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MARKET-BASED

VALUATION:
PRICE AND ENTERPRISE
VALUE MULTIPLES

Presenter
Venue
Date

VALUATION INDICATORS









Price
Multiples
Enterprise
Value
Multiples
Momentum
Indicators
METHODS FOR PRICE & ENTERPRISE VALUE
MULTIPLES









1) Method of Comparables
Economic rationale is the law of one price
2) Method Based on Forecasted Fundamentals
Reflects firm fundamentals and future cash flows
Justified Price Multiples
Can be determined using either method
PRICE-TO-EARNINGS MULTIPLE
RATIONALES & DRAWBACKS









Rationales
EPS is driver of value
Widely used
Related to stock
returns
Drawbacks
Zero, negative, or very
small earnings
Permanent vs.
transitory earnings
Management
discretion for earnings
PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS









Trailing
P/E
Uses last
years
earnings
Preferred
when
forecasted
earnings are
not available
Forward
P/E
Uses next
years
earnings
Preferred
when trailing
earnings are
not reflective
of future
EXAMPLE: FORWARD P/E
Stock price $20 .00
2011:Q1 EPS $0 .18
2011:Q2 EPS $0 .25
2011:Q3 EPS $0 .32
2011:Q4 EPS $0 .35
2011 Fiscal year forecast $1 .10
2012:Q1 EPS $0 .43
2012:Q2 EPS $0 .48
2012:Q3 EPS $0 .50
2012:Q4 EPS $0 .59
2012 Fiscal year forecast $2 .00
EXAMPLE: FORWARD P/E
1) Forward P/E based on EPS for the next 4 quarters:
EPS for the next 4 quarters = $0.35 $0.43 $0.48 $0.50 $1.76
Forward P/E based on EPS for the next 4 quarters $20 $1.76 11.4
2) Forward P/E based on EP
+ + + =
= / =
( ) ( )
S for the NTM (next 12 months):
1 11
EPS for the NTM $1.10 $2.00 $1.925
12 12
Forward P/E based on EPS for the NTM $20 $1.925 10.4
= + =
= / =
EXAMPLE: FORWARD P/E
3) Forward P/E based on the current fiscal year's EPS:
EPS for the current fiscal year $1.10
Forward P/E based on EPS for the current fiscal year $20 $1.10 18.2
4) Forward P/E based on the next fiscal ye
=
= / =
ar's EPS:
EPS for the next fiscal year $2.00
Forward P/E based on EPS for the next fiscal year $20 $2.00 10.0
=
= / =
ISSUES IN CALCULATING EPS









EPS Dilution
Underlying
Earnings
Normalized
Earnings
Differences
in Accounting
Methods
EXAMPLE: UNDERLYING EARNINGS
Reported EPS from previous four quarters $4 .00
Restructuring charges $0 .10
Amortization of intangibles $0 .15
Impairment charge $0 .20
Stock price $50 .00
EXAMPLE: UNDERLYING EARNINGS
P/E based on reported earnings $50 $4.00 12.5
Reported core earnings $4.00 $0.10 $0.15 $0.20 $4.45
P/E based on reported core earnings $50 $4.45 11.2
Underlying earnings $4.00 $0.20 $4.20
P/E based on und
= / =
= + + + =
= / =
= + =
erlying earnings $50 $4.20 11.9 = / =
EXAMPLE: NORMALIZED EARNINGS









Year EPS BVPS ROE
2010 $0.66 $4.11 16.1%
2009 $0.55 $3.67 15.0%
2008 $0.81 $2.98 27.2%
2007 $0.73 $2.12 34.4%
2006 $0.34 $1.61 21.1%
2011 stock price $24.00
EXAMPLE: NORMALIZED EARNINGS









1) Method of historical average EPS
($0.66 $0.55 $0.81 $0.73 $0.34)
Average (normalized) EPS $0.618
5
P/E $24.00 $0.618 38.8
+ + + +
= =
= / =
EXAMPLE: NORMALIZED EARNINGS









2) Method of average ROE
(16.1% 15.0% 27.2% 34.4% 21.1%)
Average ROE 22.8%
5
Average (normalized) EPS Average ROE Current equity book value per share
Average (normalized) EPS 22.8% $4.11 $0.937
P E $24.00
+ + + +
= =
=
= =
/ = / $0.937 25.6 =
JUSTIFIED FORWARD P/E FROM
FUNDAMENTALS








1
0
0 1 1
1
0
1
1
=

D
V
r g
P D E
E r g
P b
E r g
JUSTIFIED TRAILING P/E FROM
FUNDAMENTALS








0
0
0 0 0
0
0
0
(1 )
(1 )
(1 )(1 )
+
=

+
=

+
=

D g
V
r g
P D g E
E r g
P b g
E r g
EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS








