MARKET-BASED

VALUATION:
PRICE AND ENTERPRISE
VALUE MULTIPLES
Presenter
Venue
Date

VALUATION INDICATORS

Price
Multiples

Enterprise
Value
Multiples

Momentum
Indicators

METHODS FOR PRICE & ENTERPRISE VALUE

MULTIPLES

1) Method of Comparables
Economic rationale is the law of one price

2) Method Based on Forecasted Fundamentals

Reflects firm fundamentals and future cash flows

Justified Price Multiples

Can be determined using either method

PRICE-TO-EARNINGS MULTIPLE
RATIONALES & DRAWBACKS

Rationales

Drawbacks

EPS is driver of value

Zero, negative, or very

small earnings

Widely used

Permanent vs.
transitory earnings

Related to stock
returns

Management
discretion for earnings

PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS

Trailing
P/E
Uses last
years
earnings

Preferred
when
forecasted
earnings are
not available

Forward
P/E
Uses next
years
earnings

Preferred
when trailing
earnings are
not reflective
of future

EXAMPLE: FORWARD P/E

Stock price

$20 .00

2011:Q1 EPS

$0 .18

2011:Q2 EPS

$0 .25

2011:Q3 EPS

$0 .32

2011:Q4 EPS

$0 .35

2011 Fiscal year forecast

$1 .10

2012:Q1 EPS

$0 .43

2012:Q2 EPS

$0 .48

2012:Q3 EPS

$0 .50

2012:Q4 EPS

$0 .59

2012 Fiscal year forecast

$2 .00

EXAMPLE: FORWARD P/E

1) Forward P/E based on EPS for the next 4 quarters:
EPS for the next 4 quarters = $0.35 $0.43 $0.48 $0.50 $1.76
Forward P/E based on EPS for the next 4 quarters $20 $1.76 11.4

2) Forward P/E based on EPS for the NTM (next 12 months):

EPS for the NTM 1 $1.10 11 $2.00 $1.925

12
12
Forward P/E based on EPS for the NTM $20 $1.925 10.4

EXAMPLE: FORWARD P/E

3) Forward P/E based on the current fiscal year's EPS:
EPS for the current fiscal year $1.10
Forward P/E based on EPS for the current fiscal year $20 $1.10 18.2

4) Forward P/E based on the next fiscal year's EPS:

EPS for the next fiscal year $2.00
Forward P/E based on EPS for the next fiscal year $20 $2.00 10.0

ISSUES IN CALCULATING EPS

EPS Dilution

Underlying
Earnings

Normalized
Earnings

Differences
in Accounting
Methods

EXAMPLE: UNDERLYING EARNINGS

Reported EPS from previous four quarters

$4 .00

Restructuring charges

$0 .10

Amortization of intangibles

$0 .15

Impairment charge

$0 .20

Stock price

$50 .00

EXAMPLE: UNDERLYING EARNINGS

P/E based on reported earnings $50 $4.00 12.5
Reported core earnings $4.00 $0.10 $0.15 $0.20 $4.45
P/E based on reported core earnings $50 $4.45 11.2
Underlying earnings $4.00 $0.20 $4.20
P/E based on underlying earnings $50 $4.20 11.9

EXAMPLE: NORMALIZED EARNINGS

Year

EPS

BVPS

ROE

2010

$0.66

$4.11

16.1%

2009

$0.55

$3.67

15.0%

2008

$0.81

$2.98

27.2%

2007

$0.73

$2.12

34.4%

2006

$0.34

$1.61

21.1%

2011 stock price

$24.00

EXAMPLE: NORMALIZED EARNINGS

1) Method of historical average EPS

($0.66 $0.55 $0.81 $0.73 $0.34)

Average (normalized) EPS
$0.618
5

P/E $24.00 $0.618 38.8

EXAMPLE: NORMALIZED EARNINGS

2) Method of average ROE

Average ROE

(16.1% 15.0% 27.2% 34.4% 21.1%)

22.8%
5

Average (normalized) EPS Average ROE Current equity book value per share
Average (normalized) EPS 22.8% $4.11 $0.937

P E $24.00 $0.937 25.6

JUSTIFIED FORWARD P/E FROM

FUNDAMENTALS

D1
V0
r g
P0
D1 E1

E1
r g
P0
1 b

E1
r g

JUSTIFIED TRAILING P/E FROM

FUNDAMENTALS

D 0 (1 g )
V0
rg
P0
D 0 (1 g ) E0

E0
rg
P0
(1 b )(1 g )

