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1.

Explain company valuation using


market multiples based on balance
sheet measures. (p. 15-5)

3.

Identify comparable companies


for use in company valuation with
market multiples. (p. 15-12)

2.

Explain company valuation using


market multiples based on income
statement measures. (p. 15-8)

4.

Interpret and reverse-engineer market


multiples to assess the reliability of
market expectations. (p. 15-19)

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U L E

Market-Based
Valuation

Fa mily Dollar operates more than 7,000 self-service retail discount stores aimed at middle-to-low-income consumers in
the United States. Its annual revenues for the recent year exceeded $8 billion. During the past five years, revenues have
grown by 25 % and profits by 60 % . Its stock price has doubled during that same period , exh ibiting a three-year upward trend
as revealed in the following graphic.
Family Dollar Stores Stock Price

$10

2007

2008

2009

2010

2011

During this most recent 5-year period, Family Dollar's assets increased almost 13% , while its equity was stable. We might
ask: which financial metric, or combination , is a good measure of its shareholder value? Revenues? Profits? Assets? Equity?
Other? Can we use one or more of these financial metrics to estimate Family Dollar's shareholder value?
To help in this valuation , what company or companies might we use to benchmark Family Dollar's performance and/or
financial condition? Should we consider a competitor such as Dollar General ? How about Dollar Tree Stores or Big
Lo ts ?
Analysts typically utilize a number of approaches to estimate the value of a company's stock price. In prior modules, we
have covered two general methods that focus on expected free cash flows and residual operating income. In this module, we
illustrate an alternative methodology that focuses on multiples of summary financial measures, such as assets, equity, and
profit. This methodology seeks to determine the proper multiple of these summary measures to yield a value of the company's
equity. This methodology is referred to as market-based valuation.
Sources: Family Dollar Corporation 2011 Annual Report and 10-K Filing.

(continued on next page)

15-2

Module 15 I Market-Based Valuation


15-3

Module 15 I Market-Based Valuation

03:,

Market-Based Valuation

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--

....

Valuation Model

Application Using a
NOA Multiple

Appl ication Using a BV


Multiple

Selecting Comparables
for Market Multiples

Valuation Using Income


Statement Multiples

Valuation Using Balance


Sheet Multiples

o.~10.."T'

......

Valuation Model

Application Using a
NOPAT Multiple
Application Using a NI
Multiple

001'

to obtain equity value. The more commonly used market multiples are those that generate equity
value directly because investors are most often interested in equity value. However, as we shall
see, using market multiples to find equity value directly means capital structure must be considered in selecting comparable companies .

'I

Interpreting and Rev


Engineering Market

....

.llliillll

PB Ratios and
Profitability, Growth ,
and Risk

~
Interpreting and
Reverse Engineering the
PB Ratio

Deriving PE from the


ROPI Model

Interpreting and
Reverse Engineering the
PE Ratio

Valuation with Market


Multiples

Deriving PB from the


ROPI Model

I:

PE Ratios and
Profitability, Growth,
and Risk

-~

'-

This module focuses on valuation techniques usi~g ma~ket multiples. ~nlike the valuation ~ech
ni ues introduced in the previous modules, val uation ~smg ~arket multiples _does n~t ~ave ngort. I nderp"inrungs It is also problematic m that 1t does not require explicit forecasts
q h
ous t eore 1ca u

h
th t
of future performance for the company to be valued . Further, 1t requJre_s t. at. we assume a
observed market prices for the target company are not informativ.e about mtnns1c value; and ~et
it requires us to assume sim ultaneously that observed market pnces for comparable companies
accurately reflect intrinsic value.
.
d
Despite these inherent shortcomings, valuation techniques using m~ket m~lt1ples are w1 e1y
applied. They are commonly used as shortcut valuation me~hods, as screening devices, and as mean~
to create summary statistics for assessing relative valuations. ~ome wh~ use these market-base
valuation techniques argue that they are superior to other techniques precise!~ bec~use they do n~t
rely on subjective forecasts of future performance. Whatever the view, val.uat1on us.mg market mu tiples , also referred to as the method of comparables, is a common valuation techruque.

Valuation Model using Market Multiples


Valuation using market multiples is popular chiefly beca~se

of its simplicity. W~ ~imply ~e~:~~~


relevant summary measure of performance (such as earnings, book values, cas . ow~, o
from the financial statements of a target company that we wis~ to v~ue. Next, _we identify co~~;~
nies that are "comparable" to the target company on relevant d1mens10ns (descnbed later). For ce
we compute the ratio of market value to the selected summary performan
comparable Company '
.
f t" f om commeasure. The average of those ratios is the market multiple. (While an averag~ o r_a JO~ r be more
e
arable com anies is commonly employed, if a specific comparable ~om~any is ~hev~ to
~elevant as ~benchmark, then we can place more than average we1ghtm~ on its ratio.) The~, ;e
multiply the summary measure for the target company by the market ~ult1ple-that product is
estimated value of the target company. The following model reflects this process.

Value= Summary performance measure x Market multiple


This model does not specify whether the value obtained is the company value or equi~y value~
Recall that the DCF and ROPI model s in Modules 13 and 14 were used t~ value.the.ent!fe co~
an . We then find equity value by deducting the value .of net nonoperatmg. obligations (NN e!~ro~ company value. When using market multiples to estimate value, the ch.01ce of summary pity
formance measure determines whether the output is company value or equity valu~. ~an edul is
performance measure is selected (such as earnings. or book value)h, the~t~~~~tput~O~~ ~h~nethe