Retention ratio 0 .36
Dividend growth rate 4 .0%
Required return on stock 10 .0%
EXAMPLE: JUSTIFIED FORWARD P/E
FROM FUNDAMENTALS








0
1
0
1
1
=
1 0.36
= =10.7
0.10 0.04

P b
E r g
P
E
EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS








( ) ( ) ( )
Predicted P/E
11.5 2.2 DPR + 0.03 Beta + 16.2 EGR
=
+
Values for subject firm

Dividend payout ratio 0 .40
Beta 1 .20
Earnings growth rate 6 .00%
Actual P/E 15 .0
EXAMPLE: JUSTIFIED P/E FROM
REGRESSION ON FUNDAMENTALS








( ) ( ) ( )
( ) ( ) ( )
Predicted P/E
11.5 2.2 DPR 0.03 Beta 16.2 EGR
11.5 2.2 0.4 + 0.03 1.2 16.2 0.06
13.3
=
+ + +
= + +
=
METHOD OF COMPARABLES









Benchmark Value of the
Multiple Choices
Industry
peers
Industry
or sector
index
Broad
market
index
Firms
historical
values
METHOD OF COMPARABLES
USING PEER COMPANY MULTIPLES
Law of one price
Risk and earnings growth adjustments
PEG limitations:
Assumes linear relationship
Does not account for risk
Does not account for growth duration
EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG
Values for subject firm
Five-year EPS growth rate 8 .0%
Consensus EPS forecast $4 .50
Current stock price $28 .00
Values for peer group
Median P/E 9 .00
Median PEG 1 .60
EXAMPLE: METHOD OF COMPARABLES
USING P/E AND PEG
P/E $28.00 $4.50 6.2
PEG 6.2 8.0 0.78
Intrinsic value 9.0 $4.50 $40.50
= / =
= / =
= =
METHOD OF COMPARABLES
USING INDUSTRY AND MARKET MULTIPLES
Industry or Sector Index
Mean vs. median
Check industry valuation against market

Broad Market Index
Adjust for differences in fundamentals & size
Use relative values on a historical basis
METHOD OF COMPARABLES
VALUING THE MARKET
Fed Model: Earnings Yield vs. T-Bond Yield
Does not account for inflation correctly
Relationship between earnings yield &
interest rates is nonlinear
Small rate As large As in P/E

Yardeni Model
METHOD OF COMPARABLES
USING OWN HISTORICAL MULTIPLES
Rationale: Regression to the Mean
Approaches:
Average of four middle values over past 10 years
Five-year average trailing P/E
Potential Problems from Changes in
Firm business
Firm financial leverage
Interest rate environment
Economic fundamentals
Inflationary environment
USING P/ES FOR TERMINAL VALUE









Justified P/E
P/E =
(D/E)/(r g)
Sensitive to required
inputs
P/E Based on
Comparables
Grounded in market
data
If comp is mispriced,
terminal value will
be mispriced
EXAMPLE: USING P/ES FOR TERMINAL VALUE









Values for subject firm
Required rate of return 11 .0%
EPS forecast for year 3 $2 .50
Values for peer group
Mean dividend payout ratio 0 .40
Mean ROE 8 .0%
Median P/E 9 .00
EXAMPLE: USING P/ES FOR TERMINAL VALUE
USING GORDON GROWTH MODEL









( ) ( )
3 3
3
3
3
EPS Dividend payout ratio
$2.50 0.40 $1.00
Retention ratio 1 Dividend payout ratio
Retention ratio 1 0.40 0.60
Retention ratio ROE
0.60 8% 4.8%
1 $1.00 1 0.048
$16.90
0.11 0.048
=
= =
=
= =
=
= =
+ +
= = =

D
D
g
g
D g
V
r g
EXAMPLE: USING P/ES FOR TERMINAL VALUE
USING COMPARABLES









3 3
P/E EPS
9.0 $2.50 $22.50
=
= =
V
PRICE-TO-BOOK VALUE MULTIPLE
RATIONALES
Book Value Is Usually Positive
More Stable than EPS
Appropriate for Financial Firms
Appropriate for Firms that Will Terminate
Can explain stock returns
PRICE-TO-BOOK VALUE MULTIPLE
DRAWBACKS
Does Not Recognize Nonphysical Assets
Misleading when Asset Levels Vary
Can Be Misleading Due to Accounting Practices
Less Useful when Asset Age Differs
Can Be Distorted Historically by Repurchases
ADJUSTMENTS TO BOOK VALUE
Intangible
Assets
Inventory
Accounting
Off-Balance-
Sheet Items
Fair Value
JUSTIFIED P/B








