Finance ClubThursday, February 2, 2012
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Primer on Equity Valuation and Financial Ratios
Robert Shiller
• In 1981 he wrote a paper on market volatility.– He determined if a stock price is the estimate of
“something,” • (say the discounted cash flows from a corporation),
– …then market prices are too volatile in relation to tangible manifestations of that “something.”
• (he used dividends as proxy).
• He concluded markets are not as efficient as established by financial theory.
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• The ability to benefit from identifying a mispriced security depends on the market price converging to the estimated intrinsic value.
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Categories of Equity Valuation Models
• Present Value Models– Dividend Discount Model– Free Cash Flow to Equity Models
• Asset Based Valuation Models– Estimate intrinsic value of a share.
• Multiplier Models
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Market Multiple Models
• Based on share price or enterprise value multiples.
• Examples• (price to earnings)• (price to sales)• (price to book)• (price to cash flow)
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• Major advantage of using price multiples is that they allow fast relative comparisons, both cross-sectional and in time series.
• Note of caution: Difference in accounting practices can make these ratios less meaningful.
• Be wary of ratios for companies whose operations are driven by economic cycles.
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Equity Securities and Company Value
• What is one goal of a company’s management?
• Increase book value and maximize market value of its equity.
• Book value – Shareholders’ equity on balance sheet.– Management can directly affect.
• Market value
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A Company’s Market Value
• Reflects the collective and differing expectations of investors.
• Rarely will book value and market value be equal.
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Return on Equity
• This is the primary measure that equity investors use to determine effectiveness and efficiency.
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So is an increase in ROE always good?
• It depends.• What if NI decreases slower than BVE?• What if a company issues debt and
repurchases shares?– This will increase leverage and make company
risker.
• It is important to examine cause of change. (DuPont)
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Price-to-Book
• Provides an indication of investors’ expectations about future cash flows.
• Important to compare companies in the same industry.
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ExamplePfizer Novartis GlaxoSmithKline
Price $21.11 $55.66 $44.40
BVPS $11.71 $27.39 $4.67
P/B 1.80 2.03 9.51
• GSK has the highest P/B. This suggests investors’ expect higher growth opportunities in GSK. But…
Pfizer Novartis GlaxoSmithKline
Gross Margin 77.35% 67.59% 72.28
Debt/Equity 0.46 0.31 2.03
ROE 11.39% 14.11% 38.48%
• Clearly GSK is using higher financial leverage to do so.
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Valuation Based on Price MultipleApple Inc. 2012E 2011 2010 2009
Sales (billion) $155.4 $108.6 $65.1 $36.3
NI (billion) $39.6 $25.9 $14.0 $5.7
EPS $42.12 $27.68 $15.15 $6.29
P/E 12 13.8 18.7 20.4
Price $505.44 $381.98 $283.31 $128.32