I If
m any performance measure is selected (sue as
or
,. .
~~~~~t ~~ ~:~ m;d~~ i{company value, from which we must deduct net nonoperating obhgat1ons

Application of the Model using Market Multiples


There are five steps in estimating value using a market multiple . (The steps can be applied using
performance measm("S , or performance measures on a per share basis.)
1. Select the summary performance measure to use as the basis for valuation-such as earnings ,
book value, NOPAT or NOA; the model can be applied using current performance measures
or forecasted performance measures.
2. Select the comparable companies to use in determining the market multiple.
3. Compute the market multiple from the comparable compan ies' market values and performance measures .
4. Compute the target company's value using its performance measure and the market multiple.
5. 1f its performance measure is an equity performance measure (such as earnings and book
value), divide by shares outstanding to get equity value per share. If the performance measure
is a company performance measure (such as NOPAT and NOA) , subtract net nonoperating
obligations, and then divide by shares outstanding to get equity value per share. (If a per share
performance measure is used , we do not divide by shares outstanding.)

Although the steps are simple, key deci sions are made in steps I , 2 and 3. These decision s reveal
the inherent weakness of this valuation method.
First, in step l, which performance measure is the right one? This question has no answer
as there is no right measure . Company value depends on future company performance. Previous
modules of this book show that no si ngle measure entirely summarizes current period performance, much less provides a sufficient basis for forecasting future company performance. Still,
we could argue that particular measures are more suited to particular companies or industries . For
example, book value might be more suitable for companies with assets whose reported val ues
approximate market values such as with many financial firms. Earnings might be more suitabl e
for companies that are growing rapid ly with relatively little volatility. Free cash flows might be
more suitable for companies with negati ve earnings.
Second , in step 2, what companies shou ld we use as comparable companies? If comparable
companies are under- or overvalued , the computed market multiple wi ll under- or overvalue the
target company. We might appeal to market efficiency and claim that the comparable companies
are likely fairly priced , but this begs the question of why we are trying to find a value for our
target company if it is also fairly priced? Even if comparable companies are accurately priced ,
when they differ in ways that matter for valuation (such as on profitability, expected growth, and
ri sk), the computed multiple wi ll under- or overvalue our company.
RESEARCH INSIGHT

Efficient Markets and Valuation Using Comparables

There is an inherent inconsistency in using market multiples to value publicly traded companies. By
choosing to value a specific company using market multiples, the investor presumes that the target
company is not fairly valued. However, by selecting comparable companies to determine the multiple, the investor relies on the markets to accurately value those companies. How does the investor
know which companies are fairly valued and which are valued with error? Some assert that a group
of companies is valued correctly on average. However, if a company deviates from the average, is
that a pricing error or a valid variance from the distribution of intrinsic values?

Third , in step 3, how do we combine the comparable company data to produce a multiple? We
could compute the multiple for each company and then use an equal-weighted average, or combine
the data for all companies and compute a value-weighted average. Or, we could use a median of all
comparable company ratios, or use an average after eliminating the highest and lowest observations .

15-4

15-5

Module 15 I Market-Based Valuation


Module 15 I Market-Based Valuation

Again , there is no correct answer to thi s question and the others as this valuation technique is ad hoc
and the deci sions commonly made to apply it are ad hoc.
Despite deficiencies in val uing companies using market multiples, it is commonly applied
in practice. The following analyst report uses market multiples to explain and justify its current
assessment of a company's stock price. We see references to peers, or "comparables" (comps),
and the market multiple in analyzing current performance and predicting future performance
including stock price performance.
'

Data for Valuation Using Balance Sheet Multiples*


Big Lots
Company assumed value . . . . . .
Equity assumed value

Net operating assets . : : : : : : : :


Book value of equity . .. .. . . . . . : : : : : : : : : :
Net nonoperating obligations (assets) . . . . . . : : : : : : : :
Common shares outstanding ... . . ... . .. ..

Valuation of Family D o l l a r - - - - - - - - - - - --

we rate Family Dollar Neutral and our $49.00


December 2011 price target is predicated on a
50/50 weighted, blended P/E and EV/EBITDA
multiple build. Following the recent spike in the
stock subsequent to Trian 's proposal to acquire
the company for $55-$60 as well as our concerns
that some risk exists to the company's 2H11 SSS/
EPS outlook, we feel a Neutral rating is appropriate at this time.
From a fundamental perspective, we believe
opportunities still remain for the company to narrow the productivity gap that exists with peer
Dollar General, especially through its compelling
store renovation program; however, near-term
risks exist on both the top-line and margins, in
our view, as 2H11 guidance was not adjusted
after the 1Q/December miss. Moreover, from

l
2010A

Company Data

50.11
Price ($) ..... . .... .. . .. .
01 Mar 11
Date of Price .... .. ...... .
52-week Range ($) . ... . 55.62-32.30
6,471 .26
Mid cap ($ mn) ......... . .
Aug
Fiscal Year End . ... ... .. .
129
Shares O/S (mn) . .... . .. . .
49.00
Price Target ($) . . . . .
Price Target End Date .. . .. . 31Dec11

EPS (Operating) ($) ....


0 1 (Nov) ..... . . ...
02 (Feb) . .... . . ..
03(May) . . .. .. . .
Q4(Aug) . . .... . ....
FY ..... . . ...... . .
Bloomberg EPS FY($) . .
PIE (Operating) FY . . . . .

0.49A
0.81A
o.nA
0.56A
2.62A
2.58A
19.1A

2011E

$ 947
$ (186)
73.9 shares

3.64
14.1

~""""

Valuation Using a Net Operating Asset (NOA) Multiple

w:

We use the data from Exhibit J 5.J to com ute a m k

.
to estimate the value of Family Dollar
beu-in bard et mu~t1_ple based on net operating assets
both Dollar General and Big Lots whi.ch . 1:>
Y determmmg the NOA market multiple for
'
1s compute as the company a
d al d" .
by net operating assets. Exhibit 15.2 shows the results of th.
. ssume v ue iv1ded
General 's NOA market multiple is l 82 com
is computation. For example, Dollar
parables ' NOA market multiples (fr~m' Doll~~~~na:r!l:~~~~6~5:.)We then2average the com(l.82 + 2.84)/2. This market multi lei
.
ig 0 s to get .33, computed as
Dollar as follow s:
p s used to estimate the company intrinsic value of Family

Company intrinsic value = Net operating assets x NOA market multiple


$2,:379
=
$1,021
x
2.33
~~~~~~~~__J

To obtain Family Dollar 's equity intrinsic value we b


company value, which is then divided b h
su tr;~t net n~nop~ratmg oblrgat1ons from its
of common equity as follows:
y s ares outstan mg to yield Its per share intrinsic value

The balance sheet is one source of performance measures to use in estimating company value.
This section illustrates the mechanics of using balance sheet summary measures to estimate value.
First, we estimate company value for Family Dollar using a multiple of net operating assets. Next,
we estimate its equity value using a multiple of book value. The comparable companies we use
are Dollar General and Big Lots , both of which compete with Family Dollar. Summary information for all three companies , using reported fiscal year-end data for Family Dollar (August 28,
1
2010) , Dollar General (January 28, 2011) and Big Lots (January 29, 2011), is in Exhibit 15 .1 .
Market values for each company are collected on the fiscal year-end date from Yahoo! , Google,
and/or the JO-K filing. Our task is to estimate the intrinsic value of Family Dollar's equity.
1 Recall the foll owing key definitions (readily avail able from services such as Yahoo! and Google):
Company assumed value = Firm value (market value of a company 's net operating assets), whi ch is al so equal to the
market value of its common stock and net nonoperating obli gati ons.
Equity assumed value = M arket capitalizati on (market value of a company 's common stock)
Book value of equity = Book value of a company 's common stockholders ' equity

1-----l From financial

d .
..
ousan s, we round to millions for ease in computation.

Then ,

3.55

VALUATION USING BALANCE SHEET MULTIPLES


L01 Explain
company valuation
using market multiples
based on balance
sheet measures.

130.5 shares

$ 4,054
$ 2,800
341.5 shares

~ {:~;)

Equity intrinsic value = Company intrinsic value - Net nonoperating obligations


$2,780
=
$2,379
$(401)

0.58A

$2,165
$2,351
$ 761

2012E

0.98
0.98
0.68
3.18
3.13
15.7

11

F1nanc1al statements for these companies report amounts in th

a valuation perspective, FDO is now trading at


15.7x, a 2-turn premium to peers Dollar General
(12 .Bx) and Dollar Tree (13.Bx), which seems a bit
unwarranted .
In sum, we feel a Neutral rating is appropriate at this time. In our price target build , we layer
in assumptions to include a best, base, and worst
case scenario for the stock-trading multiples
vary by scenario and are determined based on
historical trading ranges and peer valuations. For
FDO, our base case scenario (50%) is based on
an absolute P/ E of 13.5x and EV/ EBITDA multiple
of 7.0x. Our best case scenario (25%) is based
on an absolute P/E of 14.5x and EV/ EBITDA multiple of 7.5x. Conversely, our worst case scenario
(25%) is based on a P/ E of 12.5x and an EV/
EBITDA multiple of 6.5x.

Family Dollar Stores, Inc (FOO; FOO US)

1 021
$

$12,499
$ 9,699
$ 6,854

Equity intrinsic value per share =

Equity intrinsic value


Common shares outstanding
$2,780
=
130.S shares

$21.30
Family Dollar stock closed at $43 34 on Frid

~t $46.37 on Tue~day, Oc~ober.26", 2010, the d~te ~~u~h~~h ~~s ~0 ~~ :~~~u~J~~~~~/ear-end, and
1

mg date). Accordmgly, this estJmate suggests that Farnil D II


k
SEC (the.ft/dates. Of course, the estimated value would have been ~ark~d~y~~ mart heddly overvalued on those
eral 's market multi le alone
d
o- .
.
.
I eren
a we used Dollar Genshows the key role ~hat the ~:ei~u~tiap\~ dp~ye~e;t ~~twe ~a? us~d ~i~ Lots' multiple alone. This
ermmmg mtnns1c value under this method.
Estimating Intrinsic Value using a Net Operating Asset Multiple

Family Dollar Donar General

Big Lots

Company assumed value


$2,165
Net operating assets . . . ~ ~ ~ ~ ~ ~ : ~ ~ ~
$12,499
Common shares outstanding

$ 1,02 1
$ 6,854
$ 761
.. .... . ............. ............... : :. : :. : : . . . . . . . . . . . . . . . . . . . . 130.5 shares
341 .5 shares
73.9 shares
NOA market multiple .. .. . .. .. . ...." ... ..
2 -33
Company intrinsic value. .

