7-Relative-valuation 2016 Valuation PDF

Preview

Summary

Download 7-Relative-valuation 2016 Valuation PDF

Description

Relative valuation 7.1

7

Introduction

Valuation multiple is an expression of market value of an asset relative to a key statistic that is assumed to relate to that value. The basic objective of relative valuation is to value assets based on how similar assets are currently priced in the market. In other words, relative valuation involves the use of similar comparable assets in valuing another asset. In relative valuation, a firm’s value is compared to that of its competitors to determine its financial worth. Relative valuation is a very useful tool in valuing an asset. Relative valuation models are alternate models to absolute value models like discounted cash flow valuation models. In discounted cash flow models, a company’s intrinsic worth is based on its estimated future free cash flows discounted to their present value. Relative valuation is also known as comparable valuation. Price earnings (P/E) ratio is the most commonly used relative valuation measure in industry. Relative valuation is a major component of many equity research reports and acquisition valuations. Most of the sell-side analysts determine the target pricebased on multiples like price-to-earnings or price-to-sales (P/S). Damodaran (2012) based on sample of 550 sell-side reports find that 67% of price targets were derived using multiples. Damodaran suggests that approximately 85% of equity research reports are based on multiples and comparables while 50% of all acquisition valuation are based on multiples. In relative valuation, the benchmark might be the multiple of a similar company or the median average value of the multiple for a peer group companies, an economic sector, an equity index, or a median or an average own past value of the multiple. The benchmark can be based on the stock’s historical price ratios, the company’s industry sector or subsector, and the market. Companies with low stock price ratios signify buy targets for value managers. Some companies may be undervalued compared to its competitors. For example, Goldman Sachs Large Cap Value selects stocks on an industry-by-industry basis on the criteria of low-value stocks compared to their industry peers. In some cases, managers select companies that are attractively valued compared to the relative broader equity market. Some of the common metrics used in relative valuation include P/E ratio, return on equity, operating margin, enterprise value (EV) and price-to-free cash flows. Empirical research advocates the use of forward-looking multiples as they are considered to be more accurate predictors of value. DCF approach is used for pure intrinsic valuation. The terminal value can be calculated using the earnings before interest, tax, depreciation, and amortization (EBITDA) multiple assumption. The major choices for value drivers include measures of cash flow, book value, earnings, and revenues. The most widely used measures are based on earnings and Valuation. © 2016 Elsevier Inc. All rights reserved.

188

Valuation

cash flows. One of the most widely used multiple is the price earnings ratio commonly known as P/E or PER. Other commonly used multiples are based on the EV of companies such as EV/EBITDA, EV/EBIT, and EV/OPAT. P/B ratio is a commonly used benchmark multiple, which compare market value to the accounting book value of the firm’s assets. The P/S ratio and EV/Sales ratio measure value relative to sales. There also exists other industry-specific value drivers like EV/Number of subscribers for telecom businesses, EV/Number of audiences for broadcasting companies. In real-estate sector, the sales comparison approach involves valuation multiples based on the surface areas of the properties being valued. Equity pricebased multiples are more significant when investors acquire minority positions in companies.

7.2

Advantages and disadvantages of relative valuation

Relative valuation requires far fewer assumptions than discounted cash flow valuation. Relative valuation is simple and easy to understand. Relative valuation is more likely to reflect market perceptions than discounted cash flow valuation. Mutual fund managers basically focus on relative value strategies to compare a stock’s price ratios like P/E, price/book (P/B), P/S with a benchmark and make a decision about the firm’s prospects. Thus, the value obtained is relative in nature. Portfolio managers are often judged for performance based on how they perform on a relative basis. Hence, relative valuation is more significant in mutual fund industry. Another advantage of relative valuation is that the technique provide information on how the market is currently valuing the stock at different levels—aggregate market, alternate industries, and individual stocks within industries. The relative valuation approach provides information on how the market is currently valuing the securities. At the same time, relative valuation does not provide guidance on whether current valuations are appropriate. Valuation could be too high or low. Suppose assume that market has been significantly overvalued. In that context, it would not be proper to compare the value of an industry to the overvalued market. In this scenario, the point that an industry is undervalued relative to market is not correct as markets are overvalued. Relative valuation techniques are appropriate when there are a good set of comparable companies and the aggregate market is fairly valued. A portfolio of stocks which are undervalued on a relative basis may still be overvalued in other estimation methods. Relative valuation is built on the assumption that markets are correct in the aggregate even if there are errors in individual securities valuation. Relative valuations are not suited when the market is over- or undervalued. Relative valuation ignores important variables of growth, risk, and cash flow measures. Relative valuation depends on market sentiments. The biggest limitation of relative valuation is the assumption that the market has valued the business correctly. Relative valuation does not account for growth. The major

