Valuation

Front 1

Companies create value by investing capital at rates that exceed their cost of capital.

Back 1

The more capital they can invest at attractive rates of return, the more value they will create, as long as the returns on capital exceeds the cost of capital, faster growth will create more value.

Front 2

Alternatives to M&A

Back 2

(buy-build-partner, minority investment).

Front 3

Remember the “Story” in Valuing Assets

Back 3

The market’s expectations for future cash flows (not accounting earnings)

The distribution of those cash flows over time
The uncertainty of those cash flows (how risky are the cash flows → “discount rate”)

The presence of growth options or opportunities

Front 4

What really matters are the drivers of cash flow/value:

Back 4

the rate at which a company can grow and its return on invested capital (relative to the cost of capital)

Front 5

FCF represents the ...

Back 5

fundamentals of a firm and is more important than net income or earnings.

Front 6

Value Creation results when...

Back 6

companies earn a return on invested capital greater than the opportunity cost of capital

Front 7

As interest rates go down

Back 7

equities usually are more attractive or offer a better return, and interest rates go up fixed income securities usually are more desirable (function of rate of return).

Front 8

Investors often react not to what actually happens

Back 8

but to the difference between what happens and what was expected to happen.

Front 9

Intrinsic Value

Back 9

is the worth of an investment that is justified by information about its payoffs.

Front 10

Company’s Stock Market Valuation

Back 10

Market’s Expectations Based on Future Performance

Front 11

When a company is publicly traded the interaction (trading activity) ...

Back 11

sets a price for those shares based on what investors think those shares are worth.

This may not be an unbiased estimate of performance.

Front 12

Shareholder returns depend primarily on

Back 12

changes in expectations more so than actual company performance

Front 13

If you buy a share of stock, you can receive cash in two ways:

Back 13

1) the company pays dividends; 2) you sell your shares, either to another investor in the market or back to the company.

Front 14

Stock valuation is more difficult than bond valuation...

Back 14

Cash flows are uncertain

The life is forever

The required rate of return is unobservable

Front 15

If dividends are expected at regular intervals forever (but are not expected to grow)

Back 15

then this valued as a no-growth perpetuity: P0 = D / R

Front 16

Suppose a stock is expected to pay a $0.50 dividend every year and the required return is 10%. What is the value of the stock?

Back 16

P0 = .50 /.10 = $5

Front 17

Company Pays all Earnings out as Dividends:

Back 17

EPS = Div

Cash Cow

Front 18

Value of a Share of Stock When Firm Acts as Cash Cow:

Back 18

EPS = DIV
R R

*fraction over R

Front 19

This Payout Policy (cash cow) is Not Optimal if

Back 19

the Company has Growth Opportunities

Front 20

If dividends are expected at regular intervals and are also expected to grow at a constant state forever, then

Back 20

this is a The Dividend Growth Model or perpetuity growth method:

Front 21

If dividends are expected at regular intervals and are also expected to grow at a constant state forever, then this is

Back 21

a The Dividend Growth Model or perpetuity growth method:

Front 22

Total Return has 2 components:

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Dividend Yield & Capital Gains Yield

Front 23

3 Stories in Stock Valuation:

Back 23

Profitability/Efficiency, Growth, Risk

Front 24

Using perpetuity growth method: Suppose a company just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?

Back 24

3.92 = .5(1=.02)/(.15-.02)

Front 25

A very profitable firm can have zero payout but be valued

Back 25

highly in the market.

Front 26

Many high growth firms do not pay dividends –

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instead they use their profits to finance future growth.

Front 27

Two Conditions must be met in order to increase shareholder value:

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1) Earnings must be retained so that projects can be funded

2) The projects must have positive net present value

Front 28

If cash is reinvested, the opportunity cost of capital is

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the expected rate of return that shareholders could have obtained by investing in financial assets.

Front 29

The goal of the firm is to earn a return on investments in real assets that is

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greater than the opportunity cost of capital or what shareholders could have received by otherwise investing in financial assets.

Front 30

If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because

Back 30

future dividends may be higher.

Front 31

Payout Ratio:

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Fraction of earnings paid out as dividends

Front 32

Retention Ratio or Plowback Ratio:

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Fraction of earnings retained or reinvested by the firm

Front 33

Sustainable Growth Rate “g” -

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Steady rate at which a firm can grow: retention ratio x return on equity.

Front 34

Earnings next year =

Back 34

earnings this year + retained earnings this year x (ROE

Front 35

Example: Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

Back 35

no growth: p = 8.33/.15 = 55.56

with growth: g = .25 x .40=.10 p=5/.15-.1=100

Front 36

If the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00.

Back 36

The difference between these two numbers is called the Present Value of Growth Opportunities (PVGO)

=100-55.56=44.44

Front 37

Most companies we evaluate are not in a state of constant growth. Therefore, we break down our valuation into an explicit forecast/planning period until we can assume it reaches

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a state of constant growth.

Front 38

If we can forecast the FCF for a company for 5 years until it reaches a steady state of constant growth, then we can use the perpetuity formula to calculate a

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“continuing value” also known as “terminal value.” This assumes you will hold the stock forever.

Front 39

TV:

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Terminal Value summarizes the value in perpetuity.

Front 40

Buffet’s perfect business “has a moat around it,” and a “knight in the castle.”

Back 40

Company that will be stronger in 5-10 years

Durable Competitive Advantage

Capable Management

Front 41

Markets might fail to reflect economic fundamentals if all of the following three conditions apply:

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Irrational investor behavior.

Systematic patterns in behavior across different investors.

Limits to arbitrage.

Front 42

Value is driven by returns on capital and growth.

Back 42

The U.S. and U.K. stock markets have been fairly priced and have oscillated around their intrinsic price-earnings ratios.

Deviations from intrinsic value occurred in the late 1970s and late 1990s. However, the stock market corrected itself within 3 +/- years to intrinsic levels.

Front 43

Stock markets in the US and UK have been fairly priced and have oscillated around their intrinsic P/E ratios.

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The intrinsic P/E ratio was typically near 15x, with the exception of high inflation years of late 70s and early 80s when it was closer to 10x

Front 44

The late 1970s and late 1990s produced significant deviations from intrinsic valuations.

Back 44

In the late 1970s, when investors were obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on equity indicate that it shouldn't have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late 1990s, when the market reached a P/E ratio of around 30—a level that couldn't be justified by 3 percent long-term real GDP growth or by 13 percent returns on book equity.

Front 45

Taking Advantage of Market Deviations

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Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value

Repurchasing shares when the market under-prices them relative to their intrinsic value

Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value

Divesting particular businesses at times when public company trading & M&A transaction multiples are higher than can be justified by underlying fundamentals

Front 46

Overall, capital markets reward companies that focus on long-term value creation. However, managers are under pressure to achieve short-term results.

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The pressure intensifies when companies mature and begin a transition from high to low growth.

Front 47

The PEG ratio

Back 47

is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.

Front 48

The Dividend Paradox.

Back 48

The value of a share is based on the expected dividends that the share is expected to pay, but forecasting dividends does not tell us much about value unless we are willing to forecast for a very long period in the future.

Front 49

Free Cash Flow is a perverse valuation concept.

Back 49

Discounted cash flow techniques involve forecasting free cash flow, but free cash flow, measured as cash from operations minus cash investment, does not capture value added in the short run. Firms reduce free cash flow by investing to generate value and increase free cash flow by liquidating.

Front 50

Book Value of Equity in the balance sheet serves as an anchor.

Back 50

Firms add value to book value by earning at a rate of return on book value in excess of the cost of capital. So a firm is worth its book value (that is, it has an intrinsic price-to-book ratio of one) if is expected to earn a rate of return on book value equal to its cost of capital, and is worth a premium over book value if it is expected to earn at a rate in excess of the cost of capital. The residual earnings valuation model, in the appendix, provides the thinking about how to calculate an intrinsic price-to-book ratio.

Front 51

Capitalized Earnings serves as an anchor.

Back 51

Firms add value to capitalized earnings by growing earnings at a rate in excess of the cost of capital. So a firm is worth the amount of capitalized forward earnings if earnings are expected to grow at a rate, after reinvestment of dividends, equal to the cost of capital. In this case its forward intrinsic P/E ratio is equal to 1/costof capital. Its intrinsic forward P/E must be greater than this if earnings growth is expected in excess of the cost of capital. The earnings capitalization growth model, in the appendix, provides the thinking about how to calculate the intrinsic P/E ratio.

Front 52

Valuation must be anchored in the book value or earnings.

Back 52

With this anchor, the analyst focuses on the amount of earnings a firm can deliver in the future, either through the prism of return on book value or growth in earnings. Straying from this focus leaves the analyst open to the speculative whims that produce price bubbles. An analyst who always examines value in terms of rate of return on book value or earnings growth has an anchor indeed.

Front 53

ROE

Back 53

Net Income ÷ Shareholder’s Equity; ROE can also be decomposed into the DuPont identity

Front 54

A number of finance scholars and practitioners have argued that stock markets are not efficient—

Back 54

that is, that they don't necessarily reflect economic fundamentals. According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.

Front 55

CF and assets more important than

Back 55

accounting earnings which can be manipulated

Front 56

To increase stock prices, a company must do one of the following which in turn signals value creation to investors:

Back 56

Earn more on existing capital than the market expects.