( )
0
0 0
PV Expected future residual earnings
1 = +
P
B B
0
0
ROE
=

P g
B r g
PRICE-TO-SALES
MULTIPLE RATIONALES
Sales Less Easily Manipulated
Sales Are Always Positive
P/S Appropriate For Mature, Cyclical, & Distressed Firms
P/S More Stable Than P/E
Can Explain Stock Returns
PRICE-TO-SALES
MULTIPLE DRAWBACKS
Sales Earnings & Cash Flow
Numerator & Denominator Not Consistent
P/S Does Not Reflect Cost Differences
P/S Can Be Misleading Due to Accounting
Practices
JUSTIFIED P/S








0 0 0
0
( / )(1 )(1 )

+
=

P E S b g
S r g
0
ROE
Sales Total assets
PM
Total assets Shareholders equity
| |
| |
|
|
|
\ .
\ .
=
=
g b
g b
EXAMPLE: CALCULATING THE ACTUAL & JUSTIFIED
P/E, P/B, & P/S








Stock price $50 .00
EPS $2 .00
Dividends per share $1 .20
Book value of equity per share $6 .25
Sales per share $15 .00
ROE 22 .5%
Required return on stock 12 .0%
EXAMPLE: CALCULATING THE ACTUAL
P/E, P/B, & P/S








0
0
0
0
0
0
$50
Actual 25.0
$2
$50
Actual 8.0
$6.25
$50
Actual 3.3
$15
= =
= =
= =
P
E
P
B
P
S
EXAMPLE: CALCULATING THE INPUTS FOR
THE JUSTIFIED
P/E, P/B, & P/S








Dividend payout ratio $1.20 $2.00 0.60
Retention ratio ( ) 1 0.60 0.40
Growth rate in dividends ( ) 0.40 22.5% 9.0%
= / =
= =
= =
b
g
EXAMPLE: CALCULATING THE JUSTIFIED
P/E, P/B, & P/S
0 0 0
0
( )(1 )(1 )
($2 $15)(0.6)(1.09)
2.9
0.12 0.09
/ +
/
= = =

P E S b g
S r g
0
0
(1 )(1 ) (1 0.60)(1 0.09)
21.8
0.12 0.09
+ +
= = =

P b g
E r g
0
0
ROE 0.225 0.09
4.5
0.12 0.09

= = =

P g
B r g
PRICE-TO-CASH-FLOW
MULTIPLE RATIONALES
Cash Flow Less Easily Manipulated
Ratio More Stable Than P/E
Ratio Addresses Quality of Earnings Issue with P/E
Ratio Can Explain Stock Returns
PRICE-TO-CASH-FLOW
MULTIPLE DRAWBACKS
Cash Flow Can Be
Distorted
FCFE More Volatile
and More Frequently
Negative
Cash Flow Increasingly
Managed by Firms
DEFINITIONS OF CASH FLOW
Earnings + Depreciation +
Amortization + Depletion
CF
From statement of cash flows
CFO
Most valid but volatile
FCFE
Best used with enterprise
value
EBITDA
JUSTIFIED PRICE-TO-CASH-FLOW RATIO








0
0
FCFE (1 )

+
=

g
V
r g
DIVIDEND YIELD
RATIONALES & DRAWBACKS









Rationales
Component of return
Dividends less risky
than future capital
gains
Drawbacks
Only one component of
return
Dividends may displace
future earnings
Market may not favor
dividends
JUSTIFIED DIVIDEND YIELD








0
0


1

=
+
D
r g
P g
INVERSE PRICE RATIOS









Price Ratio
Inverse Price Ratio

Price-to-earnings (P/E) Earnings yield (E/P)
Price-to-book (P/B) Book-to-market (B/P)

Price-to-sales (P/S) Sales-to-price (S/P)
Price-to-cash-flow (P/CF) Cash flow yield (C/P)

Price-to-dividends (P/D) Dividend yield (D/P)

