Relative Valuation II

1
 Value/Earnings and Value/Cashflow Ratios

 While Price earnings ratios look at the market value of equity relative to
earnings to equity investors, Value earnings ratios look at the market value of
the firm relative to operating earnings. Value to cash flow ratios modify the
earnings number to make it a cash flow number.
 The form of value to cash flow ratios that has the closest parallels in DCF
valuation is the value to Free Cash Flow to the Firm, which is defined as:
Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC
 Consistency Tests:
• If the numerator is net of cash (or if net debt is used, then the interest income from
the cash should not be in denominator
• The interest expenses added back to get to EBIT should correspond to the debt in
the numerator. If only long term debt is considered, only long term interest should
be added back.

2
Value/FCFF Distribution

3
 Value of Firm/FCFF: Determinants

 Reverting back to a two-stage FCFF DCF model, we get:

 (1 + g) n 
FCFF (1 + g) 1-  n (1+ g )
0  (1+ WACC)  n FCFF (1+ g)
V0 = + 0 n
WACC - g (WACC - g )(1 + WACC)n
n

• V0 = Value of the firm (today)

• FCFF0 = Free Cashflow to the firm in current year
• g = Expected growth rate in FCFF in extraordinary growth period (first
n years)
• WACC = Weighted average cost of capital
• gn = Expected growth rate in FCFF in stable growth period (after n
years)

4
 Value Multiples

 Dividing both sides by the FCFF yields,

 (1 + g) n

(1 + g) 1-
V0  (1 + WACC) n
(1+ g) n (1+ gn )
= +
FCFF0 WACC - g (WACC - gn )(1 + WACC)n

 The value/FCFF multiples is a function of

• the cost of capital
• the expected growth

5
 Alternatives to FCFF - EBIT and EBITDA

 Most analysts find FCFF to complex or messy to use in multiples

(partly because capital expenditures and working capital have to be
estimated). They use modified versions of the multiple with the
following alternative denominator:
• after-tax operating income or EBIT(1-t)
• pre-tax operating income or EBIT
• net operating income (NOI), a slightly modified version of operating
income, where any non-operating expenses and income is removed from
the EBIT
• EBITDA, which is earnings before interest, taxes, depreciation and
amortization.

6
Illustration: Using Value/FCFF Approaches to value
a firm: MCI Communications

 MCI Communications had earnings before interest and taxes of $3356

million in 1994 (Its net income after taxes was $855 million).
 It had capital expenditures of $2500 million in 1994 and depreciation
of $1100 million; Working capital increased by $250 million.
 It expects free cashflows to the firm to grow 15% a year for the next
five years and 5% a year after that.
 The cost of capital is 10.50% for the next five years and 10% after
that.
 The company faces a tax rate of 36%.

 (1.15) 
5
(1.15) 1-
(1.105)5 
5
V0 (1.15) (1.05)
= + 5
= 31.28
FCFF0 .105 -.15 (.10 - .05)(1.105)

7
 Multiple Magic

 In this case of MCI there is a big difference between the FCFF and
short cut measures. For instance the following table illustrates the
appropriate multiple using short cut measures, and the amount you
would overpay by if you used the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885

8
 Asian Telecom Companies- 2002 Growth(%)

Company Name Market EBITDA G EBIT G Cash Flow G Earnings G DPS G

Asiasat Hong Kong -1.24 -1.52 -8.13 -1.47 150.00
China Mobile China 28.88 16.70 31.23 13.54 -
China Telecom China 12.54 18.12 19.45 -10.36 -
China Unicom China 37.37 39.15 40.09 2.45 -
Indosat Indonesia 28.00 -36.66 124.48 -76.85 -8.01
Korea Telecom South Korea 14.33 26.38 8.60 12.99 -100.00
MobileOne Singapore 21.40 24.55 8.82 28.13 -
PCCW Hong Kong -2.72 -7.71 -14.67 -678.93 -
PLDT Philippines 17.59 24.89 -45.41 8.33 -100.00
Shin Corp Thailand 120.79 112.00 -132.21 87.27 -
Shin Satellite Thailand -13.73 -21.94 -9.34 -9.76 -
Singapore Telecom Singapore 15.39 -13.73 -0.53 -29.70 0.00
SK Telecom South Korea 24.11 21.75 1.29 32.49 151.57
Smartone Hong Kong 395.04 146.14 132.40 139.01 -
Telekom Malaysia Malaysia 9.26 7.04 14.70 -42.81 -
9
 Reasons for Increased Use of Value/EBITDA

