How do we value companies?

Intrinsic value• The value of a company to you is

wrong• We assume it will become right• Stock vs. other assets

Relative value• Other companies are valued

differently• If our company is an outlier, it will

tend to change to normal over time• Stock vs. stock

Estimated future Free Cash Flows

Annu

al FC

F fo

r th

at

year

Discounted Cash Flows

Discounted Cash Flows

𝑉 ≈𝐶0

𝑟 −𝑔

Net Income

PE Ratio

Estimated future Free Cash Flows

Annu

al FC

F fo

r th

at

year

PE Ratio

Price-to-Earnings MultipleRationales & Drawbacks

RationalesEPS is driver of value

Widely used

Related to stock returns

DrawbacksZero, negative, or very

small earnings

Permanent vs. transitory earnings

Management discretion for earnings

Price-to-Earnings Multiple Definitions

Trailing P/E

Uses last year’s

earnings

Preferred when

forecasted earnings are not available

Forward P/E

Uses next year’s

earnings

Preferred when trailing earnings are not reflective

of future

PEG Ratio

𝑃 /𝐸 /𝐺=𝑃 /𝐸𝑔

Issues in Calculating EPS

EPS Dilution Underlying Earnings

Normalized Earnings

Differences in Accounting Methods

Method of Comparables

Benchmark Value of the Multiple Choices

Industry peers

Industry or sector

index

Broad market index

Firm’s historical

values

Method of ComparablesUsing Peer Company Multiples

Law of one priceRisk and earnings growth adjustmentsPEG limitations:Assumes linear relationship Does not account for risk Does not account for growth duration

Using P/Es for Terminal Value

Justified P/E

P/E =(D/E)/(r – g)

Sensitive to required inputs

P/E Based on Comparable

s

Grounded in market data

If comp is mispriced, terminal value will

be mispriced

Enterprise Value

EV =

+ market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments

EBITDA

EV/EBITDA

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒𝑉𝑎𝑙𝑢𝑒𝐸𝐵𝐼𝑇𝐷𝐴

Enterprise Value/EBITDA Multiple Rationales & Drawbacks

RationalesUseful for comparing firms

of different leverage

Useful for comparing firms of different capital utilization

Usually positive

DrawbacksExaggerates cash flow

FCFF more strongly grounded

Issues in Using Enterprise Value Multiples

EV = Market Value of Stock + Debt – Cash – Investments

Justified EV/EBITDA• Positively related to FCFF growth• Positively related to ROIC• Negatively related to WACC

Comparables May Utilize TIC

Other EV Multiples• EV/FCFF• EV/EBITA• EV/EBIT• EV/S

Equity / Book Value

𝐸 /𝐵=𝐸𝑞𝑢𝑖𝑡𝑦𝑉𝑎𝑙𝑢𝑒𝐵𝑜𝑜𝑘𝑉𝑎𝑙𝑢𝑒

Price-to-Book Value MultipleRationales

Book Value Is Usually Positive

More Stable than EPS

Appropriate for Financial Firms

Appropriate for Firms that Will Terminate

Can explain stock returns

Price-to-Book Value MultipleDrawbacks

Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Due to Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

Adjustments to Book Value

Intangible Assets

Inventory Accounting

Off-Balance- Sheet Items Fair Value

Price-to-Cash-Flow Multiple Rationales

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E

Ratio Addresses Quality of Earnings Issue with P/E

Ratio Can Explain Stock Returns

Price-to-Cash-Flow Multiple Drawbacks

Cash Flow Can Be Distorted

FCFE More Volatile and More Frequently Negative

Cash Flow Increasingly Managed by Firms

Cross-Country Comparisons• Net income higher under IFRS• Shareholder's equity lower under IFRS• ROE higher under IFRS

US GAAP vs. IFRS

• P/CFO & P/FCFE most comparable• P/B, P/E, & EBITDA multiples least comparable

Valuation Multiples

• Higher inflation Lower justified price multiples• Higher pass-through rates Higher justified price

multiplesInflation