Relative Valuation Methods. Car Example How much are you willing to pay for a new Lexus?
Transcript of Relative Valuation Methods. Car Example How much are you willing to pay for a new Lexus?
Relative Valuation Methods
Car Example
How much are you willing to pay for a new Lexus?
Pricing a New Lexus
• Direct Pricing Measure: Can determine all of the features and add a price for each feature to get the total you are willing to pay.
• Relative Pricing Measure: Can price a Lexus relative to other luxury cars or relative a Toyota to determine the total you are willing to pay.
Pricing a New Lexus
Relative Pricing: • Are willing to pay 2 times as much for a fully
loaded Lexus as for a fully loaded Toyota Corolla.
• Are willing to pay 1.4 times as much for a fully loaded Toyota Camry as for a fully loaded Toyota Corolla.
Pricing a Stock
Direct Measure: Determine the future “cash flows”. Determine the future riskiness of the cash flows and discount them back by the appropriate discount rate.
Relative Measure: Can price a stock relative the stock market, relative its industry, or relative its closest competitor.
RELATIVE VALUATION METHODS
P/E Multiplier P/CF Multiplier P/S Multiplier P/BV Multiplier
P/E Multiplier Method
How much are you willing to pay per dollar of EPS of Firm A?
P/E Multiplier Method: A Relative Valuation Model
• Are you willing to pay more or less per dollar of EPS of Firm A than for an average company in the industry?
• Are you willing to pay more or less per dollar of EPS of Firm A than for an average stock in the S&P 500?
Estimate P/E Multiplier
Predict Multiplier: Estimate [P0/E1]
P0 is the unknown.Predict the ratio here not the components of the ratio!
Drivers of P/E Multiplier
2 Main Drivers of P/E Multiplier:
1. Long Run Growth Rate in EPS: Increases (decreases) lead to increases
(decreases) in the P/E ratio
2. Long Run Riskiness of EPS: Increases (decreases) lead to decreases
(increases) in the P/E ratio
Drivers of P/E Multiplier
Time Value of Money:
PV = Value = f(future cash flows,
riskiness of future cash flows)
P/E Multiplier = f(future EPS,
riskiness of future EPS)
Relative Measure: Done at Various Levels
Compare Estimates of Future Growth and Risk:
The Company versus its Closest Competitor
The Company versus its Industry
The Company versus the Stock Market
Predicting Growth in EPS g
g = (1 – Predicted DPS/EPS) X (Predicted ROE) g = (Ret.Rate) X (NI/S X S/TA X TA/C.Eq.)
DPS/EPS = Dividend Payout RatioNI/S = Net ProfitabilityS/TA = Total Asset Turnover TA/C.Eq. = Financial Leverage
Predicting Growth in EPS = g
Each of the ratios break down into finer increments that can be predicted.
Example:
NI/S = f(GP/S, OP/S, Interest Expense)
Predicting Growth in EPS: Company A
g = RR X [NI/S X S/TA X TA/C.Eq.]
Using Ratio Values Last Year:
g 0= (1- .27) X [.015 X 4.20 X 3.62] = 16.6%
Using Our Predicted Avg. Ratio Values for Next Few Yrs:
gfuture = (1- .25) X [.006 X 3.8 X 4.0] = 6.8%
Predicting Growth in EPS
Estimate of Growth Using Ratios Last Year:
Company A:
g0 = (1 - .27) X [.015 X 4.20 X 3.62] = 16.6%
Industry:
g0 = (1 - .10) X [.021 X 2.62 X 5.45] = 27.0%
Predicting Growth in EPS
Prediction for Company A Over Next Several Yrs:
gfuture = (1 - .25) X [.006 X 3.8 X 4.0] = 6.8%
Prediction for Industry Over Next Several Yrs:
gfuture = (1 - .10) X [[.026 X 3.2 X 5.2] = 38.9%
Growth Analysis: Implies a lower [P0/E1] for Company A than the industry.
Predicting Future Risk
Business Risk Financial Risk Liquidity Risk Exchange Rate Risk Political Risk
Predicting Future Risk
CAPM View:
Future Beta =
f(future business risk, financial risk, liquidity risk, exchange rate risk, political risk)
Predicting Future Risk
1. Historic Risk Assessment: Assess whether the risk has been higher or lower than the industry in the recent past.
2. Future Risk Assessment: Predict what will happen to risk for the company and the industry in the future.
Business Risk
Business Risk: Variability in annual percentage changes in operating income.
