1. Valuation: Principles and Practice
11/29/05

2. Valuation techniques Relative valuation Discounted cash flow 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.

3. Relative valuation The value of the firm is determined as:
Comparable multiple * Firm-specific denominator value
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.

4. 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 shareholders’s equity – preferred stock
Price/Sales (P/S)

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

6. Advantages and drawbacks of P/BV
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 high
P/BV is particularly appropriate for companies with primarily liquid assets (financial instituitions)
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

7. Advantages and drawbacks of P/S
Sales are generally less subject to distortion or manipulation
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 high
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 structure
Assumption:
Required rate of return, profit margin, retention ratio and growth rates are similar among comparable firms

8. 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 outliers
Overall market
Own historical
This benchmark assumes that the firm will regress to historical average levels

9. Leading and trailing P/E
Trailing (or current) P/Es is calculated using the firm’s current market price and the four most recent quarters’ EPS.
Leading P/Es is calculated using the firm’s current market price and next year’s expected earnings.

10. 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 companies.
PEG is calculated as:
P/E divided by expected earnings growth (%).

11. 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

12. 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

13. Valuation steps Estimate the discount rate
Estimate the current cash flow to equity
Estimate a growth rate(s) to estimate future cash flows
Compute the firm’s equity value

14. Discount rate and CF to equity
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

15. 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.

16. 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)

17. 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

18. 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.

19. 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.

20. 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 ex
ROC earn high ROC earn ROC closer to WACC
Leverage have little or no debt higher leverage

21. 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

22. Calculating equity value
During the high-growth stage(s), future cash flows are estimated individually and discounted.
Terminal value (commencing in period N+1) is calculated as:
where g is the stable growth stage growth rate.

23. 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)