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Chapter 14 Valuation: Market - Based Approaches Copyright © 2011 Thomson South-Western, a part Chapter 14 Valuation: Market - Based Approaches Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Market Multiples Used as An analytical tool A valuation tool Caution advised: Market multiples Market Multiples Used as An analytical tool A valuation tool Caution advised: Market multiples are shortcut valuation tools. They use just one or two accounting numbers. They are relatively simple ratios of Market value to Summary accounting measures.

Market Multiples (Contd. ) Capture relative valuation per dollar of book value or earnings. Market Multiples (Contd. ) Capture relative valuation per dollar of book value or earnings. To be applied and interpreted after considering firm’s expected future in terms of: Profitability Risk Growth

Market Multiples (Contd. ) Firm’s fundamental characteristics are necessary for comparison with other firms Market Multiples (Contd. ) Firm’s fundamental characteristics are necessary for comparison with other firms and industry averages.

Market-to-Book (MB) Ratio Reflects what the market value is, and not what should be. Market-to-Book (MB) Ratio Reflects what the market value is, and not what should be. Useful for comparison with Value-to-Book Ratio. Chapter: 14 5

Value-to-Book (VB) Ratio Residual income valuation model used to compute shareholder’s equity value. Can Value-to-Book (VB) Ratio Residual income valuation model used to compute shareholder’s equity value. Can be compared with Market-to-Book ratio to evaluate share price.

Value-to-Book (VB) Ratio – Continuing Value Model Finite Horizon Earnings Forecasts and Continuing Value Value-to-Book (VB) Ratio – Continuing Value Model Finite Horizon Earnings Forecasts and Continuing Value Computation.

VB Ratio: Insights into Valuation In equilibrium, firms maintain shareholder wealth and thus valued VB Ratio: Insights into Valuation In equilibrium, firms maintain shareholder wealth and thus valued at book value. Firm Value > Book Value of common equity, if the firm generates return greater than cost of capital. Growth adds value only when additional residual income is created for common equity shareholders.

VB Ratio: Insights into Valuation (Contd. ) Increase in risk decreases Firm Value. Firm’s VB Ratio: Insights into Valuation (Contd. ) Increase in risk decreases Firm Value. Firm’s VB Ratio differs from industry due to differences in their ROCE, RE and/or book value growth. Change current expectations about ROCE, RE and/or book value growth if VB ratio of firm changes over time.

MB and VB Ratios differ from ‘ 1’ Economic reasons: ROCE > RE (firm MB and VB Ratios differ from ‘ 1’ Economic reasons: ROCE > RE (firm has competitive advantage) ROCE < RE (firm has unprofitable projects) Accounting reasons: Firms may invest in projects for which accounting methods and principles cause ROCE to differ from RE.

Empirical properties of MB Ratio Firms with assets appearing at book value on balance Empirical properties of MB Ratio Firms with assets appearing at book value on balance sheet have MB ratio closer to ‘ 1’ Firms having off-balance sheet assets and shareholders’ equity have relatively high MB ratios. Predictive power of MB ratios Firms with higher MB ratios have higher ROCEs Diminishes as the horizon of study lengthens

Value-Earnings (VE) Ratio In theory, VE Ratio calculated as: Common equity value is determined Value-Earnings (VE) Ratio In theory, VE Ratio calculated as: Common equity value is determined as a function of expected future earnings and residual income model. Future earnings is measured as expected future comprehensive income. Chapter: 14 12

Price-Earnings (PE) Ratio projects firm value from permanent earnings. Advantages: Quick and efficient way Price-Earnings (PE) Ratio projects firm value from permanent earnings. Advantages: Quick and efficient way to value a firm. Can be readily observed for most of the firms. Chapter: 14 13

Price-Earnings (PE) Ratio (Contd. ) Disadvantages: Logical misalignment as historical earnings divided into share Price-Earnings (PE) Ratio (Contd. ) Disadvantages: Logical misalignment as historical earnings divided into share price, which reflects present value of future earnings. Historical earnings used may include unusual items and need to be normalized. Forward PE ratio is more logical as it uses a forecast of future EPS as against historical EPS.