ENTERPRISE VALUE/EBITDA MULTIPLE
RATIONALES & DRAWBACKS
Rationales
Useful for comparing firms
of different leverage
Useful for comparing firms
of different capital utilization
Usually positive
Drawbacks
Exaggerates cash flow
FCFF more strongly
grounded
ISSUES IN USING ENTERPRISE VALUE
MULTIPLES
EV = Market Value of Stock + Debt Cash Investments
Justified EV/EBITDA
Positively related to FCFF growth
Positively related to ROIC
Negatively related to WACC
Comparables May Utilize TIC
Other EV Multiples
EV/FCFF
EV/EBITA
EV/EBIT
EV/S
CROSS-COUNTRY COMPARISONS
Net income higher under IFRS
Shareholder's equity lower under IFRS
ROE higher under IFRS
US GAAP
vs. IFRS
P/CFO & P/FCFE most comparable
P/B, P/E, & EBITDA multiples least
comparable
Valuation
Multiples
Higher inflation Lower justified price
multiples
Higher pass-through rates Higher justified
price multiples
Inflation
MOMENTUM INDICATORS:
EARNINGS SURPRISES
( )
( )
( )
EPS EPS
UE
SUE
UE
EPS EPS

= =
(


t t
t t
E
t
t
E
t
o
o
( )
UE EPS EPS =
t t
E
t
MOMENTUM INDICATORS:
RELATIVE STRENGTH
Past Performance
Relative to an Index
Inherently Self-
Destructing
VALUATION INDICATORS IN PRACTICE:
AVERAGING MULTIPLES
Overestimate of index P/E
Arithmetic
Mean &
Weighted Mean
Closer to index P/E but is
influenced by small outliers
Harmonic Mean
Equal to index P/E
Weighted
Harmonic Mean
VALUATION INDICATORS IN PRACTICE:
STOCK SCREENS
Database Limitations
Variables are predetermined
Does not contain qualitative data
Look-Ahead Bias
Assumes investor has info not yet available
Sector Rotation
SUMMARY
Method of comparables
Method based on forecasted fundamentals
Price & Enterprise Value Multiples
Rationales: EPS Driver of value; widely used;
related to stock returns
Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion for
earnings
Trailing and forward P/Es
Price-to-Earnings Rationales & Drawbacks
SUMMARY
EPS dilution
Underlying earnings
Normalized earnings
Differences in accounting methods
Issues in Calculating EPS
Industry peers
Industry or sector index
Broad market index
Own historical values
Method of Comparables
SUMMARY
Rationales: Book value usually > 0, more stable than EPS,
appropriate for financial firms & firms that will terminate,
explains stock returns
Drawbacks: Doesnt recognize nonphysical assets, misleading
if asset levels vary or differ from accounting practices, less
useful when asset age differs, can be distorted by repurchases
Price-to-Book Rationales & Drawbacks
Intangible assets
Inventory accounting
Off-balance-sheet items
Fair value
Issues in Calculating Book Value
SUMMARY
Rationales: Sales less easily distorted, sales always positive,
P/S more stable than P/E, appropriate for many firms,
explains stock returns
Drawbacks: Sales Earnings & Cash flow, numerator &
denominator not consistent, does not reflect cost differences,
can be distorted
Price-to-Sales Rationales & Drawbacks
Rationales: CF less easily manipulated, more stable than
P/E, addresses quality of earnings issue, explains stock
returns
Drawbacks: can be distorted, FCFE more volatile and more
frequently negative, increasingly managed by firms
Price-to-Cash-Flow Rationales & Drawbacks
SUMMARY
CF: Earnings + Depreciation + Amortization + Depletion
CFO: From statement of cash flows
FCFE: Most valid but volatile
EBITDA: Best used with enterprise value
Measures of Cash Flow
Rationales: A component of return, dividends less risky
than future capital gains
Drawbacks: Only one component of return, dividends
may displace future earnings, market may not favor
dividends
Dividend Yield Rationales & Drawbacks
SUMMARY
Useful when denominators are small, low, or negative
(e.g., earnings)
Earnings yield, book-to-market, sales-to-price, cash
flow yield, and dividend yield
Inverse Price Ratios
EV = Market value of stock + Debt Cash
Investments
Rationales: Useful for comparing firms of different
leverage & capital utilization, usually positive
Drawbacks: Exaggerates cash flow, FCFF more
strongly grounded
Enterprise Value Multiples
SUMMARY
P/E: + related to g, related to r
P/B: + related to ROE, related to r
P/S: + related to g & PM, related to r
P/CF: + related to g, related to r
D/P: - related to g, + related to r
EV/EBITDA: + related to g and PM,
related to WACC
Justified Multiples
SUMMARY
IFRS ROE higher than GAAP ROE
P/CFO & P/FCFE most comparable
P/B, P/E, & EBITDA multiples least
comparable
Higher inflation Lower justified price
multiples
Higher pass-through rates Higher
justified price multiples
Cross-Country Comparisons
SUMMARY
Unexpected earnings (UE)
Standardized unexpected earnings (SUE)
Relative strength
Momentum Indicators
Database limitations
Potential look-ahead bias
Used in sector rotation
Stock Screens