Invest more than the market expects but only as the return on new capital exceeds the cost of capital.

Reduce cost of capital (assuming the market does not expect this).

Front 57

In general, the P/E ratio is higher for a company with a higher growth rate.

Back 57

Thus using just the P/E ratio would make high-growth companies overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

Front 58

The PEG ratio (Price/Earnings To Growth ratio) is a valuation metric for determining

Back 58

the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.

Front 59

The PEG ratio is considered to be a convenient approximation.

Back 59

It was popularized by Peter Lynch, who wrote in "One Up on Wall Street" that "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e. a fairly valued company will have its PEG equal to 1.

Front 60

The more you can invest in returns above the cost of capital, the more value you create

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(i.e., growth creates more value as long as the return on capital exceeds the cost of capital).

Front 61

You should select strategies that maximize

Back 61

the present value of expected cash flows (or economic profit, you get the same answer regardless of which you choose).

Front 62

The value of a company’s shares in the stock market equals

Back 62

the intrinsic value based on the market’s expectations of future performance (although sometimes the market’s expectations of future performance may not be a reliable estimate of future performance

Front 63

After an initial price is set, the returns that shareholders earn depend more on the changes in expectations about the company’s future performance than the actual performance of the company.

Back 63

For example, if a company is expected to earn 25 percent on its investments, but only earns 20 percent, its stock price will drop, even though the company may be earning more than its cost of capital.

Front 64

Capital budgeting

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Is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.

Process of planning & budgeting for major capital, or investment, expenditures.

Front 65

Discounted cash flow (DCF) valuation is used to find net present value (NPV).

Back 65

NPV is the present value of all future cash flows minus the present value of the cost of the investment.

This valuation requires estimating the size and timing of all of the incremental cash flows from a project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV.

Firms contemplating investments in capital projects should use the net present value rule: that is, take the project if the NPV is positive (or zero); reject if NPV is negative.

Front 66

Three Strategic Contexts in which the NPV Rule is applied

Back 66

:
Context 1: Avoid value destruction - Take only positive NPV investments.

Context 2: Avoid leaving money on the table – Take all the positive NPV investments you can find.

Context 3: Avoid settling for less than the best - Take the highest of competing positive NPV investments.

Front 67

Any NPV analysis is highly sensitive to the

Back 67

discount rate.
Selection of the proper “R” rate is critical to making the right decision.

Front 68

Managers may use models such as the CAPM or the APT to estimate a

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discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Front 69

As stated in the Brealey and Myers text on corporate finance, "Company costs of capital are nearly useless for diversified firms”

Back 69

To the extent that divisions in a corporation have degrees of risk and financial characteristics that are different from the parent corporation, using the overall corporate hurdle rate is certain to lead to incorrect decisions and failure to maximize stockholder wealth. The major consequence of using a single cut-off criterion for all projects is an intra firm misallocation of capital since projects that are initiated by high risk-divisions are more likely to be accepted because of their potentially higher return. A similar bias works against lower risk divisions in that they may be starved for capital because their relatively low returns do not match up to the corporate cost of capital, which is based on normal risk. In a typical risk-averse environment, these lower-risk projects maybe rejected in spite of the fact that on a risk-adjusted basis they might be quite acceptable. Management may, in fact, have capital budgeting procedures that work against its own objective.

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The hurdle rate

Back 70

is the minimum acceptable return on an investment.

Front 71

The hurdle rate should reflect

Back 71

the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix.

Front 72

If divisions have varying degrees of risk and financial characteristics that are different from the parent corporation, using the overall corporate hurdle rate will lead to

Back 72

incorrect decisions and failure to maximize stockholder wealth.

Front 73

Consequence: Misallocation of Capital

Back 73

Projects that are initiated by high risk-divisions are more likely to be accepted because of their potentially higher return.

Another issue mentioned in the Sloan article, “How do you Win the Capital Allocation Game” discusses Non-uniform Assumptions – assumptions about residual values, rates of growth in cash flows, inflation rates, cycle times, amounts of capital required…with different assumptions in different capital allocation requests, senior managers are compelled to compare apples and oranges in ranking projects

Front 74

Our goal is to determine how much value is created (or destroyed) from undertaking an investment.

Back 74

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for projects of this risk level.

The third step is to find the present value of the cash flows and subtract the initial investment.

Front 75

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
.

Back 75

Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal

Front 76

THE IRR IS THE INTEREST RATE AT WHICH

Back 76

NET PRESENT VALUE IS ZERO:

IRR provides a single number summarizing the merits of a project. It is the rate at which the project NPV is zero. The general rule is to accept a project with an IRR greater than the discount rate.

The pitfalls occur when there are:
1) negative cash flows;
2) mutually exclusive projects;
3) projects with different scale or timing

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If you get a very large IRR you should go back and look at your cash flow estimation again.

Back 77

In competitive markets, extremely high IRRs should be rare.

Front 78

NPV and IRR will generally give us the same decision

Back 78

Exception:

Non-conventional cash flows – when the cash flows change sign more than once, there is more than one IRR

When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation

Front 79

Non-conventional cash flows –

Back 79

the sign of the cash flows changes more than once or the cash inflow comes first and outflows come later.

Front 80

If the cash flows are of loan type,

Back 80

meaning money is received at the beginning and paid out over the life of the project, then the IRR is really a borrowing rate and lower is better.

Front 81

If cash flows change sign more than once, then you will have multiple internal rates of return.

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This is problematic for the IRR rule, however, the NPV rule still works fine.

Front 82

How long does it take to get the initial cost back in a nominal sense?

Back 82

Estimate the cash flows

Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule – Accept if the payback period is less than some preset limit

Front 83

Advantages & Disadvantages of Payback

Back 83

advantages:

Easy to understand

Adjusts for uncertainty of later cash flows

Biased towards liquidity

Disadvantages:

Ignores the time value of money

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff date

Biased against long-term projects, such as research and development, and new projects

Front 84

What matters in capital budgeting

Back 84

Cash flows matter—not accounting earnings.

Sunk costs don’t matter.

Incremental cash flows matter.

Opportunity costs matter.

Side effects like cannibalism and erosion matter.

Taxes matter: we want incremental after-tax cash flows.

Also…inflation matters. For low rates of inflation, this is often approximated:
Real Rate  Nominal Rate – Inflation Rate
While the nominal rate in the U.S. has fluctuated with inflation, the real rate has generally exhibited far less variance than the nominal rate.
In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.

Front 85

Sunk costs are not relevant

Back 85

Just because “we have come this far” does not mean that we should continue to throw good money after bad.

Front 86

Opportunity costs do matter.

Back 86

Just because a project has a positive NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.

Front 87

Erosion and cannibalism are both bad things.

Back 87

If our new product causes existing customers to demand less of current products, we need to recognize that.

Front 88

OCF =

Back 88

EBIT – Taxes + Depreciation

Front 89

OCF - Bottom-Up Approach

Back 89

Works only when there is no interest expense
OCF = NI + depreciation

Front 90

OCF -Top-down approach

Back 90

OCF = Sales – Costs – Taxes

Don’t subtract non-cash deductions

Front 91

OCF - Tax Shield Approach

Back 91

OCF = (Sales – Costs)(1 – T) + Depreciation*T

Front 92

FSA plays an important role in:

Back 92

Credit decisions

Valuation of assets and securities

Analysis of competitors

Appraising managerial performance

Front 93

FSA - Income Statement

Back 93

Sources of revenue and growth

Profitability margins & overall performance

Growth strategy

financial position

Front 94

FSA - Balance Sheet

Back 94

Evaluate liquidity, leverage, etc.

Generating CFO? Major sources and uses of cash?

Discuss use of capital structure and financing sources

“Operating” Net Working Capital & Capital Expenditures

Front 95

The stock of cash in the B/S increases from

Back 95

cash flows that are detailed in the cash flow statement.

Front 96

The stock of equity value in the B/S increases from

Back 96

net income that is detailed in the I/S and other comprehensive income and net investment by owners that are detailed in the statement of stockholders' equity

Front 97

The Balance Sheet is a snapshot of the firm’s assets and liabilities at a given point in time

Back 97

Assets are listed in order of liquidity
Ease of conversion to cash

Balance Sheet Identity
Assets = Liabilities + Stockholders’ Equity

Front 98

Liquidity is a very important concept.

Back 98

Students tend to remember the “convert to cash quickly” component of liquidity, but often forget the part about “without loss of value.” We can convert anything to cash quickly if we are willing to lower the price enough, but that doesn’t mean it is liquid.


A firm can be TOO liquid. Excess cash holdings lead to overall lower returns.

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Cash & Equivalents:

Back 99

reported at fair value

Front 100

Short Term Investments:

Back 100

reported at fair value

Front 101

Accounts Receivable:

Back 101

(quasi fair value) reported at net realizable value – the net amount expected to be received on collection

Estimation of uncollectible accounts (reserve for bad debts) is deducted from total a/r

What happens when a firm overvalues receivables (by understating reserves for bad debts)?

Front 102

Inventories:

Back 102

valued at lower of cost or market value

Front 103

Long-term Tangible Assets:

Back 103

valued at historical cost

Front 104

Recorded “Identifiable” Intangible Assets:

Back 104

valued at historical cost
Normal amortization

Front 105

Goodwill:

Back 105

valued at historical cost


Subject to revaluation & impairment

Front 106

Inventory represents the cost of unsold goods on the balance sheet.

