Lecture Note Packet 2 - Pricing:Relative Valuation - Aswath Damodaran 1 VALUATION PACKET 2 RELATIVE VALUATION ASSET-BASED VALUATION AND PRIVATE COMPANY

Lecture Note Packet 2 - Pricing:Relative Valuation - Aswath...

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Unformatted text preview: Aswath Damodaran 1 VALUATION: PACKET 2 RELATIVE VALUATION, ASSET-­‐BASED VALUATION AND PRIVATE COMPANY VALUATION Aswath Damodaran Updated: September 2015 The Essence of relaKve valuaKon? 2 ¨  ¨  In relaKve valuaKon, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relaKve valuaKon then, we need to idenKfy comparable assets and obtain market values for these assets ¤  convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price mulKples. ¤  compare the standardized value or mulKple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the mulKple, to judge whether the asset is under or over valued ¤  Aswath Damodaran 2 RelaKve valuaKon is pervasive… 3 ¨  ¨  Most asset valuaKons are relaKve. Most equity valuaKons on Wall Street are relaKve valuaKons. ¤  ¤  ¤  ¨  Almost 85% of equity research reports are based upon a mulKple and comparables. More than 50% of all acquisiKon valuaKons are based upon mulKples Rules of thumb based on mulKples are not only common but are o]en the basis for final valuaKon judgments. While there are more discounted cashflow valuaKons in consulKng and corporate finance, they are o]en relaKve valuaKons masquerading as discounted cash flow valuaKons. ¤  ¤  The objecKve in many discounted cashflow valuaKons is to back into a number that has been obtained by using a mulKple. The terminal value in a significant number of discounted cashflow valuaKons is esKmated using a mulKple. Aswath Damodaran 3 Why relaKve valuaKon? 4 “If you think I’m crazy, you should see the guy who lives across the hall” “ Jerry Seinfeld talking about Kramer in a Seinfeld episode A little inaccuracy sometimes saves tons of explanation” H.H. Munro “ If you are going to screw up, make sure that you have lots of company” Ex-portfolio manager Aswath Damodaran 4 The Market ImperaKve…. 5 ¨  RelaKve valuaKon is much more likely to reflect market percepKons and moods than discounted cash flow valuaKon. This can be an advantage when it is important that the price reflect these percepKons as is the case when ¤  ¤  ¨  ¨  ¨  the objecKve is to sell a security at that price today (as in the case of an IPO) invesKng on “momentum” based strategies With relaKve valuaKon, there will always be a significant proporKon of securiKes that are under valued and over valued. Since porbolio managers are judged based upon how they perform on a relaKve basis (to the market and other money managers), relaKve valuaKon is more tailored to their needs RelaKve valuaKon generally requires less informaKon than discounted cash flow valuaKon (especially when mulKples are used as screens) Aswath Damodaran 5 MulKples are just standardized esKmates of price… 6 Market value of equity Market value for the firm Firm value = Market value of equity + Market value of debt Multiple = Revenues a. Accounting revenues b. Drivers - # Customers - # Subscribers = # units Numerator = What you are paying for the asset Denominator = What you are getting in return Earnings a. To Equity investors - Net Income - Earnings per share b. To Firm - Operating income (EBIT) Aswath Damodaran Market value of operating assets of firm Enterprise value (EV) = Market value of equity + Market value of debt - Cash Cash flow a. To Equity - Net Income + Depreciation - Free CF to Equity b. To Firm - EBIT + DA (EBITDA) - Free CF to Firm Book Value a. Equity = BV of equity b. Firm = BV of debt + BV of equity c. Invested Capital = BV of equity + BV of debt - Cash 6 The Four Steps to DeconstrucKng MulKples 7 ¨  Define the mulKple ¤  ¨  Describe the mulKple ¤  ¨  Too many people who use a mulKple have no idea what its cross secKonal distribuKon is. If you do