MONASH

BUSINESS
SCHOOL

Week 06
BFF5220 Advanced Investments

Fundamental Analysis III

 How Weekly Topics Are Related
W1 - Trading Techniques,
Return and Risk Measures
W2 - Portfolio tools W3&4 – Asset ke Relevant to
Theory Pricing Models W4, 5 & 6 - Valuation Fundamental
Analysts
Individual MST
What if asset pricing
models fail to explain
Group Relevant to
stock returns? Quant Analysts
Assignment
W7&8 - Market (incl. trading
Should we bother Efficiency and simulation)
with equity valuation? Behavioural Finance

W9&10 – Options Trading Weekly tutorial submission

Strategies and Valuation

W11 – Futures, Forwards, and Swap W12 – Fixed Income Market

MONASH
BUSINESS 2
SCHOOL
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

2
 Relative Valuation
• Underlying principle: Similar assets should sell
at similar prices
• A current measure of performance (or a single
forecast of performance) is converted into a
value through application of a multiple for
comparable firms.
• Choosing benchmark investments:
• Most similar to the firm in need of valuation
• Often the average or median value of the multiple
for the stock’s peer group of companies or industry
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BUSINESS
4 SCHOOL
 Relative Valuation
• Steps in Relative Valuation:
• Identify similar or comparable (benchmark)
investments and recent market prices for each
• Calculate a “valuation metric” for use in valuing the
asset (for stock, often = Price / Fundamental)
• Valuation = Valuation metric x Firm’s Fundamental
• Refine the initial valuation estimate to the specific
characteristics of the investment
• If the benchmark assets themselves are not efficiently
priced, relative valuation may differ from valuation on
an absolute basis!
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BUSINESS
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 Relative valuation example: Property

• A property owner wants to estimate the price

she can attain for selling her 3 bedroom house in Caulfield.
• The house is on a 290m2 block.
• Below is a summary of the prices of other similar quality 3br
houses in Caulfield:
House Price m2 Price per m2
A $1,830,000 283 $6,466.43
B $2,005,000 320 $6,265.63 Estimated price is:
C $1,600,000 250 $6,400.00 290 x $6,411.36
D $1,647,000 258 $6,383.72 = $1,859,296
E $1,753,000 268 $6,541.04
Ave $6,411.36

6
 Relative Valuation

• Relative valuations are widely used:

• Almost 85% of equity research reports are based upon a
multiple and comparables.
• More than 50% of all acquisition valuations are based upon
multiples

• Is it important to note what they can and can not be used for:
• Can answer the question, “Which of the four big banks should I buy?”
• Can answer the question, “Which one of these overpriced IPO’s is best?”
• Can not compare value across different asset classes.
• Can not answer the question is the “stock market over valued?”
 Relative vs Fundamental Valuation (i)

• Relative valuation is much more likely to reflect market

perceptions and moods than discounted cash flow
valuation.

• This can be an advantage when it is important that the

price reflect these perceptions

Example:
• the objective is to sell a security at that price today (e.g. an IPO)

8
 Relative vs Fundamental Valuation (ii)

• Relative valuation generally requires less information than

discounted cash flow valuation (especially when multiples
are used as screens)

• Can be used when CF or dividend data is not available or

when terminal value is hard to estimate.

• Preferred when firms have negative CFs for many years but
expect positive CFs at some point in the future.

9
 Relative valuation: Multiples are just…
…standardised estimates of price!!!

Excess cash

Excess cash

Valuation =
Price multiple from peer(s) x Target firm’s Fundamental

10
 The Four Steps to Deconstructing Multiples

• Define the multiple

• In use, the same multiple can be defined in different ways by different users.
• The numerator and denominator must be consistently defined (ie both relate to
claims to the firm or equity holders).

• Describe the multiple

• If you do not know what the cross sectional distribution of a multiple is, it is difficult
to look at a number and pass judgment on whether it is too high or low.

• Analyze the multiple

• It is critical that we understand the fundamentals that drive each multiple, and the
nature of the relationship between the multiple and each variable.

