Valuation Equity Analysis II: Relative Valuation Models. Valuation Models. Price Multiples. Price to Earnings. Rationales for using P/E

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1 Valuation Equity Analysis II: Relative Valuation Models Valuation is the estimation of an asset s value based either on variables perceived to be related to future investment returns or on comparisons with similar assets. Valuation Models Absolute valuation models Relative valuation models Price Multiples Ratios of stock price to some measure of value per share. Basic idea Appealing features Price to Earnings P/E ratio = Price per share/earnings per share Two variations trailing P/E leading P/E Rationales for using P/E Earnings power is the chief driver of investment value EPS is the chief focus of security analysts attention Differences in P/Es may be related to differences in long-run average returns, according to empirical research 1

2 Drawbacks of using P/E EPS can be negative The ongoing and recurring components of earnings are the most important in determining intrinsic value. Earnings often have volatile, transient components. Management can exercise its discretion within allowable accounting practices to distort EPS as an accurate reflection of economic performance Determining Earnings Transitory, nonrecurring components of earnings that are company specific Transitory components of earnings due to cyclicality (business-cycle or industry cycle) Determining Earnings Differences in accounting methods Potential dilution of EPS Valuation using P/E Calculate P/E Select the comparison asset Calculate P/E of the comparison asset Compare the subject stock s P/E with that of the comparison asset Assess whether the differences between the two are explained by differences in fundamental determinants of the price multiple and modify conclusions about relative valuation accordingly P/E Benchmark Value peer stock peer group of companies within an industry industry representative equity index past values of the P/E for the stock, respectively. The EPS is $1.66 for and $2.10 for. What is the P/E ratio for? What is the P/E ration for? Which 2

3 EPS $1.66 $2.10 Differences in P/E If the subject stock has higher-than-average expected earnings growth rate, a higher P/E is justified If the subject stock has higher-than-average risk, a lower P/E than the benchmark P/E is justified P0 ( 1 b)( 1 + g) P0 1 b = or = E r g E r g 0 1 PEG Ratio One metric that appears to address the impact of earnings growth on P/E is the P/E to growth (PEG) ratio PEG assume linear relation between P/E and g PEG does not factor into risk Expected growth rate is difficult to estimate Price to Book Value Price per share/book value per share Book value of equity represent the investment that common shareholders have made in the company stock variable; earnings are flow a variable Determining Book Value Common Shareholders equity = shareholders equity total value of equity claims that are senior to common stock Some analysts report a tangible book value per share Goodwill represents the excess of the purchase price of an acquisition over the net asset value of tangible assets and specifically identifiable intangibles, respectively. The BVPS is $9.01 for and $11.94 for. What is the P/B ratio for? What is the P/B ration for? Which 3

4 BVPS $9.01 $11.94 Strengths of P/B Book value is generally positive even when EPS is negative BPS is generally more stable (less variable) than EPS, may be more meaningful Drawbacks of P/B BPS does not include human capital P/B can be misleading Book values reflects the historical purchase cost of assets, as well as accumulated accounting depreciation Rationales for Price to Sales Sales are generally less subject to Sales are Sales are generally more P/S has been viewed as appropriate for valuing the stock of mature, cyclical companies Drawbacks of P/S P/S does not reflect P/S does not reflect differences in cost structures Revenue recognition offer potential to distort P/S, respectively. The sales per share is $25.33 for and $33.75 for. What is the P/S ratio for? What is the P/S ration for? Which is overvalued and which is undervalued? 4

5 SPS $25.33 $33.75 Price to Cash Flow Cash flow: net income plus non-cash charges Some times P/EBITDA Cash flow is less subject to manipulation Cash flow is more stable than earnings Using price to cash flow rather than P/E addresses the issue of differences in accounting conservatism between companies (differences in earnings quality), respectively. The CFPS is $2.09 for and $3.27 for. What is the P/CF ratio for? What is the P/CF ration for? Which CFPS $2.09 $3.27 5