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Investments:Stocks

Professor Scott Hoover

Business Administration 365

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Comparables Analysis (“Comps”) A simple approach is to simply apply the industry

average/median multiple to the company today. example: P0 = $22.32

Earnings The current industry average P/E ratio is 19.59 Current EPS: $1.38 V0 = 19.59$1.38 = $27.03 Sales The current industry average P/S ratio is 1.83 Current sales per share: $23.19 V0 = 1.83$23.19 = $42.44

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A real-world example from JP MorganFirm value/ Price/

Company4/19/02

stock priceMarket

capFirm

valueLTM

EBITDA2002E

EBITDA 2003E

EBITDA2002E

EPS2003E

EPS LTG 2003 PEG

McDonald's $28.60 $37,450 $45,950 11.5x 10.2x 9.5x 19.5x 17.8x 10.0% 1.78x

YUM Brands 61.49 9,871 12,007 9.5 8.9 8.3 16.9 15.4 12.5% 1.23

Wendy’s 36.78 4,365 4,709 10.4 9.5 8.5 19.4 17.3 14.0% 1.23

Jack in the Box 31.40 1,285 1,548 7.0 6.5 5.9 13.7 12.3 15.5% 0.80

Sonic Corp 28.06 1,158 1,271 13.4 11.8 10.0 23.6 19.8 20.0% 0.99

AFC Enterprises 34.28 1,153 1,361 10.7 8.8 7.8 20.1 16.3 20.0% 0.82

Papa Johns 29.98 641 729 6.2 6.2 5.9 13.3 12.4 13.4% 0.93

Median 10.4x 8.9x 8.3x 19.4x 16.3x 14.0% 0.99x

Mean 9.8x 8.9x 8.0x 18.1x 15.9x 15.1% 1.11x

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Comment on Multiples: There are two primary approaches to multiples. 1. Estimate P/X (which we did in our first example).

X: measure of the CFs to shareholders. Exceptions: sales and the book value of equity

2. Estimate Enterprise Value/X. X: measure of the CFs to all investors.

Exceptions: sales and the book value of assets 3. Repeat analysis for forecasted years (as least 1 or 2)

e.g., ratio of today’s price to your forecasted earnings for next year.

An example: <see spreadsheet>

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Problems with “Comps” Ignores growth Ignores risk (debt structure, etc.) Biased by our choice of similar companies

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Another look at valuation basics In theory, ….

V0 = D1/(1+R) + D2/(1+R)2 + … Problems:

We can’t estimate dividends forever Some companies don’t pay dividends.

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The Malkiel Model Value stock as if it will be sold at some date (T). V0 = D1/(1+R) + D2/(1+R)2 + … + DT/(1+R)T + PT /(1+R)T How might we estimate PT (the terminal value at date T)?

Multiples Perpetual growth

Using multiples…. 1. Forecast XT, where XT is some relevant variable

(earnings, sales, etc.) at date T 2. Estimate (P/X)T, the price-to-X ratio at date T 3. PT = (P/X)T XT

Perpetual Growth 1. Estimate a long-term growth rate (g) 2. Use PT = DT+1/(R-g)

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Example: D1 = $2.20 R = 8% E0 = $4.50 g(5) = 4% (P/E)5 = 15 What is the value of the stock today?

D2 = $2.201.04 = $2.29

D3 = $2.201.042 = $2.38

D4 = $2.201.043 = $2.47

D5 = $2.201.044 = $2.57

E5 = E0(1+g)5 = $4.501.045 = $4.93

P5 = E5(P/E)5 = $73.91

V0 = $2.20/1.08+$2.29/1.082 +…+$2.57/1.085+$73.91/1.085 = $59.76

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Example: D1 = $1.00 R = 10% g(4) = 15% g() = 4%

What is the value of the stock today? D2 = $1.001.15 = $1.15 D3 = $1.001.152 = $1.32 D4 = $1.001.153 = $1.52 P4 = D5/(R-g) = D4(1+g)/(R-g)

= $1.521.04/(0.1-0.04) = $26.36 V0 = $1/1.1+…+$1.52/1.14+$26.36/1.14

= $21.90

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Problems with the Malkiel Model Estimating a future multiple is difficult.

