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  • CapitalIQ,Factset
  • gn is the growth rater is
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    1. 1. RelativeValuationValuing a company relative to anothercompany
    2. 2. In relative valuation, the value of an asset iscompared to the values assessed by the market forsimilar or comparable assets.To do relative valuation then, we need to identify comparable assets and obtain market values for theseassets convert these market values into standardized values, since the absoluteprices cannot be compared This process of standardizing creates pricemultiples. compare the standardized value or multiple for the asset being analyzedto the standardized values for comparable asset, controlling for anydifferences between the firms that might affect the multiple, to judgewhether the asset is under or over valued
    3. 3. Relative valuation is much more likely to reflectmarket perceptions and moods than discountedcash flow valuation. This can be an advantagewhen it is important that the price reflect theseperceptions as is the case when the objective is to sell a security at that price today (as in the case ofan IPO) investing on “momentum” based strategiesWith relative valuation, there will always be asignificant proportion of securities that are undervalued and over valued.Relative valuation generally requires less informationthan discounted cash flow valuation
    4. 4. Identify Peer Group• A peer group is a set of companies or assets whichare selected as being sufficiently comparable tothe company or assets being valued (usually byvirtue of being in the same industry or by havingsimilar characteristics in terms of earnings growthand/or return on investment).• Companies in the same sector/sub-sector with thesimilar size tend to serve as good comparables
    5. 5. The following sources can be used to help identify suitablecomparable companies:• The targets annual report, prospectus, and web site• Analyst research reports• BSEIndia.com• MoneyControl- cites too many competitors, howeveranalysis with only a few is given• Yahoo Finance• Economic Times- lists all companies in the sector• SifyFinance• Recent news• SIC code lookup(not valid for India)• Sector reports published by credit rating agencies-S&Ptearsheet, Value Line, and Moodys company reports• Proxy statements in which the target compares its stockprice performance with a that of peers
    6. 6. Locating The NecessaryFinancialsNecessary financials include:• Earnings per Share (EPS)• Market Capitalization (Stock Price x Shares)• Enterprise Value (Market Capitalization + Net Debt)• Earnings before Interest, Taxes, Depreciation, andAmortization (EBITDA)• Total Revenue
    7. 7. • Company Websites - Almost every public companyhas a website or investor relations department. Forthe most current quarterly or annual report youmight want to check in these places first.• Bseindia.com, nseindia.com• Yahoo!Finance- Great resource for financial news,and lays out ratios and performance data forindividual companies• MoneyControl- Provides a great deal of informationon Indian companies• Hoovers.com- Good for company analysis
    8. 8. Evaluating Multiples
    9. 9. The Four Steps toDeconstructing Multiples Define the multiple In use, the same multiple can be defined in different ways by differentusers. When comparing and using multiples, estimated by someone else, itis critical that we understand how the multiples have been estimated Describe the multiple Too many people who use a multiple have no idea what its cross sectionaldistribution is. If you do not know what the cross sectional distribution of amultiple is, it is difficult to look at a number and pass judgment on whetherit is too high or low. Analyze the multiple It is critical that we understand the fundamentals that drive each multiple,and the nature of the relationship between the multiple and eachvariable. Apply the multiple Defining the comparable universe and controlling for differences is farmore difficult in practice than it is in theory.
