1. Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Valuation: Market-Based Approaches Slides Prepared by Karen Foust Tulane University

2. Using Market Multiples in Valuing the Firm Can augment valuation with information incorporated into market value and share price Caution advised –Market multiples use just one or two accounting numbers –Relatively simple ratios of market value to summary accounting measures

3. Using Market Multiples in Valuing the Firm Relative measurements No meaning unless know firm’s expected future: –Profitability –Risk –Growth Can’t skip earlier analytical steps!

4. Market-to-Book (MB) Ratio Market value of common shareholders’ equity divided by Book value of common shareholders’ equity Reflects what market value IS, but not what SHOULD BE Useful to compare to Value-to-Book Ratio

5. Value-to-Book (VB) Ratio Use residual income valuation model to compute value of common shareholders’ equity Divide value by book value of common shareholders’ equity Can compare to Market-to-Book ratio to evaluate share price

6. MB and VB Ratios Why not equal to 1 (i.e., market equal to book and value equal to book)? Economic reasons: –ROCE > R E (firm is creating shareholder wealth) –ROCE < R E (firm destroying shareholder wealth) –Risk of firm increases R E Accounting reasons: –Accounting methods –Off-balance-sheet assets (e.g., R&D, human capital)

7. Price-Earnings (PE) Ratio Frequently quoted Usually computed as current share price divided by reported EPS Practical, but problematic –Current share price reflects future earnings prospects –Historical earnings may include unusual items –Time misalignment

8. Value-Earnings (VE) Ratio Use residual income model to value common equity Divide value of common equity by expected comprehensive income for next period Use this to evaluate PE ratio

9. PE Ratio Cautions Will differ across time due to –Transitory gains/losses Will differ across firms due to –Risk and cost of capital –Profitability –Accounting differences –Growth

10. Price Differentials Calculate amount by which the market has discounted share price for firm’s risk Use residual income model but with risk- free rate to calculate risk-neutral value for the firm Risk-neutral value per share less market price per share gives price differential Can then evaluate price differential relative to estimated risk of firm

11. Reverse Engineering So far have used three variables to determine firm value –Expected future profitability –Long-run growth –Risk-adjusted discount rate If plug in market value of common equity as firm value and use forecasted values for any 2 of the other variables, then can solve for fourth variable

12. Reverse Engineering Thus can get estimate of assumptions the market is making about the firm’s –Future profitability –Long-run growth, or –Risk

13. Academic Research Useful to analyst? –Not immediately Different levels of aggregation –Academics focus on “big picture” –Analysts on value of individual firms

14. Academic Research Capital Market Efficiency –Market highly efficient in aggregate –Contains random inefficiences—or temporary mispricings –Analysts identify these mispricings –Thus, analysts are important part of the efficiency process!