E.g., what P/E ratio would you expect for the soft drink industry in 5 years?

How might we go about estimating this? Estimating the future growth rates is difficult.

Sources of information company news/reports industry publications sustainable growth rate

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Growth-Adjusted Comps Reduces the problems with Comps Relative valuation framework Values estimated using the Malkiel approach Differs from Malkiel

expected P/X ratio estimated using set of peer stocks relies on the mean reversion of P/X ratios

Similar stocks should have the same expected P/X ratio suggests calculating “implied growth rates.”

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The Basic Methodology Use the Malkiel Model on a set of similar stocks Expected P/X ratio is chosen so that the average

misvaluation is zero.

Gives the P/X ratio that the market expects the industry to have in five years.

Note: we may be able to use this to assess whether the market is over- or undervaluing the industry.

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This gives us the following steps. 1. Choose a set of peer companies for evaluation 2. Collect the consensus analyst growth forecast

Note that we might scale these back 3. Collect estimates of the risk-free rate and the market risk

premium 4. Collect , the current dividend, and current X for each

company. X might be earnings, sales, etc.

5. Compute the value of each stock using the Malkiel model, with a common expected P/X ratio.

6. Adjust that expected P/X ratio until the average misvaluation is zero.

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Note: This a relative valuation model. We must be careful to interpret it in that light. For example, we would not say “the stock appears to be

undervalued.” Rather, we would say “the stock appears to be

undervalued relative to its peers.” An example: <see spreadsheet>

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What do we learn here? No need to estimate the expected P/X ratio and

the expected market return very accurately. Can avoid relying on analysts’ growth estimates

calculate implied growth rates assess whether or not companies can achieve those

rates. Quite useful for relative valuation and screening. Implied P/X ratio helps us assess over- or under-

valuation in the industry

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The Discounted Cash Flow (DCF) Model Intuition:

Value of firm = PV(free cash flows) + excess cash

Basic Methodology: Estimate WACC Forecast free cash flows Estimate terminal value of FCFs Discount FCFs and terminal value using WACC Add cash Subtract debt, preferred stock, ESOs

Note: it is common to… use total cash define net debt = debt-cash V = PV(FCFs) – net debt – preferred stock - ESOs

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Forecasting 1. Examine historical evidence to determine which items

tend to vary with sales and which do not. 2. Develop reasonable assumptions about each variable 3. Forecast sales 4. Create pro forma financial statements based on the

forecasts and assumptions. 5. Interpret the pro forma financial statements. 6. Conduct sensitivity analysis.

two-factor sensitivity tables 7. Revise assumptions and repeat until plan is satisfactory.

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Issues Capital Expenditures/Depreciation/Net Fixed Assets

Forecast using the identity: NFA1 = NFA0+CapEx1-Dep1

Approach #1: Forecast NFA as a % of Sales Forecast Dep as a % of NFA (from prior period) Use identity to forecast CapEx

Approach #2 Forecast Dep as a % of NFA (from prior period) Estimate CapEx from company information Use identity to forecast NFA

In most cases, we combine the approaches

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Example: Forecast CapEx for the next 4 years Information

Sales1 = $150; Sales2 = $175; Sales3 = $220; Sales4 = $260 NFA0 = $40 (from balance sheet) CapEx1 = $12 (from analyst conference call, for example) NFA/Sales = 30% (your estimate) Dep/NFA = 10% (your estimate)

Solution: bold given italics inferred from identity regular inferred from ratio assumption

1 2 3 4

Revenues $150.00 $175.00 $220.00 $260.00

NFA $48.00 $52.50 $66.00 $78.00

Dep $4.00 $4.80 $5.25 $6.60

CapEx $12.00 $9.30 $18.75 $18.60

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An example: <see spreadsheet>

Important points Sensitivity analysis is critical

Two-factor sensitivity tables The FCF-WACC relationship is critical.

FCF yield > WACC higher growth increases value FCF yield < WACC higher growth decreases value

The DCF model is best used to understand the expectations of the market Our task: In what way are those expectations likely to

change?

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Words of Wisdom

Carefully consider all news items since the last financial statements have been released.

ALWAYS compute your own ratios and collect information directly from financial statements.

Do the analysis, then choose the company.