Relative valuation

189

challenge involved in a market multiple valuation is identifying appropriate comparable companies, which are priced similar to the companies being valued. It is also necessary to make adjustments to the financial numbers, which are used to measure the market multiples of comparable companies as well as those used to value the company. In the process, the characteristics of the comparable companies must be aligned with those of the company being valued. Controlling for the differences in value drivers across companies is necessary when trying to ensure the comparability of the comparable companies and the company being valued.1 The usage of industry averages has its own limitations as companies even in the same industry may have different growth rates and rates of returns.

7.3

Drivers of relative valuation

Relative valuation measure like P/E ratio reflects the market potential of a firm in terms of earnings. P/E ratio is a technically simple model with company earnings as the value driver. The three important drivers for PE valuation are investment risk, earnings growth, and accounting measurement principles. The EV/EBITA is determined by factors like the growth rate of company, return on capital, and cost of capital. The EV/EBITA multiple increases with growth when the firm’s return on invested capital is greater than the cost of capital. Multiples reflect the market’s perception of a company’s growth prospects as two firms with similar prospects and operating characteristics must trade at similar multiples. If a firm is trading at a lower multiple than its peer companies, then it can be termed as “undervalued in the market.” If all the value drivers like discount rate, growth rate, and return on invested capital are equivalent, then the multiples for the firms must be equal. If drivers like growth are higher for a firm, then its multiple should be higher than the comparative peer firm. Hence, it can be stated that the firm trades at a premium in comparison with its peer group, which is accounted by its higher growth rate.

7.4

Steps in relative valuation

The first step of an effective valuation process involves selection of businesses, which are as similar as possible. The process of relative valuation starts with the selection of a peer group. The peer group selection is on the basis of examination of the industry of the firm. The product profile, revenues, and profits of the firm is compared with the peer group firms. Peer group valuation may not be appropriate if the firms gave negative earnings. Peer group selection is based on defining industry attributes, matching companies on size, growth, margins, asset intensity, and risk. 1

Holthausen, R.W., Zmijewski, M.E. Valuation with market multiples: how to avoid pitfalls when identifying and using comparable companies, J. Appl. Corp. Financ. 24 (3), 2635.

190

Valuation

Then the equity value is estimated by means of incorporating the effect of dilutive securities such as options, restricted stocks, convertible debt, warrants, etc. The equity value is unlevered to arrive at EV. The next stage involves identifying and measuring value drivers such as earnings and computing multiples for peer companies. The focus is on appropriate value drivers in terms of revenues, EBITDA, EBIT, and net income. The value drivers have to be adjusted to remove nonrecurring items. The next step involves identification and adjustment for differences between the selected company and its peers. The adjustments in differences between peer company and selected firm must be in terms of business strategy, size, growth, margins, asset intensity, and risk factors. Finally, the range of values for the firm is selected based on the company’s value drivers and the adjusted multiples of the peer firms. In summary, for relative valuation, a list of comparable peer companies is selected, and their market values are obtained. These market values are converted into comparable trading multiples like P/E, P/B, EV/Sales, and EV/EBITDA multiples. Then the company’s multiples are compared with the peers to assess if the firm is over- or undervalued.

