DIVIDEND DISCOUNT MODELS

Relative Valuation -II

 Agenda
• Perpetual dividends model.
• Two-phase growth model.
• The H model
• Three stage growth model.
• Relative Valuation.
• Asset based model.
Discounted Cash Flow Models
Choice of Discounted Cash Flow
Models
Valuing Common Stock Using
a Multi-period DDM
Example: Valuing Common Stock
Using
a Multperiod DDM
0 1 2 3

D $1.00 $1.05 $1.10

P $20.00
Example: Valuing Common Stock
using
a Multperiod DDM
$1.00 $1.05 $21.10
V0   2
 3
1.10 1.10 1.10
V0  $17.63
Valuing Common Stock Using
the Gordon Growth Model

D0 (1  g ) D1
V0  
rg rg
• Calculate the value of non-callable fixed-rate
perpetual preferred stock given the stock’s
annual dividend ( 2 USD) and the discount
rate. The risk-free rate (3 percent),beta (1.20)
times the equity risk premium (6 percent).
• Find the value of the preferred stock………..
 Calculating the Implied Growth Rate Using
the Gordon Growth model

• Using the previous common stock example

and the current stock price of $24, what is the
implied growth rate?
 $2.00(1  g )
$24 
0.102  g
2.448  24 g  2.00(1  g )
26 g  0.448
g  1.72%
 the value of a common stock using the
Gordon growth model
Risk-free rate 3.0%
Equity risk premium 6.0%
Beta 1.20
Current dividend $2.00
Dividend growth rate 5.0%
Current stock price $24 .00
The resulting valuation of $40.38 is greater than the current market stock price
of $24, which would indicate that the stock is undervalued in the market
 Valuing Common Stock Using
the Gordon Growth Model

CAPM: r = 3% + 1.2(6%) = 10.2%

$2.00(1  0.05) $2.10

V0    $40.38
0.102  0.05 0.102  0.05
 Example: Calculating the Implied Required
Return Using the Gordon Growth Model

• Using the previous common stock example

and the current stock price of $24, what is the
implied required return?
 D1
r g
P0
2.10
r  0.05
24
r  8.75%  5%  13.75%
the market is placing too high a required return on the stock relative to
the CAPM required return, which is why the stock is currently
undervalued in the market.
Present Value of Growth
Opportunities
E1
V0   PVGO
r
E1
PVGO  P0 
r
Present Value of Growth
Opportunities
E1
V0   PVGO
r
P0 1 PVGO
 
E1 r E1
Example: Present Value of Growth
Opportunities
Stock price $80 .00

Expected earnings $5 .00

Required return on stock 10%

Example: Present Value of Growth
Opportunities
E1
PVGO  P0 
r
5
PVGO  $80   $30
0.10
Example: Present Value of Growth
Opportunities
P0 1 PVGO
 
E r E
P0 1 30
 
E 0.10 5
16  10  6
Using the Gordon Growth Model to
Derive a Justified Leading P/E
D1
V0 
rg
P0 D1 E1

E1 rg
P0 1 b

E1 rg
Using the Gordon Growth Model to
Derive a Justified Trailing P/E
D 0 (1  g )
V0 
rg
P0 D 0 (1  g ) E0

E0 rg
P0 (1  b)(1  g )

E0 rg
Issues Using the Gordon Growth Model

Limitation
Strengths
Simple and applicable to
s
Not applicable to non-
stable, mature firms dividend-paying firms

Can be applied to entire

g must be constant
markets

g can be estimated using Stock value is very sensitive to

macro data r–g

Can be applied to firms that Most firms have nonconstant

repurchase stock growth in dividends
Choice of Discounted Cash Flow Models

• Rapidly  earnings
Transition • ROE = r
• Heavy reinvestment • Earnings & dividends
• Earnings growth
• Small or no growth matures
slows • Gordon growth
dividends • Capital reinvestment
model useful
slows
• FCFE & dividends 
Growth Maturity
 General Two-Stage DDM

D0  1  g S  D0   1  g S    1  g L 
n t n
V0   
t 1 1 r  t
 1 r  n
  r  gL 
Example: General Two-Stage DDM
Current dividend = $2.00
Growth Current dividend = $2.00
Growth for next three years = 15 percent
Long-term growth = 4 percent
Required return = 10 percent
for next three years = 15 percent
Long-term growth = 4 percent
Required return = 10 percent
Example: General Two-Stage DDM
Step 1: Calculate the first three dividends:
• D1 = $2.00 x (1.15) = $2.30
• D2 = $2.30 x (1.15) = $2.6450
• D3 = $2.6450 x (1.15) = $3.0418
Step 2: Calculate the year 4 dividend:
• D4 = $3.0418 x (1.04) = $3.1634
Step 3: Calculate the value of the constant growth
dividends:
• V3 = $3.1634 / (0.10 – 0.04) = $52.7237
Example: General Two-Stage DDM