1.82
2.84
Equity intrinsic value
.. . .
$2,379
Equity intrinsic

value~~r ~h~r~: : : : : : : : : : : : : : : : : : : : : : : : :

~~;~~~

statements

15-6

15-7

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

Valuation Using a Book Value (BV) Multiple


We can repeat the analysis above using the book value of equity as the multi~le for valuing the
company. This approach yields the intrinsic value for equity, not f~r t?e .entire company. This
method relies on different data and, as such, we will not get the same mtnns1c values as computed
in the previous section.

15-8

on the NOA market multiple is likely " better." The reason is that company financial risk does
no~ materially aff'.ect the val~e of net operating assets , but it does affect the value of equity.
Th1s means the different capital structures of Family Dollar, Dollar General , and Big Lots do
not m_atter ~he~ applying ~<?A. multiples in valuation. But, when using book value multiples
to estimate mtnns1c value, 1t 1s important to select comparables with similar capital structures.
(Later in this module we further explain the selection of comparables.)
ANALYSIS DECISION

You Are an Entrepreneur

Estimating Intrinsic Value using a Book Value Multiple

Equity assumed value .... . .................. . .


Book value of equity . . . .... . ..... . .... ... .. .

$1,422

$9,699

$2,351

$4,054

$ 947

~?~'.1:1?~. ~.~~~~-~ -~~-t-~~~~.~~~~ : :.: :. : :.:: ...::. ::. ::. ::.::.: :. ::. ::.:.... ~.~~ ..~ .~~.~~~-~ .... -~~~ :~. ~.~~.r~~ ..... .'.~:~ .~~.~~~~..
BV market multiple . .. ...... ..... ... . .... . ... .

2.44

Equity intrinsic value . ....... . . .. . . . ... . . . ... .. .

$3,470

Equity intrinsic value per share . . ..... . . . . .. .. .. . .. . .. . .

$26.59

2.39

2.48

We begin by computing the book value market multiple for both Dollar _General_ ~nd Big Lots,
which is computed as equity assumed value divided by book value of equity. Exh1b1t 15.3 ~ho"".s
the results of this computation. For example, Dollar General's book value market multiple 1s
2.39, computed as $9,699/$4,054. We then average the book value market multiples (f~om _Dollar
General and Big Lots) to get 2.44, computed as (2 .39 + 2.48)/2. This BY market multiple is used
to estimate the equity intrinsic value of Family Dollar as follows:

Equity intrinsic value


$3,470

= Book value of equity


$1,422

x BV market multiple
x
2.44

To obtain FamjJy Dollar 's equity intrinsic value per share we divide by shares outstanding as
follows:

Equity intrinsic value


Equity intrinsic value per share = Common shares outstanding
L__ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
$3,470
$26.59
=
130.5 shares
~

The $26.59 stock price estimate suggests that Family Dollar stock was ~arkedl~ ove_rvalued given
its $43.34 closing price at its fiscal year-end (and vis-a-vis the $46.37 pnce on its fil_mg date). The
estimated value would have been different had we used Dollar General 's market multiple alone , and
yet again different if we had used Big Lots ' multiple alone. ~gain, this shows the key role that the
market multiple plays in determining intrinsic value under this, ~eth?d.
.
.
e
[t is useful for us to compare estimates of Family Dollar s mtnns1c value of equ_1ty usmg th.
net operating assets multiple vis-a-vis the book value multiple. Using the NOA multiple, we ~sti
mated the intrinsic value of a share of Family Dollar to be $21.30, while the BY market mult1~le
oave
an estimate of $26.59 . For Family Dollar, these estimates differ by more than 24%, which
0
is markedly different.
.
,
.
How do we assess the quality of the different estimates? To answer this, lets co~s1d~r
t h_at ~r~ s1m1
. Iar m
the comparables. When choosing comparables, we should select compames
terms of profitability, growth, and risk. In this case, we did not control ~or ~rof1tabd1ty,_ growth ,
or financial risk-we did control for operating risk by choosing co~pames_ mt~~ same mdustryd
Still, we might have done better by choosing other retail firms with _pro~1tab1ltty, growth , ~n
f inancial risk characteristics similar to those of Family Dollar. (Later m this module we provide

.
bas ed
guidance on choosing comparables for valuation
purposes.) Consequent1y, t he estimate

You are the sole owner of a software firm that has developed a system to handle back-office processing for municipalities. During its first three years, your firm focused on developing the software
and reported sizeable research and development expenses and annual losses. An interested buyer
has approached you, and the investment bankers representing the buyer want to value your firm
using market multiples. Because your firm has reported losses, they suggest basing the valuation
on book value per share and using Oracle and SAP as comparables, which provide a book value
multiple of 8. You believe their methodology is flawed, and their price too low. What arguments can
you make in support of your position? (Answer, p. 15-23]

MID-MODULE REVIEW 1
The table below provides summary data for Johnson & Johnson (JNJ), along with Procter &
Gamble and Merck, two large cap firms that compete in many segments of JNJ's medical and

consumer products businesses.


(In millions)

Johnson & Johnson Procter & Gamble

Company assumed value . ..... . .... ..... .


Equity assumed value . .... ....... .. .... .
Net operating assets ................ . . . .
Book value of equity ... .. . .. . . . .. . ...... .
Net nonoperating obligations (assets) ...... .
Common shares outstanding .. . ......... . .

$45 ,894
$39,318
$ 6,576
2,893 shares

$238,532
$203,325
$101 ,972
$ 66,760
$ 35 ,212
3,132 shares

Merck
$ 99,560
$103,315
$ 13,809
$ 17,560
$ (3,750)
2,168 shares

Required

a. Estimate the net operating assets market multiple for Procter & Gamble and Merck. Then,
compute the average of these as the NOA market multiple for valuation and assess its
reliability.

b. Use the resu lts from part a to estimate the company intrinsic value, the equity intrinsic value,
and the equity intrinsic value per share for Johnson & Johnson.
c. Compute the book value multiple (also called price-to-book or PB) for Procter & Gamble
and Merck. Then, compute the average of these as the BY market multiple for valuation.
d. Use the results from part c to estimate equity intrinsic value and the equity intrinsic value
per share for Johnson & Johnson.
The solution is on page 15-37.

VALUATION USING INCOME STATEMENT MULTIPLES


The most commonly used performance measure for estimating company value with market mul~iples is earnings. Price-to-earnings (PE) ratios are cited in news articles and analysts ' reports , used
m stocks screens and trading strategies, and even appear as the subject of academic research. The
intuition in using earnings as the basis for valuing a company is straightforward-dividends are paid
out of earnings, and potential dividend payouts are the basis for company value. Accordingly, we

L02 Explain
company valuation
using market multiples
based on income
statement measures.