E0
rg

EXAMPLE: JUSTIFIED FORWARD P/E

FROM FUNDAMENTALS

Retention ratio

0 .36

Dividend growth rate

4 .0%

Required return on stock

10 .0%

EXAMPLE: JUSTIFIED FORWARD P/E

FROM FUNDAMENTALS

P0
1 b
=
E1
rg
P0
1 0.36
=
=10.7
E1
0.10 0.04

EXAMPLE: JUSTIFIED P/E FROM

REGRESSION ON FUNDAMENTALS
Predicted P/E
11.5 2.2 DPR + 0.03 Beta + 16.2 EGR
Values for subject firm

Dividend payout ratio

Beta
Earnings growth rate
Actual P/E

0 .40
1 .20
6 .00%
15 .0

EXAMPLE: JUSTIFIED P/E FROM

REGRESSION ON FUNDAMENTALS
Predicted P/E
11.5 2.2 DPR 0.03 Beta 16.2 EGR
11.5 2.2 0.4 + 0.03 1.2 16.2 0.06
13.3

METHOD OF COMPARABLES

Benchmark Value of the

Multiple Choices
Industry
peers

Industry
or sector
index

Broad
market
index

Firms
historical
values

METHOD OF COMPARABLES
USING PEER COMPANY MULTIPLES

Law of one price

Risk and earnings growth adjustments
PEG limitations:
Assumes linear relationship
Does not account for risk
Does not account for growth duration

EXAMPLE: METHOD OF COMPARABLES

USING P/E AND PEG

Values for subject firm

Five-year EPS growth rate
Consensus EPS forecast
Current stock price
Values for peer group
Median P/E
Median PEG

8 .0%
$4 .50
$28 .00

9 .00
1 .60

EXAMPLE: METHOD OF COMPARABLES

USING P/E AND PEG

P/E $28.00 $4.50 6.2

PEG 6.2 8.0 0.78
Intrinsic value 9.0 $4.50 $40.50

METHOD OF COMPARABLES
USING INDUSTRY AND MARKET MULTIPLES
Industry or Sector Index
Mean vs. median
Check industry valuation against market

Broad Market Index

Adjust for differences in fundamentals & size
Use relative values on a historical basis

METHOD OF COMPARABLES
VALUING THE MARKET

Fed Model: Earnings Yield vs. T-Bond Yield

Does not account for inflation correctly
Relationship between earnings yield &
interest rates is nonlinear
Small rate s large s in P/E
Yardeni Model

METHOD OF COMPARABLES
USING OWN HISTORICAL MULTIPLES
Rationale: Regression to the Mean
Approaches:
Average of four middle values over past 10 years
Five-year average trailing P/E
Potential Problems from Changes in
Firm business
Firm financial leverage
Interest rate environment
Economic fundamentals
Inflationary environment

USING P/ES FOR TERMINAL VALUE

Justified P/E

P/E Based on
Comparables

P/E =
(D/E)/(r g)

Grounded in market
data

Sensitive to required
inputs

If comp is mispriced,
terminal value will
be mispriced

EXAMPLE: USING P/ES FOR TERMINAL VALUE

Values for subject firm
Required rate of return
EPS forecast for year 3
Values for peer group
Mean dividend payout ratio
Mean ROE
Median P/E

11 .0%
$2 .50

0 .40
8 .0%
9 .00

EXAMPLE: USING P/ES FOR TERMINAL VALUE

USING GORDON GROWTH MODEL
D3 EPS3 Dividend payout ratio
D3 $2.50 0.40 $1.00
Retention ratio 1 Dividend payout ratio
Retention ratio 1 0.40 0.60
g Retention ratio ROE
g 0.60 8% 4.8%
D3 1 g
$1.00 1 0.048
V3

$16.90
rg
0.11 0.048

EXAMPLE: USING P/ES FOR TERMINAL VALUE

USING COMPARABLES

V3 P/E EPS3
9.0 $2.50 $22.50

PRICE-TO-BOOK VALUE MULTIPLE

RATIONALES

Book Value Is Usually Positive

More Stable than EPS
Appropriate for Financial Firms

Appropriate for Firms that Will Terminate

Can explain stock returns

PRICE-TO-BOOK VALUE MULTIPLE

DRAWBACKS
Does Not Recognize Nonphysical Assets

Misleading when Asset Levels Vary

Can Be Misleading Due to Accounting Practices

Less Useful when Asset Age Differs

Can Be Distorted Historically by Repurchases

ADJUSTMENTS TO BOOK VALUE

Intangible
Assets

Inventory
Accounting

Off-BalanceSheet Items

Fair Value

JUSTIFIED P/B

P0
ROE g

B0
r g
PV Expected future residual earnings
P0
1
B0
B0

PRICE-TO-SALES
MULTIPLE RATIONALES

Sales Less Easily Manipulated

Sales Are Always Positive
P/S Appropriate For Mature, Cyclical, & Distressed Firms
P/S More Stable Than P/E
Can Explain Stock Returns