$2.30 $2.6450 $3.0418 $52.7237

V0    
1.10 1.102 1.103 1.103
V0  $46.17
 Example: General Two-Stage DDM
• Using the previous example, now we’ll use the trailing P/E to
determine the terminal value
• The D4 is $3.1634
• Assume also that the projected P/E is 13.0 in year 4 and that
the firm will pay out 60 percent of earnings as dividends
• Year 4 earnings are then $3.1634 / 0.60 = $5.2724
• The stock price in year 4 is then $5.2724 × 13 = $68.54
 Example: General Two-Stage DDM

$2.30 $2.6450 $3.0418 $3.1634  $68.54

V0    
1.10 1.102 1.103 1.103
V0  $55.54
 Two-Stage H-Model

 D0   1  g L     D0  H  g S  g L  
V0 
r  gL
Example: Two-Stage H-Model

Current dividend $3.00

gs 20%
gL 6%
H 5
Required return on stock 10%
Current stock price $120
Example: Two-Stage H-Model
 D0   1  g L     D0  H  g S  g L  
V0 
r  gL

$3   1  0.06    $3  5  0.20  0.06  

V0 
0.10  0.06
V0  $79.50  $52.50  $132.00
 Solving for the Required Return Using
the Two-Stage H-Model

 D0  
r     1  g L   H   g S  g L     g L
 P0  

 3  
r     1  0.06   5   0.20  0.06     0.06  10.40%
 120  
 Example: Three-Stage Model
• Firm pays a current dividend of $1.00
• Growth rate is 20 percent for next two years
• Growth then declines over six years to stable rate of
5 percent
• Required return is 10 percent
• Current stock price is $50
 Three-Stage Model
Assumes three distinct growth stages:
• First stage of growth
• Second stage of growth
• Stable-growth phase

H-model can be used for last two stages if growth

declines linearly
 THREE-STAGE MODEL EXAMPLE

2
$1  1.20  $1  1.20 
V0  1
 2

1.10
 1.10
2 6
$1  1.20      0.20  0.05 2
$1  1.20 1.05
2 
2 2
 1.10   0.10  0.05 1.10   0.10  0.05
V0  $1.09  $1.19  $10.71  $24.99  $37.98
 Estimating the Growth Rate

g = b × ROE
• DuPont formula
Industry or • ROE = r
Macroeconomic Average
• ROE = industry ROE
The Sustainable Growth Rate

g b ROE
 The DuPont Model

 Net income   Total assets 

ROE =   
 Total assets   Shareholders' equity 

 Net income   Sales  Total assets 

ROE =    
 Sales  Total assets  Shareholders' equity 

 Net income  Dividends   Net income   Sales   Total assets 

g  
      
 Net income   Sales   Total assets   Equity 
 Example: DuPont Model

Net profit margin 5.00%

Total asset turnover 1.5

Equity multiplier 2.0

Retention ratio 60%

 Example: DuPont Model

 Net income  Dividends   Net income   Sales   Total assets 

g      Total assets    Equity 
 Net income   Sales     
g   0.60    5%    1.5    2.0 

g  9.0%
 Summary
Choice of Discounted Cash Flow Models

• Dividend discount models, free cash flow models,

residual income models
• Dividend models most appropriate for
• Mature, profitable, dividend-paying firms
• Noncontrolling shareholder perspective

Gordon Growth Model

• Assumes constant g and r > g

• Applicable to mature, stable firms
• Estimated value very sensitive to r – g denominator
 Summary
Uses of Gordon Growth Model

• Preferred stock valuation where g = 0

• PVGO – Value from future growth
• Justified leading and trailing P/Es
• Implied r and g

Phases of Growth

• Growth
• Transition
• Maturity
 Summary
Multistage Models

• General two-stage model: growth abruptly declines

• H-model: growth gradually declines
• Three-stage model: can utilize general or H-model

Sustainable Growth Rate

• g = Retention ratio × ROE

• DuPont analysis:
• ROE = Profit margin × Asset turnover × Equity
multiplier
Using Multiples for Valuation
 Why Use Multiples?
A careful multiples analysis—comparing a company’s multiples versus those of
comparable companies—can be useful in improving cashflow forecasts and testing
the credibility of DCF-based valuations.

Multiples address three important issues:

1. How plausible are forecasted cash flows?
2. Why is one company’s valuation higher or lower than its competitors?
3. Is the company strategically positioned to create more value than its
peers?

