Market value of preferred stock + Market value of debt- Cash, cash equivalents, and short-term investments * Note do not subtract any other current investments such as accounts receivable and inventory - only cash and cash equivalents!! * Calculate the harmonic mean of the peer groups forward P/Es given the following P/E values: 5.9, 8.3, 3.0, 15.0, 4.6 harmonic mean = 5/(1/5.9+1/8.3+1/3+1/15+1/4.6) = 5.5 Which of the following statements concerning the use of the P/S is correct? Statement 1 The P/S is not affected by revenue recognition practices. Statement 2 The P/S is less subject to distortion from expense accounting than is the P/E. A Statement 1 only B Statement 2 only C Both Statement 1 and Statement 2 B is correct. Statement 2 is correct because sales, as the top line of the income statement, are less subject to accounting distortion or manipulation than are other fundamentals, such as earnings. Statement 1 is incorrect because sales figures can be distorted by revenue recognition practices, in particular those tending to speed up the recognition of revenues. Which of the following statements concerning the Fed and Yardeni models is correct? Statement 3 The Fed model concludes that the market is undervalued when the market's current earnings yield is greater than the 10-year Treasury bond yield. Statement 4 The Yardeni model includes the consensus five-year earnings growth rate forecast for the market index. A Statement 3 only B Statement 4 only C Both Statement 3 and Statement 4 C - both statements are correct. The Fed model considers the equity market to be undervalued when the market's current earnings yield is greater than the 10-year Treasury bond yield. The Yardeni model incorporates the consensus five-year earnings growth rate forecast for the market index, a variable missing in the Fed model A firm's return on equity (ROE) is 12 percent, its required rate of return is 10 percent, and its expected growth rate is 7 percent. What is the firms justified price-to-book value (P/B) based on these fundamentals? P0/B0 = (ROE − g)/(r − g) = (0.12 − 0.07)/ (0.10 − 0.07) = 1.67 What are the fundamental drivers of P/E? The expected earnings growth rate and the required rate of return What are the fundamental drivers of P/B? ROE and the required rate of return Recall : P/B = (ROE - g) / (r - g) T/F: CF and EBITDA do not account for noncash revenue and net changes in working capital? True What are the fundamental drivers of P/CF? the expected growth ate of future cash flow and the required rate of return T/F: EV/EBITDA is preferred over P/EBITDA because EBITDA as a pre-interest number is a flow to all providers of capital True T/F: EV/EBITDA is frequently used in the valuation of capital-intensive businesses True