Back 106

When these goods are sold, their cost is transferred to the Income Statement and reported as cost of goods sold (or cost of sales).

Front 107

Fixed Assets

Back 107

(long-lived physical assets): Includes plants, buildings, manufacturing equipment, trucks, and furnishings. These resources are expected to produce future revenues.
Note: instead of expensing fiber optic line maintenance according to GAAP; WorldCom capitalized and depreciated it (an expense should have been reflected on I/S and thus earnings were overstated)

Front 108

Investment securities can be in the form of either debt or equity.

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Debt securities. The accounting for debt securities depends upon whether the securities are classified as: trading, held to maturity, or available-for-sale . Securities classified as trading or available-for-sale are on the balance sheet at market value (marked-to-market). Debt securities held to maturity are on the balance sheet at cost, unless there is a decline in market value (which is other than temporary), in which case the investment is written down to the lower market value.

Equity securities. The accounting for equity securities is determined by the ability of the investor to influence or control the investee’s activities. Evidence of this ability is based on the percent of voting securities controlled by the investor company. Generally, the accounting depends upon whether the investee is (i) less than 20% owned (ii) 20-50% owned or (iii) more than 50% owned.

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Types of identifiable intangible assets:

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patents, copyrights, trade names, trademarks, special formulas, processes, technologies, licenses, franchises, and customer lists.

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Goodwill: Goodwill is an unidentifiable intangible asset,

Back 110

recorded only if a firm acquires another firm. Goodwill is the difference between the purchase price and the fair value of assets acquired.
Target’s assets valued at Fair Market. The excess of purchase price over FMV of the target is allocated to intangible assets, that is further divided into “identifiable” (normal amortization) and “unidentifiable” tangible assets (“revaluation” is subject to an annual impairment review)

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The value of an asset is strongly dependent on:

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its depreciable life;

the depreciation method used

the residual value

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Short-Term Payables

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(fair value):
A/P, interest payable, taxes payable

Front 113

Short-Term & Long-Term Borrowings

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(fair value):
Short-term debt, long term bonds, lease obligations, bank loans and current portion of long term borrowing

Front 114

Accrued & Estimated Liabilities

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(quasi fair value):
Pension liabilities, accrued liabilities, warranty liabilities, unearned (deferred) revenue, estimated restructuring liabilities

Front 115

Off-balance Sheet Liabilities:

Back 115

Operating lease or synthetic lease
Securitized assets
Debt, guarantees or joint ventures of unconsolidated affiliates
Contingent liabilities – derivative transactions, legal judgments/settlements

Front 116

Long Term Debt includes:

Back 116

Bank loans: recorded at nominal value of the loan.

Bonds issued to the public

Issued at par: valued at principal amount.

Issued at premium or discount: bonds recorded at issue price, but premium or discount is amortized (expensed) over life of the bond.

Book values of debt are unaffected by changes in interest rates during the life of the loan or bond. Thus, books values and market values may differ.

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Operating lease:

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Lease expense recorded as an expense; no asset or debt created.

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Capital lease:

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when signed, a lease is recognized both as an asset (fixed asset) and a liability (debt). The amount recorded is the present value of the lease payments.

Front 119

Enron:

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The company used off-balance-sheet partnerships and according to news reports, failed to disclose nearly $4 billion in debt, instead calling them hedge instruments. The company showed $8-10 billion of on-balance-sheet debt.
Standard & Poor’s testified that Enron committed multiple acts of deceit and fraud relating to these partnerships. The off-balance-sheet partnerships had been created and designed to conceal from others the true picture of Enron’s financial status.

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Examples of Off-Balance Sheet Debt:

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1) Operating leases: Some operating leases are in substance capital leases.
2) Synthetic leases: This is an off-balance-sheet structure that allows the sponsor to gain all of the benefits of owning the asset including control of the asset and the opportunity to purchase the asset at a predetermined rate at the end of the lease without “accounting” ownership.
3) Guarantees
4) Sale of receivables
5) R&D financing arrangements
6) Take-or-pay and throughput contracts
7) Joint ventures

Off-balance-sheet financing transactions are arrangements to finance assets and create obligations that do not appear on the balance sheet.
Some types of off-balance-sheet financings are:
Operating leases
Synthetic leases
Third-party agreements
Throughput agreements
Take-or-pay agreements
Repurchase agreements
Sales of receivables with recourse

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Beware of Widening Gross Margins!

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Most retailers are in a position to boost their profits in the short term, by widening the gross margin - jacking up prices. They may be sacrificing long-term growth for a short-term profit advantage.

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Inventory turnover

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(cost of sales divided by avg inventory)

Front 123

Same-store-sales growth

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(the change in sales for stores open at least one year) & sales per square foot

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The longer inventory sits on a company's shelves,

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the lower the rate of return on those assets and the greater their vulnerability to falling prices.

Front 125

To Calculate Capital Efficiency:

Back 125

Cost of Sales/(Inventory-AP)
divide this number into gross profit margin to arrive at a turnover-like “capital efficiency”

Front 126

Current accounting rules allow retailers that sign certain long-term leases to omit the leased property from their balance sheets.

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(The basic rule is that omission is acceptable if the lease term is less than 75% of the useful life of the building.)

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Steps in Adjusting for Operating Leases

Back 127

Step 1: Discount future minimum lease payments at the firm’s borrowing rate and add amount to total debt for calc of ratios.

Step 2: Estimate implied interest expense (implied principal amount of debt times interest rate). Add implied interest expense to book interest expense and reduce lease expense by same amount.

Step 3: Reclassify balance of lease expense to depreciation expense

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To improve financial ratio analysis, Standard & Poor’s Ratings Services uses a financial model that capitalizes off-balance sheet operating lease commitments and allocates minimum lease payments to interest and depreciation expenses.

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Impacted Ratios: debt-to-capital ratios, interest coverage, funds from operations to debt, total debt to EBITDA, operating margins, and return on capital.
This technique is, on balance, superior to the alternative “factor method”, which multiplies annual lease expense by a factor reflecting the average life of leased assets.

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Statement of Cash Flows

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Describes how the firm generated and used cash during the period. Cash flows are divided into 3 types in the statement - Cash flows from the following inflows and outflows:

Operating (generated from selling products net of cash to do so)

Investing (cash spent on purchasing assets less cash received from selling assets)

Financing (cash transactions with claimants)

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A company’s ability to repay debt

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Determined by capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs

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A company’s willingness to repay debt

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Determined by the competing cash management needs; these include working capital (CA-CL), plant capacity requirements to sustain existing operations, capital expenditures for new products, service development or market expansion, shareholder dividends or debt requirements

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Cash Flow From Operations “CFO”

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Net income is nice, but cash flow is truly sweet.
CFO reflects the hard reality of how much cold currency is flowing into and out of a company.

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Steps in Reviewing Statement of Cash Flow

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Scan Big Picture

Pinpoint Good and Bad News

Major Sources and Uses of Cash

Does CFO cover CapEx?

What does the Statement of Cash Flow tell us about the company’s positioning?

Facing Bankruptcy or Top Condition?

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The firm’s weighted average cost of capital (WACC) is

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the weighted average of the expected after-tax rates of return of the firm’s various sources of capital.

It is the discount rate that should be used to discount the firm’s expected free cash flows to estimate firm value.

It can be viewed as its opportunity cost of capital.

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Opportunity cost of capital

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is the expected rate of return that its investors forgo from alternative investment opportunities with equivalent risk.

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We define the firm’s invested capital as

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capital raised through the issuance of interest-bearing debt and equity (both preferred and common).

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WACC is defined as

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the average of the estimated required rates of return for the firm’s interest-bearing debt (kd), preferred stock (kp), and common equity (ke). The weights used for each source of funds are equal to the proportions in which funds are raised.
Note that the cost of debt financing is adjusted downward to reflect the interest tax-shield.

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calculating WACC

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Step 1. Estimate capital structure and determine the weights of each component: wd, wp, we.

Step 2. Estimate the opportunity cost of each of the sources of financing: kd, kp, ke, and adjust for the effects of taxes where appropriate.

Step 3. Calculate WACC by computing a weighted average of the estimated after-tax costs of capital sources used by the firm.

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WACC assumes constant capital structure,

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if this does not exist (i.e. LBO) analyst should apply APV model

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Cost of Debt (kd)

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We use yield to maturity (YTM) on publicly-traded bonds or the risk-free rate plus a default spread given actual (or projected) debt rating

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Cost of Preferred (kp)

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Preferred generally pays a constant dividend every period (perpetuity), so we take the perpetuity formula, rearrange and solve for kp

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Cost of Common Equity (ke)

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We use CAPM methods or DCF approach

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Use yield to maturity (YTM) on publicly-traded bonds

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Risk-free rate plus default spread given actual (or projected) debt rating

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If debt is not publicly-traded, analyst should estimate Kd using the YTM on a

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portfolio of bonds with similar credit ratings and maturity.

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For debt with default risk, the expected cash flows must reflect

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the probability of default (Pb) and the recovery rate (Re) on the debt in the event of default

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when the firm’s debt is speculative-grade, the yield to maturity on the firm’s debt

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(which represents the promised, not expected, yield on the debt) will overestimate the cost of debt financing.