Multiple analysis is only useful when performed accurately. Poorly

performed multiple analysis can lead to misleading conclusions.
 What Are Multiples?
Multiples such as the Price-to-Earnings Ratio (P/E) and Enterprise-Value-to-EBITA are
used to compare companies. Multiples normalize market values by profits, book
values, or nonfinancial statistics.
Let’s examine a standard multiples analysis of Home Depot and Lowes:

Estimated Earnings per Forward-looking

Market
share (EPS) multiples, 2004
Stock price capitalization
Company July 23, 2004 $ Million 2004 2005 EBITDA P/E

Home Depot $33.00 $74,250 $2.18 $2.48 7.1 13.3

Lowe’s $48.39 $39,075 $2.86 $3.36 7.3 14.4

To find Home Depot’s P/E ratio (13.3x), divide the company’s end of week closing price
of $33 by projected 2005 EPS of $2.48. Since EPS is based on a forward-looking
estimate, this multiple is known as a forward multiple.

But which multiple is best and why are some multiples misleading?
 Key Issues
To address these questions, we will…

1. Investigate what drives multiples and how to build a multiple that focuses on
the operations of the business
Enterprise value multiples are driven by the drivers of free cash flow: return on
invested capital and growth.
To analyze an industry, use an enterprise-value multiple of forward-looking EBIT,
adjusting for non-operating items such as operating leases and excess cash.
2. Demonstrate why using the often-computed Price-to-Earnings ratio can be
misleading
The P/E ratio is not a clean measure of operating performance. The ratio
commingles operating, non-operating, and financing activities
3. Examine the benefits and drawbacks to alternative multiples
We examine the Price-to-Sales ratio, Price-Earnings-Growth (PEG) ratio, and
multiples based on non-financial (operational) data
 Back to Basics… What Drives Company Value?
To better understand what drives a multiple, let’s derive the enterprise value to EBIT
multiple using the key value driver formula.

 g 
Start with the key value NOPLAT1  
 ROIC 
Value 
driver formula. WACC  g

 g 
EBIT(1 - T)1  
Substitute EBIT(1-T)  ROIC  The enterprise value
Value  multiple is driven by:
for NOPLAT WACC  g
(1) return on new invested
capital,
(2) growth,
Divide both sides by  g  (3) the operating cash tax
(1  T)1  
EBIT to develop the Value  ROIC  rate, and
 (4) the weighted average
EBIT WACC  g cost of capital
enterprise value
multiple.
 Back to Basics… What Drives Company Value?
Let’s use the formula to predict the multiple for a company with the following
financial characteristics.
Consider a company growing at 5% per year and generating a 15% return on invested
capital. If the company has an operating cash tax rate at 30% and a 9% cost of
capital, what multiple of EBIT should it trade at?

 g 
(1  T)1  
Value  ROIC 

EBIT WACC  g

 5% 
(1  .30)1  
Value  15%   11 .7

EBIT 9%  5%
How ROIC and Growth Drive Multiples
To demonstrate how different values of ROIC and growth will generate different
multiples, consider a set of hypothetical multiples for a company whose cash tax
rate equals 30% and cost of capital equals 9%.

Enterprise value to EBITA* Increasing

ROIC
Long-term Return on invested capital
growth rate 6% 9% 15% 20% 25%
4.0% 4.7 7.8 10.3 11.2 11.8
Note how different
4.5% 3.9 7.8 10.9 12.1 12.8 combinations of
Increasing
Growth Rate 5.0% 2.9 7.8 11.7 13.1 14.0 growth and ROIC
can lead to the
5.5% 1.7 7.8 12.7 14.5 15.6
same multiple!
6.0% n/a 7.8 14.0 16.3 17.7

When ROIC > WACC, higher growth leads

to higher EV/EBITA Ratio
 Building Effective Multiples
A well-designed, accurate multiples analysis can provide valuable insights about a
company and its competitors. Conversely, a poor analysis can result in confusion. To
apply multiples properly, use the following four best practices:

Choose comparables Use multiples based

Use enterprise Eliminate non-
with similar on forward looking
value multiples operating items
prospects data

Step 1 Step 2 Step 3 Step 4

To analyze a company Use an enterprise value When building a Enterprise-value
using comparables, multiple to eliminate multiple, the multiples must be
you must first create effects from changes in denominator should adjusted for non
an appropriate peer capital structure and use a forecast of operating items hidden
group. one time gains and profits, rather than within enterprise value
losses historical profits and reported EBITA
 Step 1: Choosing Comparables

To create and analyze an appropriate peer group:

1. Start by examining other companies in the target’s industry. But how do you define
an industry?
Potential resources include the annual report, the company’s Standard Industry Classification Code
(SIC) or Global Industry Classification (GIC)

2. Once a preliminary screen is conducted, the real digging begins. You must answer a
series of strategic questions.
Why are the multiples different across the peer group?
Do certain companies in the group have superior products, better access to customers, recurring
revenues, or economies of scale?

