VALUATION TECHNIQUES
MARKET-BASED VALUATION
VALUATION TECHNIQUES
A RECAP
METHODS THAT DO NOT
INVOLVE FORECASTING
1. The method of comparables
Values stocks on the basis of
price multiples (stock price
divided by earnings, book value,
sales..) that are observed for
similar firms
2. Asset-based valuation
Values equities by adding up the
estimated fair values of the assets
of a firm and subtracting the value
of the liabilities
METHODS THAT INVOLVE
FORECASTING
1. Dividend Discount Model
Value = present value of expected
Dividends
2. Discounted Cash Flow
Analysis
Value = present value of expected
Free Cash Flow
3. Residual Earnings Analysis
Value = Book value + present value
of expected Residual Earnings
4. Earnings growth Analysis
Value = capitalized earnings + the
PV of expected Abnormal Earnings
Growth 2
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 THE METHODS OF COMPARABLES

The methods of comparables refers to the valuation

of an asset based on multiples of comparable (similar)
assets
 Purpose: to determine whether an asset is relatively
fairly valued, relatively undervalued, or relatively
overvalued in relation to the comparable assets (i.e. the
comparables, the comps, or the guideline assets)

Ex: “Walmart” with a P/E of 20 is undervalued relative

to “Target” with a P/E of 25
Note on how “comparable” is comparable?
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THE METHODS OF COMPARABLES

Economic rationale: “the law of one price”: two

identical assets should sell at the same price

Important assumption: the comps themselves are

correctly valued.
- Remember the Dot com case?

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 MARKET- BASED VALUATION
FOCUS
FOCUS
- PRICE TO EARNINGS
- PRICE TO BOOK VALUE
- PRICE TO SALES
- PRICE TO CASH FLOWS

PRICE MULTIPLES

Price multiples are ratios of a stock’s market

price to some measures of value per share
(earnings, sales, or book value per share…)

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 PRICE TO EARNINGS (P/E)

PRICE TO EARNINGS (P/E)

The trailing P/E (current P/E) : current market price of the
stock divided by the most recent four quarters’ EPS. The EPS
in such calculations are sometimes referred to as trailing
twelve months (TTM) EPS.
- is the P/E ratio published in stock listings of financial
newspaper

The leading P/E (forward P/E or prospective P/E) is

calculated by dividing the current price by next year’s expected
earnings.
P0 P0
Leading P/E ratio = Trailing P/E ratio =EPS
EPS1 0
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 PRICE TO EARNINGS (P/E)
RATIONALES & DRAWBACKS

RATIONALES DRAWBACKS

Zero, negative, or very

EPS is driver of value
small earnings

Permanent vs.
Widely used transitory earnings

Related to long-run Management

average stock returns discretion for earnings

PRICE TO EARNINGS (P/E)

THE TRAILING P/E ISSUES

The following problems should be properly addressed when

calculating the trailing P/E:
Potential dilution of EPS
Transitory, non-recurring components of earnings that are
company-specific
Transitory components of earnings due to cyclicality (business
or industry cyclicality)
Differences in accounting methods (when different companies’
stocks are being compared)

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 PRICE TO EARNINGS (P/E)
THE TRAILING P/E ISSUES

BASIC VS. DILUTED EARNINGS PER SHARE

Dilution refers to the reduction in the proportional ownership
interests as a result of the issuance of new shares.
- Basic earnings per share = total earnings divided by the
weighted average number of shares actually outstanding
during the period.
- Diluted earnings per share = total earnings divided by the
number of shares that would be outstanding if all holders of
securities such as executive stock options, equity warrants, and
convertible bonds exercised their options.
When comparing companies, analysts should use diluted EPS so that the
EPS of companies with differing amounts of dilutive securities are on a
comparable basis

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PRICE TO EARNINGS (P/E)

TRAILING P/E ISSUES – BASIC & DILUTED EPS EXAMPLE

WPP reported the following data for fiscal year ending 31

Dec, 2007:
Basic EPS: $39.6
Diluted EPS: $38

On Feb 29, 2008, the stock closed at $596.5 and the

company is preparing its earnings press release

What is the trailing P/E of this company?

