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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
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
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
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
Risk (most obviously capital structure; note that Greens equity value was unchanged by the fact that it carried debt. Is this realistic?
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.
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%
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