3. If necessary, compute the median and harmonic mean for sample

Multiples are best used to examine valuation differences across companies. If you must compute a
representative multiple, use median or harmonic mean.
Harmonic mean: Compute the EBITA/Value ratio for each company and average across companies.
Take the reciprocal of the average.
 Step 2: Use Enterprise-Value-to-EBITA Multiple
A cross-company multiples analysis should highlight differences in performance, such
as differences in ROIC and growth, not differences in capital structure.
Although no multiple is completely independent of capital structure, an enterprise
value multiple is less susceptible to distortions caused by the company’s debt-to-
equity choice. The multiple is calculated as follows:

Enterprise Value MV Debt  MV Equity


EBITA EBITA

Consider a company that swaps debt for equity (i.e. raises debt to repurchase equity).
EBITA is computed pre-interest, so it remains unchanged as debt is swapped for
equity.
Swapping debt for equity will keep the numerator unchanged as well. Note
however, that EV may change due to the second order effects of signaling,
increased tax shields, or higher distress costs.
 Step 2: Use Enterprise Value Multiples
Why is the P/E Ratio misleading?
Conversely, the P/E Ratio can be artificially impacted by a change in capital structure,
even when there is no change in enterprise value.
It can be shown, that in a world without taxes, the price to earnings ratio is a
function of the unlevered price to earnings ratio, the cost of debt, and the debt to
value ratio:

The price to earnings ratio

of an all-equity company
P K - PE u 1
K where K 
E D kd
  d
k  PE u   1
V
 

Market-based debt The cost of debt

to value ratio
 Price-to-Earnings Ratio: Why can it be
An Example:
Misleading?
Before we use the formula to test the impact of capital structure on the P/E ratio, let’s
try an example.
Consider an all-equity company whose P/E ratio is 15x.
The company’s management is considering a move to 20% debt to value, through
borrowings at 5%. Assuming no taxes, what would happen to the P/E ratio?

P K - PE u 1
K where K 
E D kd
  d
k  PE u   1
V

P 20 - 15 The P/E ratio

 20   14.1
E  .20 .0515  1 would fall!
 Price-to-Earnings Ratio: Why can it be Misleading?
To show that the P/E ratio can be artificially impacted by a change in the company’s
capital structure, we use the formula to compute multiples for companies with
varying leverage ratios.

Price to earnings
Price to earnings for an all-equity company
multiple*
10x 15x 20x 25x 40x
10% 9.5 14.6 20.0 25.7 45.0

20% 8.9 14.1 20.0 26.7 53.3

Increasing
Debt to Value 30% 8.2 13.5 20.0 28.0 70.0
40% 7.5 12.9 20.0 30.0 120.0

50% 6.7 12.0 20.0 33.3 n/m

P/E Ratio decreases as P/E Ratio increases as

leverage increases leverage increases

* Assumes a cost of debt equal to 5% and no taxes: Therefore, 1/k d equals 20x.
 Price-to-Earnings Ratio: Why can it be Misleading?
Issue 2:
The second problem with the P/E ratio is that it commingles operating and non-
operating performance. Each source can have vastly different financial
characteristics.
Excess cash has a very high P/E ratio
(because of extremely low
Non-Operating earnings). Mixing excess cash with
Gain income from operations usually
raises the P/E ratio.
One time non-operating gains and
losses such as restructuring costs
and other writeoffs will also
EBIT temporarily raise or lower
earnings, raising the P/E ratio.
Most analysts recognize this
problem and make necessary
adjustments.
 Step 3: Use Forward Looking Multiples
When building a multiple, the denominator should use a forecast of profits, rather than
historical profits.
Unlike backward-looking multiples, forward-looking multiples are consistent with the
principles of valuation—in particular, that a company’s value equals the present value
of future cash flow, not past profits and sunk costs.

Enterprise Value = Present value of FUTURE cashflows

Enterprise Value therefore…
EBITA
EBITA = should represent FUTURE profit

Research by Kim and Ritter (1999) and Lio, Nissim, and Thomas (2002) documents
that forward looking multiples increase predictive accuracy and decrease variance
of multiples within an industry.
 Step 4: Adjust for Non-Operating Items

Even the enterprise value-to-EBITA multiple commingles operating and nonoperating

items. Therefore, further adjustments must be made.

1. Excess cash and other non-operating assets have very different financial
characteristics from the core business, exclude their value from enterprise value
when comparing to EBITA.
Enterprise Value Debt  Equity  Excess Cash  NonOperating Assets

EBITA EBITA

2. The use of operating leases leads to artificially low enterprise value (missing
debt) and EBITA (lease interest is subtracted pre-EBITA). Although operating
leases affect both the numerator and denominator in the same direction, each
adjustment is of different magnitude.