- Using Basic EPS?
- Using Diluted EPS?

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 PRICE TO EARNINGS (P/E)
THE TRAILING P/E ISSUES

NON-RECURRING ITEMS AND EARNINGS PER SHARE

Items in earnings that are not expected to recur in the future
are removed b/c valuation concentrates on future cash flows
Companies may disclose adjusted earnings, non-IFRS or
non-GAAP, pro-forma earnings, core earnings…
 all these items indicate that earnings number differs in
some way from that reported in conformity with accounting
standards

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PRICE TO EARNINGS (P/E)

TRAILING P/E ISSUES – NON RECURRING ITEMS EXAMPLE
As of 24 April 2008, AZN closed at $41.95
In its 1st quarter ended 31 Mar 2008, AZN reported EPS
according to IFRS of $1.03 that included :
• $0.06 of restructuring costs
• $0.07 of amortization of intangibles arising from acquisitions
• $0.12 of impairment charges, reflecting the negative impact of a
competing generic product on the value of one of the company’s
patented products
 Adjusting for all these items, AZN reported core EPS of $1.28
for the 1st quarter of 2008
• Because the core EPS differed from the EPS calculated under
IFRS, the company provided a reconciliation of the two EPS
figures.
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 PRICE TO EARNINGS (P/E)
TRAILING P/E ISSUES – NON RECURRING ITEMS EXAMPLE
Other data for AZN as of April 2008 are given. The trailing twelve month
(TTM) EPS includes one quarter in 2008 and 3 quarters in 2007.

(1)Use AZN’s reported EPS, determine the trailing P/E of AZN as of 24 April 2008
(2) Use AZN’s reported core earnings, determine the trailing P/E of AZN as of 24
April 2008
(3) Suppose you expect the amortization charges to continue for some years and
note that, although AZN excluded restructuring charges from its core earnings,
AZN reported restructuring charges in previous years. Determine trailing P/E
based on your adjustment

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PRICE TO EARNINGS (P/E)

THE TRAILING P/E ISSUES

CYCLICALITY OF P/E
Because of cyclic effects, the most recent 4 quarters of
earnings may not accurately reflect the average or long-term
earnings power of the business, particularly for cyclical
businesses .

P/Es are very volatile: High P/Es on depressed EPS at the

bottom of the cycle and low P/Es on unusually high EPS at
the top of the cycle ( Molodovsky effect)
Is there a
way to fix this
cyclicality?

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 PRICE TO EARNINGS (P/E)
THE TRAILING P/E ISSUES

CYCLICALITY OF P/E
 Solution would be to normalize EPS: estimating the level of
EPS that the business could be expected to achieve under
mid-cyclical conditions

Historical average EPS method:

Normalized EPS = average EPS over the most recent full cycle
Average return on Equity method:
Normalized EPS = average ROE from the most recent full
cycle x current book value per share

The historical average EPS method does not account for changes
in the business’s size while the Average ROE method does 17

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PRICE TO EARNINGS (P/E)

TRAILING P/E ISSUES – CYCLICALITY EXAMPLE
On 28 Feb 2008, the closing price of ADR – a semiconductor
manufacturing company, was $10.01
The semiconductor industry is notably cyclical, thus normalized
earnings is needed for analysis purpose.
Given this data, if you believe that data from 2001 reasonably
captures the beginning of the most recent business cycle,

Calculate ADR’s normalized EPS and P/E under both methods of

earnings normalization. Explain the differences of results using 2
methods? 18

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 PRICE TO EARNINGS (P/E)
TRAILING P/E ISSUES – CYCLICALITY EXAMPLE SOLUTION
(1) Using historical average EPS over 7 years:
Normalized EPS = (0.08+0.12+0.28+0.58+0.59+0.74+0.63)/7 =
$0.43  P/E = $10.01/$0.43 = 23.3

(2) Using average ROE over 7 years:

Average ROE =(5.2%+7.3+14.4+23.1+21+24.7+19)/7 =16.39%
Normalized EPS = average ROE x current book value per share
= 16.39% * $3.34 = $0.55  P/E = $10.01/0.55 = 18.2

From 2001-2007, BVPS increased from $1.58 to $334, about 111%.

