Chapter 3 Valuation

Learning Objectives
1. Explain why some financial executives and analysts rely on valuation heuristics
instead of textbook techniques that emphasize intrinsic value.
2. Describe the main heuristics that financial executives and analysts use to compute
value.
3. Identify the biases that arise in connection with the use of valuation heuristics.
4. Identify the biases that arise in connection with the use of traditional textbook
techniques that emphasize intrinsic value.
Traditional Treatment
• The two most prominent approaches to valuation are DCF-based intrinsic valuation
and valuation by comparables.
• The most general DCF approach to the intrinsic valuation of a firm involves its future
free cash flows.
• Valuation by comparables focuses on ratios that describe the relationship between
the market value of a firm’s equity and the characteristics of that firm relative to
similar firms, to see if the relationships are comparable.
Valuation Heuristics
• P/E heuristic
– P0 = P0/E1 x E1
– Target price P1 = P1/E2 x E2
• PEG Heuristic
– P0 = PEG x E1 x G,
– where G is 100 x growth rate
• Price-to-sales Heuristic
– P0 = P0/S1 x S1, where S stands for sales
Behavioral Pitfalls Box
• What behavioral phenomena come to mind as you read its contents?
eBay’s CFO Judging eBay’s Relative Value
• On May 20, 2003 eBay’s P/E ratio was 66.2, while Wal-Mart’s P/E was 22.7.
– eBay appeared to be over twice as expensive as War-Mart.
• Analysts were expecting eBay to grow by 42.5%, while they were only expecting
Wal-Mart to grow by 14%.
– eBay’s PEG was 1.56, which was actually lower than Wal-Mart’s PEG of 1.62.
Behavioral Pitfalls Box
• What behavioral phenomena come to mind as you read its contents?

Wal-Marting of the Web

• Mary Meeker, “Queen of the Internet.”
• Just as the traditional retailer Wal-Mart came to dominate the retail sector, web-based
counterparts would emerge and dominate Internet commerce.
– Mary Meeker described the phenomenon as the “Wal-Marting of the Web.”
Morgan Stanley Team’s Target Prices for eBay
Free Cash Flow Computation

The Morgan Stanley team forecasted that free cash flows in 2011 will be $3,266,096
= 1.07 x $3,052,426.
They then applied the present value constant growth perpetuity formula PV = C/k-g to
obtain TV as
TV = $3,266,096 / (0.12-0.07)
= $65,321,907
Critical Input Growth Rates
• Exhibit 3-4 illustrates the growth rates of three critical inputs, namely revenues,
EBITDA, and free cash flows.
 • Over the forecast period from year-end 2003 through 2010,
– Revenue growth declines from 38% to 19%;
– EBITDA growth declines from 39% to 25%; and
– Free cash flow growth declines from 62% to 30%.
Biases in Foresight
• Wall Street Journal article suggested that analysts following eBay were excessively
optimistic about its future revenue stream.
– Morgan Stanley team’s forecast for the period ending in 2010 was the most
optimistic.
• Short-term growth rates are much less important than the growth rate associated with
terminal value.
– The free cash flows from 2004 through 2010 only comprise 19% of the $36.5
billion value that Morgan Stanley analysts assigned to all of eBay’s future free
cash flows.
– Terminal value comprised the lion’s share, namely 81%.
– If eBay were to grow 1% faster than the U.S. economy, it would eventually
become the U.S. economy.
Zero PVGO in Terminal Horizon Growth Opportunities Bias
• eBay not going to have field to itself  zero competitive advantage/zero PVGO.
• After-tax EBIT is after-tax EBITDA minus maintenance investment.
• After-tax EBIT can be split into two portions, one earmarked as investment for
growth and the other as cash available to be paid to the fims’ investors (FCF).
• Reinvestment for growth is the sum of net CapEx (= CapEx net of replacing
depreciated assets) and change in operating NWC.
Growth Opportunities Bias
• The reinvestment rate is the ratio reinvestment for growth / after-tax EBIT
• Terminal horizon zero-PVGO requires that the reinvestment rate must equal g∕k,
where g is the growth rate and k is the discount rate.
• Morgan Stanley assumed that g/k would be 7/12 = 58.3%.
• Is there any hint that eBay was planning to invest 58.3% of its after-tax EBIT on net
CapEx and working capital during the terminal horizon?
P/E and PEG Representativeness Bias?
• Are analysts and CFOs, inclined to form judgments of P∕E in which they implicitly
view high earnings growth as representative of high PVGO?
 • If P is stock price and V is intrinsic value per share, then a firm’s intrinsic forward P∕E
ratio is
VE/E = [kE × (1 − PVGO∕VE)]−1
• What’s the connection to PEG?
Mistaking Growth for Growth Opportunities
• The Morgan Stanley team titled its April 2003 report on eBay “Tales of a Growth
Machine.”
• Analysts are inclined to mistake growth in EPS for growth opportunities
– Positive growth opportunity requires ROE > kE.
• From the time that eBay went public, through June 2004, eBay's ROE < its kE of 12%.
1/n Heuristic
• The 1/n heuristic is a rule of thumb that assigns the same weight to each technique, as
if they are all equally valid.
• Very wide dispersion in values associated with P/E, PEG, price-to-sales, and DCF.
• Meeker averaged the numbers, which in her words, “combine to an average fair value
of about $106.”
Biases Using CAPM Check the Fine Print
• In practice, the estimates for the risk premium are wide and varied.
• Estimates for beta are wide and varied.
• Morgan Stanley team’s 12% rate obtained by using a CAPM expected return of 9.5%,
and adding 2.5% to reflect “company-specific risks.” (which is not taught in finance
textbook!!)