Enterprise Value Debt  PV(Operating Leases)  Equity


EBITA EBITA  Implied Lease Interest
 Step 4: Adjust for Non-Operating Items

3. When companies fail to expense employee stock options, reported EBITA will
be artificially high. Enterprise value should also be adjusted upwards by the
present value of outstanding stock options.

Enterprise Value Debt  Equity  PV(All Outstandin g Options)


EBITA EBITA  Newly Issued Options

4. To adjust enterprise value for pensions, add the present value of unfunded
pension liabilities to debt plus equity. To remove gains and losses related to plan
assets, start with EBITA, add the pension interest expense, and deduct the
recognized returns on plan assets.

Enterprise Value Debt  Equity  Unfunded Pension Liabilitie s


EBITA EBITA - Recognized Net Pension Gains
 Building a Clean Multiple: An Example

$ Million Home Depot Lowe’s

Outstanding debt 1,365 3,755
Let’s adjust the enterprise Market value of equity 74,250 39,075
multiples of Home Depot Enterprise value 75,615 42,830

and Lowe’s for excess cash

Capitalized operating leases 6,554 2,762
and operating leases. Excess cash (1,609) (1,033)
Adjusted enterprise value 80,560 44,559
Before adjustments, Home
Depot’s forward looking 2005 EBITA 8,691 4,589

enterprise-value multiple is Implied interest from leases 340 154

Adjusted 2005 EBITA 9,031 4,743
within 7 percent of that for
Lowe’s. After adjustments,
Home Depot Lowe’s
the difference drops to 5
Raw enterprise value multiple 8.7 9.3
percent.
Adjusted enterprise value multiple 8.9 9.4
 An Examination of Alternative Multiples
Although we have so far focused on enterprise-value multiples based on EBITA , other
multiples can prove helpful in certain situations.
Price-to-Sales Multiple. An enterprise-value-to-sales multiple imposes an additional
important restriction beyond the EV/EBITA multiple: similar operating margins on
the company’s existing business. For most industries, this restriction is overly
burdensome.
Price Earnings Growth (PEG) Ratio. Whereas a price-to-sales ratio further restricts
the enterprise-to-EBITA multiple, the PEG ratio is more flexible than the enterprise
multiple, because it allows expected growth to vary across companies.
EV/EBITDA vs. EV/EBIT multiples. EBITDA is popular because the statistic is closer to
cashflow than EBIT, but fails to measure reinvestment, or capture differences in
equipment outsourcing.
Multiples of operational data. When financial data is sparse, compute non-financial
multiples, which compare enterprise value to one or more operating statistics,
such as Web site hits, unique visitors, or number of subscribers.
 Alternate Multiples: Price-to-Sales Multiple

An enterprise-value-to-sales multiple imposes an additional important restriction:

similar operating margins on the company’s existing business. For most industries,
this restriction is overly burdensome. To see this, consider the following analysis:

Circuit Linens ‘n Best Home Bed Bath &

City things Buy Depot Lowe’s Beyond

Enterprise/Sales

Enterprise/EBITA

Price/Earnings

0 15 30 45 60
Home Depot estimated share price*

Applying the enterprise value to sales multiple from various retailers to Home Depot
revenue would estimate its “fair” stock price somewhere between $4 and $60, too
wide to be helpful.
 Alternate Multiples: PEG Ratios
Whereas a price-to-sales ratio further restricts the enterprise-to-EBITA multiple, the
Price-Earnings-Growth (PEG) ratio is more flexible, because it allows expected profit
growth to vary across companies. We measure the PEG ratio as the enterprise value
multiple divided by expected EBITA growth.

Expected
To calculate Home Depot’s adjusted
Enterprise profit Enterprise
multiple growth PEG ratio PEG ratio, divide forward looking
Hardline retailing
enterprise multiple (7.1x) by its EBITA
Home improvement growth rate (11.8%).
Home Depot 7.1 11.8 0.60
Lowe’s 7.3 17.2 0.42

Home furnishing
Bed Bath & Beyond 9.9 16.1 0.61 Based on the enterprise-based PEG
Linens ’n Things 5.1 15.4 0.33 ratio, Bed Bath & Beyond trades at a
significant premium to Linens ‘n
Things.
 Alternate Multiples: PEG Ratios
There are two major drawbacks to using a PEG ratio:
1. There is no standard time frame for measuring the growth in profits. The valuation
analyst must decide to use one year, two year or long term growth.
2. The PEG ratio incorrectly assumes Comparing Multiples to Growth Rates

a linear relationship between

multiples and growth 25

Consider company valuations 20

presented in the graph (the
dotted line). As growth Enterprise value to EBITA 15
declines, the enterprise value
multiple also drops, but by a 10

declining rate.
5
A low growth company, such as
Company 1, would be
0
undervalued using the PEG 0 2 4 6 8

ratio. Long-term growth rate

Percent
 Alternative Multiples: EV to EBITDA
Many financial analysts use multiples of EBITDA, rather than EBITA, because
depreciation is a noncash expense, reflecting sunk costs, not future investment.
But EBITDA multiples have their own drawbacks. To see this, consider two companies,
who differ only in outsourcing policies. Because they produce identical products at
the same costs, their valuations are identical ($150).
What is each companies EV to EBITDA multiple and why are they different?

