Valuation Methods

Methods of Corporate
Valuation
 Asset-Based Methods
 Using Comparables
 Free Cash Flow Methods
 Option-Based Valuation
Asset-Based Methods
 Balance sheet approach:
 Cash and working capital (book value close to its
realizable value)
 Property, Equipment, and Land (appraisal value)
 Intangibles.
 Book value of equity vs market value of
equity
Relative Valuation
 What is relative valuation?
 What is the logic underlying relative
valuation?
 Using comparables
What is relative valuation?
 Relative to revenues or cash flows
 Relative to Earnings
 Relative to the Book Value of Equity
Relative to Revenue
 Price/Sales (PS)
 Value/Sales (VS)
 Usually used in valuing retailing firms
Relative to Earnings
 Price/Earnings Ratio (PE)
 Trailing Price/Earnings Ratio (trailing PE)
 A trailing PE is a price-earnings ratio based on the
most recent 12 months' results. U.S. companies report
quarterly, so a trailing PE is computed based on the
most recent four quarters.
 Forward Price/Earnings Ratio (forward PE)
 Also called estimated PE. Forward PE divides a stock's
current price by its estimated future earnings per share.
Forward PE is often used to compare a company's
current earnings to its estimated future earnings.
Relative to the Book Value of
Equity
 Price/Book Value (PBV)
 Market to book Value (MB)
Advantages to using multiples
in valuation analysis
 Require fewer explicit assumptions than
DCF
 Easy to compute and don’t require
forecasting
 Commonly quoted and used by
management and press
Disadvantages to using
multiples in valuation analysis
 Require more implicit assumptions than
DCF
 Logic behind valuation analysis is often
misunderstood
 Identification of comparable firms is
subjective
What is logic underlying
relative valuation? P/E ratio
 Think about a basic DCF model (Gordon’s
Growth Model)
DPS1
Value of Equity P0 
re  g n
 Divide both sides by earnings per share
P0 DPS1 1
  PE
EPS0 EPS0 re  g n

P0 1
 (Payout Ratio) 1+g n   PE
EPS0 re  g n
Comparing two PE ratios
across firms assumes …
 Identical payout ratio
 Identical cost or equity
 Identical expected stable-growth rate
What is logic underlying relative
valuation? Price to book value
DPS1
Value of Equity P0 
re  g n

 Divide both sides by book value of equity

P0 DPS1 1
  PBV
BV0 BV0 re  g n
P0 EPS1 DPS1 1
  PBV
BV0 BV0 EPS1 re  g n
P0 1
 ROE0 (Payout Ratio) 1+g n   PBV
BV0 re  g n
Comparing two PE ratios
across firms assumes …
 Identical payout ratio
 Identical cost or equity
 Identical expected stable-growth rate
 Identical ROE
What is logic underlying relative
valuation? Price to sales
DPS1
Value of Equity P0 
re  g n
 Divide both sides by sales
P0 DPS1 1
  PS
Sales0 Sales0 re  g n
P0 EPS1 DPS1 1
  PS
Sales0 Sales0 EPS1 re  g n

P0 1
 Gross Profit Margin 0 (Payout Ratio) 1+g n   PS
Sales0 re  g n
Comparing two PE ratios
across firms assumes …
 Identical payout ratio
 Identical cost or equity
 Identical expected stable-growth rate
 Identical Gross profit margin
Using comparables
 Construct the multiple for the set of comparable
firms
 Average the multiple across the set of
comparable firms
 Compare individual firm to this average
 Differences may be attributed to differences in
underlying logic of multiple
 Differences may be attributed to inefficient
markets (price)
Remember to control for
differences between firms
 Growth
 Payout
 Risk
 ROE
 Profit Margin
Ways to control for differences between firms
 Sample firms and sort according to attributes (Growth,
Payout, Risk, ROE, Profit)
 Requires a large number of potential comparables
 Compare your firm to subset of comparables with similar
attributes
 Modify the multiples to make them more comparable
 Divide the PE ratio by the expected growth rate in EPS (PEG
Ratio)
 Divide PBV ratio by the ROE (Value Ratio)
 This assumes firms are comparable on all other attributes
 Run regression of multiples on attributes
PE  0  1 growth  2 payout  3risk  
 Use coefficient values from regression and attributes for the firm
to predict the correct multiple for the firm.
 Regression-based multiple
analysis
 Damodaran ran regressions on 2,475 firms using data from
1998

 PE=291.27*Growth+37.74*Payout+21.62*Beta
 PBV=3.99*Payout-0.79*Beta+60.65*growth+31.56*ROE
 PS=11.56*Growth+1.41*Payout-1.42*Beta+11.93*Margin
Free cash flow method
 Free cash flows to equity
 Free cash flows to firm
 Basic case
 Firms with insufficient valuation data
 Acquisition valuation
Option base valuation
 Real option approach in valuing firm