ACVALCO Q3

Certainty Equivalent Approach

- is based on the assumption that individuals have different
levels of risk aversion.
- the concept of equivalence is commonly used in various
areas, including investment analysis, insurance, and
decision theory, to assess and compare options with varying
levels of risk and uncertainty
Risky = P120,000
Guaranteed = P111,110
Accounting For Risk
- higher risk = higher return
- increase the required rate of return (discount rate), add risk
premium to the risk-free rate
- alternatively, you can trim cash flows instead

Value of the project = P281,438

Firm Value
Enterprise Value Four Keys to Using Multiples
- we rely on multiples to scale stock prices to a common
denominator
1. Definitional Tests

Kinds of P/E ratio

Relative Valuation
- also called valuation using multiples is the notion of
comparing the price of an asset to the market value of
similar assets
- uses the market value as the basis for the valuation (must
be similar in industry)
- can be used if you don’t want to undergo discounted cash
flow techniques
1. Look for comparables (same size, same industry)
2. Scale the prices to a common variable (through the use of
multiples)
● Price to Earnings ratio (Stock Price / EPS), if EPS is
not given then you can calculate EPS (Net Income -
Preferred Dividends / Average Number of Common
Shares Outstanding)
● Price to Book ratio (Stock Price / BVPS), if BVPS is
not given then you can calculate BVPS Common
Equity / Average Number of Common Shares
Outstanding)
a. Trailing P/E ratio - EPS of last 12 months
b. Forward P/E ratio - EPS of 12 months into the future
note: ratios should be consistent
Consistency
P/E = Stock Price / EPS = Equity Value / Earnings
EV/EBIT = Enterprise Value / EBIT
Uniformity
- what accounting policy is being used? (example:
depreciation method and useful life)
2. Descriptive Tests
- multiples can as low as 0 and can be as high as who
knows high (no definite amount)
- not a normal distribution but a skilled to the right
distribution (central tendency)
- using median is more reliable
3. Analytical Tests
- analyze why P/E ratios are high or low
- high P/E ratios = may be overvalued (can use the dividend
growth model as basis)

On average, the market is correct in pricing the stocks

3. Differences of a company to other similar companies
should be taken into consideration if it's significant. 4. Application Tests
- how are we going to use the P/E ratio as a multiple?
 ● compare with comparables - selection of comparable companies, most young
● control for differences companies are not publicly listed yet (use forward earnings
as an alternate)
How to control for differences?
1. Subjective Adjustments
- may lack objectivity
2. Modified Multiples
- using another multiple method
3. Statistical Techniques

Valuation Across The Life Cycle (Aswath Damodoran)

I. Young Companies
- refers to a company in the early stages of operations
● Idea companies
● Start-up companies
● Second-stage companies
Characteristics:
- absence of history
- little or zero revenues, operating losses
PV on year 5 @ 10% to reach the future value
- dependence on private equity (might not yet be publicly
listed)
II. Growth Companies
- high mortality rate (not expected to survive; will not become
- a company whose value that comes from assets that are
mature)
yet to be acquired rather than existing investments
- shares of stock lacks liquidity (founders may find it hard to
- any company whose business generates significant
sell stocks of the company due to lack of marketability)
positive cash flows or earnings, which increase at
significantly faster rates than the overall economy
Notable concerns in discounted cash flow techniques:
- organic growth rates
- we can’t predict cash flows due to absence of history
- company made effiecient decisions to grow their earnings
- we can not, most likely, calculate the beta (since young
- market measures (like P/E ratios but its not conclusive)
companies don’t have returns as it lacks history)
- most company’s value would come from the terminal value
Characteristics:
- dynamic financials (unstable, unpredictable growth)
Survivability’s two scenarios:
- high multiples
1. Probability of survival
- less debt (cash inflows are used for reinvestment)
2. Probability of bankruptcy
- short and shifting history
note: get the weighted average of the 2 probabilities to get a
rough estimate of a young company’s survivability
Notable concerns in discounted cash flow techniques:
- revenue grows initially at a faster pace before it converges
Notable concerns in relative valuation:
with the typical growth rate of mature companies
- the variable that will be scaled to (P/E ratio, P/B ratio)
- operating margin ratios need to be adjusted as the
company matures (to arrive in the free cash flows, operating
profits may not be sustainable)
- changing risk across time (discount rates are expected to
be different as required return also changes)
note: growth companies are riskier than matured companies
so discount rates in growth companies are higher

Notable concerns in relative valuation:

- should not use revenues multiples (as growth companies
may be incurring losses instead of profit or revenues don’t
translate to profit)
- forward earnings
- adjusting for growth

The First Chicago Method

- a valuation approach that uses both discounted cash flow
and relative valuation methods
- is generally used for start-up (young) or growth companies
- involves the development of three different scenarios, with
cash flows and an exit price (using a multiple)
- other inputs include required rate of returns and
probability of each scenario to happen
- expected value approach is used in arriving at the
business’ value