1. The multiple can be computed even for firms that are reporting net
losses, since earnings before interest, taxes and depreciation are
usually positive.
2. For firms in certain industries, such as cellular, which require a
substantial investment in infrastructure and long gestation periods, this
multiple seems to be more appropriate than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the firm
prior to all discretionary expenditures, the EBITDA is the measure of
cash flows from operations that can be used to support debt payment at
least in the short term.
4. By looking at cashflows prior to capital expenditures, it may provide a
better estimate of “optimal value”, especially if the capital expenditures
are unwise or earn substandard returns.
5. By looking at the value of the firm and cashflows to the firm it allows
for comparisons across firms with different financial leverage. 10
 Value/EBITDA Multiple

 The Classic Definition

Value Market Value of Equity + Market Value of Debt

EBITDA Earnings before Interest, Taxes and Depreciation

 The No-Cash Version

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

EBITDA Earnings before Interest, Taxes and Depreciation

 When cash and marketable securities are netted out of value, none of
the income from the cash and securities should be reflected in the
denominator.

11
Enterprise Value/EBITDA Distribution – US

12
 Enterprise Value/EBITDA : Global Data
6 times EBITDA may seem like a good rule of
thumb..

13
But not in early 2009…

14
The Determinants of Value/EBITDA Multiples:
Linkage to DCF Valuation

 Firm value can be written as:

FCFF1
V0 =
WACC - g

 The numerator can be written as follows:

FCFF = EBIT (1-t) - (Cex - Depr) -  Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) -  Working Capital
= EBITDA (1-t) + Depr (t) - Cex -  Working Capital

15
 From Firm Value to EBITDA Multiples

 Now the Value of the firm can be rewritten as,

EBITDA (1 - t) + Depr (t) - Cex -  Working Capital
Value =
WACC - g

 Dividing both sides of the equation by EBITDA,

Value (1- t) Depr (t)/EBITDA CEx/EBITDA  Working Capital/EBITDA
= + - -
EBITDA WACC- g WACC -g WACC - g WACC - g

16
 A Simple Example

 Consider a firm with the following characteristics:

• Tax Rate = 36%
• Capital Expenditures/EBITDA = 30%
• Depreciation/EBITDA = 20%
• Cost of Capital = 10%
• The firm has no working capital requirements
• The firm is in stable growth and is expected to grow 5% a year forever.

17
 Calculating Value/EBITDA Multiple

 In this case, the Value/EBITDA multiple for this firm can be estimated
as follows:
Value (1- .36) (0.2)(.36) 0.3 0
= + - - = 8.24
EBITDA .10 -.05 .10 -.05 .10 - .05 .10 - .05

18
 Value/EBITDA Multiples and Taxes

VEBIT DA Multiples and T ax Rates

16

14

12

10
Value/EBITDA

0
0% 10% 20% 30% 40% 50%
Tax Rate

19
 Value/EBITDA and Net Cap Ex

Value/EBIT DA and Net Cap Ex Ratios

12

10

8
Value/EBITDA

0
0% 5% 10% 15% 20% 25% 30%
Net Cap Ex/EBITDA

20
Value/EBITDA Multiples and Return on Capital

Value/EBIT DA and Return on Capital

12

10

8
Value/EBITDA

WACC=10%
6 WACC=9%
WACC=8%

0
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return on Capital

21
 Analyzing the Value/EBITDA Multiple

 While low value/EBITDA multiples may be a symptom of

undervaluation, a few questions need to be answered:
• Is the operating income next year expected to be significantly lower than
the EBITDA for the most recent period?
• Does the firm have significant capital expenditures coming up?
• Does the firm have a much higher cost of capital than other firms in the
sector?
• Does the firm face a much higher tax rate than other firms in the sector?

22
 Value/EBITDA Multiples: Market

 The multiple of value to EBITDA varies widely across firms in the

market, depending upon:
• how capital intensive the firm is (high capital intensity firms will tend to
have lower value/EBITDA ratios), and how much reinvestment is needed
to keep the business going and create growth
• how high or low the cost of capital is (higher costs of capital will lead to
lower Value/EBITDA multiples)
• how high or low expected growth is in the sector (high growth sectors will
tend to have higher Value/EBITDA multiples)

23
 Price-Book Value Ratio: Definition

 The price/book value ratio is the ratio of the market value of equity to
the book value of equity, i.e., the measure of shareholders’ equity in
the balance sheet.
 Price/Book Value = Market Value of Equity
Book Value of Equity
 Consistency Tests:
• If the market value of equity refers to the market value of equity of
common stock outstanding, the book value of common equity should be
used in the denominator.
• If there is more that one class of common stock outstanding, the market
values of all classes (even the non-traded classes) needs to be factored in.

