DIVIDEND DISCOUNT MODELS

Agenda

• Perpetual dividends model.• Two-phase growth model.• The H model• Three stage growth model.• Relative Valuation.• Asset based model.

• 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 )$24

0.102

2.448 24 2.00(1 )

26 0.448

1.72%

g

g

g g

g

g

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

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?

1

0

2.100.05

248.75% 5% 13.75%

Dr g

P

r

r

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.

Issues Using the Gordon Growth Model

Choice of Discounted Cash Flow Models

General Two-Stage DDM

0 00

1

1 1 1

1 1

t nnS S Lt n

t L

D g D g gV

r r r g

Example: General Two-Stage DDM

Current dividend = $2.00Growth Current dividend = $2.00Growth for next three years = 15 percentLong-term growth = 4 percentRequired return = 10 percentfor next three years = 15 percentLong-term growth = 4 percentRequired return = 10 percent

Example: General Two-Stage DDMStep 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

0 2 3 3

0

$2.30 $2.6450 $3.0418 $52.7237V

1.10 1.10 1.10 1.10V $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

0 2 3 3

0

$2.30 $2.6450 $3.0418 $3.1634 $68.54

1.10 1.10 1.10 1.10$55.54

V

V

Two-Stage H-Model

0 00

1

L S L

L

D g D H g gV

r g

Example: Two-Stage H-Model

Current dividend $3.00gs 20%gL 6%H 5Required return on stock 10%Current stock price $120

Example: Two-Stage H-Model

0 00

0

0

1

$3 1 0.06 $3 5 0.20 0.06

0.10 0.06

$79.50 $52.50 $132.00

L S L

L

D g D H g gV

r g

V

V

Solving for the Required Return Using the Two-Stage H-Model

0

0

1

31 0.06 5 0.20 0.06 0.06 10.40%

120

L S L LD

r g H g g gP

r

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

2

0 1 2

22

2 2

0

$1 1.20 $1 1.20

1.10 1.106$1 1.20 0.20 0.05 $1 1.20 1.052

1.10 0.10 0.05 1.10 0.10 0.05

$1.09 $1.19 $10.71 $24.99 $37.98

V

V

THREE-STAGE MODEL EXAMPLE

Estimating the Growth Rate

The Sustainable Growth Rate

The DuPont Model

Net income Total assetsROE =

Total assets Shareholders' equity

Net income Sales Total assetsROE =

Sales Total assets Shareholders' equity

Net income Dividends Net income Sales Total assets

Net income Sales Total assets Equity

g

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

Net income Sales Total assets Equity

0.60 5% 1.5 2.0

9.0%

g

g

g

Summary

Summary

Summary

Using Multiples for

Valuation

Why Use Multiples?

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.

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.

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:

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.

Company

Home Depot

Lowe’s

Stock priceJuly 23, 2004

Market capitalization$ Million

Estimated Earnings per share (EPS)

Forward-looking multiples, 2004

2004 2005 EBITDA P/E

$33.00

$48.39

$74,250

$39,075

$2.18

$2.86

$2.48

$3.36

7.1

7.3

13.3

14.4

But which multiple is best and why are some multiples misleading?

Key Issues

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

To address these questions, we will…

Back to Basics… What Drives Company Value?

gWACCROIC

g1T)(1

EBIT

Value

gWACCROIC

g1NOPLAT

Value

gWACCROIC

g1T)-EBIT(1

Value

Substitute EBIT(1-T)

for NOPLAT

Start with the key value

driver formula.

Divide both sides by

EBIT to develop the

enterprise value

multiple.

To better understand what drives a multiple, let’s derive the enterprise value to EBIT multiple using the key value driver formula.

(1) return on new invested capital,

(2) growth, (3) the operating cash tax

rate, and (4) the weighted average

cost of capital

The enterprise value multiple is driven by:

Back to Basics… What Drives Company Value?

gWACCROIC

g1T)(1

EBIT

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?

7.11%5%915%5%

1)30.(1

EBIT

Value

How ROIC and Growth Drive Multiples

When ROIC > WACC, higher growth leads to higher EV/EBITA Ratio

Note how different combinations of growth and ROIC can lead to the same multiple!