15-9

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

should pay more for companies that generate more earnings. Thjs section illustr~tes the mec~anics
of usina net operating profit after tax (NOPAT) and net income (Nl) as the basis for valuation by
markermultiples. (For simplicity, NOPAT computations as~ume a tax r~te of 35%_ for comparues
in thjs module.) First, we estimate company value for Family Dollar using a mul~1ple of N<_)pAT.
Next, we estimate its equity value using a multiple of NI. ~he comparable companies w_e again ~se
are Dollar General and Big Lots, both of which compete with Family Dollar. Summary _m~ormation
for all three companies, using reported fiscal year-end data for each co"!1pany (see Exh1b1t 15.l for
further explanation), is in Exhibit 15.4. Our task is to estimate the equity and company values for
Family Dollar using Dollar General and Big Lots as comparables.
Data for Valuation Using Income Statement Multiples
Family Dollar Dollar General

(In mlHlons)

From financial
statements

Company assumed value ... ...... . ... . . .


Equity assumed value ............. . ....
Net operating profit after tax . . ... . ........
Net income .. .. ....... .. . . ... . ... . ..
Common shares outstanding ........... . ...

$366
$358
130.5 shares

$12,499
$ 9,699
$ 816
$ 628
341.5 shares

Big Lota
$2,165
$2,351
$ 224
$ 223
73.9 shares

Valuation Using a Net Operating Profit After Tax (NOPAT) Multiple


We use the data from Exhibit 15 .4 to compute a market multiple. based on ne~ ~perating profit
after tax (NO PAT) to estimate the value of Family Dollar. _We _begm by determmmg the NOPAT
market multiple for both Dollar General and Big Lots, which _is compute~ as company assumed
value divided by NOPAT. Exhibit 15.5 reports the results of this computation. For example, Dollar General's NOPAT market mu ltiple is 15.32, computed as $12,499!$816. We then average the
comparables' NOPAT market multiples (from Dollar General _and Big Lots) to g~t 1~.5? , computed as (15.32 + 9.67)/2. This market multiple is used to estimate the company mtnns1c value
of Family Dollar as follows:

Company intrinsic value


$4,575

= Net operating profit after tax


$366

x NOPA T market multiple


x
12.50

Tills estimate suggests that Family Dollar was overvalued with respect to its $43.34 closing price
at its fiscal year-end (and vis-a-vis its $46.37 price on the filing date) . The estimated value would
have been different had we used Dollar General's market multiple alone (Family Dollar would
have been estimated to be undervalued at its fiscal year-end), and yet again different if we had
used Big Lots ' multiple alone, and yet again different if we had computed a weighted average.
Tills shows the key role of the market multiple .

Valuation Using a Net Income (NI) Multiple


We can repeat the analysis above usi ng a net income multipl e as the basis for valuing the company. Tills approach produces the intrinsic value of the equity, not of the entire company. Tills
method relies on different data and, as such, we will not get the same intrinsic values computed
in the prior section.
Estimating Intrinsic Value Using a Net Income Multiple
Family Dollar Dollar General

Big Lots

Equity assumed value ... . .. . .. ... ..... . .... . ....... .


Net income .... . .. . . .... . . ......... . .. . .. . .. . . . ... .
Common shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 358

$ 628

130.5 shares

341.5 shares

$2,351
$ 223
73.9 shares

NI market multiple . ........................... . . . . . .


Equity intrinsic value ............ . . . .... . . ...... ... .. .
Equity intrinsic value per share......... . .... . ..... ... . .

12.99
$4,650
$35.63

15.44

10.54

$9,699

We begin by computing the net income market multiple for both Dollar General and Big Lots,
willch is computed as equity assumed value divided by net income. Exhibit 15.6 shows the results
of this computation. For example, Dollar General's net income market multiple is 15.44, computed as $9,699/$628. We then average the net income market multiples (from Dollar General
and Big Lots) to get 12.99, computed as (15.44 + 10 .54)/2. This NI market multiple is used to
estimate the equity intrinsic value of Family Dollar as follows:

Equity intrinsic value = Net income x NI market multiple


= $358 x
12.99
$4,650

Estimating Intrinsic Value Using a Net Operating Profit after Tax Multiple
Family Dollar Dollar General

(In millions, except per share amounts)

Big Lots

$2,165
$12,499
$ 224
$ 816
$ 366
Net operating profit after tax
_ shares
.5 shares
73.9 shares
341 . ............................. .
Common shares outstanding ............. : .::.::.:: : . : :. : . . . .130
.. . . . 5
. . . .... ...........
12.50
15.32
9.67
. . . . . . . . .. . .. . . .. .. . . . . . . .. . . . . . . .. . . . . .. . . .. . . . . . . . . . . . .
NOPAT market multiple . . .. . ..... . ....... . . . ..
$4,575
Company intrinsic value . .. ....... . . . .. . .. .... .. .
$4,976
Equity intrinsic value .. . . ............ . ...
Equity intrinsic value per share . . ..... .. .......... . ....
$38.1 3
Company assumed value . ...... .. .... . . . ....

To obtain Family Dollar's equity intrinsic value w_e. subtract net nonoperat~ng obli_gations (~~
Exhibit 15 .1) from company value, which is then d1v1ded by shares outstandmg to yield the P
share intrinsic value of its common equity as follows:

Equity intrinsic value = Company intrinsic value - Net nonoperating obligations


=
$4,575
$(401)
$4,976
Then,

Equity intrinsic value

Equity intrinsic value per share

= Common shares outstanding

L__ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

$38.13

$4,976

130.5 shares

To obtain Family Dollar's equity intrinsic value per share we divide by shares outstanding as
follows:

Equity intrinsic value


Equity intrinsic value per share = ---"-~------Common shares outstanding
$4,650
$35.63
=
130.5 shares
The $35.63 stock price estimate suggests that Family Dollar stock was slightly overvalued based
on a $43.34 closing price at its fiscal year-end (and vis-a-vis its $46.37 price on the filing date).
The estimated value would have been different had we used Dollar General's market multiple
alone , and yet again different if we had used Big Lots' multiple alone, and again different if we
had computed a weighted average.
It is again useful for us to compare estimates of Family Dollar's intrinsic value of equity
using the NOPAT multiple vis-a-vis the NI multiple. Using the NOPAT multiple, we estimated
the intrinsic value of a share of Famjly Dollar to be $38.13, while the NI market multiple gave an
estimate of $35.63. How do we assess the quality of the different estimates? The estimate using
the NO PAT market multiple is likely better (for the same reasons that the NOA multiple was superior to the BY multiple for balance sheet methods) . That is, we did not select comparabJes with
similar capital structures. When selecting comparables, we should select firms that are similar on
profitability, growth, and risk. Although the comparables do control for operating risk , by choosing companies in the same industry, we did not control for financial risk. Consequently, because
financial risk affects the equity value, but not the company value, we prefer the NOPAT multiple.

15-10

15-11

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

T hi s means the differe nt capital structures of Famil y Doll ar, Doll ar ~en eral , _and Big Lot~ do not
matter when appl ying NOPAT multiples in valuation . But, w h~ n u ~ m_g net 1~ come multiples to
estimate intrinsic va lue, it is important to select com parables with similar capita l structures.

Valuation Using Industry-Based Multiples


indu stries have spec ific measures re lated to characteristics of the indu stry that are closely
S
ome
1 . d
l
fi
watched by investors and analysts. For example , in the reta1 111 ustry sa _es ~er square oot of
selling space is a commo n measure used to understand the sa l ~s each locati on is abl e to generate
relati ve to its size. Another example is the airline industry, whi ch '.ocuses on revenue_s, expenses
or profits per available seat mile (one aircraft seat flow n o ne ITille, ~ hether occupied or ~ot).
These measures can be used to create additional " industry-based" multiples that can be examined
in valuing a company.
.
.
.
To illustrate the use of an industry-based multiple to est1ma~e value, and usmg data from the
MD&A section of the IOK , we find in fi scal year 2010 that Family Dol_lar sales per square foot of
selling space was approx imately $ 163. [n contrast , Doll ar General and Big Lots had sales ~r squar:e
"1oot of se11.mg space of $201. and $ 166 , respecti vely Ex hibit 15 .7 shows the results
ofth1s analysis
.
for these three companies . The $38 .98 stock price estimate suggests that Family_ D_oll ~ ~tock was
slightly overvalued based on a $43 .34 closing price at its fi scal year-end (and v1s-a-v1s its $46.37
price on the filing date) .