24
Book Value Multiples: US stocks

25
Price to Book: U.S., Europe, Japan and Emerging
Markets – January 2012

26
 Price Book Value Ratio: Stable Growth Firm

 Going back to a simple dividend discount model,

DPS1
P0 
r  gn

 Defining the return on equity (ROE) = EPS0 / Book Value of Equity,

the value of equity can be written as:
BV0 * ROE * Payout Ratio * (1  gn )
P0 
r-gn

P0 ROE * Payout Ratio * (1  g n )

 PBV =
BV 0 r-g n

 If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,
P0 ROE * Payout Ratio
 PBV =
BV 0 r-g n

27
 Price Book Value Ratio: Stable Growth Firm
Another Presentation

 This formulation can be simplified even further by relating growth to

the return on equity:
g = (1 - Payout ratio) * ROE
 Substituting back into the P/BV equation,
P0 ROE - gn
 PBV =
BV 0 r-gn

 The price-book value ratio of a stable firm is determined by the

differential between the return on equity and the required rate of return
on its projects.

28
Price Book Value Ratio for a Stable Growth Firm:
Example

 Jenapharm was the most respected pharmaceutical manufacturer in

East Germany.
 Jenapharm was expected to have revenues of 230 million DM and
earnings before interest and taxes of 30 million DM in 1991.
 The firm had a book value of assets of 110 million DM, and a book
value of equity of 58 million DM. The interest expenses in 1991 is
expected to be 15 million DM. The corporate tax rate is 40%.
 The firm was expected to maintain sales in its niche product, a
contraceptive pill, and grow at 5% a year in the long term, primarily by
expanding into the generic drug market.
 The average beta of pharmaceutical firms traded on the Frankfurt
Stock exchange was 1.05.
 The ten-year bond rate in Germany at the time of this valuation was
7%; the risk premium for stocks over bonds is assumed to be 5.5%.
29
 Estimating a Price/Book Ratio for Jenapharm

 Expected Net Income = (EBIT - Interest Expense)*(1-t)* 1+g) = (30 -

15) *(1-0.4)* (1.05) = 9.45 mil DM
 Return on Equity = Expected Net Income / Book Value of Equity =
9.45 / 58 = 16.29%
 Cost on Equity = 7% + 1.05 (5.5%) = 12.775%
 Price/Book Value Ratio = (ROE - g) / (r - g) = (.1629 - .05) / (.12775 -
.05) = 1.46
 Estimated MV of equity = BV of Equity * Price/BV ratio = 58 * 1.46
= $ 84.50 mil DM

30
Price Book Value Ratio for High Growth Firm

 The Price-book ratio for a high-growth firm can be estimated

beginning with a 2-stage discounted cash flow model:
 (1+ g)n 
EPS0 * Payout Ratio * (1 + g) * 1  
 (1+ r) n  EPS0 * Payout Ratio n * (1+ g)n *(1+ g n )
P0 = +
r -g (r - g n )(1+ r) n

 Dividing both sides of the equation by the book value of equity:

 

n
(1+ g)  
ROE* Payout Ratio *(1+ g) * 1 
P0   (1+ r) n  ROE n * Payout Ratio n *(1+ g) n *(1+ g n ) 
=  + 
BV0 r-g (r - gn )(1+ r)n
 
 

where ROE = Return on Equity in high-growth period

ROEn = Return on Equity in stable growth period

31
 PBV Ratio for High Growth Firm: Example

 Assume that you have been asked to estimate the PBV ratio for a firm
which has the following characteristics:
High Growth Phase Stable Growth Phase
Length of Period 5 years Forever after year 5
Return on Equity 25% 15%
Payout Ratio 20% 60%
Growth Rate .80*.25=.20 .4*.15=.06
Beta 1.25 1.00
Cost of Equity 12.875% 11.50%
The riskfree rate is 6% and the risk premium used is 5.5%.