The estimate of normalized EPS of $0.55 from the average ROE
method reflects the use of information on the current size of the
company better than does the $0.43 calculated from the historical
average EPS. 19

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PRICE TO EARNINGS (P/E)

LEADING P/E (FORWARD P/E)

Leading P/E (forward P/E or prospective P/E) = the current

price divided by next year’s expected earnings.

“Next year expected earnings” can be:

Next four quarters, or
Next 12 months (NTM): typically combines the annual EPS
estimates from two fiscal years, weighted to reflect the
relative proximity of the fiscal year

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 PRICE TO EARNINGS (P/E)
LEADING P/E (FORWARD P/E) EXAMPLE
On Nov 30, 2007, Alcatel-Lucent (ALU) – a French/US merger in
telecom equipment manufacturing industry ‘s stock closed at
$7.37 and have the following EPS data:

As of 30 Nov 2007, calculate the following:

• ALU’s forward P/E based on next four quarters EPS
• ALU’s forward P/E based on next twelve month (NTM) 21

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PRICE TO EARNINGS (P/E)

LEADING P/E (FORWARD P/E) EXAMPLE SOLUTION
P/E based on next four quarter EPS:
Q4 2007 EPS (estimate) ($0.03)
Q1 2008 EPS(estimate) ($0.02)
Q2 2008 EPS (estimate) $0.02
Q3 2008 EPS (estimate) $0.10
EPS for next 4 quarters $0.07
 P/E = $7.37/$0.07 = 105.3

Next twelve month (NTM) P/E:

As of 30 Nov 2007,one month remained in fiscal year 2007
Next 12 month EPS = 1/12 * FY07E EPS + 11/12 * FY08E EPS
= 1/12 * (-0.56) + 11/12 * 0.3 = $0.228
 P/E = $7.37/$0.228 = 32.3
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 PRICE TO EARNINGS (P/E)
FORWARD P/E BASED ON FUNDAMENTAL FORECASTS
Justified (fundamental) P/E – a P/E that is fair, warranted,
or justified based on fundamentals
Leading P/E ratio
Div 1 Div 1
P0 (r  g ) EPS 1 (1  retention _ ratio )
  
EPS 1 EPS 1 (r  g ) (r  g )
What is the
assumption if
Trailing (current) we calculate
P/E ratio justified P/E
this way?
The picture can't be display ed.

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PRICE TO EARNINGS (P/E)

FORWARD P/E BASED ON FUNDAMENTAL FORECASTS

When using a complex DCF model to value the stock

(i.e. a model with varying growth rates and varying
assumptions about dividends), you cannot express the
P/E as a function of fundamental, constant variables. In such
cases, you can still calculate a justified P/E by dividing the
value per share (that results from a DCF model) by estimated
EPS.

Ex: If you use a three-stage FCFE model to come up with the

intrinsic equity value per share of $325 (as of May 2008); and in
your model the forecasted EPS over next 4 quarters is $21.66
 your justified (forward) P/E ratio = $325/$21.66 = 15
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 BENCHMARK P/E

The subject stock’s P/E is compared with the P/E of the

benchmark to arrive at relative valuation. Benchmarks can be:
The P/E of the most closely matched individual stock.
The average or median value of the P/E for the company’s
peer group companies within an industry.
The average or median value of the P/E for the company’s
industry or sector.
The P/E for a representative equity index
An average past value of the P/E for the stock.
Valuation errors are less likely when we use an equity index or
a group of stocks than when we use a single stock, because
the former choices involve an averaging.
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BENCHMARK P/E
GENERAL RULE OF THUMB

All else being equal:

If the subject stock has higher-than-average (or

higher-than-median) expected earnings growth,
a higher P/E than the benchmark P/E is justified

If the subject stock has higher-than-average (or

higher-than-median) risk (operating or financial), a
lower P/E than the benchmark P/E is justified

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 BENCHMARK P/E
PEER GROUP COMPANIES – EXAMPLE 1
You are valuing Verizon Communication (VZ) using trailing P/E.
The following data is available for you:

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BENCHMARK P/E
PEER GROUP COMPANIES – EXAMPLE 1 (CONT.)