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CAPM

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may be used to estimate a company’s Ke based on the risk-free rate plus a premium for equity risk.

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To understand the relation between risk and return it is useful to decompose the risk associated with an investment into two components:

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Systematic risk or nondiversifiable risk

Nonsystematic risk or diversifiable risk

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Systematic risk or nondiversifiable risk

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Variability that contributes to the risk of a diversified portfolio
Examples: market factors such as changes in interest rates and energy prices that influence almost all stocks.
The logic of the CAPM suggests that stocks that are very sensitive to these sources of risk should have high required rates of return, since these stocks contribute more to the variability of diversified portfolios.

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Nonsystematic risk or diversifiable risk

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Variability that does not contribute to the risk of a diversified portfolio.
Examples: random firm-specific events such as lawsuits, product defects, and various technical innovations.
These sources of risk should have almost no effect on required rates of return because they contribute very little to the overall variability of diversified portfolios.

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“Risk-adjusted return” CAPM takes into account

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beta, the risk free rate, and the expected return on the market. It is also the equation for the Security Market Line:

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Beta is =

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Cov(Ri,RM)/Var(RM)

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Risk free rate

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Identifying the risk-free rate: Analysts typically use current yields on U.S.
Treasury securities to define the risk-free rate of interest when evaluating the cost of
capital in the United States. When applying the CAPM in other economies, it is customary
to use their domestic risk-free rates so as to capture differences in rates of inflation
between the United States and that economy.
Choosing a maturity: As a general rule, we want to match the maturity of the riskfree
rate with the maturity of the cash flows being discounted. In practice, maturity
matching is seldom done, however. Most textbooks suggest that short-term rates be used
as the risk-free rate, since they are consistent with the simplest version of the CAPM.
However, because the estimated cost of equity is typically used to discount distant cash
flows, it is common practice to use a long-term rate for, say, 10- or 20-year maturities as
the risk-free rate. We agree with this practice, however, as we note below, the beta estimate
used in the CAPM equation should also reflect this longer-maturity risk-free rate.

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There is a reward for bearing risk

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There is not a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away

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How do we measure market/systematic risk?
.

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We use the beta coefficient

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What does beta tell us?

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A beta of 1 implies the asset has the same systematic risk as the overall market
A beta < 1 implies the asset has less systematic risk than the overall market
A beta > 1 implies the asset has more systematic risk than the overall market

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Market Portfolio -

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Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.

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Beta -

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Sensitivity of a stock’s return to the return on the market portfolio.

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Firm’s historical or predicted βe

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Estimated by regressing the firm’s excess stock returns on the excess returns of a market portfolio, where excess returns are defined as the returns in excess of the risk-free return
Analysts typically estimate using historical returns
We must ensure this accurately reflects the relationship between risk and return in the future

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Factors favoring historical company beta

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-Using current capital structure in developing weights
-No change expected in business mix

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Factors favoring forecasted beta

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-Using future weights, not historical weights to estimate WACC
-Projecting change in business mix

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Factors favoring historical industry beta:

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-Change in business mix expected
-Firm in Chapter 11
-Firm betas vary substantially by source
-Firm not publicly-traded

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Beta estimate based on βe of comparable firms

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Publicly-traded peers selected by business mix and relative risk

Involves adjustments for differences in capital structure
Involves “unlevering” the betas for each of the sample firms to remove the influence of capital structure

This is Preferred estimation method for privately-held firms

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levering/unlevering beta

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To unlever: levered βe for comparable group/(1+(debt to equity ratio)*(1- tax rate))
To relever: average unlevered beta for comparable group * (1+(target debt to equity ratio)*(1- tax rate))

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many analysts make a common mistake.

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They fail to match the maturity of the risk-free rate, used in Equation 4.6 to calculate beta, with the maturity of the rate used to calculate the equity risk remium.Very simply, if you use a long-term Treasury bond yield as the risk-free rate, then the excess return on the market used to calculate beta should be the excess return of the market portfolio over the long-term Treasury bond return. Although we typically estimate a company’s beta using historical returns, we should always be mindful that our objective is to estimate the beta coefficient that reflects the relationship between risk and return in the future. Unfortunately, the beta estimate is just that—an estimate—and is subject to estimation error.

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Time Frame for measurement of βe:

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A longer time frame (5 years) smoothes out irregularities in the market, which may be present over shorter periods of time.

A shorter period (2 years) may be more appropriate for companies in dynamic, high growth industries or for recently restructured companies.

Typically at least 3 years is used to capture statistically significant return experience.

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Equity risk premium

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is an estimate of excess returns above the risk-free rate.
The “extra” return earned for taking on risk
Treasury bills are considered to be risk-free
The risk premium is the return over and above the risk-free rate

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Historical data suggest that the equity risk premium for the market portfolio has averaged

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6% - 8% per year over the past 75 years.

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Proposed modifications of CAPM – i.e. size premium
.

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Ibbotson Associates, divides firms into discrete groups based on the total market value of their equity (the following is based on the 2006 Ibbotson NYSE Decile-Size Premium Data):
Large-cap: firms with market value of equity above $7.1B - no size premium.
Mid-cap: firms with market value of equity between $7.14B and $1. 7B – apply size premium of 1.02%.
Low-cap: firms with market value of equity between $1.728B and $587M – apply size premium of 1.81%
Micro-cap: firms with market value of equity below $586M - apply size premium of 3.95%

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The cost of equity for smaller companies is generally

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underestimated in relation to the S&P 500.

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Another approach to estimate ke is through the use of multifactor risk models that capture the risk of investments with multiple betas and factor risk premiums.

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Risk factors:
Macroeconomic variables: changes in interest rates, inflation, or GDP
Factor portfolios

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The Fama-French three-factor model is the most widely used

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It attempts to capture the determinants of equity returns using three risk premiums:
The equity risk premium of the CAPM: RMRF – return on equity index minus 30 day T-bills
A size risk premium: SMB (small minus big) – return on small cap portfolio minus return on large cap portfolio
A risk premium related to the relative value of the firm when compared to its book value (historical cost-based value): HML (high minus low)

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Limitations of cost of equity estimates based on historical returns

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Historical security returns are highly variable.
Market conditions are changing.
Historical returns exhibit survivor bias.

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imputed rate of return

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Instead of using the DCF model to determine the value of an investment, the method takes observed values and estimated cash flows and estimates the internal rate of return, or the implied cost of equity capital.

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Capital Structure

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Use market value weights for capital structure
If a change is expected, target weights should replace current weights

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Cost of Capital Best Practices

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Yield on a long-term bond in the estimation of the market risk premium, as well as in calculating the excess market returns that are used in the estimation of beta
Use multiple methods for estimating ke
The focus of our analysis should be forward-looking; but should not ignore historical data.

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The market comparables approach plays an important role in the pricing of IPOs.

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The lead underwriter determines an initial estimate of a range of values for the issuer’s shares. The estimate typically is the result of a comparables valuation analysis.
Underwriters like to price the IPO at a discount, typically 10% to 25%, to the price the shares are likely to trade on the market. Underwriters argue that this helps generate good after-market support for the offering.

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The underwriter will utilize several valuation ratios such as the ones discussed in this chapter. For example, the underwriter may estimate enterprise value using an EBITDA multiple and then subtract the firm’s net debt (i.e., interest-bearing debt less the firm’s cash reserves) to get an estimate of the issuer’s equity value. The price per share then is simply equity value divided by the number of shares the firm is issuing.

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Given the variety of comparables and valuation ratios typically used in this analysis, this exercise will result in a range of equity prices (say $10 to $15 per share) for the new issue, not a single offering price.

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After setting the initial price range, the underwriters go through what is known as a “book-building” process,

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where they gauge the level of investor interest. Specifically, over the weeks leading up to the offering date, the lead underwriter and company executives travel around the country meeting with potential investors. These visits are known as the “road show.” During these visits the underwriter’s sales force collects information from potential institutional investors related to their interest in purchasing shares at various prices within the initial valuation range. This information forms the basis for the “book,” which contains nonbinding expressions of interest in buying shares of the IPO at various prices, generally within the initial price range.

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relative valuation

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Step 1: Identify similar or comparable investments and recent market prices for each.
Step 2: Calculate a “valuation metric” for use in valuing the asset.
Step 3: Calculate an initial estimate of value.
Step 4: Refine or tailor your initial valuation estimate to the specific characteristics of the investment
Does the company deserve a premium or discount
Dick’s Sporting Goods and UPS IPO Valuation cases

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The primary reason for the popularity of public comps valuation analysis is the model’s simplicity.

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Unlike the DCF methods, valuations based on price multiples do not require detailed multiple-year forecasts of a number of parameters, including growth, reinvestment, and cost of capital. Under the price multiple approach, a current measure of performance (or a single forecast of performance) is converted into a value through application of a price multiple for comparable firms.

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The method of comparables involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued in relation to a benchmark value of the multiple.

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A current measure of performance (or a single forecast of performance) is converted into a value through application of a multiple for comparable firms.
Choices for the benchmark value of a multiple include the multiple of a closely matched individual stock and the average or median value of the multiple for the stock’s peer group of companies or industry.

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The economic rationale underlying the method of comparables

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is the law of one price—the economic principle that two identical assets should sell at the same price.

he method of comparables is perhaps the most widely used approach for analysts reporting valuation judgments on the basis of price multiples.