32
 Estimating Price/Book Value Ratio

 The price/book value ratio for this firm is:

  5
1  (1.20)  
0.25 * 0.2 * (1.20) *
  (1.12875) 5  0.15 * 0.6 * (1.20)5 * (1.06) 
PBV =  + = 2.66
(.12875 - .20) (.115 - .06) (1.12875) 5 
 
 

33
 PBV and ROE: The Key

PBV and ROE: Risk Scenarios

3.5

2.5
Price/Book Value Ratios

Beta=0.5
2 Beta=1
Beta=1.5

1.5

0.5

0
10% 15% 20% 25% 30%
ROE

34
 PBV/ROE: Oil Companies
Company Name Ticker Symbol PBV ROE
Crown Cent. Petr.'A' CNPA 0.29 -14.60%
Giant Industries GI 0.54 7.47%
Harken Energy Corp. HEC 0.64 -5.83%
Getty Petroleum Mktg. GPM 0.95 6.26%
Pennzoil-Quaker State PZL 0.95 3.99%
Ashland Inc. ASH 1.13 10.27%
Shell Transport SC 1.45 13.41%
USX-Marathon Group MRO 1.59 13.42%
Lakehead Pipe Line LHP 1.72 13.28%
Amerada Hess AHC 1.77 16.69%
Tosco Corp. TOS 1.95 15.44%
Occidental Petroleum OXY 2.15 16.68%
Royal Dutch Petr. RD 2.33 13.41%
Murphy Oil Corp. MUR 2.40 14.49%
Texaco Inc. TX 2.44 13.77%
Phillips Petroleum P 2.64 17.92%
Chevron Corp. CHV 3.03 15.69%
Repsol-YPF ADR REP 3.24 13.43%
Unocal Corp. UCL 3.53 10.67%
Kerr-McGee Corp. KMG 3.59 28.88%
Exxon Mobil Corp. XOM 4.22 11.20%
BP Amoco ADR BPA 4.66 14.34%
Clayton Williams Energy CWEI 5.57 31.02%
Average 2.30 12.23%
35
 PBV versus ROE regression

 Regressing PBV ratios against ROE for oil companies yields the
following regression:
PBV = 1.04 + 10.24 (ROE) R2 = 49%
 For every 1% increase in ROE, the PBV ratio should increase by
0.1024.

36
Looking for undervalued securities - PBV Ratios
and ROE

 Given the relationship between price-book value ratios and returns on

equity, it is not surprising to see firms which have high returns on
equity selling for well above book value and firms which have low
returns on equity selling at or below book value.
 The firms which should draw attention from investors are those which
provide mismatches of price-book value ratios and returns on equity -
low P/BV ratios and high ROE or high P/BV ratios and low ROE.

37
The Valuation Matrix

MV/BV

Overvalued
Low ROE High ROE
High MV/BV High MV/BV

ROE-r

Undervalued
Low ROE High ROE
Low MV/BV Low MV/BV

38
Large Market Cap Firms: PBV vs ROE: January 2001

39
 Price to Book & ROE - Banks

Company Name PBV (11/03) ROE 2002

Liu Chong Hing Bank 0.87 5.27

Wing Lung Bank 1.48 9.52

CITIC International Financial 1.55 8.63

ICBC 1.69 11.44

Bank of East Asia 1.89 6.87

Wing Hang Bank 2.31 10.71

Dah Sing Financial 2.40 13.73

BOC Hong Kong 2.54 11.72

Standard Chartered 2.59 10.47

HSBC Holdings 2.78 12.31

Hang Seng Bank 4.40 23.02

40
 U.S. Banks: Market Cap > $ 1 billion

5.00

MEL

SNV
CBH

3.75

WABC

WFC CYN
CFR
BBT WL
P
B VLY CMB
2.50 PNC
V NBAK
ZION FULT SKYF
HU FBF
ASO MRBK
TRMK WB
OV
STI
CBC CBSS
BPOP
FVB BAC
FSCO RGBK
UPC PFGIFTU
SOTR
1.25 KEY

UB
BOH

BWE

0.12 0.16 0.20 0.24

ROE

41
 Value/Book Value Ratio: Definition

 While the price to book ratio is a equity multiple, both the market
value and the book value can be stated in terms of the firm.
 Value/Book Value = Market Value of Equity + Market Value of Debt
Book Value of Equity + Book Value of Debt

42
Value/Book Ratio: Description

43
 Determinants of Value/Book Ratios

 To see the determinants of the value/book ratio, consider the simple

free cash flow to the firm model:
FCFF1
V0 =
WACC - g

 Dividing both sides by the book value, we get:

V0 FCFF1 /BV
=
BV WACC - g

 If we replace, FCFF = EBIT(1-t) - (g/ROC) EBIT(1-t),we get

V0 ROC - g
=
BV WACC - g
44
 Value/Book Ratio: An Example

 Consider a stable growth firm with the following characteristics:

• Return on Capital = 12%
• Cost of Capital = 10%
• Expected Growth = 5%
 The value/BV ratio for this firm can be estimated as follows:
Value/BV = (.12 - .05)/(.10 - .05) = 1.40
 The effects of ROC on growth will increase if the firm has a high
growth phase, but the basic determinants will remain unchanged.

45
 Value/Book and the Return Spread

Value/BV Ratios and Return Spreads

4.50

4.00

3.50

3.00
Value/BV Ratio

2.50 WACC=8%
WACC=10%
WACC=12%
2.00

1.50

1.00

0.50

-
0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%
-2%

-1%

ROC - WACC

46
 Price Sales Ratio: Definition

 The price/sales ratio is the ratio of the market value of equity to the
sales.
 Price/ Sales= Market Value of Equity
Total Revenues
 Consistency Tests
• The price/sales ratio is internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.

47
Revenue Multiples: US stocks

48
 Price/Sales Ratio: Determinants

 The price/sales ratio of a stable growth firm can be estimated

beginning with a 2-stage equity valuation model:
DPS1
P0 
r  gn

 Dividing both sides by the sales per share:

P0 Net Profit Margin * Payout Ratio *(1 g n )
 PS=
Sales 0 r-gn

49
 Price/Sales Ratio for High Growth Firm

 When the growth rate is assumed to be high for a future period, the
dividend discount model can be written as follows:
 (1+ g)n 
EPS0 * Payout Ratio * (1 + g) * 1  
 (1+ r) n  EPS0 * Payout Ratio n * (1+ g)n *(1+ g n )
P0 = +
r -g (r - g n )(1+ r) n

 Dividing both sides by the sales per share:

 
 (1+ g) n  
Net Margin * Payout Ratio * (1+ g) * 1 
P0   (1+ r)n  Net Margin n * Payout Ratio n * (1+ g) n *(1 + gn ) 
= +
Sales 0  r -g (r - gn )(1 + r)n 
 
 

where Net Marginn = Net Margin in stable growth phase

50
 Price Sales Ratios and Profit Margins

 The key determinant of price-sales ratios is the profit margin.

 A decline in profit margins has a two-fold effect.
• First, the reduction in profit margins reduces the price-sales ratio directly.
• Second, the lower profit margin can lead to lower growth and hence lower
price-sales ratios.
Expected growth rate = Retention ratio * Return on Equity
= Retention Ratio *(Net Profit / Sales) * ( Sales / BV of Equity)
= Retention Ratio * Profit Margin * Sales/BV of Equity

51
 Price/Sales Ratio: An Example

High Growth Phase Stable Growth

Length of Period 5 years Forever after year 5
Net Margin 10% 6%
Sales/BV of Equity 2.5 2.5
Beta 1.25 1.00
Payout Ratio 20% 60%
Expected Growth (.1)(2.5)(.8)=20% (.06)(2.5)(.4)=.06
Riskless Rate =6%
  (1.20) 5
 
0.10 * 0.2 * (1.20) * 1 
  (1.12875)5  0.06 * 0.60 * (1.20) 5 * (1.06) 
PS =  +  = 1.06
(.12875 - .20) (.115 -.06) (1.12875) 5
 
 

52
 Effect of Margin Changes

Price/Sales Ratios and Net M argins

1.8

1.6

1.4

1.2

1
PS Ratio

0.8

0.6

0.4

0.2

0
2% 4% 6% 8% 10% 12% 14% 16%
Net Margin

53
 PS/Margins: Greek Retailers

Comp any PS Net Ma rgin

SPAKIANAKIS SA 0.25 2.88%
KOTSOVOLOS SA 0.48 1.91%
SANYO HELL AS 1.12 5.07%
IMAGE-SOV2VD SA 1.31 2.86%
GERMAN0 S 1.49 6.94%
ELEKTRONIKI 1.61 6.29%
JUMBO 1.68 6.08%
PHiLIPPOS NAKAS 1.71 5.04%
GOODY'S 2.24 6.77%
HELLENIC DUTY 5.60 19 .49%
AS COMPANY 7.02 8.23%
FOLL I-FOLLIE 10 .82 29 .08%

