RELATIVE

VALUATION
Its all rela3ve.

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

The Essence of rela3ve valua3on?

In rela3ve valua3on, the value of an asset is compared

to the values assessed by the market for similar or
comparable assets.
To do rela3ve valua3on then,

we need to iden3fy comparable assets and obtain market values

for these assets
convert these market values into standardized values, since the
absolute prices cannot be compared This process of
standardizing creates price mul3ples.
compare the standardized value or mul3ple for the asset being
analyzed to the standardized values for comparable asset,
controlling for any dierences between the rms that might
aect the mul3ple, to judge whether the asset is under or over
valued

3!

Mul3ples are just standardized es3mates of

price
Market value of equity

Market value for the firm

Firm value = Market value of equity
+ Market value of debt

Multiple =

Revenues
a. Accounting
revenues
b. Drivers
- # Customers
- # Subscribers
= # units

Market value of operating assets of firm

Enterprise value (EV) = Market value of equity
+ Market value of debt
- Cash

Numerator = What you are paying for the asset

Denominator = What you are getting in return

Earnings
a. To Equity investors
- Net Income
- Earnings per share
b. To Firm
- Operating income (EBIT)

Cash flow
a. To Equity
- Net Income + Depreciation
- Free CF to Equity
b. To Firm
- EBIT + DA (EBITDA)
- Free CF to Firm

Book Value
a. Equity
= BV of equity
b. Firm
= BV of debt + BV of equity
c. Invested Capital
= BV of equity + BV of debt - Cash

4!

The Four Steps to Deconstruc3ng Mul3ples

Dene the mul3ple

Describe the mul3ple

Too many people who use a mul3ple have no idea what its cross sec3onal
distribu3on is. If you do not know what the cross sec3onal distribu3on of
a mul3ple is, it is dicult to look at a number and pass judgment on
whether it is too high or low.

Analyze the mul3ple

In use, the same mul3ple can be dened in dierent ways by dierent

users. When comparing and using mul3ples, es3mated by someone else, it
is cri3cal that we understand how the mul3ples have been es3mated

It is cri3cal that we understand the fundamentals that drive each mul3ple,

and the nature of the rela3onship between the mul3ple and each variable.

Apply the mul3ple

Dening the comparable universe and controlling for dierences is far

more dicult in prac3ce than it is in theory.

5!

Deni3onal Tests

Is the mul3ple consistently dened?

Proposi3on 1: Both the value (the numerator) and the

standardizing variable ( the denominator) should be to the same
claimholders in the rm. In other words, the value of equity
should be divided by equity earnings or equity book value, and
rm value should be divided by rm earnings or book value.

Is the mul3ple uniformly es3mated?

The variables used in dening the mul3ple should be es3mated
uniformly across assets in the comparable rm list.
If earnings-based mul3ples are used, the accoun3ng rules to
measure earnings should be applied consistently across assets.
The same rule applies with book-value based mul3ples.

6!

Example 1: Price Earnings Ra3o: Deni3on

PE = Market Price per Share / Earnings per Share
There are a number of variants on the basic PE ra3o in
use. They are based upon how the price and the
earnings are dened.
Price: is usually the current price
is some3mes the average price for the year
EPS: EPS in most recent nancial year
EPS in trailing 12 months (Trailing PE)
Forecasted EPSnnext year (Forward PE)
Forecasted EPS in future year
7!

Example 2: Enterprise Value /EBITDA Mul3ple

The enterprise value to EBITDA mul3ple is obtained by

ne^ng cash out against debt to arrive at enterprise
value and dividing by EBITDA.

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

=
EBITDA
Earnings before Interest, Taxes and Depreciation

Why do we net out cash from rm value?

What happens if a rm has cross holdings which are
categorized as:
Minority interests?
Majority ac3ve interests?

8!

Descrip3ve Tests

What is the average and standard devia3on for this mul3ple,

across the universe (market)?
What is the median for this mul3ple?

How large are the outliers to the distribu3on, and how do we

deal with the outliers?

The median for this mul3ple is o_en a more reliable comparison point.

Throwing out the outliers may seem like an obvious solu3on, but if the
outliers all lie on one side of the distribu3on (they usually are large
posi3ve numbers), this can lead to a biased es3mate.

Are there cases where the mul3ple cannot be es3mated? Will

ignoring these cases lead to a biased es3mate of the
mul3ple?
How has this mul3ple changed over 3me?
9!

Mul3ples have skewed distribu3ons

PE Ra&os for US stocks: January 2014
700.

600.

500.

400.

Current
Trailing

300.

Forward

200.

100.

0.
0.01 To 4 To 8 8 To 12 12 To
4
16

Aswath Damodaran!

16 To
20

20 To
24

24 To
28

28 To
32

32 To
36

36 To
40

40 To
50

50 To
75

75 To
100

More

10!

Analy3cal Tests

What are the fundamentals that determine and drive these mul3ples?

Proposi3on 2: Embedded in every mul3ple are all of the variables that drive every
discounted cash ow valua3on - growth, risk and cash ow pajerns.
In fact, using a simple discounted cash ow model and basic algebra should yield
the fundamentals that drive a mul3ple

How do changes in these fundamentals change the mul3ple?