7.5

Relative valuation techniques

In relative valuation, the value of any firm can be standardized with respect to earnings, book value of assets, revenues, or firm-specific measures. Multiples are classified as earnings multiples, book value multiples, revenue multiples, and sector-specific multiples. In earnings multiple, the value of any asset is a multiple of the earnings that asset generates. The value of the operating assets can be expressed as a multiple of EBITDA or operating income. Book value multiples like P/B ratio indicates whether a firm is under- or overvalued. Tobin Q is a measure of replacement value multiple. Ratios like P/S and values to sales are examples for revenue multiples. Industry-specific multiples are also used for relative valuation of firms in specific sectors. The numerator of the multiple can be either equity value or firm value. The equity value is based on either book value or market value. The firm value can be based on the EV, which is the sum of the value of debt and equity net of cash. The denominator of the multiple is an equity measure or a firm measure. The equity measure is based on earnings per share, net income, or book value of equity. The analyst’s choice for the comparison stocks and benchmark value of the multiple must be based on either one of the following: (i) the firm’s peers within its industry, (ii) the firm’s industry or sector, (iii) the representative broad market equity index, and (iv) the average historical price multiple for the firm. The selection of company’s peer within it industry for the method of comparables is based on the law of one price, which states identical assets should sell for the same price.

Relative valuation

191

7.5.1 Forward multiples Forward multiples are basically applied to a firm’s next 12 months EBITDA or EBIT. This measure basically focus on a firm’s predicted earnings for the next year. Forward multiples are used to value high-growth companies that expect better future earnings in the future period. Forward multiple is basically useful for companies that have recently engaged in a major restructuring activity like M&A or introduced a new product. A firm recovering from a downturn may focus on forward multiple if the future business in next 12 months is expected to recover. Firms with project backlog in future use forward multiples for valuation purposes. Many publicly traded firms are valued based on projected rather than historical earnings and cash flows. Projections or forward estimates are made by equity analysts for estimation of valuation multiples. Forward estimates are obtained from sources like Bloomberg, First Call, and IBES. The projections are provided on a calendar year basis for consistency.

7.5.1.1 Equity price-based multiples Equity value multiples are calculated using denominators relevant to equity holders.

7.5.1.1.1 Earnings multiplier—P/E ratio The earnings multiple technique consists of a detailed assumption of future earnings per share and an estimate of earnings multiplier (P/E) ratio. P/E 5 Share price/Earnings per share

Investment analysts and advisors highlight the significance of P/E ratio. The P/E ratio valuation plays an important role among investment analysts and advisors. In earning-based valuation model, the value of equity of firm is estimated as a function of the observed P/E ratio for some peer company or the mean/median P/E ratio for peer companies. The drawback for PE-based valuation is that earnings per share can be subjected to distortions due to differences in accounting rules and capital structure between firms. P/E ratio is the most commonly used equity multiple. Stock market valuation basically focusses on price earning multiple commonly called P/E ratio (Kenth and Stina, 2008). P/E ratio is a useful indicator of expectations of growth opportunities. P/E multiples do vary with growth prospects. In other words, P/E ratio reflects the market optimism regarding the firm’s growth prospects. Analysts must decide if they are more or less optimistic than the perception conveyed by the market multiple. Mathematically, it can be proved that P/E ratio increases with ROE. High ROE projects give the firm good opportunities for growth. Higher reinvestment rate increases P/E ratio only if the investments undertaken by the firm offer an expected rate of return greater than the market capitalization rate. A common thumb rule in Wall Street is that the growth rate ought to be roughly equal to the P/E ratio. Riskier firms will have higher required rates of return. The P/E ratio for such firms will be lower. P/E ratio is based on earnings growth and risk. Forward P/E also known as estimated P/E ratio is a forward-looking indicator, which can be used to compare current earnings to future earnings. Forward P/E ratio uses the current share price and divides by