Comp A Comp B
Revenues 100 100 Company B outsources
Company A
Raw materials (10) (35) manufacturing to another
manufactures product
company
with their own Operating costs (40) (40)
equipment EBITDA 25
50 Incurs depreciation cost
indirectly through an
Incurs depreciation
increase in the cost of raw
cost directly
Depreciation (30) (5) material)
EBITA 20 20
Alternative Multiples: EV to EBITDA
Because both companies produce identical products at the same costs, their valuations
are identical ($150). Yet, there EV/EBITDA ratios differ. Company A trades at 3x
EBITDA (150/50), while Company B trades at 6x EBITDA (150/25).

Comp A Comp B
Multiples
Enterprise value ($ Million) 150.0 150.0
Enterprise value/EBITDA 3.0 6.0
Enterprise value/EBITA 7.5 7.5

When computing the enterprise-value-to-EBITDA multiple, we failed to recognize that

Company A (the company that owns its equipment) will have to expend cash to
replace aging equipment.
Since capital expenditures are recorded as an investing cash flow they do not appear
on the income statement, causing the discrepancy.
 Multiples on Non-Financial (Operational) Data
Multiples based on nonfinancial (i.e. operational) data can be computed for new
companies with unstable financials or negative profitability. But to use an
operational multiple, it must be a reasonable predictor of future value creation,
and thus somehow tied to ROIC and growth.
Many analysts used operational multiple to value young Internet companies at the
beginning of the Internet boom. Examples of these multiples included:

Enterprise Value Enterprise Value Enterprise Value

Website Hits Number of Subscribers Unique Visitors

A few cautionary notes:

1. Non-financial multiples should be used only when they provide incremental
explanatory power above financial multiples.
2. Non-financial multiples, like all multiples, are relative valuation tools. They
do not measure absolute valuation levels.
 Closing Thoughts
A multiples analysis that is careful and well reasoned will not only provide a useful check
of your DCF forecasts but will also provides critical insights into what drives value in a
given industry. A few closing thoughts about multiples:
1. Similar to DCF, enterprise value multiples are driven by the key value drivers,
return on invested capital and growth. A company with good prospects for
profitability and growth should trade at a higher multiple than its peers.
2. A well designed multiples analysis will focus on operations, will use forecasted
profits (versus historical profits), and will concentrate on a peer group with similar
prospects.
P/E ratios are problematic, as they commingle operating, non-operating, and
financing activities which lead to misused and misapplied multiples.
3. In limited situations, alternative multiples can provide useful insight. Common
alternatives include the price-to-sales ratio, the adjusted price earnings growth
(PEG) ratio, and multiples based on non-financial (operational) data.
 Valuation Ratios versus DCF¹
• Do both
• Both entail use of value estimates, professional
judgment, quality of information and purpose of
valuation.
• Acquisition of specific, known asset or company, and
good data, Comps may be better.
• Acquisition of general, non-specific or unknown
asset or company, DCF may be better.
¹ See Titman, Valuation-The Art and Science of Corporate Investment Decisions, 2011, pgs. 291-2.
 Market-Based Methods: Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MV C/VIC):
Trailing Forward
Comparable Company Price/Sales Price/Book
P/E1 P/E2 Average
Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4
Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71
British Petroleum (BP) 9.18 7.68 0.69 2.17
Chevron Corp (CVX) 10.79 8.05 0.91 2.54
Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86
ConocoPhillips (COP) 11.92 6.89 0.77 1.59
Total SA (TOT) 8.75 8.73 0.80 2.53
Eni SpA (E) 3.17 7.91 0.36 0.81
PetroChina Co. (PTR) 11.96 10.75 1.75 2.10
Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16
Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49
Equals Estimated Value of Target $40.72 $27.42 $81.77 $57.32 $51.81
1
Trailing or Current 52 week average. 2Projected 52 week average. 3Billions of Dollars.
 Valuation ExxonMobil Chemical
• ExxonMobil, 3rd largest following BASF & DuPont
• Division earned $3.428 Billion
• Hypothetical – assume spin off of division.
– What is the baseline valuation? (Next slide )
– Modify baseline to adjust for relative size.
– Consider growth factors
 Equity Valuation Using PE Ratios
Chemical Company P/E Ratios
Share Price ÷ EPS = P/E Ratio
BASF $ 70.47 $ 5.243 13.44
Bayer 35.64 1.511 23.59
Dow Chemical 47.40 4.401 10.77
DuPont 41.00 2.572 15.94
Eastman 51.69 5.75 8.99
Chemical
FMC 59.52 5.729 10.39
Rohm & Hass 45.02 2.678 16.81
Average 14.28
 Market Cap and PE Ratios
P/E Ratio Market Cap (Billions)
BASF 13.44 $ 38.25
Bayer 23.59 25.63
Dow Chemical 10.77 45.25
DuPont 15.94 40.61
Eastman Chemical * 8.99 4.10
FMC * 10.39 2.20
Rohm & Hass * 16.81 10.01
Average (Big 4) 15.94 $37.44
Average (Small 3)* 12.06 5.44
 Variation of PE Ratio
Share Price Current EPS Current/ Forecast EPS Forward P/E
Trailing P/E Ratio
Ratio
BASF $ 70.47 $ 5.243 13.44 $ 7.27 9.69
Bayer 35.64 1.511 23.59 2.69 13.27
Dow 47.40 4.401 10.77 5.71 8.30
DuPont 41.00 2.572 15.94 3.04 13.48
Eastman 51.69 5.75 8.99 5.93 8.71
FMC 59.52 5.729 10.39 5.66 10.51
Rohm & 45.02 2.678 16.81 3.12 14.44
Hass
Average 14.28 11.20
 Valuation of ExxonMobil
• Baseline valuation
– Earnings $3.428B X P/E Ratio 14.28 = $48.94 B
• Modification to reflect relative size
– Earnings $3.428B X P/E Ratio 15.94 = $54.63 B
• Further modification
– Substantial dispersion (10.77 – 23.59) in P/E Ratios
even among top 4 firms indicate risk and growth
potential must be considered.
 Market-Based Methods:
Same or Comparable Industry Method