PRICE-TO-SALES
MULTIPLE DRAWBACKS
Sales Earnings & Cash Flow
Numerator & Denominator Not Consistent

P/S Does Not Reflect Cost Differences

P/S Can Be Misleading Due to Accounting
Practices

JUSTIFIED P/S
P0
(E0 / S0 )(1 b)(1 g )

S0
rg

g b ROE

Sales
Total assets
g b PM0

Total assets Shareholders equity

EXAMPLE: CALCULATING THE ACTUAL & JUSTIFIED

P/E, P/B, & P/S
Stock price
EPS
Dividends per share
Book value of equity per share
Sales per share
ROE
Required return on stock

$50 .00
$2 .00
$1 .20
$6 .25
$15 .00
22 .5%
12 .0%

EXAMPLE: CALCULATING THE ACTUAL

P/E, P/B, & P/S
P0
$50
Actual

25.0
E0
$2
P0
$50
Actual

8.0
B0
$6.25
P0
$50
Actual

3.3
S0
$15

EXAMPLE: CALCULATING THE INPUTS FOR

THE JUSTIFIED
P/E, P/B, & P/S
Dividend payout ratio $1.20 $2.00 0.60
Retention ratio (b) 1 0.60 0.40
Growth rate in dividends (g ) 0.40 22.5% 9.0%

EXAMPLE: CALCULATING THE JUSTIFIED

P/E, P/B, & P/S
P0
(1 b)(1 g )
(1 0.60)(1 0.09)

21.8
E0
rg
0.12 0.09

P0 ROE g 0.225 0.09

4.5
B0
rg
0.12 0.09
P0 (E0 S0 )(1 b)(1 g ) ($2 $15)(0.6)(1.09)

2.9
S0
rg
0.12 0.09

PRICE-TO-CASH-FLOW
MULTIPLE RATIONALES

Cash Flow Less Easily Manipulated

Ratio More Stable Than P/E
Ratio Addresses Quality of Earnings Issue with P/E
Ratio Can Explain Stock Returns

PRICE-TO-CASH-FLOW
MULTIPLE DRAWBACKS

Cash Flow Can Be

Distorted
FCFE More Volatile
and More Frequently
Negative
Cash Flow Increasingly
Managed by Firms

DEFINITIONS OF CASH FLOW

CF
CFO
FCFE
EBITDA

Earnings + Depreciation +
Amortization + Depletion
From statement of cash flows
Most valid but volatile

Best used with enterprise

value

JUSTIFIED PRICE-TO-CASH-FLOW RATIO

FCFE0 (1 g )
V0
rg

DIVIDEND YIELD
RATIONALES & DRAWBACKS

Rationales

Drawbacks

Component of return

Only one component of

return

Dividends less risky

than future capital
gains

Dividends may displace

future earnings
Market may not favor
dividends

JUSTIFIED DIVIDEND YIELD

D0
rg

P0
1 g

INVERSE PRICE RATIOS

Price Ratio

Inverse Price Ratio

Price-to-earnings (P/E)

Earnings yield (E/P)

Price-to-book (P/B)

Book-to-market (B/P)

Price-to-sales (P/S)

Sales-to-price (S/P)

Price-to-cash-flow (P/CF)

Cash flow yield (C/P)

Price-to-dividends (P/D)

Dividend yield (D/P)

ENTERPRISE VALUE/EBITDA MULTIPLE

RATIONALES & DRAWBACKS

Rationales

Drawbacks

Useful for comparing firms

of different leverage

Exaggerates cash flow

Useful for comparing firms

of different capital utilization

Usually positive

FCFF more strongly

grounded

ISSUES IN USING ENTERPRISE VALUE

MULTIPLES
EV = Market Value of Stock + Debt Cash Investments
Justified EV/EBITDA
Positively related to FCFF growth
Positively related to ROIC
Negatively related to WACC