15-12

By choos ing to compute an estimate that incl udes sales- per-square-foot and not NOA , we get an
average estimate of $34.83, whic h is more than 10% hi gher than the $30 .41 estimate of the intrinsic value of Family Do ll ar that excl udes sales-per-sq uare-foot. Before deciding what multiples to
use and how we mi ght appro priately we ight them, we must understand more about the purpose
and rol e of selecting comparabl e companjes.

MID-MODULE REVIEW 2
The table below reports s ummary data for Johnson & Johnson (JNJ), along with that for Procter
& Gamble and Merck, two large cap firms that compete in many segments of JNJ's medical and

consumer products businesses.


(In mllions)
Company assumed valu e . ... . .... .. .. .
Equity assumed value .. . . . ... . ..... . .
Net operating profit after tax . . . . . . . .. . .
Net income . .. . . .. . . . .. . . .. . . . . .. . . .
Net nonoperating obligations (assets) . . . .
Common shares outstanding .. . . . . . ... .

Johnson a Johnson

Procter & Gamble

Merck

$10,563
$11 ,053
$ 6,576
2,893 shares

$238,532
$203,325
$ 11 ,188
$ 10,340
$ 35,212
3,132 shares

$ 99,560
$103,315
$ 4,181
$ 4,434
$ (3,750) .
2, 168 shares

Required

a. Estimate the NOPAT market multiple for Procter & Gamble and for Merck. Then , compute

Estimating Intrinsic Value Using an Industry-Based Multiple


Family Dollar Dollar General

Big Lots

$9,699
$2,351
1
Equity assumed value .
$
$ 166
20
Sales per square foot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
130~5 :~!res 341.5 shares
73.9 shares
Common shares outstanding . ..... . -. : :. :: .: :. ::.: :.: :.:::.::. : ................ . ..................................... .. ..
S~I~~ -~~; ;~~~~~ f~~t ~~~k~t ~~iti'~ j~.
31.21
48.25
14.16
$5 ,087
Equity intrinsic value . .... . .. . .... . . . . . .

. . . . . . .. . . . . . . . . . .

Equity intrinsic value per share . .... . . ... . . . . .

the average of these as the NOPAT market mu ltiple for valuation . If we believed that one
company's multiple was more reliable than another, how could be adjust our estimation ?
b. Use the results from part a to estimate the company intrinsic value , the equity intrinsic value ,
and the equity intrinsic value per share for JNJ.
c. Compute the NI mu ltiple (also called eq uity-to-income) for Procter & Gamble and for Merck .
Then , compute the average of these as the NI market multiple for valuation .
d. Use the results from part c to estimate equity intrinsic value and the equity intrinsic value
per share for JNJ .

$38.98

The solution is on page 15-37.

The limitations of the use of an industry-based multiple must be .rec~~ ni zed . In th.is case, we are
using a measure that foc uses o n sales rather than foc using on prof1tab1hty. Furt~er, _if the company
we are trying to value has a diffe rent cost structure than its comparables, thi s will add error to
our estimation .

Combining Estimates from Differing Multiples


In prior sections we arri ved at a variety of estimates of the val~e of Fam ily Dollar. Ra~her than
attempting to weigh the merits of the diffe rent estimat~s, s~me ~~ vestors prefer to co~bme th:
in the hope that estimati on error for a spec ific mul tiple 1s m1t1?ated by oth~r mul tiples . T_ a
combination is typi call y done using a simple aver~ge of t~e estimates. Cons1d_er the follow 1~d
Exhi"bi't 15 8 , which combines the van ous estimates
that we prev io usly comput
examp le m
.
-~ ot
for Famil y Dollar. In the first column we exclude the estimate based o n s~l es -pe r- sq uare o si~
whereas the second column excludes the estimate based on NOA . We do this to show the sen
tivity to thi s combination method .

SELECTING COMPARABLES FOR MARKET MULTIPLES


When valuing companies using market multiples, it is important to select comparables similar
on profitability, growth , and ri sk . We begin this secti o n by demon strating how theoreti call y correct market multiples can be deri ved fro m the res idual income o perating (ROPI) mode l. We then
examine how suc h multipl es change with variations in key characteri stics of the comparab les.
It is important for us to remember that all market multiples, except industry-based multiples,
illustrated in the prev ious sectio ns can be deri ved from the residual income operating model.
However, in this secti on we limit ourselves to the Price-to-Book (the BY multiple used earlier)
and Price-to-Earnings (the NI multipl e used earlier) multiples . The reason is that they are the
multiples most commonly used in practice. This section describes how key factors-such as
profitability, growth , and operating ri sk- should guide our selection of comparab les. Ho wever,
as we ex plained in previous sections, choosing comparables fo r NOA and NO PAT multiples does
not depend on similar capital structures.

Combining Estimates of Equity Intrinsic Value per Share

Multiple Used
Net Operating Assets ......... . . . . . . . . .
Book Value . . .... . ..... . .. . ..... . .. .
Net Operating Profit after Tax . .. .. .. . . . . .
Net Income .... . ...... ... . . .
Sales per Square Foot . ... . . .. . . . . . . . ..
Average of Estimates ........ . . . . .. . . . .

Estimate #1
$21 .30
$26.59
$38.13
$35.63

$30.41

Estimate #2

Deriving Price-to-Book from Residual Operating Income Model


Reca ll from Module 14 the follo wing residual operating income (ROPI) model.

$26.59
$38.13
$35.63
$38.98

$34.83

Fir m value = NOA

+ Present value of expected ROPI, discounted using r w

Specifically, residual operating income is operating income in excess of a fair rate of return o n
beginning net operating assets:

L03 Identify
comparable companies
for use in company
valuation with
market multiples.

Module 15 I Market-Based Valuation


15-13

Module 15 I Market-Based Valuation

ROPI = NOPAT - (NOABeg


where
NOA

Next, we compute the value of the equity for the high profitability Company A as $250, computed as $100 in NOA plus the $150 present value of future ROPI. Similarly, the low profitability Company B's value of equity is $150, computed as $ 100 in NOA plus the $50 present value.
From these results we obtain the theoretically correct equity multiple for the high profitability Company A of 2 .5, computed as l plus the quantity of the $ 150 present value divided by
the $100 owners ' equity. Similarly, the low profitability Company B's multiple is 1.5, computed
as l plus the quantity of the $50 present value divided by the $ 100 owners ' equity. These results
yield the following inference: PB increases with company expected profitability .

rw )

= Net operating assets at beginning of period


r = Weighted average cost of capital
w

Beg

lf we divide both sides of the ROPI model by book .value. of ~quity (OE), we have a formula for the
price-to-book, or PB , ratio (we exclude the algebraic denvat1on):

PB= 1

Present value of expected ROPI, discounted using r w


OE

PB Increases with Company Expected Growth


Exhibit 15 .10 reports data for two companies with identical net operating assets ($100), capital
structures, and profitability. Both companies have RNOA (and ROE) of 22%, and have similar
operating risk (with a weighted average cost of capital of 10%) . However, Company C is a high
growth firm , with a perpetual growth rate of 4%, compared to a growth rate of 0% for Company
D. (Recall that a zero growth rate in ROPT does not imply a zero growth rate in net income .)
Using the formula for the present value of a perpetuity with growth of g, we find the present
value of expected future residual income for the high growth Company C is $200, computed as
$12/(0 .10 - 0 .04). For the no growth Company D, the present value is $120, computed as $12/
(0.10 - 0 .00).