• Apply the multiple

• Defining the comparable universe and controlling for differences is far more difficult
in practice than it is in theory.

11
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

4
 Relative Valuation
• Relative valuation using P/E:
• The most widely used valuation multiple

Example: Applying a P/E for relative valuation

You are analyzing an Example company with $10 million in net income.
Comparable firms are currently trading in the market at 20 times earnings.
This price multiple is calculated by dividing the price per share by comparable firm’s EPS

Net Income for Example firm $ 10 (Millions)

Comparable Firm P/E Ratio 20.0x
Relative Valuation of Example firm based on P/E $ 200.0 (Millions)

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BUSINESS
13 SCHOOL
 Relative Valuation
• Relative valuation using P/E: (cont.)

• Suppose that Exxon-Mobil (XOM) was considering the sale

of its chemical division via an initial public offering. How
much can Exxon expect to receive?
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BUSINESS
14 SCHOOL
 Relative Valuation
• Relative valuation using P/E: (cont.)
Valuation of Exxon’s chemical division:
• Applying an average P/E ratio of 14.28x from similar
firms
• The earnings of Exxon’s chemical division is $3.428B
Valuation ≈ $48.94B

• Are the comparable firms of the same size as

Exxon’s chemical division (3rd in the world!)?
• The comparable firms should be very large ones!
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BUSINESS
15 SCHOOL
 Relative Valuation
• Relative valuation using P/E: the relation with DDM model
D1 E1(1-b) P0 1-b
O k -g k -g E1 k -g
• Riskier firms  Higher k  Lower P/E
• P0/E1 could be calculated using the firm’s k, b and g
• Then multiplied with EPS1 (forecast EPS) to get intrinsic
value per share  P/E approach ≈ DDM
• Compared with P/E in Relative Valuation: Get the
average P0/E1 of comparable firms, multiply it with
your firm’s EPS1  Target Forward P/E ratio
• Alternatively, use target trailing P/E (i.e. P/E using historical
12-month Earnings) x your firm’s EPS0
MONASH
BUSINESS
50 SCHOOL
 Relative Valuation
• Relative valuation using P/B (Price-to-Book value of
Equity): the relation with RIM model
Recall the RIM:
Equity value
NI1 - k e x BVE O NI2 - k e x BVE1 NI3 - k e x BVE 2
= BVEO + + 2
+ 3
+⋯
1 + ke 1 + ke 1 + ke
Divide both sides by book value of equity BVE0:
PO ROE1 - k e ROE 2 - k e 1 + gbve 1
= 1+ + +⋯
BO 1 + ke 1 + ke 2
 P/B depends on:
• The magnitude of future abnormal ROE
• Growth in book value (gbve)
When growth in book value = constant, P0 = 1 + ROE-ke
B0 ke- g MONASH
BUSINESS
17 SCHOOL
 Relative Valuation

• Relative valuation using P/B (cont.)

• P/B can be calculated using firm’s own ROE, ke, g. Multiply it
with firm’s B0 per share to obtain intrinsic value per share
 P/B approach ≈ RIM with constant growth

• P/B in Relative Valuation: Get the average P0/B0 of comparable

firms  Target P/B. Then multiply it with your firm’s B0

 Very similar to using P/E

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BUSINESS
18 SCHOOL
 Relative Valuation
• Other Relative Valuation Ratios for Equity Valuation
• P/CF (Price-to-Cash Flow)
• Using CF instead of earnings  Less subject to accounting
manipulation
• FCFE (why?)