not know what the cross secKonal distribuKon of a mulKple is, it is difficult to look at a number and pass judgment on whether it is too high or low. Analyze the mulKple ¤  ¨  In use, the same mulKple can be defined in different ways by different users. When comparing and using mulKples, esKmated by someone else, it is criKcal that we understand how the mulKples have been esKmated It is criKcal that we understand the fundamentals that drive each mulKple, and the nature of the relaKonship between the mulKple and each variable. Apply the mulKple ¤  Defining the comparable universe and controlling for differences is far more difficult in pracKce than it is in theory. Aswath Damodaran 7 DefiniKonal Tests 8 ¨  Is the mulKple consistently defined? ¤  ¨  ProposiKon 1: Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. Is the mulKple uniformly esKmated? The variables used in defining the mulKple should be esKmated uniformly across assets in the “comparable firm” list. ¤  If earnings-­‐based mulKples are used, the accounKng rules to measure earnings should be applied consistently across assets. The same rule applies with book-­‐value based mulKples. ¤  Aswath Damodaran 8 Example 1: Price Earnings RaKo: DefiniKon 9 PE = Market Price per Share / Earnings per Share ¨  There are a number of variants on the basic PE raKo in use. They are based upon how the price and the earnings are defined. Price: EPS: Aswath Damodaran is usually the current price is someKmes the average price for the year EPS in most recent financial year EPS in trailing 12 months Forecasted earnings per share next year Forecasted earnings per share in future year 9 Example 2: Staying on PE raKos 10 ¨  Assuming that you are comparing the PE raKos across technology companies, many of which have opKons outstanding. What measure of PE raKo would yield the most consistent comparisons? a.  b.  c.  d.  Price/ Primary EPS (actual shares, no opKons) Price/ Fully Diluted EPS (actual shares + all opKons) Price/ ParKally Diluted EPS (counKng only in-­‐the-­‐money opKons) Other Aswath Damodaran 10 Example 3: Enterprise Value /EBITDA MulKple 11 ¨  The enterprise value to EBITDA mulKple is obtained by nejng cash out against debt to arrive at enterprise value and dividing by EBITDA. Enterprise Value Market Value of Equity + Market Value of Debt - Cash = EBITDA Earnings before Interest, Taxes and Depreciation 1.  2.  Why do we net out cash from firm value? What happens if a firm has cross holdings which are categorized as: ¤  ¤  Minority interests? Majority acKve interests? Aswath Damodaran 11 Example 4: A Housing Price MulKple 12 The bubbles and busts in housing prices has led investors to search for a mulKple that they can use to determine when housing prices are gejng out of line. One measure that has acquired adherents is the raKo of housing price to annual net rental income (for renKng out the same house). Assume that you decide to compute this raKo and compare it to the mulKple at which stocks are trading. Which valuaKon raKo would be the one that corresponds to the house price/rent raKo? a.  Price Earnings RaKo b.  EV to Sales c.  EV to EBITDA d.  EV to EBIT Aswath Damodaran 12 DescripKve Tests 13 ¨  ¨  What is the average and standard deviaKon for this mulKple, across the universe (market)? What is the median for this mulKple? ¤  ¨  How large are the outliers to the distribuKon, and how do we deal with the outliers? ¤  ¨  ¨  The median for this mulKple is o]en a more reliable comparison point. Throwing out the outliers may seem like an obvious soluKon, but if the outliers all lie on one side of the distribuKon (they usually are large posiKve numbers), this can lead to a biased esKmate. Are there cases where the mulKple cannot be esKmated? Will ignoring these cases lead to a biased esKmate of the mulKple? How has this mulKple changed over Kme? Aswath Damodaran 13 1. MulKples have skewed distribuKons… 14 PE Ra&os for US stocks: January 2015 700. 