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If we may find that an asset is undervalued relative to a comparison asset or group of assets, and we may expect the asset to outperform the comparison asset or assets on a relative basis.

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However, if the comparison asset or assets themselves are not efficiently priced, the stock may not be undervalued—it could be fairly valued or even overvalued (on an absolute basis)

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reasons for going public

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Capital Raising:

Growth

Expansion

Repay debts

Ownership Considerations:

Buy shares from existing shareholders

Cash out owners

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10 key steps to an IPO

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Choose underwriter “beauty contest”
File registration statement and proxy with SEC
SEC studies registration statement during “waiting period”
Distribute copies of “red herring” with price left blank
Management and underwriters make presentations to prospective investors in a “road show”
Underwriters receive oral indications of willingness to buy
Registration statement becomes effective unless the SEC sends a letter of comment suggesting changes
When registration statement becomes effective, a price is determined and selling efforts get underway
- Valuation typically determined through market analysis, comparables, and demand for offering
Distribution of shares takes place through a syndicate of investment banks
If offering does not “trade up” right away the syndicate will usually support the price for the first week or so before breaking the syndicate

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Dicks sporting goods IPO

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IPO Pricing at a Discount!
Dick's had to lure institutional investors by lowering the offering price.
Priced 10/15/02 at $12.25 a share
Below an expected range of $15 to $18
Implied value based on comps valuation analysis was $26-36

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Green Shoe Clause:

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In the underwriting agreement, there is a clause that is known as the overallotment provision. The phrase was first used with the Green Shoe Company.
The clause allows the underwriter to purchase an extra amount of shares several weeks after an IPO (the amount can be as much as 15%).
Typically, the underwriter will exercise this option when the stock goes above the offering price.
The investment bankers desire this option to cover excess demand. However, the firm may not need the additional capital.
Options last for about 30 days and involve no more than 15% of newly issued shares.
A clear benefit to the underwriter and a cost to the issuer. The underwriter exercises the option if the price of the new issue exceeds the offering price.

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Basic Equity Valuation Methodologies

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In determining value, there are several basic analytical tools that are commonly used by financial analysts:
Analysis of Selected Publicly Trading Company Multiples –

The “Street” Approach to valuation
Implied values based on multiples of publicly traded comparable companies or past merger and acquisitions
Relative Valuation Using Market Comps (Chapter 6)

Discounted Cash Flow Models
Earnings & Free Cash Flows are discounted to present (perpetuity model, etc.)
Enterprise Valuation: Enterprise DCF (coming in Chapters 7-8)

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Relative Valuation

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Technique used to value businesses, business units, and other major investments.

Assumes similar assets should sell at similar prices.

The critical assumption underlying the approach is that the “comparable” assets/transactions are truly comparable to the investment being evaluated.

Relative valuation should be used to complement DCF analysis

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DCF models estimate the “intrinsic” value of a firm. Price multiples value a firm “relative” to how similar firms are valued by the market at the moment.

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An asset expensive on an intrinsic value basis may be “cheap” on a price multiple basis.

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Relative Valuaiton Metrics

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Step 1: Identify similar or comparable investments and recent market prices for each.
Step 2: Calculate a “valuation metric” for use in valuing the asset.
Step 3: Calculate an initial estimate of value.
Step 4: Refine or tailor your initial valuation estimate to the specific characteristics of the investment.

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Enterprise value (EV) is

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total company value (the market value of debt, common equity, and preferred equity) minus the value of cash and investments.

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Use of Diluted Shares Outstanding to calculate Equity Value

Back 194

Stock Price x Diluted Shares Outstanding

The Treasury Stock Method

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Enterprise Value is typically calculated with a Net Debt figure

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(subtract Cash and Equivalents).
It is important to compare each company on common terms.
Company with non-operating assets (cash and marketable securities)

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LTM is a term used to describe financial results during the period of the last 12 months.

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It can also be called Trailing Twelve Months (TTM).
The process of calculating LTM involves locating a company’s most recent reporting period and counting back 12 months.
So if it has been 6 months since the company reported its 10K that is your adjustment, 3 months, etc.

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When calculating a P/E ratio using trailing earnings, care must be taken in determining the EPS number. The issues include

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transitory, nonrecurring components of earnings that are company-specific;
transitory components of earnings due to cyclicality (business or industry cyclicality);
differences in accounting methods; and
potential dilution of earnings per share.

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Because of cyclic effects, the most recent four quarters of earnings may not accurately reflect the average or long-term earnings power of the business, particularly for cyclical businesses—businesses with high sensitivity to business or industry cycle influences. Trailing earnings per share for such stocks are often depressed or negative at the bottom of the cycle and unusually high at the top of the cycle.

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Empirically, P/Es for cyclical companies are often highly volatile over a cycle without any change in business prospects: high P/Es on depressed EPS at the bottom of the cycle and low P/Es on unusually high EPS at the top of the cycle, a countercyclical property of P/Es known as the Molodovsky effect. Named after Nicholas Molodovsky who wrote on this in the 1950s. P/Es may be negatively related to the recent earnings growth rate but positively related to anticipated future growth rate, because of expected rebounds in earnings.

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Nomalized EPS can be used to create a normalized P/E. Two methods for nomalizing EPS?

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The method of historical average EPS. Normal EPS is calculated as average EPS over the most recent full cycle.
The method of average ROE. Normal EPS is calculated as the average return on equity from the most recent full cycle, multiplied by current book value per share.

Which method is preferred?
The first method is one of several possible statistical approaches to the problem of cyclical earnings. The method does not account for changes in the business’s size, however.
The second alternative, by using recent book value per share, reflects more accurately the effect on EPS of growth or shrinkage in the company’s size. For that reason, the method of average ROE is sometimes preferred.

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The analyst should consider the impact of potential dilution on earnings per share.

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Dilution refers to the reduction in the proportional ownership interests as a result of the issuance of new shares.

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Companies are required to present both basic earnings per share and diluted earnings per share.

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Basic earnings per share reflect total earnings divided by the weighted average number of shares actually outstanding during the period.
Diluted earnings per share reflect division by the number of shares that would be outstanding if holders of securities such as executive stock options, equity warrants, and convertible bonds exercised their options to obtain common stock.

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The treasury stock method is an easy way to calculate diluted shares outstanding.

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We assume that options or warrants are exercised and the proceeds from the exercise of the options or warrants are used to purchase common stock for the treasury.

The treasury stock method increases the number of shares outstanding whenever the exercise price is below the market price of the common stock.

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The treasury method is used to calculate the value of “vested” or “in-the-money” options to arrive at a fully diluted shares value.

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To calculate fully diluted shares, use the Treasury Method formula:
[(stock price- strike price)/(stock price)] x number of options outstanding
Simplifying this equation, we get: [1-(strike price/stock price)] x number of options outstanding

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Underlying logic: When the stock price is higher than the strike price, the option is “in-the-money” because we can buy the stock price at the cheaper, strike price. The difference is also known as the spread. This is the money that we would make if we were to exercise the options, because we can buy it at the strike price and sell it at the market stock price. In this example, our spread for each option is $22-10 = $12.

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This is how much the option is worth. If we were to use the option to buy more common shares at the current market stock price, we would need to exchange 1.83 ($22/12) options for each common share. Given this option-to-common stock exchange rate, we can calculate the number of common stock that we would receive if we were to convert the 200 options we currently have. Thus, we would receive 109 common shares (200/1.83) for our 200 options.

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One metric that appears to address the impact of earnings growth on P/E ratios is P/E to growth (PEG) ratio.

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The PEG ratio is calculated as the stock’s P/E divided by the expected earnings growth rate. The ratio in effect calculates a stock’s P/E per unit of expected growth. Stocks with lower PEGs are more attractive than stocks with higher PEGs, all else equal.

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The PEG ratio is useful, but must be used with care for several reasons:

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The ratio assumes a linear relationship between P/E ratios and growth. The model for P/E in terms of DDM shows that in theory the relationship is not linear.
The ratio does not factor in differences in risk, a very important component of P/E ratios.
The ratio does not account for differences in the duration of growth. For example, dividing P/E ratios by short-term (5 year) growth forecasts may not capture differences in growth in long-term growth prospects.

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In the P/E ratio, the measure of value, EPS, is a flow variable relating to the income statement.

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By contrast, the measure of value in the P/B ratio, book value per share, is a stock or level variable coming from the balance sheet.

Intuitively, book value per share attempts to represent the investment that common shareholders have made in the company, on a per-share basis.

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Book value is generally positive even when

Back 208

EPS is negative

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Book value per share is more stable than EPS

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P/B may be more meaningful than P/E when EPS are abnormally high or low, or are highly variable.

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As a measure of net asset value per share, book value per share has been viewed as appropriate for valuing companies composed chiefly of liquid assets, such as

Back 210

finance, investment, insurance, and banking institutions

Also used in valuation of companies that are not expected to continue as a going concern

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Because book value is a cumulative balance sheet amount, book value is generally positive even when EPS is negative. We can generally use P/B when EPS is negative,

Back 211

whereas P/E based on a negative EPS is not meaningful.

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Because book value per share is more stable than EPS, P/B may be more meaningful than P/E when EPS are

Back 212

abnormally high or low, or are highly variable.

Front 213

As a measure of net asset value per share, book value per share has been viewed as

Back 213

appropriate for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions. For such companies, book values of assets may approximate market values.