This formula reveals the parameters determining PB ratios: residual operatin.g income, the expec~
rowth rate in residual operating income, the weighted average cost of cap1~ , and the company s
OE is less for companies with debt in their capital structure. From this formula we can show
everage- .
hi h
pected to generate no future residual operating income should sell at book
that companies w c are ex
..
d hi
value and carry a PB of 1. Companies with lower profita?thty,.low~r expected gr~~th r~tes, an gher
d'
t
h Id sell at lower PB ratios Companies with higher profitab1ltty, higher expected
iscouhnt rta esans d~~wer discount rates should ~ell at higher PB ratios. Further, levered companies will
growt ra es,
h
l t'
the next section
sell at higher PB ratios than unlevered companies . We explain t ese re a ions in
.

PB in Relation to Growth

PB Ratios in Relation to Profitability, Growth, and Risk

Net

The arameters determining PB are readily identified if we assume a si~pl~ model for future
resid~al operating income. One simple model assumes that residual operating inco.me grows at a
constant rate , g, in perpetuity. Using the formula for the present value of a perpetuity, we express
the present value of residual income as follows:
Expected ROPI
Present value of expected ROPI =
rw_ g

Company C: High growth .... . . .. ..


Company D: Low growth ..........

g is the growth rate in ROPI each period


r is the weighted average cost of capital
We u:e this model in the following sections to value the present valu.e of expected residu;i op:ir~
ating income for purposes of illustrating the relation between PB ratios and the factors o pro it
ability, growth rates, operating risk , and leverage.

PB Increases with Company Expected Profitability

Exhibit 15 9 reports data for two companies with identical net operating assets (of~ I 00) and 1de~
tical ca it~l structures (all equity). Company A has RNOA (and ROE) of 22%, wh~le C?mpa~yh a
has RN~A (and ROE) of 14%. We assume these companies have the same ~perat~ng nsk (wit.
weighted average cost of capital of 10%), and we expect perpetual growth m residual operating

income equal to 2% for both .


h' h y l e Using the model for the present value of a perpetuity with growth of g (w LC LS a uA Amount/[r - g]) , we determine the present value of expected future R?~I for Compan~ 5~s
$ 150 , computed as $ 12/(0 .10-0.02). The present value for the low profitab1hty Company Bis $

EXHIBIT 15.9

......

equity

RNOA ROE

$100
$100

$100
$100

22%
22%

22%
22 %

Reeldual

Expected
growth rate

Present value

operating

of expected

of
equity

oo'o
I
7C

$'2
I

2%

10%

$ 4

2%

$150
$ 50

$250
$150

~asaetll
~a~tin~~~Ow
~8c.unr
~m~1e1~~~~R~N~OA::-:R:O:E:-_..:~
' cap1
:::ltal=-~~lncome
::-~~-~--;-R;:~~
OPl ROPl
~~ustng
~-r-~-;;
L~~~~--~~--~~--~-oper
Company A: High profitability . . ... .
Company B: Low profitability . . . . .. .

$100
$100

$ <I 00
$100

22/o
14%

"
22 O10
14%

10%
10%

$12
$12

4%
0%

$200
$120

Expectllcl

Yelue
of
equity

$300
$220

PB Decreases with Increasing Company Operating Risk

PB in Relation to Operating Risk

Value

Weighted
average cost

~ROPI

Reelduel

cost operating growth rate

Exhibit 15 .11 reports data for two companies with identical net operating assets ($100), identical capital structures (no debt), and identical RNOA of 22%. However, Company E is a high
operating risk firm , operating in an industry with high technological uncertainty, while Company
F has low operating risk. Accordingly, high risk Company E has a higher cost of capital (15 %)
compared with the low risk Company F (10%).
Using the formula for the present value of a perpetuity with growth of g, we find the present value of expected future residual income for the high risk Company E is $46 .7 , computed
as $7/(0.15 - 0.00) . For the low risk Company F, the present value is $120, computed as $12/
(0.10 - 0 .00).

PB in Relation to Profitability
Net

Income

evenige

Next, we compute the value of the equity for the high growth Company C as $300, computed as
$100 in NOA plus the $200 present value. Similarly, the low growth Company D's value of equity
is $220 , computed as $100 in NOA plus the $ 120 present value.
From these results we obtain the theoretically correct equity multiple for the high growth
Company C of 3.0, computed as l plus the quantity of the $200 present value divided by the $100
owners' equity. Similarly, the low growth Company D's multiple is 2.2, computed as 1 plus the
quantity of the $120 present value divided by the $100 owners' equity. These results yield the
following inference: PB increases with company expected growth .

EXHIBIT 15.11
<

of capital

Pnleent value
of expected
ROPI uelng r

Weighted

Owners'

operatil~

where
Expected ROPI is for period t

15-14

OWnera'

Company E: High operating risk . . . .


Company F: Low operating risk. . . . .

$100
$100

$100
$100

RNOA ROE
22%
22%

22%
22%

Weighted

Reeldual

evenige cost

opendlng

of Cllpltal

Income

15%
10%

$12

$7

Expectllcl
growth rate
ROPI

0%
0%

$46.7

$146.7

$120

$220

15-15

Module 15 I Market- Based Valuation

Module 15 I Market-Based Valuation

Next , we compute the value of equity for the high risk Company E as $146.7, computed as $ 100
in NOA plus the $46 .7 present value. Similarly, the low risk Company F's value of equity is $220
computed as $100 in NOA plus the $ 120 present value.
'
From these results we obtain the theoretically correct equity multiple for the high risk Company E of 1.47, computed as l plus the quantity of the $46.7 present value divided by the $100
owners ' equity. Similarly, the low risk Company F's multiple is 2.2, computed as l plus the
quantity of the $120 present value divided by the $ 100 owners' equity. These results yield the
following inference: PB decreases as company operating risk increases .

BUSINESS INSIGHT Quality of Comparables and Simple Controls

Selecting firms with similar operating risk, leverage, and profitability can improve our valuations.
Yet, it is unlikely to compensate for the substantive deficiencies in the technique. The table below
shows RNOA, leverage, and PB ratios for a set of consumer stocks (pretax ROA is between 8% and
9% for all). We see from this small sample that simple controls-for industry, current profitability,
and leverage-explain little of the variation in PB ratios.
Company

BUSINESS INSIGHT Fair Value Accounting and PB Ratios

The FASB's recent writings suggest a preference for fair value accounting, which it regards as more
relevant than historical cost accounting. Beginning in fiscal 2008, companies were permitted, but
not necessarily required, to value any financial asset or liability at fair value and to record changes
in fair value in income. We should consider this rule when choosing comparables for valuation by
market multiples because companies using fair value accounting will tend to have lower PB ratios
and more volatile earnings than those using historical cost accounting .

PB Increases with Company Leverage

PB in Relation to Leverage
Net
Debt
operating (8% Owners'
....._ rate) equity RNOA

Company G: Unleveraged....... .
Company H: Leveraged ..........

$100
$100

$ 0

$100

$60

$ 40

22%
22%

ROE

22%
46%

Weighted
Cost of Reaklual Growth Present value
average cost equity operating rate In of expected
of capital
capital Income
ROPI ROPI using r.

Value
of
equity

Debt-to-Equity

8.6%
8.6
8.7

Brown Shoe Company ....... . .. ... . . .. . . . . . .. . . . .


Burger King Holdings . .... . .. . .. . . . ... . . . . ... ... . .
Cabelas .. .... ... .. . . . ... . . . . ... . ... .. . . . ..... .
ConAgra Food ....... .. .. . . . . . . .. . . .. ..... . . . .. .
Ruddick Corporation ... .. . . .. . ... . . . . .. .. . ..... .