• Multiply target’s earnings or revenues by

market value to earnings or revenue ratios for
the average firm in target’s industry or a
comparable industry.
• Primary advantage is the ease of use and
availability of data.
• Disadvantages include presumption industry
multiples are actually comparable and
analysts’ projections are unbiased.
 PEG Ratio = PE Ratio/Earnings Growth
• Used to adjust relative valuation methods for differences in growth rates among
comparable firms.
• Many current models assumes zero or minimal growth
• BES/CPS example: BES/CPS 15 & 9% respectively vs industry 12.4 & 11%.
• Helpful in determining which of a number of different firms in same industry
exhibiting different growth rates may be the most attractive.
(MVT/VIT) = A and
VITGR

MVT = A x VITGR x VIT

Where A = Market price to value indicator relative to the growth rate of
value indicator (e.g., (P/E)/ EPS growth rate)
MVT = Market value of target
VIT = Value indicator for target (e.g., EPS)
VITGR = Projected growth rate in value indicator (e.g., EPS)
 Applying the PEG Ratio

An analyst is asked to determine whether Basic Energy Service (BES) or

Composite Production Services (CPS) is more attractive as an acquisition target.
Both firms provide engineering, construction, and specialty services to the oil,
gas, refinery, and petrochemical industries.
BES and CPS have projected annual earnings per share growth rates of 15
percent and 9 percent, respectively. BES’ and CPS’ current earnings per share are
$2.05 and $3.15, respectively. The current share prices as of June 25, 2008 for
BES is $31.48 and for CPX is $26. The industry average price-to-earnings ratio
and growth rate are 12.4 and 11 percent, respectively. Based on this
information, which firm is a more attractive takeover target as of the point in
time the firms are being compared?
Industry average PEG ratio: 12.4 (PE Ratio) /.11
(Growth rate of earnings) = 112.73
BES: Implied share price = 112.73 x .15 x $2.05 = $34.66
10.1% undervalued
CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96
22.9% undervalued
Answer: The difference between the implied and actual
share prices for BES and CPX is $3.18 (i.e., $34.66 -
$31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is
more undervalued than BES at that moment in time.
 Asset-Based Methods:
Tangible Book Value
• Tangible book value (TBV) = (total assets - total
liabilities - goodwill)
• Target’s estimated value = Target’s TBV x [(industry
average or comparable firm market value) / (industry
or comparable firm TBV)].
• Often used for valuing
– Financial services firms where tangible book value
is primarily cash or liquid assets
– Distribution firms where current assets constitute
a large percentage of total assets
 Valuing Companies Using Asset Based Methods
Ingram Micro distributes information technology products worldwide. The firm’s share
price on 8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and the
firm’s beta is .89. Shareholders’ equity is $3.4 billion and goodwill is $.7 billion. Ingram
has 172 million (.172 billion) shares outstanding. The following firms represent Ingram’s
primary competitors.