PE Ratio Cautions Factors causing PE ratios to differ across firms: Risk and the PE Ratio Cautions Factors causing PE ratios to differ across firms: Risk and the Cost of capital Growth and Profitability Accounting differences Accounting measures earnings in annual periods Growth

PE Ratios and Earnings Growth Approaches: Perpetuity-With-Growth approach Assumes firms current period earnings grow PE Ratios and Earnings Growth Approaches: Perpetuity-With-Growth approach Assumes firms current period earnings grow at a constant rate “g”. Firm is valued as the present value of a permanent stream of future earnings. Chapter: 14 16

PE Ratios and Earnings Growth (Contd. ) Price-Earnings-Growth approach Used as a rule of PE Ratios and Earnings Growth (Contd. ) Price-Earnings-Growth approach Used as a rule of thumb to assess share price relative to earnings and expected future earnings growth. Chapter: 14 17

Value-Earnings-Growth (VEG) Ratio PEG model implies the following value model for the VEG ratio: Value-Earnings-Growth (VEG) Ratio PEG model implies the following value model for the VEG ratio: Assumptions of the model: Earnings have a perpetual growth. Earnings generate an ROCE equivalent to RE.

Value-Earnings-Growth (VEG) Ratio (Contd. ) Reinvested earnings generate an ROCE equivalent to RE. Value-Earnings-Growth (VEG) Ratio (Contd. ) Reinvested earnings generate an ROCE equivalent to RE.

PE Ratio Measurement Issues Growth Ratio does not consider firm-specific differences in long -term PE Ratio Measurement Issues Growth Ratio does not consider firm-specific differences in long -term earnings growth. Transitory earnings Past earnings used in computation of ratio are not indicative of future earnings. Past earnings may contain non-recurring elements.

PE Ratios: Empirical Properties Predictors of future earnings growth A low percentage increase (decrease) PE Ratios: Empirical Properties Predictors of future earnings growth A low percentage increase (decrease) in earnings is followed by a High percentage earnings increase for the high PE portfolios, vice versa for the low PE portfolios. Articulation of MB and PE Ratios Future residual income is higher for high MB firms than for low MB firms. Current period residual income is much lower than future residual income for high PE firms.

Price Differentials offer an approach to evaluate market’s pricing of risk. Where PDIFF = Price Differentials offer an approach to evaluate market’s pricing of risk. Where PDIFF = Price differential RNV = Risk-neutral Value (calculated by substituting risk free rate for cost of capital in Residual Income Model). Chapter: 14 22

Price Differentials (Contd. ) Used to evaluate the extent to which market is discounting Price Differentials (Contd. ) Used to evaluate the extent to which market is discounting share prices for risk: If PDIFF > Risk of firm, shares are over-discounted or under-valued. If PDIFF < Risk of firm, shares are under-discounted or over-valued.

Reverse Engineering Variables in Valuation Process Value Expected future profitability Expected long-run future growth Reverse Engineering Variables in Valuation Process Value Expected future profitability Expected long-run future growth Expected risk-adjusted discount rates Assumes market price equals value and solves for assumptions about other variables.

Academic Research Whether academic research models and empirical evidences are relevant in making buy/sell Academic Research Whether academic research models and empirical evidences are relevant in making buy/sell or hold recommendations? Research in accounting provides insights into relations between accounting numbers and capital market variables. Empirical evidence available on relative degree of market efficiency with respect to earnings.

Academic Research (Contd. ) Capital Market Efficiency The degree to which market prices react Academic Research (Contd. ) Capital Market Efficiency The degree to which market prices react completely and quickly to available accounting information. Positions taken in securities after study of accounting information drive prices to efficient levels. Analysts are driving forces involved in identifying and correcting security mispricing.

Academic Research (Contd. ) Market efficiency and Earnings The Bernard and Thomas studies (1989 Academic Research (Contd. ) Market efficiency and Earnings The Bernard and Thomas studies (1989 – 90’) reveal market is highly, but not completely, efficient with respect to quarterly earnings. There are returns to be earned by being good at forecasting and reacting to earnings. Insightful financial statement analysis lead to betterthan-average returns by identifying stocks that are temporarily mispriced.

Academic Research (Contd. ) Use of Valuation models to form portfolios The Frankel and Academic Research (Contd. ) Use of Valuation models to form portfolios The Frankel and Lee studies implement a 3 -year forecast horizon version of the residual income model to compute fundamental share value of firms. Portfolios are formed with highest V/P ratios and lowest V/P ratios