• P/Sales
• Useful for firms with low or negative earnings in early
growth stage
• Any issue with using Sales? (think equity value vs. firm
value)
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BUSINESS
19 SCHOOL
 Relative Valuation
• Relative Valuation Ratios for Firm Valuation
Enterprise Value (net of Excess Cash) = EV =
= Market value o f equity + Market value o f debt
- E xcess Cash
• EV / EBITDA
• EV / EBIT
• EV / Sales
• Activities multiples:
• Denominator = No of subscribers of a cable firm
• Denominator = Hits on a web page for an internet firm
•…

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BUSINESS
20 SCHOOL
 Which Multiple?
• Picking one key multiple is usually the best approach.
• Managers in every sector tend to focus on specific variables when
analyzing strategy and performance. The multiple used will generally
reflect this focus:
• In retailing: The focus is usually on same store sales (turnover) and
profit margins. Not surprisingly, the revenue multiple is most common
in this sector.
• In financial services: The emphasis is usually on return on equity. Book
Equity is often viewed as a scarce resource, since capital ratios are
based upon it. Price to book ratios dominate.
• In technology: Growth is usually the dominant theme. PEG ratios were
invented in this sector.
 Which Multiple?
The KPMG Valuation Practices Survey asks Australian valuation practitioners which
valuation approach they use. The following results were reported in 2017:
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

44
 Process of Valuing Private Companies
• Not different from the process of valuing public companies.
• Forecast cash flows,
• Estimate a discount rate based upon the riskiness of the cash flows,
• compute a present value.

• As with public companies, you can either value

• The entire business (How?)
• The equity in the business (How?)

• When valuing private companies, you face additional problems:

• No market value for either debt or equity
• The financial statements:
• are likely to go back fewer years,
• have less detail, and
• have more holes in them.

24
 Problem 1. No Market Value?

• Market values as inputs:

Any inputs that require MV cannot be estimated.

• Debt ratios for going from unlevered to levered betas

• Debt ratios for computing cost of capital (WACC)
• Market prices to compute the value of options granted to employees.

• Market value as output:

• Valuing publicly traded firms: the market value operates as a measure of
reasonableness.
• Valuing private firms: the value stands alone.

• Market price based risk measures, such as beta and bond ratings,
will not be available for private businesses.

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 Problem 2. Cash Flow Estimation
• Shorter history:
• Private firms often have been around for much shorter time periods
 less historical information available on them.
• Different Accounting Standards:
• The accounting statements for private firms are often based upon different
accounting standards than public firms.
• Public firms operate under much tighter constraints on what to report and
when to report.
• Intermingling of personal and business expenses:
• In the case of private firms, some personal expenses may be reported as
business expenses.
• Separating “Salaries” from “Dividends”:
• It is difficult to tell where salaries end and dividends begin in a private firm,
• They both end up with the owner!

26
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

44
 Private to Private transaction
In private to private transactions, a private business is sold by one
individual to another.
There are three key issues that we need to confront in such
transactions:
• Neither the buyer nor the seller is diversified.
• Consequently, risk and return models that focus on just the systematic risk (i.e.,
risk that cannot be diversified away) will seriously under-estimate the discount
rates.
• The investment is illiquid.
• The buyer of the business will have to factor in an “illiquidity discount” to
estimate the value of the business (recall Pastor and Stambaugh liquidity risk
premium in estimating expected returns to publicly traded stocks)
• Key person value:
• There may be a significant personal component to the value.
• In other words, the revenues and operating profit of the business reflect
• not just the potential of the business
• but also the presence of the current owner.

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 An example: Valuing a restaurant
• You have been asked to value an upscale French restaurant
for sale by the owner (who also happens to be the chef).
• Both the restaurant and the chef are well regarded

• Business has been good for the last 3 years.

• The potential buyer is a former investment banker

• who tired of the rat race,

• has decide to cash out all of his savings and

• use the entire amount to invest in the restaurant.

29
 An example: Valuing a restaurant (cont.)

• You have access to the financial statements for the last 3

years for the restaurant.
• In the most recent year, the restaurant reported $ 1.2 million in revenues,

• and $ 400,000 in pre-tax operating profit .

• The firm has no conventional debt outstanding.

• It has a lease commitment of $120,000 each year for the next 12 years.

• The owner has historically claimed $20,000 of personal expenses through the
business accounts.