54
 Regression Results: PS Ratios and Margins

 Regressing PS ratios against net margins,

PS = -.10 + 36.29 (Net Margin) R2 = 78%
 Thus, a 1% increase in the margin results in an increase of 0.36 in the
price sales ratios.
 The regression also allows us to get predicted PS ratios for these firms

55
 Predicted PS Ratios

Symb ol Comp any PS Pred icted PS Unde r or Over Val

SFA SPAKIANAKIS SA 0.25 0.94 -73 .28%
KOTSV KOTSOVOLOS SA 0.48 0.59 -18 .47%
SANYO SANYO HELL AS 1.12 1.74 -35 .37%
IKONA IMAGE-SOV2VD SA 1.31 0.94 39 .82%
GERM GERMAN0 S 1.49 2.42 -38 .41%
ELATH ELEKTRONIKI 1.61 2.18 -26 .47%
BABY JUMBO 1.68 2.11 -20 .39%
NAKAS PHXLXPPOS NAKAS 1.71 1.73 -1.38%
GOODY GOODY'S 2.24 2.36 -5.01%
HDF HELLENIC DUTY 5.60 6.97 -19 .72%
ASCO AS COMPANY 7.02 2.89 14 3.07 %
FOLL I FOLL X-FOLLXE 10 .82 10 .45 3.51%

56
 Current versus Predicted Margins

 One of the limitations of the analysis we did in these last few pages is
the focus on current margins. Stocks are priced based upon expected
margins rather than current margins.
 For most firms, current margins and predicted margins are highly
correlated, making the analysis still relevant.
 For firms where current margins have little or no correlation with
expected margins, regressions of price to sales ratios against current
margins (or price to book against current return on equity) will not
provide much explanatory power.
 In these cases, it makes more sense to run the regression using either
predicted margins or some proxy for predicted margins.

57
A Case Study: The Internet Stocks

30

PKSI

LCOS SPYG
20
INTM MMXI
SCNT

MQST FFIV ATHM

A CNET
d DCLK
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P 10 CSGP CBIS NTPA
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GSVI ROWE

-0.8 -0.6 -0.4 -0.2

AdjMargin

58
PS Ratios and Margins are not highly correlated

 Regressing PS ratios against current margins yields the following

PS = 81.36 - 7.54(Net Margin) R2 = 0.04
(0.49)
 This is not surprising. These firms are priced based upon expected
margins, rather than current margins.

59
Solution 1: Use proxies for survival and growth:
Amazon in early 2000

 Hypothesizing that firms with higher revenue growth and higher cash
balances should have a greater chance of surviving and becoming
profitable, we ran the following regression: (The level of revenues was
used to control for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) =
30.42
Actual PS = 25.63
Stock is undervalued, relative to other internet stocks.

60
 Solution 2: Use forward multiples

 You can always estimate price (or value) as a multiple of revenues,

earnings or book value in a future year. These multiples are called
forward multiples.
 For young and evolving firms, the values of fundamentals in future
years may provide a much better picture of the true value potential of
the firm. There are two ways in which you can use forward multiples:
• Look at value today as a multiple of revenues or earnings in the future
(say 5 years from now) for all firms in the comparable firm list. Use the
average of this multiple in conjunction with your firm’s earnings or
revenues to estimate the value of your firm today.
• Estimate value as a multiple of current revenues or earnings for more
mature firms in the group and apply this multiple to the forward earnings
or revenues to the forward earnings for your firm. This will yield the
expected value for your firm in the forward year and will have to be
discounted back to the present to get current value.

61
An Example of Forward Multiples: Amazon in early
2000

 Amazon.com lost $0.63 per share in 2000 but is expected to earn $ 1.50 per
share in 2005. At its current price of $ 49 per share, this would translate into a
price/future earnings per share of 32.67.
 In the first approach, this multiple of earnings can be compared to the
price/future earnings ratios of comparable firms. If you define comparable
firms to be e-tailers, Amazon looks reasonably attractive since the average
price/future earnings per share of e-tailers is 65. If, on the other hand, you
compared Amazon’s price to future earnings per share to the average price to
future earnings per share (in 2004) of specialty retailers, the picture is bleaker.
The average price to future earnings for these firms is 12, which would lead to
a conclusion that Amazon is over valued.
 In the second approach, the current price to earnings ratio for specialty
retailers, which is estimated to be 20.31 to the earnings per share of Amazon in
2004 (which is estimated to be $1.50). This would yield a target price of
$30.46. Discounting this price back to the present using Amazon’s cost of
equity of 12.94% results in a value per share:
Value per share = Target price in five years/ (1 + Cost of equity)5
= $30.46/1.12945 = $16.58.
62
 Value/Sales Ratio: Definition

