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# Relative valuation

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### Relative valuation

1. 1. 1
2. 2. ◦ Sales Multiple◦ P/E multiple◦ Price to Book multiple◦ Enterprise value to EBIT multiple 2
3. 3.  If valuation is being done for an IPO or a takeover, ◦ Value of firm = Average Transaction P/E multiple × EPS of firm ◦ Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be) If valuation is being done to estimate firm value ◦ Value of firm = Average P/E multiple in industry × EPS of firm This method can be used when ◦ firms in the industry are profitable (have positive earnings) ◦ firms in the industry have similar growth (more likely for “mature” industries) ◦ firms in the industry have similar capital structure 3
4. 4.  The application of this method is similar to that of the P/E multiple method. Since the book value of equity is essentially the amount of equity capital invested in the firm, this method measures the market value of each rupee of equity invested. This method can be used for ◦ companies in the manufacturing sector which have significant capital requirements. 4
5. 5.  This multiple measures the enterprise value , that is the value of the business operations (as opposed to the value of the equity). In calculating enterprise value, only the operational value of the business is included. Generally Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded. 5
6. 6. A B CEnterprise market value/sales 1.4 1.1 1.1Enterprise market value/EBITDA 17.0 15.0 19.0Enterprise market value/free cash flows 20 26 26Application to XYZ Co.Sales Rs. 200 croresEBIDTA Rs. 14 croresFree cash flow Rs. 10 crores 6
7. 7. A B C AverageEnterprise market value/sales 1.4 1.1 1.1 1.2Enterprise market value/EBITDA 17.0 15.0 19.0 17.0Enterprise market value/free cash flows 20.0 26.0 26.0 24.0Application to XYZ Co. Average ValueSales Rs. 200 crores 1.2 Rs. 240 croresEBIDTA Rs. 14 crores 17.0 Rs. 238 croresFree cash flow Rs. 10 crores 24.0 Rs. 240 crores 7
8. 8. D E FEnterprise market value/sales 2.6 1.9 0.9Enterprise market value/EBITDA 10.0 21.0 4.0Enterprise market value/free cash flows 21.0 30.0 24.0Application to PQR Co.Sales Rs. 300 croresEBIDTA Rs. 15 croresFree cash flow Rs. 7.5 crores 8
9. 9. D E F AverageEnterprise market value/sales 2.6 1.9 0.9 1.8Enterprise market value/EBITDA 10.0 21.0 4.0 11.7Enterprise market value/free cash flows 21.0 30.0 24.0 25.0Application to PQR Co. Average ValueSales Rs. 300 crores 1.8 Rs. 540 croresEBIDTA Rs. 15 crores 11.7 Rs. 175.5 croresFree cash flow Rs. 7.5 crores 25.0 Rs. 187.5 crores Can this be used as a dependable guide for valuation 9
10. 10.  Using fundamentals ◦ Valuation related to fundamentals of business being valued Using comparables ◦ Valuation is estimated by comparing business with a comparable fit 10
11. 11.  Using fundamentals for multiples to be estimated for valuation ◦ Relates multiples to fundamentals of business being valued, eg earnings, profits ◦ Similar to cash flow model, same information is required ◦ Shows relationships between multiples and firm characteristics 11
12. 12.  Using Comparables for estimation of firm value ◦ Review of comparable firms to estimate value ◦ Definition of comparable can be difficult ◦ May range from simple to complex analysis 12
13. 13.  Simple and easy to use Useful when data of comparable firms and assets are available. Require less time and efforts Easier to justify and sell. Closer to the market value (more value if the comparable firm is getting more in the market) 13
14. 14.  Easy to misuse Selection of comparable can be subjective Errors in comparable firms get factored into valuation model RGC (Risk, Growth, Cash Flow) may be ignored. Have a short shelf life (compared to fundamentals). 14
15. 15.  I) Select the relevant measure and value drivers. II) Identification of the “COMPS”. III) Select and calculate appropriate multiple – aggregation of multiple into single number through analysis of “COMPS”. IV) Apply to the company V) Make final adjustments for non-operating assets, Contingent liabilities and convertibles. 15
16. 16.  Equity multiple or entity multiple ? Which value driver/ multiple to use? Trailing multiple or forward looking multiple? More number of multiples vs. less multiples ? 16
17. 17.  Matching principle – numerator and denominator should have consistent definition Capital structure – equity multiple is greatly affected by the capital structure than entity multiple Difference in earning guidance and investment and payout policy Enterprise value most of the requires approximation of debt value Stage of business life cycle Empirical research supports forward looking multiples processing two years analysts forecast 17
18. 18.  Use industry classification system or at least list firm’s competitors SIC: Standard Industrial classification GICS: Global industry classification benchmark Size and region Number of comparables- 4 to 8 ideal size ( plus or minus 2 18
19. 19.  Management Style Size Product & Customer diversification Technology Key Financial trends Strategic & operational strategies Market positioning & maturity of operation Geographical consideration Trading volume of selected companies Price volatility (σ) Distribution of multiples – across the sector & market 19
20. 20.  P/E (Price Earning Ratio) P/B (Price to Book Ratio) Equity / Sales Equity / Cash flow Equity / PAT Equity / Book value of share 20
21. 21.  MVIC / Sales MVIC / EBITDA MVIC / EBIT MVIC / Book value of invested capital MVIC/TA 21
22. 22.  PER – most commonly used multiples Make sure definition is consistent & uniform PER = MPS / EPS Variant of PER Current PER = Current MPS / Current EPS Some analyst may use average price over last 6m or a year Trailing PER = Current MPS / EPS based on last 4 quarters. [or, LTM: Last twelve months] Forward PER = Current MPS / expected EPS during next F/Y EPS may further be based on fully diluted basis or primary basis EPS may include or exclude extraordinary items 22