30
 Past income statements…

3 years ago 2 years ago Last year

Revenues $800 $1,100 $1,200 Operating at full capacity
- Operating lease
expense $120 $120 $120 (12 years left on the lease)
(Owner/chef does not draw
- Wages $180 $200 $200 salary)
- Material $200 $275 $300 (25% of revenues)
- Other operating
expenses $140 $185 $200 (Includes personal expenses)
Operating income $180 $340 $400
- Taxes $72 $136 $160 (40% tax rate)
Net Income $108 $204 $240

All numbers are in thousands

31
 Step 1: Estimating discount rates

• The risk and return models that we draw on so widely with public
companies may not easily transfer to private to private transactions.
 Intuitively, the buyer of this restaurant will care about all risk, not just market risk.

• When valuing private-to-private transactions, two assumptions are

likely to be violated:
• No market prices or returns to use in estimation.
• The buyer is not diversified.
 In the example, the buyer will have his entire wealth tied up in the restaurant
after the purchase.

• Need to estimate a total beta that incorporates both market and

firm-specific risk.
 1.1. Estimating a total unlevered beta

• The CAPM (market) beta for 45 high-end restaurants is 1.18.

• From the market beta to the total beta:
• we need a measure of how much of the risk in the firm comes from the market
• and how much is firm-specific.

, , ,

⟺ ,

• Total Unlevered Beta

= Market Beta/ Correlation with the market
= 1.18 / 0.5 = 2.36
 1.2. Estimate a debt to equity ratio and cost of equity
• No market equity (or debt!) for a private business
 Estimate market values.

• You should not use book debt to equity ratios!

• Assuming that the industry average of publicly traded firms
applies to the private firm is not a bad assumption…

• Assuming that our restaurant will have a D/E ratio (14.33%)

average publicly traded restaurant:
Levered beta = Unlevered beta * (1+(1-tax rate)*D/E)
=2.36 (1 + (1-.4) (.1433)) = 2.56

Cost of equity = rf + levered beta * (rm – rf)

=4.25% + 2.56 (4%) = 14.50%
(Assuming T Bond rate of 4.25%; 4% is the equity risk premium)
34
 1.3. Estimating a cost of debt and capital

• No credit rating or any recent bank loans to use as reference.

• Firm reported operating income and lease expenses (treated as
interest expenses)
Coverage Ratio = Operating Income / Interest (Lease) Expense
= 400,000 / 120,000 = 3.33
Rating based on coverage ratio = BB + , Default spread for BB+ = 3.25%*
After-tax Cost of debt = (Risk free rate + Default spread) (1 – tax rate)
= (4.25% + 3.25%) (1 - .40) = 4.50%
• To compute the cost of capital, use the same industry average
debt ratio that we previously used to lever the betas.
Cost of capital = 14.50% (100/114.33) + 4.50% (14.33/114.33) = 13.25%
(Using debt-to-equity ratio of 14.33% from previous slide)

35
 1.3. Estimating a cost of debt and capital (cont.)

* The default spread for a given (synthetic) rating may change over
time (Why?)
 Use the updated default spread for the synthetic rating!

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

36
 Step 2: Clean up the financial statements

Stated Adjusted
Revenues $1,200 $1,200
- Operating lease expenses $120 Leases are financial expenses
- Wages $200 $350 ! Hire a chef for $150,000/year
- Material $300 $300
$20,000/year were actually personal
- Other operating expenses $200 $180 expenses
Operating income $400 $370
- Interest expnses $0 $69.62 7.5% of $928.23 (see below)
Taxable income $400 $300.38
- Taxes $160 $120.15
Net Income $240 $180.23

Debt 0 $120,000
$928.23 ! PV of $120 pa for 12 years @7.5%
million

7.5% p.a = pre-tax cost of debt from slide 35.

37
 Step 3: Assess the impact of the “key” person
• Part of the draw of the restaurant comes from the current chef.
When Steve Jobs announced he was leaving Apple in 2011, the stock lost $30 billion!