 The value/sales ratio is the ratio of the market value of the firm to the
sales.
 Value/ Sales= Market Value of Equity + Market Value of Debt-Cash
Total Revenues

63
EV Sales across markets

64
 Value/Sales Ratios: Analysis of Determinants

 If pre-tax operating margins are used, the appropriate value estimate is

that of the firm. In particular, if one makes the assumption that
• Free Cash Flow to the Firm = EBIT (1 - tax rate) (1 - Reinvestment Rate)
 Then the Value of the Firm can be written as a function of the after-tax
operating margin= (EBIT (1-t)/Sales
  (1 + g) n  
(1 - RIR growth )(1 + g)* 1 n  n 
Value   (1+ WACC)  (1- RIR stable)(1 + g) *(1+ g n ) 
= After - tax Oper. Margin * +
Sales 0  WACC - g (WACC - g n )(1+ WACC) n 
 
 

g = Growth rate in after-tax operating income for the first n years

gn = Growth rate in after-tax operating income after n years forever (Stable
growth rate)
RIRGrowth, Stable = Reinvestment rate in high growth and stable periods
WACC = Weighted average cost of capital

65
 Value/Sales Ratio: An Example

 Consider, for example, the Value/Sales ratio of Coca Cola. The

company had the following characteristics:
After-tax Operating Margin =18.56% Sales/BV of Capital = 1.67
Return on Capital = 1.67* 18.56% = 31.02%
Reinvestment Rate= 65.00% in high growth; 20% in stable growth;
Expected Growth = 31.02% * 0.65 =20.16% (Stable Growth Rate=6%)
Length of High Growth Period = 10 years
Cost of Equity =12.33% E/(D+E) = 97.65%
After-tax Cost of Debt = 4.16% D/(D+E) 2.35%
Cost of Capital= 12.33% (.9765)+4.16% (.0235) = 12.13%
  (1.2016) 10  
(1- .65)(1.2016) * 1 10  10 
Value of Firm 0   (1.1213)  (1- .20)(1.2016) * (1.06) 
= .1856 * + = 6.10
Sales 0  .1213 - .2016 (.1213 - .06)(1.1213) 10 
 
 

66
Value Sales Ratios and Operating Margins

Coca Cola: T he Operating M argin Effect

12 250

10
200

150
Value/Sales Ratio

$ Value
Value/Sales
6
$ Value

100

50
2

0 0
6% 8% 10% 12% 14% 16% 18% 20%
Operating Margin

67
 U.S. Specialty Retailers: V/S vs Operating Margin
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68
 The value of a brand name

 One of the critiques of traditional valuation is that is fails to consider

the value of brand names and other intangibles.
 The approaches used by analysts to value brand names are often ad-
hoc and may significantly overstate or understate their value.
 One of the benefits of having a well-known and respected brand name
is that firms can charge higher prices for the same products, leading to
higher profit margins and hence to higher price-sales ratios and firm
value. The larger the price premium that a firm can charge, the greater
is the value of the brand name.
 In general, the value of a brand name can be written as:
Value of brand name ={(V/S)b-(V/S)g }* Sales
(V/S)b = Value of Firm/Sales ratio with the benefit of the brand name
(V/S)g = Value of Firm/Sales ratio of the firm with the generic product

69
Illustration: Valuing a brand name: Coca Cola

Coca Cola Generic Cola Company

AT Operating Margin 18.56% 7.50%
Sales/BV of Capital 1.67 1.67
ROC 31.02% 12.53%
Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)
Expected Growth 20.16% 8.15%
Length 10 years 10 yea
Cost of Equity 12.33% 12.33%
E/(D+E) 97.65% 97.65%
AT Cost of Debt 4.16% 4.16%
D/(D+E) 2.35% 2.35%
Cost of Capital 12.13% 12.13%
Value/Sales Ratio 6.10 0.69
70
 Value of Coca Cola’s Brand Name

