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Valuation: Principles and Practice


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Title: Valuation: Principles and Practice

Valuation Principles and Practice
  • 11/29/05

Valuation techniques
  • Relative valuation
  • the value of an asset is derived from the pricing
    of 'comparable' assets, standardized using a
    common variable such as earnings, cash flows,
    book value or revenues.
  • Discounted cash flow valuation
  • The value of an asset is the discounted expected
    cash flows on that asset at a rate that reflects
    its riskiness.

Relative valuation
  • The value of the firm is determined as
  • Comparable multiple Firm-specific denominator
  • A firm is considered over-valued (under-valued)
    if the calculated price (or multiple) is greater
    (less) than the current market price (comparable
    firm multiple)
  • Assumption Comparable firms, on average, are
    fairly valued, i.e., multiples are the same
    across comparable firms.

Relative valuation
  • Examples of relative valuation multiples
  • Price/Earnings (P/E)
  • Earnings calculations should exclude all
    transitory components
  • variants include EBIT multiples, EBITDA
    multiples, Cash Flow multiples
  • Price/Book (P/BV)
  • Book value of equity is total shareholderss
    equity preferred stock
  • Price/Sales (P/S)

Advantages and drawbacks of P/E
  • Advantages
  • Earnings power is the chief driver of investment
  • Main focus of security analysts
  • The P/E is widely recognized and used by
  • Differences in P/E may be related to long-run
    differences in average return (low P/E
  • Drawbacks
  • If earnings are negative, P/E does not make
    economic sense
  • Reported P/Es may include earnings that are
  • Earnings can be distorted by management
  • Assumption
  • Required rate of return, retention ratio and
    growth rates are similar among comparable firms

Advantages and drawbacks of P/BV
  • Advantages
  • Since book value is a cumulative balance sheet
    amount, it is generally positive
  • BV is more stable than EPS, therefore P/BV may be
    more meaningful when EPS is abnormally low or
  • P/BV is particularly appropriate for companies
    with primarily liquid assets (financial
  • Disadvantages
  • Human capital is not considered
  • Differences in firm size can lead to incorrect
    comparable values
  • Differences in asset age among companies may make
    comparing companies difficult
  • Assumption
  • Required rate of return, return on equity,
    retention ratio and growth rates are similar
    among comparable firms

Advantages and drawbacks of P/S
  • Advantages
  • Sales are generally less subject to distortion or
  • Sales are positive even when EPS is negative
  • Sales are more stable than EPS, therefore P/S may
    be more meaningful when EPS is abnormally low or
  • P/S is particularly appropriate for valuing
    mature companies
  • Disadvantages
  • High growth in sales may not translate to
    operating profitability
  • P/S does not reflect differences in cost
  • Assumption
  • Required rate of return, profit margin, retention
    ratio and growth rates are similar among
    comparable firms

Benchmarks for comparison
  • Peer companies
  • Constituent companies are typically similar in
    their business mix
  • Industry or sector
  • Usually provides a larger group of comparables
    therefore estimates are not as effected by
  • Overall market
  • Own historical
  • This benchmark assumes that the firm will regress
    to historical average levels

Leading and trailing P/E
  • Trailing (or current) P/Es is calculated using
    the firms current market price and the four most
    recent quarters EPS.
  • Leading P/Es is calculated using the firms
    current market price and next years expected

PEG Ratio
  • When comparable firm P/Es are used to calculate
    the value of a firm, the assumption is that the
    firm has characteristics that are similar to that
    of the average comparable firm.
  • However, differences may exist. For example, a
    higher P/E for a particular firm may be justified
    because the firm has higher growth.
  • The Price/Earnings-to-Growth (PEG) accounts for
    differences in the growth in earnings between
  • PEG is calculated as
  • P/E divided by expected earnings growth ().