600. 500. 400. Current Trailing 300. Forward 200. 100. 0. 0.01 To 4 To 8 8 To 12 12 To 4 16 Aswath Damodaran 16 To 20 20 To 24 24 To 28 28 To 32 32 To 36 36 To 40 40 To 50 50 To 75 75 To 100 More 14 2. Making staKsKcs “dicey” 15 Current PE Trailing PE Forward PE Number of firms 7887 7887 7887 Number with PE 3403 3398 2820 Average 72.13 60.49 35.25 Median 20.88 19.74 18.32 Minimum 0.25 0.4 1.15 Maximum 23,100. 23,100. 5,230.91 Standard deviation 509.6 510.41 139.75 Standard error 8.74 8.76 2.63 Skewness 31. 32.77 25.04 25th percentile 13.578 13.2 14.32 75th percentile 33.86 31.16 25.66 Aswath Damodaran 15 3. Markets have a lot in common : Comparing Global PEs 16 PE Ra&o Distribu&on: Global Comparison in January 2015 25.00% 20.00% Aus, Ca & NZ 15.00% US Emerg Mkts Europe 10.00% Japan Global 5.00% 0.00% 0.01 To 4 To 8 8 To 12 12 To 4 16 Aswath Damodaran 16 To 20 20 To 24 24 To 28 28 To 32 32 To 36 36 To 40 40 To 50 50 To 75 75 To 100 More 16 3a. And the differences are someKmes revealing… Price to Book RaKos across globe – January 2013 17 Aswath Damodaran 17 4. SimplisKc rules almost always break down…6 Kmes EBITDA was not cheap in 2010… 18 Aswath Damodaran 18 But it may be in 2015, unless you are in Japan, Australia or Canada 19 EV/EBITDA: A Global Comparison -­‐ January 2015 25.00% 20.00% US 15.00% A,C & NZ Emerg Mkts Europe 10.00% Japan Global 5.00% 0.00% <2 2 To 4 4 To 6 6 To 8 8 To 10 To 12 To 16 To 20 To 25 To 30 To 35 To 40 To 45 To 50 To 75 To More 10 12 16 20 25 30 35 40 45 50 75 100 Aswath Damodaran 19 AnalyKcal Tests 20 ¨  What are the fundamentals that determine and drive these mulKples? ¤  ¨  ProposiKon 2: Embedded in every mulKple are all of the variables that drive every discounted cash flow valuaKon -­‐ growth, risk and cash flow paverns. How do changes in these fundamentals change the mulKple? ¤  ¤  The relaKonship between a fundamental (like growth) and a mulKple (such as PE) is almost never linear. ProposiKon 3: It is impossible to properly compare firms on a mulKple, if we do not know how fundamentals and the mulKple move. Aswath Damodaran 20 A Simple AnalyKcal device 21 Equity Multiple or Firm Multiple Equity Multiple Firm Multiple 1. Start with an equity DCF model (a dividend or FCFE model) 1. Start with a firm DCF model (a FCFF model) 2. Isolate the denominator of the multiple in the model 3. Do the algebra to arrive at the equation for the multiple 2. Isolate the denominator of the multiple in the model 3. Do the algebra to arrive at the equation for the multiple Aswath Damodaran 21 I . PE RaKos 22 ¨  To understand the fundamentals, start with a basic equity discounted cash flow model. ¤  With the dividend discount model, P0 = DPS1 r − gn ¤  Dividing both sides by the current earnings per share, P0 Payout Ratio*(1+ g n ) = PE= EPS0 r-gn ¤  If this had been a FCFE Model, Aswath Damodaran FCFE1 r − gn (FCFE/Earnings)*(1+ g n ) P0 = P0 = PE= EPS0 r-gn 22 Using the Fundamental Model to EsKmate PE For a High Growth Firm 23 ¨  The price-­‐earnings raKo for a high growth firm can also be related to fundamentals. In the special case of the two-­‐stage dividend discount model, this relaKonship can be made explicit fairly simply: " (1+g)n % EPS0 *Payout Ratio*(1+g)*$1− n ' n # (1+r) & EPS0 *Payout Ratio n *(1+g) *(1+g n ) P0 = + r-g (r-g n )(1+r)n ¤  For a firm that does not pay what it can afford to in ¨  dividends, subsKtute FCFE/Earnings for the payout raKo. Dividing both sides by the earnings per share: " Aswath Damodaran (1 + g)n % ' Payout Ratio * (1 + g) * $ 1 − # (1+ r) n & P0 Payout Ratio n *(1+ g) n * (1 + gn ) = + EPS0 r -g (r - g n )(1+ r) n 23 A Simple Example 24 ¨  Assume that you have been asked to esKmate the PE raKo for a firm which has the following characterisKcs: Variable High Growth Phase Stable Growth Phase Expected Growth Rate 25% 8% Payout RaKo 20% 50% Beta 1.00 1.00 5 years Forever a]er year 5 Riskfree