Biases in Hindsight
• At the end of June 2004, eBay’s stock price reached $180 (on a presplit basis).
• Annualized geometric return of 7.9% for eBay and 7.2% for the S&P 500, April 2003
– December 2014.
• Excessive optimism?
Overconfidence?
 • Does the downside-upside range provide the basis for making an assessment of
overconfidence on the part of the Morgan Stanley team’s April 2003 price target?
Forecast vs. Actual During Intermediate Horizon
• What does the comparison tell us?

Accuracy?
• Morgan Stanley team was reasonably accurate in their forecasts for revenue and
EBITDA up through the end of 2008 when the global financial crisis occurred.
• They were less accurate in their forecasts of taxes, working capital, and capital
expenditures.
• Their forecasts of eBay’s free cash flows were, if anything, too low through the end of
2009.
– Only in 2010 did eBay’s actual free cash flow fall short of the Morgan Stanley
team’s forecast.
After 2010
• Actual FCF below forecasted FCF.
• Growth rate of FCF after 2010 is highly variable, but appears consistent with the
forecasted growth rate after 2011.
• It just began at a lower level.
Morgan Stanley Report in 2010
• By 2010 the Morgan Stanley team, with some but not all of the original members, had
changed parts of its approach.
– By 2008, it had dropped the use of the PEG heuristic.
– By 2010, it was only using free cash flow-based DCF.
– It modified its views on the long-term growth rate of free cash flows, and
lowering its forecast from 7% to 4.5%, with the terminal horizon beginning in
2020.
The FCF-Heuristic
• Cash flow available to be paid to investors sums cash flow from operations and
interest paid, and then subtracts cash flow from investment.
• The textbook formula for the free cash flow FCF of a firm, used by analysts sums:
EBIT(1 − tax rate)
Depreciation
− CapEx
− Change in Working Capital
Formulas Not the Same
• In retrospect, investors who relied on the textbook formula for free cash flow to
estimate the amount of cash eBay generated that was available to be paid to them
would have felt duped or deceived.
• Which one is correct?
• Only the second one captures cash flow generated during a year that is available to be
paid to the firm’s investors.
Agency Conflicts
• Managers of firms prefer favorable coverage from analysts to unfavorable coverage.
• Analysts whose firms seek to do business with companies have an incentive to
generate favorable (optimistic) reports.
• Agency conflict might induce analysts to view valuation heuristics as instruments to
provide numbers they want to deliver.
Corporate Nudges
• Apply a variety of valuation techniques that are firmly grounded in textbook theory, in
addition to crude ratio-based heuristics, and weight them sensibly.
• Ensure that terminal value based on free cash flow features zero PVGO, and if not,
have a reasonable explanation for why not.
• Develop confidence intervals for valuation judgments that can be calibrated over time.
• Avoid the dogmatic use of heuristics that tie P/E to earnings growth.
• Prepare free cash flow forecasts based on cash flow from operations, cash flow from
investment, and interest paid.
Summary
• Heuristics and biases play a major role in judgments of valuation, both by financial
executives and by analysts.
 – The most salient heuristics and biases pertain to excessive optimism,
overconfidence, representativeness, and anchoring.
• Important questions for identifying pitfalls associated with valuation are the
following:
– Do CFOs rely on a PEG heuristic because they regard earnings growth as the
basis for P∕E?
– Does the assumed growth rate for terminal value reflect excessive optimism?
– Do analysts generally view earnings growth as representative of growth
opportunities in the sense of PVGO?
– Do analysts’ free cash flow forecasts for the terminal period implicitly assume
positive growth opportunities?
– Does the actual stock price lying outside of a forecast range imply the
presence of overconfidence?
– In arriving at a discount rate, do analysts anchor on estimates based on the
CAPM?
– Do analysts, financial executives, and investors misframe free cash flows
because they employ the textbook definition of free cash flow?