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Differences in P/B ratios may be related to

Back 214

differences in long-run average returns, according to empirical research.

Front 215

Other assets besides those recognized in accounting may be critical operating factors, human vs. physical capital.

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P/B can be misleading as a valuation indicator when there are significant differences among the level of assets employed by companies.

Front 216

Accounting effects on book value may compromise book value as a measure

Back 216

of shareholders’ investment in the company.

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Inflation and technological change eventually drive a wedge between the book value and the market value of assets.

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As a result, book value per share often poorly reflects the value of shareholders’ investments.

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We don’t like the P/EBITDA multiple, because

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EBITDA is a flow to both debt and equity. A multiple using total company value in the numerator was logically more appropriate.

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Because the numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common stock.

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If the analyst can assume that the business’s debt and preferred stock (if any) are efficiently priced, the analyst can also draw an inference about the valuation of common equity.

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EV / EBITDA

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Rationale:
More appropriate than P/E for comparing companies with different financial leverage (debt)
EBITDA is a pre-interest earnings figure, in contrast to EPS, which is post-interest.
By adding back depreciation and amortization, EBITDA controls for differences in depreciation and amortization across businesses
Good for valuation of capital-intensive businesses (for example, cable companies and steel companies).
EBITDA is frequently positive when EPS is negative.

Drawbacks:
EBITDA will overestimate cash flow from operations if working capital is growing
Free cash flow to the firm more directly reflects the amount of required capital expenditures, has a stronger link to valuation theory than EBITDA. Only if depreciation expenses match capital expenditures do we expect EBITDA to reflect differences in businesses’ capital programs. This can be meaningful for the capital-intensive businesses to which this multiple is often applied.

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Firms gorw and expand their operations in one of two ways;

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1) they acquire productive capacity by assembling the necessary assets, or alternatively, they acquire the productive assets of and existing firm. In the case of the firm assembling the neessary assets itself, the valuation problem is called project valuation. In the case of a firm acquiring productive assets by purchasing an existing firm, we refer to the valuation problem as one of enterprise valuation.

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Issues to consider when valuing an investment

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1) does the "story" make sense - does the firm have an advantage due to specialized knowledge or circumstance that allows it to capture the benefits of the investment?
2) What are the risks entailed in the investment and how can they be assessed and dealt with in the analysis?
3) how can the investment be finaced? - Should the project be financed on the firms balance sheet or should it be fianced off the blance sheet with nonrecourse debt?
4) How does the investment affect near-term earnings?
5)does the investment have inherent flexibilities that allow the firm to modify it in response to changing circumstances?

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enterprise valuation

Back 223

the valuation of an entire firm

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Investment evaluation process

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1) Conduct a strategic assesment - Value proposition
2) estimate the investments value - crunch the numbers
3)Prepare an investmetn evaluation report and recommendations to management
4)Evaluate the investments strategic assumptions
5) review and evaluate the methods and assumptions used to estimate the investments NPV
6) Adjust for inherent estimation errors induved by bias, and formulate a recommendation regarding the proposed investment
7)make a decision
8)seek fianl managerial and possibly board approval

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Bias may enter into the investment evaluation process because of

Back 225

Human nature: Psychologists have found that individuals tend to be overconfident and overly optimistic about their own ideas.

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If a project can be easily funded internally, it is more likely to be approved than

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if it requires external funding.

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hurdle rate

Back 227

the minimum rate of return on acceptable projects

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cash flows recieved at different times have different values, and they can only be aggregated after

Back 228

properly adjusting for the time value of money.

Front 229

The idea behind DCF is simple

Back 229

The value of an investment is determined by the magnitude and timing of the cash flows it is expected to generate

Front 230

Steps of DCF analysis

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1) Forecast the amount and timing of future cash flows - PFCF

2) Estimate a risk-appropriate discount rate - WACC

3)Discount the Cash Flows

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Three Key Issues related to the proper definition of investment cash flows

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1) what cash flows are relavent to the valuation of a project or investment

2) Are the cash flow forecasts either conservative or optimistic

3) what is the difference between equity and project cash flows

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Relavent cash flows

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these include the cash flows directly generated by the investment as well as the indirect effects that the investment may have on a firms other lines of business

Front 233

True net or incremental cash flows

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The new product cash flows net of cannibalization

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A common mistake in the calculation of cash flows has to do with what are known as

Back 234

sunk costs

expenditures that either have already been made or must be made regardless of whether the firm proceeds with the investment. as a result, sunk costs are not incremental costs and should thus be ignored in the investment analysis

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in general the research and development costs (incurred in the past) should be viewed as

Back 235

sunk costs and should not be relevant to the analysis

Front 236

it is critical that only the .... be considered in performing the valuation of the project

Back 236

the incremental costs and incremental revenues that are a direct result of the firms decision to undertake a project

Front 237

2 examples where we tend to observe what are clearly hoped for rather than expected cash flows are

Back 237

emerging markets and venture capital investments

Front 238

and investment projects cash flow is simply the sum of the

Back 238

cash inflows and outflows from the project

Front 239

Equity Free Cash Flow - EFCF

Back 239

focuses on the cash flow that is available for distribution to the firms common shareholders.

consequently EFCF is used to value the equity claim in the project.

therefore EFCF represents the cash produced by the project that can be distributed to the firms equity holders or owners. these distributions can take the form of cash dividends or share repurchases

Front 240

Project Free Cash Flow - PFCF

Back 240

this definition combines the cash flows available for distribution to both the firms creditors and equity holders. PFCF becomes the basis for estimating the value of the project as a whole

Front 241

in the term free cash flow, the word free refers to

Back 241

the fact that the cash flow under discussion is available --not needed for any particular purpose.
the cash flow equals the amount of cash left over after paying all expenses including any additional investments in the project

Front 242

the allocation of the original cost against revenues in the form of depreciation and amortization expenses does not

Back 242

Represet an actual cash payment since they are not out of pocket payments.

Front 243

Capex can be calculated by

Back 243

analyzing how ppe (net) changes over time on the balance sheet

the amount of capex in any given period reflects the amount of plant and equipment that physically wears out and needs replacement in combination with the demands of growing revenues, which require added plant and equipment capacity.

Front 244

The cash flow impact of any additional investment in the firm must make in working capital then is measured by the

Back 244

change in operating net working capital

Front 245

as a project winds down and revenue stabilizes and then decline,

Back 245

the firms need for working capital will decrease, which means that the change in operating net working capital becomes negative

Front 246

When a firm uses debt to partially finance its investments there are two cash flow consequences

Back 246

1) When the debt is issued there is a cash inflow equal to the net proceeds from the issue

2) The firm must make cash outlays for principal and interest throughout the life of the loan. Since interest expense is tax deductible, it reduces the taxes the firm has to pay

Front 247

shareholder cash flows become more volatile when

Back 247

the firm utilizes financial leverage

this added volatility in EFCF is a direct result of the fact that the creditor return is fixed.

Thus as projects EBIT grows large, a larger fraction of the higher EBIT goes to the firms shareholders.

Front 248

the effect of financial leverage

Back 248

is to reduce the required investment by equity holders and at the same time increase the risk of the shareholders investment. Because of the higher risk, shareholders require higher rates of return to entice them to invest in levered projects, other things remaining constant

Front 249

PFCF

Back 249

The cash flow available from the proejct that can be distributed to both the creditors and owners.

combines the cash flows available for distribution to all the firms sources of capital (creditors, preferred and common stockholders)

Front 250

In essence, PFCF is EFCF for

Back 250

a project that has been all equity financed

Front 251

Price decay function

Back 251

commonly used in evaluating prices of high-tech products such as computer semiconductors.

this means that every time the cumulative market volume of production and sales for a given product doubles the price will drop by a certain percentage - this relationship is sometimes referred to as the experience curve

Front 252

Learning curve model

Back 252

each time production volume doubles the per unit variable costs associated with that product will drop by a certain percentage (i.e. 30 %) of the variable cost corresponding to half the current volume.

Front 253

contribution margin

Back 253

(price per unit - variable cost per unit)/ unit price

Front 254

Net Present Value

Back 254

the difference in the present value of the projects expected future cash flows and the initial cost of making the investment

Front 255

IRR

Back 255

the compound rate of return earned on the investment

Front 256

Mutually exclusive investments

Back 256

multiple alternatives or competing projects where the firm must select only one

Front 257

payback model

Back 257

the method is straightforward and involves estimating the number of years of expected future cash flows that are required to sum to the investments initial outlay

3 drawbacks

1) it doesnt account for time value of money

2) it ignores the value of cash flows received after the payback period.

3) The cutoff is not tied to market conditions. it depends on the managers biases and may often be outdated

Front 258

npv

Back 258

the project offer a NPV equal to the difference in the expected value we have placed on it and the cost of making the investment

Front 259

IRR

Back 259

the discount rate that will result in a zero NPV for the investment.

Front 260

Scenario analysis

Back 260

is the technique that helps the analysts explore the sensitivity of an investments value under different situations or scenarios that might arise in the future.

Here we use the term scenario to refer to different sets of assumptions about the realized values of each of the value drives

Front 261

in a break even sensitivity analysis we ask the question:

Back 261

what is the critical value of a particular driver that pushes the NPV down to zero.

although this approach can be useful in identifying drivers that are critical to project success it has its limitations.