McCormick & Schmicks Seafood Restaurant ... ... . .. .

PB Ratio

50.7%

0.9

0.0

8.6

8.8
8.8

127.1
44.2
26.8

8.8
8.8
8.8

131.0
54.3
74.6

2.7
1.5
1.6
4.9

8.9
8.9
8.9
8.9

36.9
61 .7
5.2

2.1
2.8

36.6

2.2
1.4
1.7
2.1

MID-MODULE REVIEW 3
The following table reports data for Companies A through E with identical net operating assets
($100), but with differences in debt levels , returns, cost of capital , and growth .
Net

operating
Company

assets

A . .. ....

$100
$100
$100
$100
$100

B . .. ....
C ... . ...
D .. .... .
E ... . .. .

Debt
Weighted
Cost of
(6% Owners'
average cost equity
rate) equity RNOA ROE
of capital
capital

$ 0
$ 0
$ 0
$ 0
$60

$100
$100
$100
$100
$ 40

16%
12%
16%
16%
16%

16%
12%
16%
16%
31%

10%
10%
10%
12%
10%

10%
10%
10%
12%
12.1%

Residual
operating

Income

Growth
rate In
ROPI

PreMnt value

Value

of expected
Value of
ROPI Using r. company

of
equity

2%
2%
4%
2%
2%

10%

10%

$12

0%

$120

$220

Required

10%

11.5%

$12

0%

$120

$160

Assume that the present value of expected ROPI follows a perpetuity with growth g (Value =
Amount/[r - g]). Determine the theoretically correct PB ratio for each company A through E.
b. State the relation between the PB ratio and that of profitability, expected growth in ROPI ,
expected operating risk, and financial leverage. Identify two companies for each of the four
relations that illustrate that relation (companies can be listed more than once).

Why would we pay more for a dollar of equity than for a dollar of net operating assets? The
reason is that for every dollar of net operating assets, the company generates ROPI with a present
value of $1.20 ($120/$100). However, for every dollar of equity, the company generates ROPI
with a present value of $3 ($120/$40) . Accordingly, this scenario shows that levered PB ratios are
higher than unlevered PB ratios and yields the following inference: PB increases with company
leverage .
In sum, when selecting comparable firms to use in valuation based on a multiple of book
value, we should select firms with similar operating profitability, similar expected growth , and
similar risk - both operating and financial.

MDC Holdings ... . ..... .. .... . . .. ........... . . . .


Dow Jones & Company .... . . .... . ..... . . .. ..... .
lconix Brand Group .. .. . . .... . . ..... .... . ....... .
Oxford Industries . ... ... .. . .... . . ...... ... . .. .. . .

News Corporation .. .... ................... . .. .. .


Lifetime Brands . .... .. .. .. .... . .. . ........ .. ... .

PB ratios are higher than Price-to-NOA ratios when companies carry debt. The Price-to-NOA
ratio is often referred to as an unlevered PB ratio . Exhibit 15 .12 reports data for two companies
with identical net operating assets ($100), identical weighted average cost of capital (10%), identical RNOA of 22% , and identical growth of 0%. However, Company G finances its operations
with equity, while Company H finances its operations with $60 of 6% debt and $40 of equity. The
cost of equity capital for Company G is 10%, while it is 11.5% for Company H .2
Using the formula for the present value of a perpetuity with growth of g, we find the present
value of expected future residual income for both the unleveraged and leveraged companies is
$ 120, computed as $12/(0.10-0.00). Consequently, the theoretically correct Price-to-NOA multiple for both companies is 2.2, computed as 1 plus the quantity of the $120 present value divided
by the $ 100 NOA. The unleveraged Company G's PB ratio is the same as its 2.2 Price-to-NOA
multiple . However, the PB multiple for the leveraged Company His 4.0, computed as I plus the
quantity of the $120 present value divided by the $40 owner's equity.
EXHIBIT 15.12

RNOA

IV Debt)
Recall from Module 12 that the weighted average cost of capital is r"' = ( r" X - -

rv Firm

JV Equ;ry)
re X - - . The
IV Firm

hi gh leverage Company H has debt of $60, with an after-tax interest rate of 6%. That company 's intrinsic value is $220,
its intrinsic value of debt is $60, and its intrinsic value of equity is $ 160.

a.

The solution is on page 15-37.

Deriving Price-to-Earnings from Residual Operating Income Model


We can derive a model for the theoretical value of the price-to-earnings (PE) ratio using the
residual operating income model in a way similar to what we did for the PB model.
PE =

(1

+re) X
re

(i

+ [Present value

ofexp~cted changes in RI])


Earmngs

15-16

15-17

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation


3

The derivation is a bit complex, but the intuition is straightforward . That is, the PE ratio equals
(approximately 4 ) the capitalized value of current income, including normal income and residual
income , plus the capitalized present value of changes in future residual income . Also, because we
are capitalizing total income , including its operating and nonoperating components, we use the
di scount rate for equity where the capitalization factor is ( I + re)/re.
To see how the PE formula works, we use the company data from Exhibit 15.1 2 to determine
the theoretical expression for the PE ratio . For the unleveraged company, recall that equity value
is $220 , computed as the $ 100 net operating assets plus the $ 120 present value of ROPI. The cost
of equity capital for the unleveraged company is 10%, which means its capitalization factor is
11 , computed as (1 + 0 .10)/0 .10. Its net income is $22 (computed from RNOA X NOA), which
yields a $242 company value using the capitalized total earnings ($22 X l I). This is near the
$220 intrinsic value.5
For the leveraged company in Exhibit 15 .12, recall that equity value is $ 160, which equals
the $ 100 net operating assets minus the $60 debt plus the $ 120 present value of ROPI . The cost of
equity capital for the leveraged company is 11 .5%, and the capitalization factor is 9.7, computed
as (l + 0 .115)/0 .115. Its net income is $18.4 (computed from RNOA X NOA , less 6% X Debt),
which implies a $ 178 company value using capitali zed total earnings ($ 18.4 X 9 .7). This is near
the $ 160 intrinsic value. 6

RESEARCH INSIGHT

If current earnings are a good forecast of future earnings, then the forward PE ratio (price divided
by forecasted EPS) will be close to the trailing PE ratio (price divided by past EPS). If earnings are
expected to increase, the forward PE ratio will be lower than the trailing PE ratio, and vice versa.
The plot below shows the relation of forward PE ratios to trailing PE ratios in late 2007 for housing
stocks. Beginning in mid-2006, home sales and mortgage originations, which had reached record
highs, began to decline dramatically. What does the data suggest the market was expecting in
terms of forward earnings growth for the typical housing stock? (Hint: Draw the diagonal from the
coordinate (0, 0) to (20, 20) and inspeet the distribution of observations above and below the line.)
w_e see that the market expected earnings to decline as suggested by the forward PE ratio being
higher than the trailing PE ratio.
Forward PE versus Trailing PE for Housing Stocks in 2007

UJ
0..

"E
~

u.

We refer to the formula for the theoretical value of the PE ratio to provide insight into the factors that should affect cross-sectional variation in PE ratios. A review of the formula reveals that
only growth and risk affect PE, not profitability. In contrast to the PB ratio , which increases with
operating profitability, PE ratios are unaffected by RNOA . Earnings of$ LO are capitalized at the
same rate , regardless of whether the underlying RNOA is 5% or 50% . However, expected growth
in residual income leads to higher PE ratios, and hi gher cost of equity capital leads to lower PE
ratios. Thus , in selecting comparables to use for valuing a firm based on an earnings multiple, we
should consider expected earnings growth and risk (both operating and financial risk).
3

We can adapt the ROPI model to ex press eq uity value as a function of the book val ue of owners' equity (OE) and
residual income (RI ) as fo ll ows:
Equiy value = OE + Present value of ex pected RI , discounted usi ng re
where:

Residual

OE.,., =

income (RI ) is net income in excess of a fa ir rate of return on beginning equity

= NI - (OEBeg

r.)