Market Value/ Beta¹ Projected 5-Year

Tangible Book Value Net Income Growth
Rate¹ (%)
Tech Data .91 .90 11.6

Synnex .70 .40 6.9

Corporation
Avnet 1.01 1.09 12.1

Arrow .93 .97 13.2

Based on this information, what is Ingram’s tangible book value per share (VI T)? What is
the appropriate industry average market value to tangible book value ratio (MV IND/VIIND)?
Estimate the implied market value per share for Ingram (MV T) using tangible book value
as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to
its 8/21/08 share price?
¹ Note both Beta and 5 Year Growth Rate used to cull out “irrelevant” Company.
 Solution to Ingram Problem
• Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70¹

• Based on risk as measured by the firm’ beta and the 5-year projected earnings
growth rate, Synnex is believed to exhibit significantly different risk and growth
characteristics and is excluded from the calculation of the industry average
market value to tangible book value ratio. Therefore, the appropriate industry
average ratio is as follows:

MVIND/VIIND = .95 [i.e., (.91+1.01+.93)/3]

• Ingram’s implied value per share = MVT = (MVIND/VIIND) x VIT = .95 x $15.70 = $14.92

• Based on the implied value per share, Ingram was over-valued on 8/21/08 when its
share price was $19.30
¹ Note, we are deriving tangible book value by assuming it equals equity less intangible assets (goodwill).
 Asset-Based Methods: Liquidation Method
• Value assets as if sold in an “orderly” fashion (e.g., 9-12
months) and deduct value of liabilities and expenses
associated with asset disposition. Used in Chapter 7/11
Bankruptcy Cases in US.
• While varies with industry,
– Receivables often sold for 80-90% of book value
– Inventories might realize 80-90% of book value depending
on degree of obsolescence and condition
– Equipment values vary widely depending on age and
condition and purpose (e.g., special purpose)
– Book value of land may understate market value
– Prepaid assets such as insurance can be liquidated with a
portion of the premium recovered.
Asset-Based Methods: Liquidation Method

• Nortel Networks – Canadian Company

– July 1, 2011 pursuant to Bankruptcy
– Sold 6,000 patents for $4.5 Billion at auction to
Rockstar Bidco.
– Consortium Apple, EMC, Microsoft, RIM & Sony
– Google – defensive, stalking horse bid to
discourage suits over Android & Chrome.
– Intel – early bidder but teamed with Google
 Asset-Based Method: Break-Up Value
• Target viewed as series of independent operating units,
whose income, cash flow, and balance sheet statements
reflect intra-company sales, fully-allocated costs, and
operating liabilities specific to each unit
• After-tax cash flows are valued using market-based
multiples or discounted cash flows analysis to determine
operating unit’s current market value
• The unit’s equity value is determined by deducting
operating liabilities from current market value Mkt. Cap
• Aggregate equity value of the business is determined by
summing equity value of each operating unit less
unallocated liabilities and break-up costs
• May be used by private equity/hedge and LBO deals.
 McGraw Hill Spin Off ?¹
• August 2011 – Publisher & S&P owner
• Pressure from activist hedge fund Jana Partners and
Ontario Teachers’ Pension Plan.
• Meetings between MH (Goldman) & Jana
• MH –”mini conglomerate of non related information
businesses”. “Education – capital intensive and plodding
growth”?
• Lazard & JPMorgan Chase – breakup value $55 per share
versus $41 current price.
¹ See website, McGraw Hill Faces Breakup Pressures, Business Week, August 2, 2011 .
 Replacement Cost Method
• All target operating assets are assigned a value
based on what it would cost to replace them.
• Each asset is treated as if no additional value is
created by operating the assets as part of a going
concern.
• Each asset’s value is summed to determine the
aggregate value of the business.
• This approach is limited if the firm is highly
profitable (suggesting a high going concern
value) or if many of the firm’s assets are
intangible.
 Weighted Average Valuation Method
An analyst has estimated the value of a Estimated Relative Weighted
company using multiple valuation Value ($M) Weight Avg. ($M)
methodologies. The discounted cash
flow value is $220 million, 220 .30 66.0
comparable transactions’ value is
$234 million, the P/E-based value is
$224 million and the liquidation value 234 .40 93.6
is $150 million. The analyst has
greater confidence in certain
methodologies than others. Estimate 224 .20 44.8
the weighted average value of the
firm using all valuation
methodologies and the weights or 150 .10 15.0
relative importance the analyst gives
to each methodology.
1.00 219.4