rate = T.Bond Rate = 6% Number of years Required rate of return = 6% + 1(5.5%)= 11.5% Aswath Damodaran " (1.25)5 % .20*(1.25)*$1− 5' 5 P0 # (1.115) & .50*(1.25) *(1.08) = + = 28.75 EPS0 .115-.25 (.115-.08)(1.115)5 24 a. PE and Growth: Firm grows at x% for 5 years, 8% therea]er 25 PE Ratios and Expected Growth: Interest Rate Scenarios 180 160 140 Ratio r=4% r=6% r=8% r=10% 100 PE 120 80 60 40 20 0 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Expected Growth Rate Aswath Damodaran 25 b. PE and Risk: A Follow up Example 26 PE Ratios and Beta: Growth Scenarios 50 45 40 35 g=25% g=20% g=15% g=8% 25 PE Ratio 30 20 15 10 5 0 0.75 1.00 1.25 1.50 1.75 2.00 Beta Aswath Damodaran 26 Example 1: Comparing PE raKos across Emerging Markets-­‐ March 2014 (pre-­‐ Ukraine) 27 Russia looks really cheap, right? Aswath Damodaran 27 Example 2: An Old Example with Emerging Markets: June 2000 28 Country PE Ratio Argentina Brazil Chile Hong Kong India Indonesia Malaysia Mexico Pakistan Peru Phillipines Singapore South Korea Thailand Turkey Venezuela 14 21 25 20 17 15 14 19 14 15 15 24 21 21 12 20 Aswath Damodaran Interest Rates 18.00% 14.00% 9.50% 8.00% 11.48% 21.00% 5.67% 11.50% 19.00% 18.00% 17.00% 6.50% 10.00% 12.75% 25.00% 15.00% GDP Real Growth 2.50% 4.80% 5.50% 6.00% 4.20% 4.00% 3.00% 5.50% 3.00% 4.90% 3.80% 5.20% 4.80% 5.50% 2.00% 3.50% Country Risk 45 35 15 15 25 50 40 30 45 50 45 5 25 25 35 45 28 Regression Results 29 ¨  The regression of PE raKos on these variables provides the following – PE = 16.16 R Squared = 73% Aswath Damodaran -­‐ 7.94 Interest Rates + 154.40 Growth in GDP -­‐ 0.1116 Country Risk 29 Predicted PE RaKos 30 Country PE Ratio Argentina Brazil Chile Hong Kong India Indonesia Malaysia Mexico Pakistan Peru Phillipines Singapore South Korea Thailand Turkey Venezuela 14 21 25 20 17 15 14 19 14 15 15 24 21 21 12 20 Aswath Damodaran Interest Rates 18.00% 14.00% 9.50% 8.00% 11.48% 21.00% 5.67% 11.50% 19.00% 18.00% 17.00% 6.50% 10.00% 12.75% 25.00% 15.00% GDP Real Growth 2.50% 4.80% 5.50% 6.00% 4.20% 4.00% 3.00% 5.50% 3.00% 4.90% 3.80% 5.20% 4.80% 5.50% 2.00% 3.50% Country Risk 45 35 15 15 25 50 40 30 45 50 45 5 25 25 35 45 Predicted PE 13.57 18.55 22.22 23.11 18.94 15.09 15.87 20.39 14.26 16.71 15.65 23.11 19.98 20.85 13.35 15.35 30 PE raKos globally: July 2014 31 Aswath Damodaran 31 Example 3: PE raKos for the S&P 500 over Kme 32 PE Ra&os for the S&P 500: 1969-­‐2014 50.00 45.00 On Jan 1, 2015 PE = 17.95 Normalized PE -­‐ = 24.16 CAPE = 21.62 40.00 35.00 30.00 PE 25.00 Normalized PE 20.00 CAPE 15.00 10.00 0.00 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 5.00 Aswath Damodaran 32 Is low (high) PE cheap (expensive)? 33 ¨  A market strategist argues that stocks are expensive because the PE raKo today is high relaKve to the average PE raKo across Kme. Do you agree? a.  b.  Yes No If you do not agree, what factors might explain the higher PE raKo today? ¨  Would you respond differently if the market strategist has a Nobel Prize in Economics? ¨  Aswath Damodaran 33 E/P RaKos , T.Bond Rates and Term Structure 34 Earnings to Price versus Interest Rates: S&P 500 16.00% 14.00% 12.00% 10.00% 8.00% Earnings Yield T.Bond Rate 6.00% Bond-­‐Bill 4.00% 2.00% 0.00% -­‐2.00% Aswath Damodaran 34 Regression Results 35 ¨  ¨  ¨  There is a strong posiKve relaKonship between E/P raKos and T.Bond rates, as evidenced by the correlaKon of 0.65 between the two variables., In addiKon, there is evidence that the term structure also affects the PE raKo. In the following regression, using 1960-­‐2014 data, we regress E/P raKos against the level of T.Bond rates and a term structure variable (T.Bond -­‐ T.Bill rate) E/P = 3.47% + 0.5661 T.Bond Rate – 0.1428 (T.Bond Rate-­‐T.Bill Rate) (4.93) (6.15) (-­‐0.67) R squared = 40.94[% ¨  Going back to 2008, this is what the regression looked like: E/P = 2.56% + 0.7044 T.Bond Rate – 0.3289 (T.Bond Rate-­‐T.Bill Rate) (4.71) (7.10) (1.46) R