Enterprise value to EBITA*

Return on invested capital

6% 9% 15% 20% 25%Long-term growth rate

7.8

7.8

7.8

7.8

7.8

10.3

10.9

11.7

12.7

14.0

11.2

12.1

13.1

14.5

16.3

4.7

3.9

2.9

1.7

n/a

11.8

12.8

14.0

15.6

17.7

4.0%

4.5%

5.0%

5.5%

6.0%

Increasing Growth Rate

Increasing ROIC

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%.

Building Effective Multiples

Step 1To analyze a company using comparables, you must first create an appropriate peer group.

Step 3When building a multiple, the denominator should use a forecast of profits, rather than historical profits

Step 2Use an enterprise value multiple to eliminate effects from changes in capital structure and one time gains and losses

Step 4Enterprise-value multiples must be adjusted for non operating items hidden within enterprise value and reported EBITA

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 with similar prospects

Use multiples based on forward looking

data

Use enterprise

value multiples Eliminate non-

operating items

Step 1: Choosing ComparablesTo 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 MultipleA 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:

EBITA

EquityMVDebt MV

EBITA

ValueEnterprise

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:

dud

u

k

1K

1PEkVD

PE-KK

E

P

where

Market-based debt to value ratio

The cost of debt

The price to earnings ratio of an all-equity company

Price-to-Earnings Ratio: Why can it be Misleading?An Example:

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?

dud

u

k

1K

1PEkVD

PE-KK

E

P

where

1.14115.05.20

15-2002

E

P

The P/E ratio

would fall!

Price-to-Earnings Ratio: Why can it be Misleading?

*Assumes a cost of debt equal to 5% and no taxes: Therefore, 1/kd equals 20x.

Price to earnings multiple* Price to earnings for an all-equity company

10x 15x 20x 25x 40x

14.6

14.1

13.5

12.9

12.0

20.0

20.0

20.0

20.0

20.0

25.7

26.7

28.0

30.0

33.3

9.5

8.9

8.2

7.5

6.7

45.0

53.3

70.0

120.0

n/m

10%

20%

30%

40%

50%

Increasing Debt to Value

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.

P/E Ratio decreases as leverage increases

P/E Ratio increases as leverage increases

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 earnings). Mixing excess cash with 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 temporarily raise or lower earnings, raising the P/E ratio. Most analysts recognize this problem and make necessary adjustments.

EBIT

Non-OperatingGain

Step 3: Use Forward Looking Multiples

Enterprise ValueEBITA

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.

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

therefore…

Step 4: Adjust for Non-Operating ItemsEven 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.

EBITA

AssetsngNonOperatiCashExcessEquityDebt

EBITA

ValueEnterprise

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.

Interest Lease ImpliedEBITA

EquityLeases) ngPV(OperatiDebt

EBITA

Value Enterprise

Step 4: Adjust for Non-Operating Items

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.

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.

OptionsIssuedNewlyEBITA

Options)gOutstandinPV(AllEquityDebt

EBITA

ValueEnterprise

GainsPension Net Recognized-EBITA

sLiabilitiePensionUnfundedEquityDebt

EBITA

ValueEnterprise

Building a Clean Multiple: An Example

$ Million Home Depot Lowe’s

Raw enterprise value multiple

Adjusted enterprise value multiple

8.7

8.9

9.3

9.4

3,755

39,075

42,830

1,365

74,250

75,615

Outstanding debt

Market value of equity

Enterprise value

2,762

(1,033)

44,559

6,554

(1,609)

80,560

Capitalized operating leases

Excess cash

Adjusted enterprise value

4,589

154

4,743

8,691

340

9,031

2005 EBITA

Implied interest from leases

Adjusted 2005 EBITA

Home Depot Lowe’s

Let’s adjust the enterprise multiples of Home Depot and Lowe’s for excess cash and operating leases.

Before adjustments, Home Depot’s forward looking enterprise-value multiple is within 7 percent of that for Lowe’s. After adjustments, the difference drops to 5 percent.

An Examination of Alternative MultiplesAlthough 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

Home Depot estimated share price*

0 15 30 45 60

Enterprise/Sales

Enterprise/EBITA

Price/Earnings

Circuit City

Linens ‘n things

Best Buy

Home Depot Lowe’s

Bed Bath & Beyond

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.