    10. 10. P/E ratioPE = Market Price per Share / Earnings per SharePrice: is usually the current priceis sometimes the average price for the yearEPS: EPS in most recent financial yearEPS in trailing 12 monthsForecasted earnings per share next yearForecasted earnings per share in future year
    11. 11. To understand the fundamentals, start with a basicequity discounted cash flow model. With the dividend discount model, Dividing both sides by the current earnings per share, If this had been a FCFE Model,1. gn-The expected growth rate in earnings per share2. r- The riskiness of the equity, which determines the cost of equityP0=DPS1r-gnP0EPS0= PE=Payout Ratio*(1+gn )r-gnP0 =FCFE1r -gnP0EPS0=PE=(FCFE/Earnings)*(1+gn )r-gn
    12. 12. For a High Growth FirmThe price-earnings ratio for a high growth firm can alsobe related to fundamentals. In the special case of thetwo-stage dividend discount model, this relationshipcan be made explicit fairly simply: For a firm that does not pay what it can afford to in dividends, substituteFCFE/Earnings for the payout ratio.Dividing both sides by the earnings per share:P0 =EPS0*Payout Ratio*(1+g)* 1-(1+g)n(1+r)næèçöø÷r-g+EPS0*Payout Ration*(1+g)n*(1+gn )(r-gn )(1+r)nP0EPS0=Payout Ratio *(1+g)* 1-(1+g)n(1+ r)næèç öø÷r -g+Payout Ration *(1+g)n*(1+gn )(r -gn)(1+ r)n
    13. 13. PEG Ratio PEG Ratio = PE ratio/ Expected Growth Rate in EPS For a 2-stage equity discounted cash flow model: Dividing both sides of the equation by the earnings givesus the equation for the PE ratio. Dividing it again by theexpected growth g:P0 =EPS0*Payout Ratio*(1+g)* 1-(1+g)n(1+r)næèçöø÷r-g+EPS0*Payout Ration*(1+g)n*(1+gn )(r-gn )(1+r)nPEG=Payout Ratio*(1+g)* 1-(1+g)n(1+r)næèçöø÷g(r-g)+Payout Ration*(1+g)n*(1+gn )g(r-gn )(1+r)n
    14. 14. • The PEG ratio is a function of risk, payout and expectedgrowth. Thus, using the PEG ratio does not neutralizegrowth as a factor.• Proposition 1: High risk companies will trade at much lowerPEG ratios than low risk companies with the same expectedgrowth rate.Corollary 1: The company that looks most under valued on a PEG ratio basis in asector may be the riskiest firm in the sector• Proposition 2: Companies that can attain growth moreefficiently by investing less in better return projects will havehigher PEG ratios than companies that grow at the same rateless efficiently.Corollary 2: Companies that look cheap on a PEG ratio basis may be companieswith high reinvestment rates and poor project returns.• Proposition 3: Companies with very low or very high growthrates will tend to have higher PEG ratios than firms withaverage growth rates. This bias is worse for low growth stocks.Corollary 3: PEG ratios do not neutralize the growth effect.
    15. 15. Price to Book Value Ratio• Going back to a simple dividend discount model,• Defining the return on equity (ROE) = EPS0 / Book Valueof Equity, the value of equity can be written as:• If the return on equity is based upon expected earningsin the next time period, this can be simplified to,P0 =DPS1r -gnP0 =BV0*ROE*Payout Ratio*(1+gn )r-gnP0BV0= PBV=ROE*Payout Ratio*(1+gn )r-gnP0BV0= PBV=ROE*Payout Ratior-gn
    16. 16. • This formulation can be simplified even further byrelating growth to the return on equity:g = (1 - Payout ratio) * ROE• Substituting back into the P/BV equation,• The price-book value ratio of a stable firm isdetermined by the differential between the returnon equity and the required rate of return on itsprojects.• A company that is expected to generate a ROEhigher its cost of equity should trade at a price tobook ratio one.P0BV0= PBV=ROE - gnr-gn
    17. 17. EV to EBITDA The value of the operating assets of a firm can be written as: Now the value of the firm can be rewritten as Dividing both sides of the equation by EBITDA, The determinants of EV/EBITDA are: The cost of capital Expected growth rate Tax rate Reinvestment rate (or ROC)EV0 =FCFF1WACC-g
    18. 18. EV/Sales Ratio• If pre-tax operating margins are used, the appropriate valueestimate is that of the firm. In particular, if one makes thereplaces the FCFF with the expanded version:Free Cash Flow to the Firm = EBIT (1 - tax rate) (1 - Reinvestment Rate)• Then the Value of the Firm can be written as a function of theafter-tax operating margin= (EBIT (1-t)/Salesg = Growth rate in after-tax operating income for the first n yearsgn = Growth rate in after-tax operating income after n years forever (Stablegrowth rate)RIR Growth, Stable = Reinvestment rate in high growth and stable periodsWACC = Weighted average cost of capitalValueSales0=After-tax Oper. Margin*(1-RIRgrowth )(1+g)* 1-(1+g)n(1+WACC)næèçöø÷WACC-g+(1-RIRstable )(1+g)n*(1+gn )(WACC-gn )(1+WACC)néëêêêêùûúúúú
    19. 19. Papers• http://www.uhu.es/ijdar/10.4192/1577-8517-v4_4.pdf• http://realequityresearch.dk/Documents/Z-Score_Altman_1968.pdf