Measure: CV in % Change in Op Income
%Chg Op Inc
CV in Op Inc = -------------------
Mean%Chg Op Inc
Business Risk
• CV in % Change in Op. Income (past 3 years) Company A = 4.39
• CV in % Change in Op. Income (past 3 years) Industry = 1.47
Industry has had lower business risk than Company A. Predict no changes in this relationship in the future.
Financial Risk
Financial Risk: Increased variability in EPS due to the use of debt.
Measures of Financial Risk:
Debt Ratios
Interest Coverage Ratios
Financial Risk
• Average TA/C.Eq. Company A (past 3 years) = 2.95
• Average TA/C.Eq. Industry (past 3 years) = 6.01
Industry has had higher financial risk than Company A using this ratio. Predict financial risk of Company A will increase, while that of the Industry will decrease.
Liquidity Risk
Liquidity Risk: Inability to sell the stock quickly at a known price.
Measures of Liquidity Risk:
# Stockholders
#Shares Outstanding
#Average Daily Volume of Shares Traded
#Institutional Holdings
Liquidity Risk
Measures of Liquidity Risk: Are similar for Company A and for its industry.
Industry has had similar liquidity risk. Predict this relationship will stay the same.
Beta
• Current Beta Company A = .58
• Current Beta Industry = .45
Company A currently has more systematic risk than the industry. Given we predict no change in business risk or liquidity risk, but an increase in financial risk for Company A relative the industry, we predict the relative beta will rise for Company A in the future.
Drivers of P/E Multiplier
Growth: • Historic relative growth lower than industry.• Predict relative growth will drop further.
Risk: • Historic relative risk higher than industry.• Predict relative risk will rise further.
Drivers of P/E Multiplier
• Growth Assessment: Predict [P0/E1] for Company A will be lower than for the industry.
• Risk Assessment: Predict [P0/E1] will be lower for Company A than for the industry.
• Overall: Predict [P0/E1] will be lower for Company A than for the industry
Forecast [P0/E1]
• Industry: Analysts using [P0/E1] = 10.0
• Should use less than 10 for Company A. Decide to use 7.0.
• Implies a Relative P/E of 7.0/10.0 = .70
P/E Multiplier Method
Take the product of the estimated P/E multiplier (ratio) and estimated EPS1.
[P0/E1] X [E1] = Estimated P0
Estimated P0 = Intrinsic Value0
Predict EPS Next 12 Months
Next Step:
Predict EPS for the next 12 months: [E1]
Forecast E1
Method 1:
g = RR1 X [NI/S1 X S/TA1 X TA/C.Eq.1] Company A: Ratios from Past Year:
g0 = (1- .27) X [.015 X 4.20 X 3.62] = 16.6%
Company A: Predictions for Next Year:
g1 = (1- .25) X [.007 X 3.8 X 3.70] = 7.4%
Forecast E1
Method 2:
Create a set of proforma financial statements for Company A for the next 12 months and use the estimate of [E1] from the proforma income statement.
Forecast E1
Company A
E0 = $1.35
Predicted E1= 1.35 (1.074) = $1.45
Intrinsic Value Company A
• Estimated Intrinsic Value Company A Today = 7.0 X $1.45 = $10.15
• Stock is currently trading at $16.15
• We issue a “sell” recommendation.
Implied P/E Ratio
• Can see the current price of Company A of $16.15 and the market consensus forecast for E1 of $1.47.
• This results in an implied P0/E1 ratio of
$16.15/1.47 = 10.98 times.
• We predict a [P0/E1] of 7.0 times and E1of $1.45.
Estimate Target Price1
[P1/E2] X E2= Estimate of P1 = Target Price1 where
[P1/E2] = forecasted multiplier 12 months from today.
E2 = forecasted EPS for 12 month period starting one year from today.
P/E Multiplier Trailing vs Standard
Often analysts also examine
[P0/E0] = The Trailing P/E Ratio
For valuation we ultimately want [Po/E1]or [P1/E2]!!
Trailing P/E
Trailing P/E Ratios:
• Company A = $16.15/1.35 = 11.96
• Industry = $18.08/1.26 = 14.35
• S&P 500 = 21.50
Relative P/E = 11.96/14.35 = .83 (industry)
Relative P/E = 11.96/21.50 = .56 (market)
Typical in Analyst Report
I. Table: Show the following for: Company, Industry (or closest competitor) and Market Proxy
• Trailing P/E • Prediction of P0/E1
• Prediction of P1/E2
• Prediction of E1 and Intrinsic Value0
• Prediction of E1 and Target Price1
• Relative P/E Ratios
Typical in Report
II. Discussion
Discussion of the drivers of growth and risk for the company versus its competitors and/or the market.