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:

Alternate Multiples: PEG Ratios

Enterprise multiple

Expected profit growth

Enterprise PEG ratioHardline retailing

Home improvement

7.1

7.3

11.8

17.2

0.60

0.42

Home Depot

Lowe’s

Home furnishing

9.9

5.1

16.1

15.4

0.61

0.33

Bed Bath & Beyond

Linens ’n Things

To calculate Home Depot’s adjusted PEG ratio, divide forward looking

enterprise multiple (7.1x) by its EBITA growth rate (11.8%).

Based on the enterprise-based PEG ratio, Bed Bath & Beyond trades at a

significant premium to Linens ‘n Things.

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.

Alternate Multiples: PEG Ratios

0

5

10

15

20

25

0 2 4 6 8

Long-term growth ratePercent

Ente

rpris

e va

lue

to E

BITA

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 a linear relationship between multiples and growth

Consider company valuations presented in the graph (the dotted line). As growth declines, the enterprise value multiple also drops, but by a declining rate.

A low growth company, such as Company 1, would be undervalued using the PEG ratio.

Comparing Multiples to Growth Rates

Alternative Multiples: EV to EBITDA

Depreciation

EBITA

Revenues

Raw materials

Operating costs

EBITDA

Comp B

Company B outsourcesmanufacturing to another

company

Incurs depreciation cost indirectly through an

increase in the cost of raw material)(5)

20

100

(35)

(40)

25

Comp A

(30)

20

100

(10)

(40)

50

Company A manufactures product

with their own equipment

Incurs depreciation cost directly

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?

Alternative Multiples: EV to EBITDA

MultiplesEnterprise value ($ Million)

Enterprise value/EBITDA

Enterprise value/EBITA

150.0

6.0

7.5

150.0

3.0

7.5

Comp BComp A

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.

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).

Multiples on Non-Financial (Operational) Data

Enterprise ValueWebsite Hits

Enterprise ValueNumber of Subscribers

Enterprise ValueUnique Visitors

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:

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 ThoughtsA 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.

58

Market-Based Methods: Comparable Company Example

Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies

Target Valuation Based on Following Multiples (MVC/VIC):

Comparable CompanyTrailing

P/E1

Forward P/E2 Price/Sales Price/Book

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

1Trailing or Current 52 week average. 2Projected 52 week average. 3Billions of Dollars.

59

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 - 60)– Modify baseline to adjust for relative size. (Slide 61)– Consider growth factors (Slide 62)

60

Equity Valuation Using PE RatiosChemical 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 Chemical 51.69 5.75 8.99

FMC 59.52 5.729 10.39

Rohm & Hass 45.02 2.678 16.81

Average 14.28

61

Market Cap and PE RatiosP/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 $37.44Average (Small 3)* 12.06 5.44

62

Variation of PE RatioShare Price Current EPS Current/

Trailing P/E Ratio

Forecast EPS

Forward P/E 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 & Hass

45.02 2.678 16.81 3.12 14.44

Average 14.28 11.20

63

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.

64

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.

65

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)

66

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? 67

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% undervaluedCPX: Implied share price = 112.73 x .09 x $3.15 = $31.96 22.9% undervaluedAnswer: 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

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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/ Tangible Book Value

Beta¹ Projected 5-Year Net Income Growth

Rate¹ (%)

Tech Data .91 .90 11.6

Synnex Corporation

.70 .40 6.9

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 (VIT)? 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 (MVT) 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. 70

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).

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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.

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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

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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.

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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.

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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.

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Weighted Average Valuation Method

An analyst has estimated the value of a company using multiple valuation methodologies. The discounted cash flow value is $220 million, comparable transactions’ value is $234 million, the P/E-based value is $224 million and the liquidation value is $150 million. The analyst has greater confidence in certain methodologies than others. Estimate the weighted average value of the firm using all valuation methodologies and the weights or relative importance the analyst gives to each methodology.

Estimated

Value ($M)

Relative

Weight

Weighted

Avg. ($M)

220 .30 66.0

234 .40 93.6

224 .20 44.8

150 .10 15.0

1.00 219.4

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