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CFA Level 2 2015 - Equity - Reading 35 - Market-based Valuation: Price and Enterprise Value Multiples
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Justified price multiple is...
what the multiple should be if the stock is fairly valued
Pros and cons of P/Es
(+) EPS is the primary determinant of investment value
(+) The P/E ratio is popular in the investment community
(+) Empirical research shows that P/E differences are significantly related to long-run average stock returns
(-) Earnings can be negative
(-) Earnings are volatile, transitory and make the interpretation of P/Es difficult
(-) Management discretion can distort reported earnings
Pros and cons of P/Bs
(+) BV is positive
(+) BV more stable than EPS
(+) BV is an appropriate measure of net asset value for firms that primarily hold liquid assets (finance, investment, insurance and banking firms)
(+) P/B can be useful in valuing companies that are expected to go out of business
(+) Empirical research shows that P/B help explain differences in long-run average stock returns
(-) P/Bs do not reflect the value of intangible economic assets (human capital)
(-) P/Bs can be misleading when there are significant differences in the asset size of the firms
(-) Different accounting conventions can obscure comparability (GAAP vs IFRS)
(-) Inflation and technological change can cause the book and market values to differ significantly
Pros and cons of P/Ss
(+) Meaningful for distressed firms
(+) Sales revenue difficult to manipulate
(+) P/S ratios are not as volatile as P/Es
(+) Appropriate for valuing stocks in mature or cyclical industries and startups, value investment management companies and partnerships
(+) Empirical research...
(-) High growth in sales does not necessarily mean high growth in income
(-) P/S ratios do not capture differences in cost structures across companies
(-) Revenue recognition practices can distort sales forecasts (bill and hold)
Pros and cons of P/CFs
(+) CF harder for managers to manipulate than earnings
(+) P/CF more stable than P/E
(+) Reliance on CF rather than EPS handles the problem of differences in the quality of reported earnings, which is a problem for P/E
(+) Empirical research...
2 cons have to do with the definition of cash flow:
(-) Items affecting actual CFO are ignored when the EPS + NCC estimate is used (noncash revenue and NWC changes are ignored)
(-) FCFE is preferable to CFO, but FCFE is more volatile than CFO
Pros and cons of D/Ps (dividend yield)
(+) Dividend yield contributes to total investment return
(+) Dividends are not as risky as the capital appreciation component of total return
(-) Ignores capital appreciation
(-) Dividends paid now displace future earnings, which implies a trade-off between current and future cash flows
Underlying earnings
AKA persistent, continuing or core earnings are earnings that exclude: nonrecurring components, such as:
gains and losses from asset sales
asset write-downs
provisions for future losses and
changes in accounting estimates
Molodovsky effect
The countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle and low P/Es at the top of the cycle
Normalized EPS
An estimate of EPS in the
middle
of the business cycle
2 methods to normalize earnings
(1) Method of historical average EPS
(2) Method of average ROE multiplied by the current BVPS
Average ROE method is preferred because it takes into account size effects
Earnings Yield (E/P)
High E/P suggests a
cheap
security and a low E/P suggests an
expensive security
The Fed Model
predicts the return on the S&P 500 on the basis of the relationship between forecasted earnings yields and yields on bonds
With a 10-year T-bond yielding 2.93%, the justified P/E on the S&P would be 1/0.0293 = 34.1
The Yardeni Model
It incorporates the expected growth rate in earnings:
CEY = CBY - b x LTEG + residual
CEY: current EY on the market index
CBY: current Moody's A-rate corporate bond yield
LTEG: consensus 5-year earnings growth rate for the market index
b: the weight the market gives to five-year earnings projections
Justified trailing P/E
Justified leading P/E
Justified P/Es and inflation
ρ: real rate of return (r-I)
λ: how much inflation can the company pass through to buyer
I: inflation
Justified P/B ratio
Book value per share:
Justified P/S ratio
= Net profit margin (E0/S0)
x
trailing P/E
Justified P/CF ratio
4 types of CF might be used:
(1) CF = NI + NCC
(2) Adjusted CF = CFO + ((net cash interest outflow x (1-t))
(3) FCFE = CFO - FCInv + net borrowing
(4) EBITDA
!! Adjusted CFO should be used when comparing CFO reported under IFRS with CFO reported under US GAAP
Justified EV/EBITDA
EV/ EBITDA
Justified Dividend Yield
Predicted P/E
can be estimated from linear regression of historical P/Es on its fundamental variables, incl. expected growth and risk.
3 limitations of predicted P/Es
(1) The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain
(2) The relationships between P/E and the fundamental variables examined may change over time
(3) Multicollinearity is often a problem in these time series regressions
Frequently encountered P/E benchmarks include:
P/E of another company's stock in a similar industry with similar operating characteristics
Average or median P/E of peer group within the company's industry
Average or median P/E for the industry
P/E of an equity index
Average historical P/E for the stock
PEG ratio
3 drawbacks of PEG ratio
(1) The relationship between P/E and g is not linear
(2) Doesn't account for risk
(3) Doesn't reflect the duration of the high-growth period for a multistage valuation model
Terminal value based on a justified P/E ratio
Terminal value based on comparables
EV =
EV/EBITDA indicates the value of the overall company, not equity
EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
Pros and cons of EV/EBITDA
(+) More useful than P/E when comparing firms with different degrees of financial leverage
(+) Useful for valuing capital-intensive businesses with high levels of depreciation
(+) Usually positive
(-) EBITDA will overstate CFO if working capital is growing, ignores how different revenue recognition policies affect CFO
(-) FCFF more strongly linked with valuation theory than EBITDA. EBITDA will be adequate measure if capital expenses equal depreciation expenses
!! EBITDA overestimates cash flow from operations if working capital is growing
Total Invested Capital (TIC)
AKA market value of invested capital
= market value of equity and debt
4 sources of differences in cross-border valuation comparisons
Accounting methods
Cultures
Risk
Growth opportunities
Least-affected ratios from international differences
P/adjusted CFO
P/FCFE
Most-affected ratios from international differences
P/B
P/E
P/EBITDA
EV/EBITDA
Momentum indicators...
relate either the market price or a fundamental variable like EPS to the time series of historical or expected value
3 Momentum indicators
Earnings surprise
Standardized unexpected earnings
Relative strength
Unexpected earnings or earnings surprise =
Standardized Unexpected Earnings (SUE)
Earnings Surprise / σ of Earnings surprise
weighted harmonic mean
with the P/Es denoted by X
weights as w
4 means
- Arithmetic mean most affected by outliers
- Harmonic mean puts more weight on smaller values
- Median or weighted harmonic mean with outliers excluded may be the most appropriate measures of the P/E
- For an equal weighted portfolio or index, the harmonic mean and weighted harmonic mean will be equal
High RSI (Relative Strength Index) would be relevant for a portfolio managed with...
a growth/momentum investment style
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