squared = 50.71% The R-­‐squared has dropped and the T.Bond rate and the differenKal with the T.Bill rate have noth lost significance. How would you read this result? Aswath Damodaran 35 II. PEG RaKo 36 ¨  ¨  PEG RaKo = PE raKo/ Expected Growth Rate in EPS ¤  For consistency, you should make sure that your earnings growth reflects the EPS that you use in your PE raKo computaKon. ¤  The growth rates should preferably be over the same Kme period. To understand the fundamentals that determine PEG raKos, let us return again to a 2-­‐stage equity discounted cash flow model: " (1+g)n % EPS0 *Payout Ratio*(1+g)*$1− n ' n # (1+r) & EPS0 *Payout Ratio n *(1+g) *(1+g n ) P0 = + r-g (r-g n )(1+r)n ¨  Dividing both sides of the equaKon by the earnings gives us the equaKon for the PE raKo. Dividing it again by the expected growth ‘g: " (1+g)n % Payout Ratio*(1+g)*$1− n ' n # (1+r) & Payout Ratio n *(1+g) *(1+g n ) PEG= + g(r-g) g(r-g n )(1+r)n Aswath Damodaran 36 PEG RaKos and Fundamentals 37 ¨  Risk and payout, which affect PE raKos, conKnue to affect PEG raKos as well. ¤  ImplicaKon: When comparing PEG raKos across companies, we are making implicit or explicit assumpKons about these variables. ¨  Dividing PE by expected growth does not neutralize the effects of expected growth, since the relaKonship between growth and value is not linear and fairly complex (even in a 2-­‐stage model) Aswath Damodaran 37 A Simple Example 38 ¨  Assume that you have been asked to esKmate the PEG raKo for a firm which has the following characterisKcs: Variable High Growth Phase Stable Growth Phase Expected Growth Rate 25% 8% Payout RaKo 20% 50% Beta 1.00 1.00 ¨  Riskfree rate = T.Bond Rate = 6% ¨  Required rate of return = 6% + 1(5.5%)= 11.5% ¨  The PEG raKo for this firm can be esKmated as follows: " (1.25)5 % 0.2 * (1.25) * $1− 5' 0.5 * (1.25)5 *(1.08) # (1.115) & PEG = + = 115 or 1.15 5 .25(.115 - .25) .25(.115-.08) (1.115) Aswath Damodaran 38 PEG RaKos and Risk 39 Aswath Damodaran 39 PEG RaKos and Quality of Growth 40 Aswath Damodaran 40 PE RaKos and Expected Growth 41 Aswath Damodaran 41 PEG RaKos and Fundamentals: ProposiKons 42 ¨  ProposiKon 1: High risk companies will trade at much lower PEG raKos than low risk companies with the same expected growth rate. ¤  ¨  ProposiKon 2: Companies that can avain growth more efficiently by invesKng less in bever return projects will have higher PEG raKos than companies that grow at the same rate less efficiently. ¤  ¨  Corollary 1: The company that looks most under valued on a PEG raKo basis in a sector may be the riskiest firm in the sector Corollary 2: Companies that look cheap on a PEG raKo basis may be companies with high reinvestment rates and poor project returns. ProposiKon 3: Companies with very low or very high growth rates will tend to have higher PEG raKos than firms with average growth rates. This bias is worse for low growth stocks. ¤  Corollary 3: PEG raKos do not neutralize the growth effect. Aswath Damodaran 42 III. Price to Book RaKo 43 ¨  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 wriven as: BV0 *ROE*Payout Ratio*(1+ g n ) P0 = r-gn P0 ROE*Payout Ratio*(1+ g n ) = PBV= BV0 r-g n If the return on equity is based upon expected earnings in the next Kme period, this can be simplified to, P0 ROE*Payout Ratio = PBV= BV0 r-g ¨  Aswath Damodaran n 43 Price Book Value RaKo: Stable Growth Firm Another PresentaKon 44 ¨  ¨  This formulaKon can be simplified even further by relaKng growth to the return on equity: g = (1 -­‐ Payout raKo) * ROE SubsKtuKng back into the P/BV equaKon, P0 ROE - g n = PBV= BV0 r-gn ¨  ¨  The price-­‐book value raKo of a stable firm is determined by the differenKal between the return on equity and the required rate of return on its projects. Building on this equaKon, a company that is expected to generate a ROE higher (lower than, equal to) its cost ...
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