Equity #36 - Market Based Valuation

Question 1

what to know

Answer 1

LOS 36.a

• rationale
• drawbacks
• calculation
• fundamental influence
• calculate justified ratio
• use it with a stock

Question 2

trailing P/R probelms

Answer 2

LOS 36.c,d

• transitory, nonrecurring components of earnings that are company-specific
• cyclicality components of earnings due to business or industry trends
• differences in account practices
• potential dilution of EPS

Question 3

underlying earnings

Answer 3

LOS 36.e

Analysts want to remove nonrecurring items from earnings for forecasting purposes. Result is persistent, continuing, and core earnings.

Nonrecurring items to remove include:

• gain/loss on asset sales
• asset write-downs - impairment
• loss provisions (restructuring, etc)
• changes in accounting estimates

Two methods:

• historical EPS
• avg ROE (preferred)

Question 4

“justified price multiple”

Answer 4

LOS 36.b

Can be justified by two methods:

• comparables
• forecasted fundamentals

Example using P/E:

• P/E > V₀/E ⇒ stock P is undervalued
• P/E < V₀/E ⇒ stock P is overvalued​

Question 5

using P/E in valuation

Answer 5

LOS 36.c

Rationales:

• EPS (earnings power) is primary determinant of investor value
• popularity
• empirically explains long-run avg stock returns

Problems:

• “E” can be negative
• “E” is volatile, so difficult to interpret
• management disrection distorts reports “E”

Question 6

using P/B in valuation

Answer 6

LOS 36.c

Rationales:

• “B” usually positive
• “B” more stable than EPS
• “B” good NAV measure for firms with large liquid assets e.g. banks, insurance, etc.
• useful for valuing firms going out of business
• empirically explains long-run avg stock returns

Problems (that cause BV != MV):

• doesn’t recognize value of nonphysical assets
• misleading for large firm size differences
• different accounting methods add to errors
• inlation and technology changes

Question 7

using P/S in valuation

Answer 7

LOS 36.c

Rationales:

• P/S meaningful even for distressed firms
• sales rev difficult to manipulate vs. EPS
• not as volatile as P/E
• appropriate for mature, cyclical industries and for start-ups with no historical earnings
• empirically explains long-run avg stock returns

Problems:

• higher sales doesn’t mean higher operating profits
• doesn’t capture cost structure differences
• revenue manipulation/acceleration can distort it

Question 8

using P/CF in valuation

Answer 8

LOS 36.c

Rationales:

• CF harder to manipulate than earnings
• more stable than P/E
• solves accrual accounting differences
• empirically explains long-run avg stock returns

Problems:

• EPS + NNC ignores some items affecting CFO
• FCFE preferred but more volatile than CFO

Question 9

using dividend yield (D/P) in valuation

Answer 9

LOS 36.c

Rationales:

• Div contributes to total investment return
• Div not as risky as cap apprec component of TR

Problems:

• Div only one component of stock return
• higher Div = slower growth, all else equal

Question 10

multiple influencers

Answer 10

LOS 36.g

All else equal:

• P/E ⇔ +g, -r_e
• P/S ⇔ +profit margin, -r_e
• P/CF ⇔ +g of FCFE, -r_e
• D/P ⇔ -g, +r_e

Question 11

calculate P/E, P/B and P/S based on forecasted fundamentals and DCF valuation

Answer 11

LOS 36.h

lead P/E = P₀/E₁ = (1-b) / (r-g); (1-b) is “payout ratio”

P₀/B₀ = (ROE - g) / (r-g)

P₀/S₀ = (E₀/S₀) x (1 - b)(1 + g) / (r-g)

Question 12

PEG ratio

Answer 12

LOS 36.k

PEG = P/E x 1/g

• lower PEG are more attractive, all else equal

Question 13

using price multiples to estimate terminal value, V_T

Answer 13

LOS 36.l

for P/E, P/B, P/S, P/CF price multiples:

V_T = price multiple x terminal vaue of fundamental variable i.e. denominator

Question 14

four common measures of CF for CF multiples and EV multiples

Answer 14

LOS 36.m

1. E + NCC = NI + D + amort + depletion
   E + NCC = EPS + D/Sh + amort/Sh + depl/Sh
2. adjusted CFO = CFO + (noncash int outflow)(1 - T)
   better value est. than E + NCC
3. FCFE = CFO - CapEx - principal pmt to debtholders
   even better value est. but FCFE more volatile
4. EBITDA = EBIT + D + amort (for forecasting)
   EBITDA = recur. earn cont. ops + Int + T + D + amort (for historical values)

Question 15

EV/EBITDA

Answer 15

LOS 36.n

EV = MV_equity + MV_debt + MV_pref - cash & equiv

EBITDA is a pre-interest ernaings measure and therefore measure of cash flow to the firm, both debt and equity holders.

EV/EBITDA commonly used to measure relative company value.

Question 16

using EV/EBITDA in valuation

Answer 16

LOS 36.n

EV/EBITDA commonly used to measure relative company value

Rationales:

• useful to compare firms with different degrees of financial leverage
• EBITDA useful for valuing capital-intensive businesses with high depreciation
• EBITDA usually positive

Problems:

• if working capital (WC) is growing, EBITDA will overstate CFO
• FCFF more strongly linked to value than EBITDA

Question 17

momentum indicators

Answer 17

LOS 36.p

momentum indicators relate price (or EPS, etc.) to:

• historical values of itself or benchmark
• estimated values of itself or benchmark

Question 18

earnings surprise / unexpected earnings

Answer 18

LOS 36.p

earnings surprise = reported EPS - expected EPS

standardized unexpected earnings (SUE):

SUE = (EPS surprise) / σ_{EPS surpise to analyst est.}

Question 19

relative strength

Answer 19

LOS 36.p

relative strength - compares a stock’s price or return over given time period with its own historical performance or to group of peer stocks

Rationale: patterns of persistence or reversal may exist in stock returns

Question 20

weighted harmonic mean

Answer 20

LOS 36.p

portfolio or index price multiple is calculated this way

wtd harm mean P/E = 1 (w₁/PE₁ + w₂/PE₂ + … + w_n/PE_n)