Given the above information, address the following:

(1) Should you use Mean or Median P/E as the benchmark
P/E for analyzing Verizon stock?
(2) Is Verizon relatively fairly valued, relatively overvalued, or
relatively undervalue? Assuming no differences in
fundamentals among the peer group companies
(3) Identify stocks in the list that appears to be relatively
undervalued when the median trailing P/E is used as a
benchmark

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 USING P/E TO OBTAIN TERMINAL VALUE IN
MULTI-STAGE DIVIDEND DISCOUNT MODELS
Terminal value: value projected at end of estimation
horizon
Can use price multiples (P/E or P/B – explained later) to
estimate terminal value – we call such multiples “terminal
price multiples”

Terminal value (Vn) = P/E x Earnings forecast

Terminal
price multiple

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USING P/E TO OBTAIN TERMINAL VALUE IN

MULTI-STAGE DIVIDEND DISCOUNT MODELS
You are valuing the stock of an oil exploration company. You
have projected earnings and dividends 3 years out (to t=3)
Given the following data and estimates:
• Required rate of return = 0.1
• Average dividend payout rate for mature companies in the
market = 0.45
• Industry average ROE = 0.13
• EPS3 = $3
• Industry average P/E = 14.3

- Calculate terminal value using your estimated industry

average P/E as the benchmark
- Estimate the terminal value using the Gordon Growth model
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 USING P/E TO OBTAIN TERMINAL VALUE IN
MULTI-STAGE DIVIDEND DISCOUNT MODELS
Terminal value using comparables:
Vn = Benchmark value of P/E x EPS3 = 14.3 x $3 = $42.9

Terminal value using Gordon Growth Model:

The picture can't be display ed.

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PRICE TO BOOK VALUE (P/B)

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 PRICE TO BOOK VALUE (P/B)

The price to Book value (P/B)

= Market price per share/ Equity Book value per share
in which:

Common shareholders’ equity

= book value per share
# common shares outstanding

(Shareholders’ equity) minus (the total value of equity

claims that are senior to common stock) = Common
shareholders’ equity
Possible senior claims to common stock include the value
of preferred stock and dividends in arrears on preferred
stock
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RATIONALES AND DRAWBACKS FOR THE

USE OF P/B
THE PROS:
Book value is generally positive even when EPS = 0 or
negative
More stable than EPS
THE CONS:
Book value, like earnings, are affected by accounting
decisions on depreciation and other variables
Inflation and technology change drives a big gap b/w book
value and market value of assets
Book value may not carry much meaning for service and
technology firms that do not have significant tangible assets
Intangible assets generated internally (as opposed to being
acquired) are not shown as assets on a company’s balance
sheet 34

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 PRICE TO BOOK VALUE (P/B) EXAMPLE

Based only on this information, discuss the valuation of MER relative

to the industry and peer companies 35

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PRICE TO BOOK VALUE (P/B) EXAMPLE

SOLUTION

• MER was selling at a P/B that was 75% of the industry mean
P/B. At the same time, its ROE was roughly equivalent to the
industry’s. Solely on the basis of the data given, MER
appears to be slightly undervalued relative to the industry
benchmark.

• MER however appears to be overvalued with respect to MS

and GS
• Compared with MS, MER has the same P/B but a lower
expected ROE and higher risk, as judged by Beta
• Compared with GS, MER has a higher P/B but lower
expected ROE and higher risk, as judged by Beta

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