• If you are buying the restaurant, you should consider this drop off
when valuing the restaurant.
 If 20% of the patrons are drawn to the restaurant because of the
chef’s reputation, the expected operating income will be lower if
the chef leaves.
• Adjusted operating income (existing chef) = $ 370,000
• Operating income (adjusted for chef departure) = $296,000

• The owner/chef of the restaurant loss can be mitigated through:

• non-compete agreement, and/or
• contract to stay on for a period of time.

38
 Step 4: Don’t forget valuation fundamentals
Growth rate and CAPEX assumptions:
• Assumptions about growth have to be consistent with
reinvestment assumptions.
• In the long term,
Reinvestment rate = Expected growth rate/Return on capital
• In this case, we will assume a 2% growth rate in perpetuity and
a 20% return on capital.
Reinvestment rate = g/ ROC = 2%/ 20% = 10%

• Note: Even if the restaurant does not grow in size, this

reinvestment is what you need to make to keep the restaurant
both looking good (remodeling) and working well (new ovens
and appliances)!

39
 Step 5: Complete the valuation

Inputs to valuation:
Adjusted EBIT = $ 296,000
Tax rate = 40%
Cost of capital = 13.25%
Expected growth rate = 2%
Reinvestment rate (RIR) = 10%

Valuation
Value of the restaurant = Expected FCFF next year / (Cost of capital –g)
= Expected EBIT next year (1- tax rate) (1- RIR)/ (Cost of capital –g)
= 296,000 (1.02) (1-.4) (1-.10)/ (.1325 - .02)
= $1.449 million
Value of equity in restaurant = $1.449 million - $0.928 million
= $ 0.521 million

40
 Step 6: Consider the effect of illiquidity
• In private company valuation, illiquidity is a constant
theme (Why?)
• The illiquidity discount to the value of a private firm
tends to be between 20-30%.
• But illiquidity should vary across:
• Companies: Healthier and larger companies, with more liquid assets, should
have smaller discounts.
• Time: Liquidity is worth more when the economy is doing badly and credit is
tough to come by than when markets are booming.
• Buyers: Liquidity is worth more to buyers who have shorter time horizons and
greater cash needs.

• Assuming a discount of 25%, the valuation would be:

$0.521 (1-0.25) = $0.391 million

41
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

44
 Private company valuations: Alternative scenarios

• Two mechanisms for a private-to-public transaction:

• Private to public transactions: You can value a private firm for sale to a publicly
traded firm.

• Private to IPO: You can value a private firm for an initial public offering.

• There should be no total beta effect, since the equity holders

can diversify.
• Also no illiquidity effect as the share will be traded on an
exchange.
• Tax bracket differences between private owners vs. public
owners  CF implications
Other than the above, the valuation will look very much like the
valuation of a publicly traded company!

43
 MONASH
BUSINESS
SCHOOL

Week 06: Fundamental Analysis III

Overview of Relative Valuation

Application of Relative Valuation
Issues with Valuation of Private Firms
Private-to-private Valuation
Private-to-public Valuation
Final Thoughts on Valuation
(BKM Ch. 18
Damodaran: Valuing Private Firms (available on Moodle)
Fabozzi, Focardi, and Jonas (2015), “Equity Valuation: Science, Art, or Craft?”,
CFA Institute Research Foundation, Ch.1&2 (link available on Moodle))

44
 Final Thoughts on Valuation

• “Intrinsic value always depends upon assumptions, and

unless all investors always agree with these assumptions,
there will never be one true value in practice

• “Intrinsic value does exist, but its estimation requires

research,… a (huge) cost…
• … to turn profitable, market price has to be far from intrinsic value,
• and this is most likely when large information asymmetries exist”

• “Intrinsic values are dynamic and can change with major non-
anticipated shocks in supply and demands”

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 Final Thoughts on Valuation

• “Fundamental (intrinsic) value can still be used… to

outperform the market,
• But only for investors (who) have a sufficiently long time horizon”

• “Intrinsic value can be used in a very narrow sense,…”

• But… (it) can be used… to facilitate analysts / investors obtain a
deep understanding how firms create long term value

• “The most interesting aspect of DCF models is sensitivity

analysis”

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 MONASH
BUSINESS
SCHOOL

Thank you!