 Value of Coke’s Brand Name = ( 6.10 - 0.69) ($18,868 million) = $102

billion
 Value of Coke as a company = 6.10 ($18,868) million) = $ 115 Billion
 Approximately 88.69% of the value of the company can be traced to
brand name value

71
 Choosing Between the Multiples

 As presented in this section, there are dozens of multiples that can be

potentially used to value an individual firm.
 In addition, relative valuation can be relative to a sector (or
comparable firms) or to the entire market (using the regressions, for
instance)
 Since there can be only one final estimate of value, there are three
choices at this stage:
• Use a simple average of the valuations obtained using a number of
different multiples
• Use a weighted average of the valuations obtained using a nmber of
different multiples
• Choose one of the multiples and base your valuation on that multiple

72
 Averaging Across Multiples

 This procedure involves valuing a firm using five or six or more

multiples and then taking an average of the valuations across these
multiples.
 This is completely inappropriate since it averages good estimates with
poor ones equally.
 If some of the multiples are “sector based” and some are “market
based”, this will also average across two different ways of thinking
about relative valuation.

73
 Weighted Averaging Across Multiples

 In this approach, the estimates obtained from using different multiples

are averaged, with weights on each based upon the precision of each
estimate. The more precise estimates are weighted more and the less
precise ones weighted less.
 The precision of each estimate can be estimated fairly simply for those
estimated based upon regressions as follows:
Precision of Estimate = 1 / Standard Error of Estimate
where the standard error of the predicted value is used in the
denominator.
 This approach is more difficult to use when some of the estimates are
subjective and some are based upon more quantitative techniques.

74
 Picking one Multiple

 This is usually the best way to approach this issue. While a range of
values can be obtained from a number of multiples, the “best estimate”
value is obtained using one multiple.
 The multiple that is used can be chosen in one of two ways:
• Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the highest
value.
• Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc.
and run regressions of these multiples against fundamentals, use the
multiple that works best at explaining differences across firms in that
sector.
• Use the multiple that seems to make the most sense for that sector, given
how value is measured and created.

75
 Self Serving Multiple Choice

 When a firm is valued using several multiples, some will yield really
high values and some really low ones.
 If there is a significant bias in the valuation towards high or low
values, it is tempting to pick the multiple that best reflects this bias.
Once the multiple that works best is picked, the other multiples can be
abandoned and never brought up.
 This approach, while yielding very biased and often absurd valuations,
may serve other purposes very well.
 As a user of valuations, it is always important to look at the biases of
the entity doing the valuation, and asking some questions:
• Why was this multiple chosen?
• What would the value be if a different multiple were used? (You pick the
specific multiple that you want to see tried.)

76
 The Statistical Approach

 One of the advantages of running regressions of multiples against

fundamentals across firms in a sector is that you get R-squared values
on the regression (that provide information on how well fundamentals
explain differences across multiples in that sector).
 As a rule, it is dangerous to use multiples where valuation
fundamentals (cash flows, risk and growth) do not explain a significant
portion of the differences across firms in the sector.
 As a caveat, however, it is not necessarily true that the multiple that
has the highest R-squared provides the best estimate of value for firms
in a sector.

77
 A More Intuitive Approach

 As a general rule of thumb, the following table provides a way of

picking a multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure VEBITDA Firms in sector have losses in early
years and reported earnings can
vary
depending on depreciation method
REITa P/CF Generally no cap ex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different
78
 Sector or Market Multiples

 The conventional approach to using multiples is to look at the sector or

comparable firms.
 Whether sector or market based multiples make the most sense
depends upon how you think the market makes mistakes in valuation
• If you think that markets make mistakes on individual firm valuations but
that valuations tend to be right, on average, at the sector level, you will
use sector-based valuation only,
• If you think that markets make mistakes on entire sectors, but is generally
right on the overall market level, you will use only market-based
valuation
 It is usually a good idea to approach the valuation at two levels:
• At the sector level, use multiples to see if the firm is under or over valued
at the sector level
• At the market level, check to see if the under or over valuation persists
once you correct for sector under or over valuation.
79
 Reviewing: The Four Steps to Understanding
Multiples

 Define the multiple

• Check for consistency
• Make sure that they are estimated uniformally
 Describe the multiple
• Multiples have skewed distributions: The averages are seldom good
indicators of typical multiples
• Check for bias, if the multiple cannot be estimated
 Analyze the multiple
• Identify the companion variable that drives the multiple
• Examine the nature of the relationship
 Apply the multiple

80