23. 23.  For Growth Company forward PER will consistently give low value than trailing PER Bullish valuer use forward PER to conclude that stock is undervalued. Bearish valuer will consider Current PER to justify that Stock is overvalued. Full Impact of dilution may not occur during next year leading to lower EPS. While using industry PER be careful about outliers MLF (money loosing firm) creates a bias in selection Equity value is calculated based on existing outstanding shares but EPS is on fully diluted basis. 23
24. 24.  PEG = PER / expected growth in EPS One mistake analyst will make to consider growth in operating income rather than EPS Growth should be consistent with PER calculation Never use forward PER for PEG as it amounts to double counting of growth Lower the PEG better the stock If PER is high without growth prospect, PEG will be high – risky firm PEG does not consider risk taken in growth and sustainability of growth. 24
25. 25.  P/B ratio = market value of equity / book value of equity Book value is computed from the Financial Statement Price of book ratio near to 4 is highly priced stock [mean P/B ratio of all listed firm in USA during 2006 was 4] Price to Sales ratio (Revenue multiple) = market value of equity Revenue The larger the revenue multiple better it is. Generally there is no sectoral Revenue multiple. 25
26. 26.  MVIC multiple look at market value of operating assets of the firm (and not only for equity invested). MVIC multiple is not affected by Finance leverage. If firms under comparison are differing in their financial leverage, put more reliance on MVIC multiple. 26
27. 27.  The market approach is especially relevant if standard of value is FMV. No company is exactly comparable to another, this approach requires best of extensive guidance that market can provide. The subject company need not be exactly in the similar business but should be impacted by the same economic influences. Size difference between two companies can be adjusted for: Equity or MVIC multiple can be used for valuing either controlling or minority interest. MVIC multiple is preferable for valuing controlling interest and equity multiple for minority interest 27
28. 28.  If MVIC is used to value on a minority interest basis, no adjustment should be made to the subject company’s actual capital structure (since minority shareholders cannot force such an adjustment) Equity should be taken on a fully diluted basis (For options, warrants, convertibles, the no. of equity units should be computed as if conversion rights were exercised. [No. of units of ES O/S = no. of ES after dilution] 28
29. 29.  MVIC = Equity + PS + LTD + current portion of LTID [or all IBD, i.e. interest bearing debt] [may also subtract cash or cash equivalent. Marketable securities are included with cash equivalent] This is more preferable because different cash mix creates problem. 29
30. 30.  MVIC should be on M P basis and it is not book value. Market value of equity multiple can be either on per share basis or on a total basis. Price per share/ EPS or, MV of Equity/PAT Round multiple to one decimal MVIC should be on a total company basis rather than on a per-share basis 30
31. 31.  Conceptually only LTD (including current portion of LTD) should be considered. Due to practical difficulty we use AIBL [ difficult to assess how much interest is short term or long term. Some companies use ST debt as if it is LTD] 31
32. 32. Description of the subject Co. in terms of Line of business ◦ Market served ◦ Size: Revenue and Asset ◦ Other criteriaI) Then use above information to select guideline Co.II) Based on definition create a population of companies in similar line of businessIII) Normalize financials of both subject Co. & guideline Co.IV) Carryout comparative Financial analysisV) Identify and list similarities and assess relative strength and weakness. [site visit and management interviews helps] 32
33. 33. VI) Gather industry & economic date. Identify positions of subject Co. in industry. Assess how economic factor will affect both. VII) Choose what multiples to rely on and the appropriate value for each multiple. Two factors that influence selection of multiples of operating variables are Growth prospects of subject company relative to guideline Risk 33
34. 34. Industry Best measure of valueAuto Price to Earnings (PE) multipleBanking PE and Price to Book Value (PBV) or Adjusted PBV multipleCement PE, Enterprise Value to Earnings before interest, tax, depreciation & amortisation (EV/EBITDA), EV/tonneEngineering Forward PE, which reflects the order book position of the company
35. 35. Industry Best measure of valueFMCG PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratiosReal Estate Net asset value (NAV), which is book value at market prices. Also look at debt levelsTelecom PE and DCF, because there is a future stream of cash flows for upfront heavy investmentOil & Gas Residual reserves of energy assetsTechnology Trailing PE and its growth
36. 36. Industry Factors ImpactingAuto Volume growth, realisations, operating profit margins, new product launchesBanking Loan growth, non-performing assets, net interest margins, CASA ratioCement Dispatches, operating costs, regional demand supply equationEngineering Order book inflows, execution skills, marginsFMCG RoE, RoCE, margins, volume growth, new products, market share
37. 37. Industry Factors ImpactingReal Estate Debt levels, liquid assets, inventory levels, promoters’ ability to raise fundsUtilities & Project costs, plant load factors, rawPower material costs, debt equity ratiosTelecom OPEX , ARPU, TOWERS, debt equity ratiosOil & Gas Project costs, debtequity ratiosTechnology Order inflow, ability to contain costs, service verticals, profitability, client attrition