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Greens Health Inc., a privately owned Supermarket chain has expected earnings of $20 million per year on sales of $205 million with total assets of $80 million.
In a proposed IPO, Greens will issue 10 million shares so forecast EPS is $2 per share; the firm is all equity .
Using data on suitable comparables, compute a valuation matrix
9.
Valuation Matrix: P/E Ratios Vons 18 Safeway 19 PE Ratio Comparables Implied Stock Price 36 38 Average 18.5 37 Using an average stock price of $37, firm value is estimated to be $37 10m = $370 million Source: Compustat (Wharton) Raios for 1995
10.
Valuation: Price/Sales Ratios Vons .24 Safeway .38 P/S Ratio Comparables Implied Firm Value 49.2 77.9 Average .31 63.6 Firm value is estimated to be $63.6 million
11.
Valuation: Market/Book Ratios Vons 2.0 Safeway 6.9 M/B Ratio Comparables Implied Firm Value 160.0 552.0 Average 1.3 356.0 Firm value is estimated to be $356.0 million
Are the comparables really comparable? Firms differ in many significant dimensions including
Growth rates
Cash flows
Risk (most obviously capital structure; note that Greens equity value was unchanged by the fact that it carried debt. Is this realistic?
15.
Pitfalls in Comparables: III Suppose the unobserved true relation between stock price and earnings is Price = $9.00 + 12 EPS For Vons, say EPS =$1.50, so Price = $27 and P/E =18 For Greens, we have value = $9.00 +12 x 2 = $33 The multiples approach misprices by $4.00 or twelve percent of firm value -- other relations could be off more.
Simplest approach is to assume first-year cash flow and perpetual growth and discount rates
More convincing approach is to use explicit cash flow projections over a forecast period and discount continuing value using simplest approach for cash flows after forecast period
We obtain discount rates for equity using a model of risk such as the CAPM
CAPM states that the expected or required return on an asset the sum of two components
The risk free rate
A risk premium
The risk premium is times the market risk premium, historically about 8%
25.
CAPM Beta measures the sensitivity of the stock’s return to the return on the market portfolio. Note that beta depends on the firm’s leverage. The Capital Asset Pricing Model states that the expected return on an asset is
Investment bankers assist corporations (and governments) in designing securities for sale to public or private markets
Traders and analysts of investment banks are usually called are said to work on the sell side of a securities firm, or are called sell side analysts or sell side traders or brokers
Venture-capital firms provide financing to new firms, often firms in new technologies, requiring both technical and financial skills
Hedge funds are unregistered investment vehicles for wealthy investors’ or institutional funds, often using complex investment strategies requiring sophisticated financial analytical skills
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