1) only considers one value driver at a time while holding others equal

2) we don't have any idea about the probabilities associated with exceeding or dropping below the break even value drivers

3) we do not have a formal way of incorporating consideration for interrelationships between variables

Front 262

Monte Carlo simulation

Back 262

Provides a powerful tool that can help the analyst evaluate what can happen to an investments future cash flows and summarize the possibilities in a probability distribution

Front 263

to describe the appropriate discount rate that should be used to calculate the value of an investments future cash flows, financial economists use terms like

Back 263

opportunity cost of capital

Front 264

Weighted Average Cost of Capital
WACC

Back 264

the weighted average of the expected after-tax rates of return of the firms various sources of capital

can be viewed as the opportunity cost of capital - which is the expected rate or return that its investors forgo from alternative investment opportunities with equivalent risk

Front 265

in addition to providing the appropriate discount rate to calculate the firms value, firms track their WACC and use it as a

Back 265

benchmark for determinging the appropriate discount rate for new investment projects, for valuing acquisition candidates, and for evaluating their own performance.

Front 266

If we are using conservative cash flows then,

Back 266

we would want to use a lower discount rate. Similarly, if the estimated cash flows are really "hoped for" cash flows, then we will need a higher discount rate to offset the optimistic cash flow forecasts.

Front 267

Invested capital

Back 267

capital raised through the issuance of interest-bearing debt and equity (common and preferred).

specifically excludes all non interest bearing liabilities such as accounts payable, as well as unfunded pension liabilities and leases

Front 268

enterprise value

Back 268

the sum of the value of the forms equity and interest-bearing liabilities

Front 269

the cost of debt financing is the rate of return

Back 269

required by the firms creditors, adjusted downward by a factor equal to one minus the corporate tax rate (1-T) to reflect the fact that the firm's interest expense is tax-deductible.

Front 270

WACC weights and opportunity costs, should be based on

Back 270

market value rather than book values for the firms securities because market values, unlike book values, represent the relative values placed on the firms securities at the time of the analysis.

Front 271

analysts typically apply WACC in a way that assumes

Back 271

that it will be constant in all future periods. this means that they implicitly assume the weights for each source of financing, the costs of capital for debt and equity, and the corporate tax rate are constant.

Front 272

WACC calculation steps

Back 272

1) Evaluate the firms capital structure and determine the relative importance of each component in the mix

2) Estimate the opportunity cost of each of the sources of financing and adjust it for the effects of taxes where appropriate.

3) Calculate the firm's WACC by computing a weighted average of the estimated after tax costs of capital sources used by the firm

Front 273

Firm and project free cash flow are calculated in

Back 273

exactly the same way

Front 274

in general, analysts assume that

Back 274

the period length is one year, and they ignore the fact that the cash flow accrues over the course of the year

Front 275

It is common practice among private equity investors to value equity

Back 275

directly

Front 276

in practice, capital structure weights are typically calculated using market values only for

Back 276

equity securities

for debt securities, book values are often substituted for market values, since market prices for corporate debt are often difficult to obtain

Front 277

Corporate bond ratings

Back 277

AAA - Prime
AA+ - High Grade
A+ - Upper Medium Grade
BBB+ - Lower Medium Grade
BB+ - Noninvestment Grade
BB - Speculative
CCC - Substantial Risk
DDD - Default

Front 278

Calculating YTM of a firms debt is difficult for forms with a large amount of

Back 278

debt that is privately held, and hence does not have market prices readily available.

Because of this it is standard practice to estimate the cost of debt using the yield to maturity on a portfolio of bonds with similar credit ratings and maturity as the firms outstanding debt

Front 279

The yield to maturity is calculated using

Back 279

The promised interest and principal payments and thus can be considered a reasonable estimate of the cost of debt financing only when the risk of default is so low that promised cash flows are reasonably estimates of expected cash flow.

Front 280

There are two ways to estimate the cost of debt for below investment grade debt.

Back 280

the first method inloves estimating the expected cash flows of the debt using expected rates of default and recovery rates, and using these expected cash flows to calculate the internal rate of return on debt.
The second method applies the capital asset pricing model (capm). The CAPM requires an estimate of the beta of the debt, along with an expected return premium on the stock market.

Front 281

Convertible bonds represent a hybrid form of financing that is both debt and equity since

Back 281

the holder can, at his or her discretion, convert the bond into a prescribed number of common shares. Since thse bonds have the conversion feature, they typically carry a lower rate of interest and consequently their estimated yield to maturity understates the true cost of debt.

Front 282

The cost of capital obtained by issuing convertible bonds can be thought of as a

Back 282

weighted average of the cost of issuing straight bonds and the cost of the exchange feature (call option), where the weights equal the relative contributions of the two components to the value of the security.

Front 283

Estimating the cost of straight (nonconvertible) preferred stock is straightforward,

Back 283

since it typically pays the holder a fixed dividend each period forever

Front 284

note that the preferred dividend is also a promised dividend in the same way that the interest on corporate bonds is promised interest, and thus

Back 284

Does not necessarily represent the divident that the preferred stockholder expects to recieve

Front 285

the key thing to remember here is that the standard method for estimating the cost of preferred stock is biased upward,

Back 285

yielding estimated costs that are higher than the expected costs

Front 286

The cost of common equity capital is the most difficult to estimate we have to make in evaluating the firms cost of capital.

Back 286

The difficulty arises from the fact that the common shareholders are the residual claimants of the firms earnings

Hence there is no promised or prespecified return based on a financial contract

The relavent cost of equity is simply the rate of return investors expect from investing in the firms stock

Front 287

One of the basic tenants of finance is that if investors are risk averse,

Back 287

they will require a higher rate of return to hold riskier investments

Front 288

The bais intuition of the CAPM is that the

Back 288

relevant risk of a stock is determined by how that stock contributes to the overall volatility of a well-diversified portfolio.

Front 289

According to the CAPM, stocks that are highly volatile on their own but contribute little to the volatilty of well diversified portfolio

Back 289

should require lower rates of return than their counterparts that may be less volatile, but which contribute more to the volatility of well diversified portfolios.

Front 290

two components of risk associated with investment

Back 290

1) the variability that contributes to the risk of a diversified portfolio - systematic risk - non diversifiable risk

2) the variability of that does not contribute to the risk of a diversified portfolio - nonsystematic risk - diversifiable risk

Front 291

Sources of systematic risk include

Back 291

random firm specific events such as lawsuits, product defects, and various technical innovations

Front 292

The three CAPM inputs

Back 292

1) Risk free interest rate
2) beta
3) the market risk premium

Front 293

As a general rule we want to match the maturity o the risk free rate with

Back 293

the maturiy of the cash flows being discounted

Front 294

A firms beta representes the sensitivity of its equity returns to

Back 294

variations in the rates of return on the overall market portfolio

Front 295

A stocks beta should be estimated by

Back 295

regressing the firms excess stock returns on the excess returns of a market portfolio, where excess returns are defined as the returns in excesss of the risk free return

Front 296

Many analysts make a common mistake.

Back 296

They fail to match the maturity of the risk free rate with the maturity of the rate used to calculate the equity risk premium

Front 297

Firms that use more financial leverage have higher

Back 297

betas

Front 298

Steps in unlevering

Back 298

1) we must identify a sample of firms that face similar business risks

2) we must unlever the betas for each of the sample firms to remove the influence of their particular capital structures on their beta coefficients

3) we average the unlevered beta coefficients and finally relever them to reflect the capital structure of the firm in question

Front 299

Determining the market risk premium requires a prediction of the

Back 299

future spread between the rate of return on the market portfolio and the risk free return

Front 300

Academic research has failed to find a significant

Back 300

cross sectional relationship betwen the beta estimates of stocks and their future rates of return

Front 301

the geometric mean return is te appropriate way to measure the rate of return earned during a particular historical sequence, however,

Back 301

the geometric mean is not the best estimator of future returns unless we expect this sample path to be repeated in the future

Front 302

when all future samples paths are equally likely the best estimate of the forward looking returns is the

Back 302

arithmetic mean

Front 303

size premiums

Back 303

Large cap firms: more than 4.794 in market cap - no size premium

Medium Cap: between 4.794 and 1.167 billion - size premium of .91 %

low cap firms: 1.167 billion to 331 million - size premium of 1.7%

Micro cap: below 331 million - size premium of 4.01 %

Front 304

The most widely used factor model is the Fama-french three factor model that

Back 304

attempts to capture the determinants of equity returns using three risk premiums

1) the equity risk premium of the CAPM
2)a size risk premium
3) a risk premium related to the relative value of the firm when compared to its book value

Front 305

in the fama french three factor model

Back 305

ERP is the equity risk pemium

SMBP is the small minus big premium - estimated from historical return differences in large and small cap stocks (3.36%)

HMLP is the high minus low risk premium - estimated as the difference between the historical average annual returns on the high book-to-market (value) and low book-to-market (growth) portfolios - 4.4%

Front 306

If we believe that the past is a good indicator of the future, then we should use the three factor model. However,

Back 306

one might believe that the relatively high returns of value stocks and low returns of growth stocks represent a market inefficiency that is not likely to existin in the future, now that the "value effect" is very well known. In this case, one might prefer the traditional CAPM, which is better grounded in theory

Front 307

Three fundamental problems with using historical returns as the basis for estimating the equity risk premiums

Back 307

1) historical returns vary widely over time, resulting in large equity risk premiums

2) recent changes in the tax status of equity returns and the rapid rate of expansion in access to global equity markets are likely to have driven down the equity risk premium

3) finally, historical returns over the long term, at least in the united states, may be too high , relative to what we can expect in the future

Front 308

Looking forward we can say that there are at least three key market factos that have changed over time and that can potentially lead to an equity risk premium that is lower in the future than it was in the past.

