Financial Statement Analysis &Problem Solving Assignment

FIN 437 Security Analysis

Lecture 5

Security Valuation, Part 2:

P/E Ratio (Chapter 13)

Major equity valuation models

I Discounted cash flow (present value) I Dividend Discount I Free Cash Flow

I Multiplier models I Price multiples (e.g. P/E ratio) I Enterprise value ratios

I Asset-based models I Asset less liabilities and preferred stock

P/E Ratio based on fundamentals

I Trailing P/E uses realized past year EPS

I Leading P/E uses a forecast of the next 12 months’ EPS

I Consider the Gordon growth model, assuming market is efficient:

P0 = V0 = D1

k − g

I Divide both sides by projected earning E1:

P0 E1

= D1/E1 k − g =

1 − b k − g

P/E Ratio based on fundamentals

P0 E1

= D1/E1 k − g =

1 − b k − g

I Also referred to as a “justified” P/E

I How the firm’s P/E ratio should be related to its fundamentals

I (1-b): expected dividend payout ratio I k: required rate of return on equity I g: expected constant growth rate of dividends

I Example: A firm has an expected dividend payout ratio of 60%, a required rate of return of 11%, and an expected dividend growth rate of 5%. Calculate the firm’s fundamental (justified) leading P/E ratio. Ans: P/E = 0.6 / (0.11 - 0.05) = 10

P/E Ratio based on peer group I Compare P/E ratio of the firm to P/E ratio of peer group

I A higher (lower) P/E than peer group implies over(under)-valuation

I To get a valuation:

Pfair0 = ( P0

E1,company )×E1,company = (

P0 E1

)PeerGroup×E1,company

I To form a peer group usually involves: I Use classification codes find firms in the same industry I Examine firms’ annual reports to see if they identify key

competitiors I Examine competitors’ annual reports to identify other

competitiors I Confirms that comparable firms have similar sources of

sales and earnings, sources of demand, and in similar geographic markets

P/E ratio and other price multiples

I Price-sales (P/S) ratio: a firm’s stock price divided by sales per share.

I Price-book value (P/B) ratio: a firm’s stock price divided by book value of equity per share.

I Price-cash flow (P/CF) ratio: a firm’s stock price divided by cash flow per share, where cash flow may be defined as operating cash flow or free cash flow.

P/E ratio and other price multiples Fiscal Year-End 2015 Lagging Industry Ratios 2015 Total stockholders equity $55.60 Price-to-earnings $8.60 Net revenues $77.30 Price-to-cash flow $4.60 Net income $3.20 Price-to-sales $1.40 Net cash flow from operations $17.90 Price-to-book value $3.60 Stock price $11.40 Shares outstanding 4.476

I The figures are for Ray’s Candy. All figures except the stock price are in millions.

I Calculate Rays lagging P/E, P/CF, P/S, and P/B ratios. Judge whether the firm is undervalued or overvalued using the industry averages.

I Ans: P/E = 15.9; P/CF = 2.9; P/S = 0.7; P/B = 0.9 The price multiples are lower in all cases except for the P/E multiple. This cross-sectional evidence suggests that the stock is undervalued.

PEG ratio

I P/E ratios commonly are taken as proxies for the expected growth in dividends or earnings.

I PEG ratio, the ratio of P/E to g, should be about 1.

I Peter Lynch, One Up on Wall Street:”The P/E ratio of any company that’s fairly priced will equal its growth rate. Im talking here about growth rate of earnings. . . . If the P/E ratio of Coca-Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.”

I The PEG ratio for the S&P over the last 20 years typically ranges between 1 and 1.5.

Enterprise value multiples

I Enterprise value (EV) measures total company value. EV can be viewed as what it would cost to acquire the firm:

I EV = market value of common and preferred stock + market value of debt - cash and short-term investments

I EV is used to compare the values of firms that have significant differences in capital structure

I Market value of debt is often not available.

I EV/EBITDA is the most common EV multiples

I EBITDA = earnings before interest, taxes, depreciation, and amortization

Enterprise value multiples

I Ray, Inc., is a manufacturer of small kitchen appliances. The following figures are from its most recent financial statements except for the market value of long-term debt, which has been estimated from financial market data.

I Calculate the EV/EBITDA multiple.

Stock price $30.00 Shares outstanding 300,000 Market value of long-term debt $800,000 Book value of long-term debt $1,100,000 Book value of total debt $2,600,000 Cash and marketable securities $300,000 EBITDA $1,200,000