192

Valuation

the total EPS earnings over the estimated future 12 months. Trailing P/E is found out by dividing the current share price by the total EPS earnings over the past 12 months. In other words, the trailing P/E (also referred to as the current P/E) uses the past four quarters of earnings, referred to as the trailing 12-month (TTM) EPS. The forward P/ E (also referred to as the leading or prospective P/E), which uses next year’s expected earnings (based on the analyst or database estimates). The P/E ratio of a high-growth firm is a function of the expected growth rate in abnormal growth rate. Firms with higher cost of equity will often have lower P/E ratio compared to a firm with lower cost of equity. The rise of market interest rates will lead to higher cost of equity and lower PE ratio. If the P/E ratio of a company’s stock is greater than that of market index like DJIA or S&P 500, then the firm would be overvalued and vice versa. The forward P/E is preferred over the trailing P/E when trailing earnings are not representative of the firm’s future. The trailing P/E is preferred when forecasted earnings are not available, which is often the case for small firms that are not widely followed. If earnings are zero or negative, the analyst may use a longer-term or future (positive) earnings figure. Regardless, the analyst should use the same definition of earnings when making comparisons across firms. When analyst use trailing P/E, adjustments have to be made with respect to potential dilution of EPS, transitory nonrecurring earnings, transitory earning components, which are attributable to business cycles and differences in accounting methods. Basic EPS utilizes the actual number of shares outstanding during the period. Diluted EPS utilizes the number of shares that would be outstanding and the accompanying earnings if all executive stock options, equity warrants, and convertible bonds were exercised. Disadvantages of P/E ratio The earnings which forms the denominator of the P/E ratio is an accounting measure, which is influenced by accounting rules, use of historical cost in depreciation, and inventory valuation. In times of inflation, historic cost depreciation and inventory costs tend to underrepresent the true economic values. P/E ratios are generally inversely related to inflation rate. P/E measure might be distorted if the firms use earnings management to improve the apparent profitability of the firm. P/E ratios can also be affected by business cycles as reported earnings can fluctuate substantially over a business cycle. P/E ratio cannot be used if earnings are negative. One of the major flaws of P/E multiples is that they are affected by capital structure. Unlevered companies (all equity firms) with high P/E ratio can increase its P/E ratio artificially by swapping debt for equity. Earnings include many nonoperating items like restructuring charges and write-offs, which are one-time events that often make P/E ratios misleading. In 2002, AOL Time Warner wrote-off nearly $100 billion in goodwill and other intangibles. The company had an EBITDA of $6.4 billion but recorded a loss of $98 billion due to the write-off. P/E ratio in this case was misleading as earnings were negative.2

2

Goedhart, M., Koller, T., Wessels, D. The right role for multiples in valuation, Mckinsey Finance, 711.

Relative valuation

193

7.5.1.1.2 Price earning growth ratio Price earning growth (PEG) is calculated by dividing the P/E by the projected earnings growth rate of the firm. Suppose a company has a P/E ratio of 25 and analysts expect its earnings to grow by 15%, then its PEG would be 1.66. The firm is trading at a premium compared to its growth rate. PEG ratio is obtained by dividing the P/E ratio by the growth rate in earnings per share. It is most suited for valuing high-growth companies like technology firms. PEG ratios can be used to compare valuation of firms that are in the same businesses. If the expected growth rate in earnings per share is based on earnings in the most recent period, then the current PE ratio should be used to compute the PEG. Basically, a forward P/E is used in the PEG ratio, but trailing P/E is more effective in calculating PEG. PEG ratio 5 PE ratio/Expected growth rate in EPS

PEG relies heavily on earnings estimates by analysts, which may go wrong. Hence for calculation of PEG, good margin of errors have to be provided in earnings estimate. Firms with PEG ratio of 1 is considered to be fairly valued, while those higher than one is considered to be overvalued. PEG ratio of ,1 indicates undervaluation. The P/E ratio of any firm that is fairly priced will be equal to its growth rate. In theory, the lower the PEG ratio the better—implying that we are paying less for future earnings growth. PEG ratio combines prices and forecasts of earnings and earnin...