The rela3onship between a fundamental (like growth) and a mul3ple (such as PE) is
seldom linear. For example, if rm A has twice the growth rate of rm B, it will
generally not trade at twice its PE ra3o
Proposi3on 3: It is impossible to properly compare rms on a mul3ple, if we do not
know the nature of the rela3onship between fundamentals and the mul3ple.

11!

PE Ra3o: Understanding the Fundamentals

To understand the fundamentals, start with a basic equity discounted

cash ow model.
With the dividend discount model,

DPS1
r g n earnings per share,
Dividing both sides by the current
P0 =

If this had been a FCFE

P0 Model, Payout Ratio * (1 + g n )
EPS0

= PE =

P0 =

r-gn

FCFE1
r gn

P0
(FCFE/Earnings) * (1+ g n )
= PE =
EPS0
r-g n

12!

The Determinants of Mul3ples

Value of Stock = DPS 1/(k e - g)

PE=Payout Ratio
(1+g)/(r-g)
PE=f(g, payout, risk)

PEG=Payout ratio
(1+g)/g(r-g)

PBV=ROE (Payout ratio)

(1+g)/(r-g)

PEG=f(g, payout, risk)

PBV=f(ROE,payout, g, risk)

PS= Net Margin (Payout ratio)

(1+g)/(r-g)
PS=f(Net Mgn, payout, g, risk)

Equity Multiples

Firm Multiples
V/FCFF=f(g, WACC)
Value/FCFF=(1+g)/
(WACC-g)

V/EBIT(1-t)=f(g, RIR, WACC)

Value/EBIT(1-t) = (1+g)
(1- RIR)/(WACC-g)

V/EBIT=f(g, RIR, WACC, t)

Value/EBIT=(1+g)(1RiR)/(1-t)(WACC-g)

VS=f(Oper Mgn, RIR, g, WACC)

VS= Oper Margin (1RIR) (1+g)/(WACC-g)

Value of Firm = FCFF 1/(WACC -g)

13!

Applica3on Tests

Given the rm that we are valuing, what is a comparable rm?

While tradi3onal analysis is built on the premise that rms in the same
sector are comparable rms, valua3on theory would suggest that a
comparable rm is one which is similar to the one being analyzed in terms
of fundamentals.
Proposi3on 4: There is no reason why a rm cannot be compared with
another rm in a very dierent business, if the two rms have the same
risk, growth and cash ow characteris3cs.

Given the comparable rms, how do we adjust for dierences

across rms on the fundamentals?

Proposi3on 5: It is impossible to nd an exactly iden3cal rm to the one

you are valuing.

14!

An Example: Comparing PE Ra3os across a

Sector
Company

Market Capitalization

Current PE

Trailing PE

Forward PE

Expected growth

PEG ratio

The Walt Disney Company

$126,427

20.60

20.60

18.40

12.40%

1.66

Twenty-First Century Fox, Inc.

$70,451

9.93

11.51

19.70

20.90%

0.55

Time Warner Inc.

$56,889

18.84

14.53

15.50

12.60%

1.15

Viacom, Inc.

$35,492

14.82

14.82

14.80

13.10%

1.13

The Madison Square Garden Company

$4,300

30.19

29.53

28.50

17.60%

1.68

Lions Gate Entertainment Corp.

$4,270

18.40

19.87

19.40

20.00%

0.99

Live Nation Entertainment, Inc.

$4,068

NA

NA

NM

9.00%

NA

Cinemark Holdings Inc.

$3,445

20.40

21.44

16.60

14.80%

1.45

Regal Entertainment Group

$3,089

21.33

18.06

17.70

10.00%

1.81

DreamWorks Animation SKG Inc.

$2,764

NA

NA

43.30

82.30%

NA

AMC Entertainment Holdings, Inc.

$2,079

32.85

20.28

14.90

86.60%

0.23

World Wrestling Entertainment Inc.

$1,608

51.21

142.29

NM

20.00%

7.11

Rentrak Corporation

$648

NA

NA

152.80

115.00%

NA

Carmike Cinemas Inc. (NasdaqGS:CKEC)

$606

6.29

6.48

24.40

6.75%

0.96

Average

$22,581

22.26

29.04

32.17

31.50%

1.70

Median

$3,756

20.40

19.87

18.90

16.20%

1.15

15!

Another example: European Banks

16!

Is Deutsche Bank cheap?

Trading at 0.67 3mes book equity, Deutsche looks cheap, rela3ve to the rest of
the sector. However, part of the reason for this may be its low return on equity of
-0.93% in 2013.
Because these rms dier on both capital policy and return on equity, we run a
regression of PBV ra3os on both variables:
PBV =

0.48
(2.63)

+ 1.58 ROE + 3.55 Tier 1 capital ra3o

(2.44)
(2.76)

R2 = 23.66%

The predicted PBV ra3o for Deutsche Bank, based on its return on equity of -0.93
percent and its 3er 1 capital ra3o of 15.13%, would be 1.003.
Predicted PBVDeutsche Bank = 0.48
+ 1.58 (-0.0093) + 3.55 (.1513) = 1.003
Because the actual PBV ra3o for Deutsche Bank at the 3me of the analysis was
0.67, this would suggest that the stock is under valued, rela3ve to other banks.

17!

Task
Given how the
sector in which
your rm
operates is being
priced, es3mate
a rela3ve value
for your rm.

18!

Read
Chapter 12