Comparables May Utilize TIC

Other EV Multiples

EV/FCFF
EV/EBITA
EV/EBIT
EV/S

CROSS-COUNTRY COMPARISONS

US GAAP
vs. IFRS
Valuation
Multiples
Inflation

Net income higher under IFRS

Shareholder's equity lower under IFRS
ROE higher under IFRS

P/CFO & P/FCFE most comparable

P/B, P/E, & EBITDA multiples least
comparable

Higher inflation Lower justified price

multiples
Higher pass-through rates Higher justified
price multiples

MOMENTUM INDICATORS:
EARNINGS SURPRISES
UEt EPSt E EPSt

SUEt

EPSt E EPSt

EPSt E EPSt

UEt

UEt

MOMENTUM INDICATORS:
RELATIVE STRENGTH

Past Performance
Relative to an Index
Inherently SelfDestructing

VALUATION INDICATORS IN PRACTICE:

AVERAGING MULTIPLES
Arithmetic
Mean &
Overestimate of index P/E
Weighted Mean

Harmonic Mean

Closer to index P/E but is

influenced by small outliers

Weighted

Equal
to
index
P/E
Harmonic Mean

VALUATION INDICATORS IN PRACTICE:

STOCK SCREENS

Database Limitations
Variables are predetermined
Does not contain qualitative data

Look-Ahead Bias
Assumes investor has info not yet available

Sector Rotation

SUMMARY
Price & Enterprise Value Multiples
Method of comparables
Method based on forecasted fundamentals

Price-to-Earnings Rationales & Drawbacks

Rationales: EPS Driver of value; widely used;
related to stock returns
Drawbacks: Zero, negative, or very small earnings;
transitory components; management discretion for
earnings
Trailing and forward P/Es

SUMMARY
Issues in Calculating EPS

EPS dilution
Underlying earnings
Normalized earnings
Differences in accounting methods

Method of Comparables

Industry peers
Industry or sector index
Broad market index
Own historical values

SUMMARY
Price-to-Book Rationales & Drawbacks
Rationales: Book value usually > 0, more stable than EPS,
appropriate for financial firms & firms that will terminate,
explains stock returns
Drawbacks: Doesnt recognize nonphysical assets, misleading
if asset levels vary or differ from accounting practices, less
useful when asset age differs, can be distorted by repurchases
Issues in Calculating Book Value

Intangible assets
Inventory accounting
Off-balance-sheet items
Fair value

SUMMARY
Price-to-Sales Rationales & Drawbacks
Rationales: Sales less easily distorted, sales always positive,
P/S more stable than P/E, appropriate for many firms,
explains stock returns
Drawbacks: Sales Earnings & Cash flow, numerator &
denominator not consistent, does not reflect cost differences,
can be distorted
Price-to-Cash-Flow Rationales & Drawbacks
Rationales: CF less easily manipulated, more stable than
P/E, addresses quality of earnings issue, explains stock
returns
Drawbacks: can be distorted, FCFE more volatile and more
frequently negative, increasingly managed by firms

SUMMARY
Measures of Cash Flow

CF: Earnings + Depreciation + Amortization + Depletion

CFO: From statement of cash flows
FCFE: Most valid but volatile
EBITDA: Best used with enterprise value

Dividend Yield Rationales & Drawbacks

Rationales: A component of return, dividends less risky
than future capital gains
Drawbacks: Only one component of return, dividends
may displace future earnings, market may not favor
dividends

SUMMARY
Inverse Price Ratios
Useful when denominators are small, low, or negative
(e.g., earnings)
Earnings yield, book-to-market, sales-to-price, cash
flow yield, and dividend yield
Enterprise Value Multiples
EV = Market value of stock + Debt Cash
Investments
Rationales: Useful for comparing firms of different
leverage & capital utilization, usually positive
Drawbacks: Exaggerates cash flow, FCFF more
strongly grounded

SUMMARY

Justified Multiples

P/E: + related to g, related to r

P/B: + related to ROE, related to r
P/S: + related to g & PM, related to r
P/CF: + related to g, related to r
D/P: - related to g, + related to r
EV/EBITDA: + related to g and PM,
related to WACC

SUMMARY

Cross-Country Comparisons
IFRS ROE higher than GAAP ROE
P/CFO & P/FCFE most comparable
P/B, P/E, & EBITDA multiples least
comparable
Higher inflation Lower justified price
multiples
Higher pass-through rates Higher
justified price multiples

SUMMARY
Momentum Indicators

Unexpected earnings (UE)

Standardized unexpected earnings (SUE)
Relative strength
Stock Screens
Database limitations
Potential look-ahead bias
Used in sector rotation