Discounted cash flow valuation Equity valuation
  • The value of equity is obtained by discounting
    expected cash flows to equity, i.e., the residual
    cash flows after meeting all expenses, tax
    obligations and interest and principal payments,
    at the cost of equity, i.e., the rate of return
    required by equity investors in the firm.
  • where,
  • CF to Equityt Expected Free Cash Flow to
    Equity in period t
  • re Cost of Equity

Discounted cash flow valuation Equity valuation
  • Since we cannot estimate cash flows forever, we
    estimate cash flows for a growth period and
    then estimate a terminal value, to capture the
    value at the end of the period

Valuation steps
  • Estimate the discount rate
  • Estimate the current cash flow to equity
  • Estimate a growth rate(s) to estimate future cash
  • Compute the firms equity value

Discount rate and CF to equity
  • Discount rate
  • The appropriate discount rate in valuing equity
    is the cost of equity which can be estimated
    using the CAPM.
  • CF to equity (FCFE)
  • We will use the estimated FCFE equation to
    calculate CF to equity as this provides a better
    long run estimate.
  • Non-recurring items should be excluded from net
    income calculations

Tax rate
  • The choice is between the effective (taxes paid /
    taxable income) and the marginal tax rate.
  • In doing projections, it is far safer to use the
    marginal tax rate since the effective tax rate is
    really a reflection of the difference between the
    accounting and the tax books.
  • If you choose to use the effective tax rate,
    adjust the tax rate towards the marginal tax rate
    over time.

Estimating growth (in EPS)
  • A key assumption in all discounted cash flow
    models is the period of high growth, and the
    pattern of growth during that period. In general,
    we can make one of three assumptions
  • there is no high growth, in which case the firm
    is already in stable growth
  • there will be high growth for a period, at the
    end of which the growth rate will drop to the
    stable growth rate (2-stage)
  • there will be high growth for a period, at the
    end of which the growth rate will decline to a
    lower growth rate and then decline further after
    a period of time to a stable growth rate(3-stage)

Current growth
  • The current growth rate in earnings can be used
    as an estimate of futures earnings growth during
    the first high-growth stage of the firm.
  • gEPS Retained Earningst-1/ NIt-1 ROE
  • Retention Ratio ROE
  • b ROE

Determinants of length of high growth period
  • Size of the firm
  • Success usually makes a firm larger. As firms
    become larger, it becomes much more difficult for
    them to maintain high growth rates
  • Current growth rate
  • While past growth is not always a reliable
    indicator of future growth, there is a
    correlation between current growth and future
    growth. Thus, a firm growing at 30 currently
    probably has higher growth and a longer expected
    growth period than one growing 10 a year now.

Determinants of length of high growth period
  • Barriers to entry and differential advantages
  • Ultimately, high growth comes from high project
    returns, which, in turn, comes from barriers to
    entry and differential advantages.
  • The question of how long growth will last and how
    high it will be can therefore be framed as a
    question about what the barriers to entry are,
    how long they will stay up and how strong they
    will remain.

Firm characteristics as growth changes
  • Variable High Growth Firms Stable Growth tend
    to Firms tend to
  • Risk be above-average risk be average risk
  • Dividend Payout pay little or no dividends pay
    high dividends
  • Net Cap Ex have high net cap ex have low net cap
  • ROC earn high ROC earn ROC closer to WACC
  • Leverage have little or no debt higher leverage

Estimating stable growth inputs
  • Start with the fundamentals
  • Profitability measures such as return on equity,
    in stable growth, can be estimated by looking at
  • industry averages for these measure, in which
    case we assume that this firm in stable growth
    will look like the average firm in the industry
  • cost of equity, in which case we assume that the
    firm will stop earning excess returns on its
    projects as a result of competition.
  • Average industry retention ratios or firm
    retention ratios can also be used

Calculating equity value
  • During the high-growth stage(s), future cash
    flows are estimated individually and discounted.
  • Terminal value (commencing in period N1) is
    calculated as
  • where g is the stable growth stage growth rate.

DCF vs. relative valuation
  • DCF valuation assumes that markets make mistakes
    in estimating value (i.e., current price is not
    an accurate reflection of the value of the firm)
    and these mistakes tend to be corrected over time
    and can occur over entire sectors.
  • Relative valuation assumes markets are correct on
    average (i.e., comparables on average are
    correctly priced)