Back 308

1) the first has to do with taxes
2) increased participation in the stock market
3) increased globalization of security markets

Front 309

implied cost of equity capital

Back 309

the internal rate of return -IRR

Front 310

the ERP is estimated in one of two ways

Back 310

1) the average spread of historical equity returns over a US treasury yield

2) gordon growth model

Front 311

Analysts typically estimate the growth rate G as the product of

Back 311

the average return on equity (ROE) and the reinvestment rate for all equities where the reinvestment rate is simply one minus the fraction of firm earnings distributed to shareholders through dividends (pay out ratio)

Front 312

The most widely used method for identifying the discount rate for new investments is to use the firms WACC. However,

Back 312

this approach has some rather severe shortcomings when a firm invests in projects with widely varying risk charecteristics

Front 313

Influence costs

Back 313

these added costs include the extra time and effort a project advocate spends trying to justify a lower discount rate, as well as the time spent by managers charged with evaluating the project, who must figure out the extent of the bias

Front 314

Most investments are financed using corporate finance which means that

Back 314

the debt used to finance the investment comes from corporate debt issues that are guaranteed by the corporation as a whole

Front 315

A fully integrated firm is one that is

Back 315

engaged in every activity associated with its product

Front 316

project financed using nonrecourse debt financing

Back 316

With nonrecourse debt, the project is the sole source of collateral and the debt holders have no recourse to the sponsoring firm's assets in the event of default

investments that are project financed are very similar to an independent firm, since lenders loan money based solely on the ability of the project cash flows and assets to repay it.

Front 317

Bankruptcy remoteness

Back 317

means that if the borrowers were to go into bankruptcy its creditors would not have nay claim on the assets of the project-financed asset

Front 318

The focus of project financed investments is typically on the

Back 318

equiyt invested in the project, which is valued with the "flow-through-to-equity approach. This approach is simply a discounted cash flow model that focuses directly on the valuation of the equity invested in the project, rather than the value of the project as a whole.

Front 319

If a project is more highly levered

Back 319

the equity beta will be higher which means the cost of equity is higher, and the value of equity is lower

Front 320

Project value =

Back 320

project equity value + book value of project debt

= PFCF/Project finance WACC

Front 321

Debt capacity of a project

Back 321

the amount of additional debt the firm can take on as a result of undertaking the project, without lowering the firms credit rating. In general riskier projects will have lower debt capacities since they require more equity to offset their higher risk

Front 322

What determines the debt capacity of a project

Back 322

Probably the first determinant is the volatility of the projects cash flows. If they are more volatile, the the project may have less debt capacity than the firm.

one should also consider the extent to which the investment project contributes to the firms diversifcation. If adding the project reduces the volatility of the firms total cash flows because of the diversification effect, then the project will have a higher debt capacity.

Finally it is worth noting that investments that can be sold easily with minimal loss of value may also have higher debt capacities

Front 323

Firms generally require that accpeted projects have a substantial NPV cushion or

Back 323

margin of safety

Front 324

Winners curse

Back 324

the winning bidder in an auction, being the most optimistic of all the bidders, is likely to be too optimistic and may thus have overbid

Front 325

Relative valuation

Back 325

uses market prices from observed transactions to impute the value of a firm or investment opportunity.

the critical assumption of this approach is that the comparable transactions are truly comparable to the investment being evaluated

the important thing is that we select a valuation metric that is closely related to the investments ability to generate cash flows or other benefits

Front 326

Relative valuation 4 steps

Back 326

1) identify similar or comparable investments and recent market prices for each

2) calcaulate a valuation metric for use in valuing the asset.

3) calculate an initial estimate of value

4) Refine or tailor your initial valuation estimate to the specific charecterisitcs of the investment

Front 327

Capitalization rate

Back 327

is the reciporcal of the multiple used to value a property.

the cap rate is not always the discount rate

Front 328

The difference between the cap rate and the discount rate increases with

Back 328

the growth rate anticipated in future cash flows

Only when there is zero anticipated growth in future cash flows are the discount rate and cap rate equal

Front 329

Operating leverage

Back 329

cash flows are more sensitive to changes in revenues

higher fixed costs relative to revenues --> greater level of operating leverage

Front 330

the cap rate and discount rate are the same in the case of a

Back 330

perpetuity

Front 331

The most popular approach used by business professionals to estimate a firms enterprise value involves the use of a multiple of an accounting earnings number

Back 331

EBITDA

Front 332

the enterprise value of a firm

Back 332

is the sum of the values of the firms interest bearing debt and its equity minus the firms cash balance on the date of the valuation

Front 333

net debt

Back 333

interest bearing debt - cash

Front 334

owners equity = enterpise value -

Back 334

net debt

Front 335

FFCF is often more volatile than

Back 335

EBITDA because FFCF includes considerations for new investments in CAPEX and NWC which are discretionary to varying degrees and vary over the business cycle.

Thus in those years when large capital investments are being made EBITDA significantly overstates the FFCF and vice versa

Front 336

Since EBITDA measures only the earnings of the firms assets already in place, it ignores

Back 336

the value of the firms new investments

Front 337

FFCF is often negative because

Back 337

capital expenditures often exceed internally generated capital. As a result, FFCF multiples are unlikely to be as reliable as multiples base don EBITDA

Front 338

In any valuation that utilizes EBITDA multiples, it is important to take into account differences between

Back 338

the value of the growth opportunities of the firm being valued and the growth opportunities of the comparison firms

Front 339

EBITDA multiples are much less useful for evaluating businesses whose values come mainly from

Back 339

future growth opportunities

Front 340

Firms that incur higher levels of fixed operating costs but lower variable costs will experience

Back 340

more volatile swings in profits as their sales rise and fall over the business cycle

Front 341

Financial buyer

Back 341

a private equity investor or hedge fund - usually want a discount

Front 342

Strategic buyer

Back 342

can realize synergies by acquiring and controlling the investment, may be willing to pay a control premium

Front 343

Private companies often sell at a discount to

Back 343

their publicly traded counterparts since they cannot be sold as easily.

Front 344

Equity analysts tend to foucs their attention on estimating the earnings of firms they evaluate and then use the

Back 344

Price to earnings - P/E ratio to evaluate the price of the common stock.

Front 345

A stable growth firm is one that is expected to grow indefinitely at a constant rate.

Back 345

The P/E multiple of such a firm is determined by its constant rate of growth, and can be calculated by solving the gordon growth model

Front 346

The P/E ratio

Back 346

current market price of a firms coommon stock divided by the firms annual earnings per share.

Front 347

Forward P/E ratios are lower than the current (trailing) P/E's

Back 347

in instances where earnings are expected to grow and are higher in instances in which earnings per share is expected to decline

Front 348

For a stable growth firm, the P/E multiple is determined by the

Back 348

firms dividend payout policy, the required rate of return of the stockholders, and the rate of return the firm expects to earn on reinvested earnings

Front 349

The P/E multiple decreases as the firm

Back 349

retains a larger fraction of its earnings

Front 350

since we do not expect a firm to be able to achieve high growth forever, describing the firms growht prospects requires two growth periods

Back 350

We assume that the firm experiences very high growth lasting for a period of N years followed by a period of much lower but stable growth

Front 351

Price per share (IPO)

Back 351

equity value/# of shares the firm is issuing

Front 352

After setting the initial price range for an IPO unerwriters go through waht is known as a "book-building" process, where they

Back 352

gauge the level of investor interest

Front 353

Underwriters like to price an IPO at a discount, typically 10 - 25% to the price the shares are likely to trade on the market.

Back 353

Underwriters argue that this helps generate good after-market support for the offering.

Front 354

P/E as equity valuation ratio

Back 354

Firms with an established record of positive earnigns that do not have significant noncash expenditures

EPS (firm) X P/E (industry)

Front 355

PEG as equity valuation ratio

Back 355

Firms that face stable prospects for future growht in EPS as well as similar capital structures and simlar industry risk attributes

(growth rate of EPS/EPS) (firm) X PEG ratio (industry)

Front 356

Market to Book as equity valuation ratio

Back 356

Firms wose balance sheets are reasonable reflections of the market values of their assets. Financial institutions are the classic case.

book value of equity (firm) X Martket to book ration (industry)

Front 357

Enterprise Value to EBITDA as enterprise valuation ratio

Back 357

Firms that have significant noncash expenses - like industries with large investments in fixed assets - health care, oil and gas, telecom

EBITDA (firm) X EV to EBITDA ratio (industry)

Front 358

Enterprise Value to Cash Flow as Enterprise valuation ratio

Back 358

Firms with stable growth and thus predictable capital expenditures - chemicals, paper products, forestry, industrial metals

FFCF (firm) X EV to FFCF ratio (industry)

Front 359

Enterprise Value to Sales as enterprise valuation ratio

Back 359

Young firms and start ups that do not have an established history of earnings

Sales (firm) X EV to Sales Ratio (industry)