Owners ' equity at beginning of the period

', = Cost of equity capital


Lei's

_
RI
Rl 2
RI 3
RI 4
also recall that Equity value 0 = BV 0 + ... ~+(I + r.) 2 +( I + re) 3 + (l + re) 4 + . .. ,and that RI, -

NI , - (re X BY,) . By addin g di vidend s at time 0 to both sides, ex pandin g the RI terms, and cancellin g out common
)
~RI
~RI
RI
I + r
(
terms, the ex pression si mplifi es to Eq uity0 = _r_e X Nl 0 + -+( 1I) + - - 2-2 + - -3 -3 + ... - Di vidend0 .
c
r0
( I + re)
( 1 + re)
Assuming that the current peri od di vidend is small relati ve to current eq uity value, the theoretical PE rati o equal s the
capitali zation factor, ( I +re)/re, times I plus the present value of changes in ex pected residual income.
4 Thi s

is an approximation because on the ri ght hand si de we should subtract the current di vidend payout ratio . However,
in most cases, the c urrent peri od di vi dend payout ratio is small relative to other factors , and can be ignored.

5 This

is $22 too hi gh, which is why the ex pression is approximate . The "error" is because by assuming$ I00 beginning
net operating assets, $22 income, and $ I00 ending net operatin g assets, we implicitly ass ume that all earnin gs are paid
out as dividend s. Such dividend s are unavailable to increase future earnings, and so are not capitali zed. We can correct
the capitalization factor by subtractin g from it the current dividend payout ratio, in thi s case $22/$22, or I . This gives
a capitalization factor of 10, which yield s the correct intrinsic value of $220, computed as $22 X 10. In practice this
correction is rarely made, because the resulting valuation errors are usuall y small.
6 Again,

thi s value approximati on is hi gh. The "error" is because we ass ume (see previous footnote) that all earnings
are paid out as dividends and so are unavai lable to increase future earnings. We can correct the capitali zation factor by
subtractin g from it the current di vidend payout ratio , in thi s case $ 18.4/$ 18.4 , or I . Thi s gives the correct capitali zation
factor of 8 .7.

20 -(1
18
16 ...Y1
_y
14
12 _y
10 y
8
6 _jll
4 _jll
2 _jll
0 IL:
0

-V1

Cll

PE Ratios in Relation to Profitability, Growth, and Risk

Forward PE Ratios versus Tl'ailing PE Ratios

~
~

_._

......., '

....

-V

f
8

_r
6

,~

-, .-

...L.

1,, ~I -,

....... l!.1~

,~,,,..

~--,-

-f'.

10
12
Trailing PE

~;..-

14

.L

I
16

-f'.
18

_/

20

MID-MODULE REVIEW 4
Cummi~s'. lnc.'s (CMI) book value of equity is $3,195 million and its forward earnings estimate is
$_932 ~ll10n. V'!e also collect the following information for CMl and a peer group of companies
(1dentif1ed by ticker symbol) from the machinery sector.

Ticker
CMI. . .... .
VOLVY ... .
PH .. . .. .. .
CAT ..... ..
DE ....... .
CNH . . .. ..
PCAR . .. ..
ETN .. . ....
DHR . .....
IR .. .... ..
ITW . .. .. ..
ITI . ... . . .

MarketCap*

PB

Forward PE

5-Year Hlstorlcal

(MIUlons)

(Current)

(FY1)

Growth Rate

ROE
(1'40)

52 %
45
40
40
36
34
31
29
23
21
20
15

25 %
19
19
44
22
9
28
23
20
30
20
24

$35,244
12,512
45,477
38,443
15,167
20,035
13,834
27,424
12,186
28,639
11,473

2.89
2.75
5.28
4.77
2.64
3.86
2.92
3.41
2.35
3.05
3.32

14.5
14.1
13.3
17.4
23.8
16.3
14.0
22 .6
12.5
15.7
17.9

Debt-to-Equity
(Prior Year)
23 %
44
23
258
155
80
69
43
36
17
11
17

' Market cap refers to market capitalization , or firm value, as perceived by market participants.

Required

a. !de~tif!' a set of companies from this list to use as comparables for estimating the equity
mtrms1c value of CMI using the market multiples approach .
b. Estim~te the equity intrinsic value of CMI using PB ratios from the comparable companies .
For this part assume the comparables are VOLVY, PH, PCAR, ETN, DHR and IR .
c. Estim~te the equity intrinsic value of CMl using PE ratios from the comparable companies.
For this part assume the comparables are VOLVY, PH , PCAR, ETN , DHR and IR.
The solution is on page 15-38.

15-18

15-19

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

INTERPRETING AND REVERSE ENGINEERING


OF MARKET MULTIPLES
L04 Interpret and
reverse-engineer
market multiples to
assess the reliability of
market expectations.

Despite problems inherent in using the market multiple method to value companies , the PB and
PE ratios are common in the investment world. One reason they are so widely quoted is that
they economically convey the market's (combined) expectations about growth rates and discount
rates for companies . By making assumptions about one of those two factors, the investor can
infer expectations about the other that are impounded in current prices . The section explains how
to interpret such multiples and describes the reverse engineering of market multiples to assess
observed stock prices .

Case 1

Interpreting and Reverse Engineering the PB Ratio


Reverse engineering is the process of observing market price metrics such as the PB and PE ratio
and assessing the quality of the underlying expectations supporting that observed stock price. The
PB ratio is especially apt for reverse engineering. Toward that end , recall the followin g relation
(see footnote 4):
Equity value

If we divide both sides by OE we get:


Equity value
= 1
OE

Present value of expected RI


OE

Case 3

The left hand side is PB . If we then assume that residual income is a perpetuity (that is, Present
value of expected RJ = RJ/[re - g]), we can algebraically derive (details not shown for brevity) the
following PB formula:

PB= 1

Expected ROE - re
re _ g

Case 3 assumes that we know the market's expectation about the discount rate (10%
in Scenarios A and B , and 9% in Scenarios C and D) and growth rate (7 % in Scenarios A and
C , and 6% in Scenarios Band D), and then we solve for Limited Brands' implied ROE. Results
show that Limited Brands must maintain a high level of profitability (from 43.4% to 78.8 %) in
perpetuity to justify its 18 .2 PB ratio.
EXHIBIT 15.14

This is a tractable PB formula with three unknowns: Expected ROE , discount rate re, and
growth rate g. We can manipulate these unknowns to infer the market's expectations about
these valuation parameters. Specifically, to infer the value of a specific one we must make
assumptions about the other two . This provides us a structure for reasoning about valuation
parameters underlying an observed stock price. The illustrations in this module assume stability in the parameters over an infinite horizon. Additional insights are possible from varying the
parameters over shorter horizons.
To illustrate, let's take a look at Limited Brands , the retail parent company of Victoria 's
Secret, White Barn Candle Company, C.O. Bigelow, Bath & Body Works, and Henri Bendel.
Exhibit 15.13 presents data from Limited Brands as of mid-2011 (based on trailing four quarter
data ending July 2011). Trailing refers to numbers reported in the prior period , whereas forward refers to numbers expected to be reported in the next period.

,! EXHIBIT 15.13
Financial Information for Limited Brands ($ millions)
'
Market value of equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Book value of equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ROE (based on trailing 4 quarters). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ROE (based on most recent quarter) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Case 1 assumes that we know the market's expectation for ROE (67 .5% in Scenarios
A and B , and 26.4% in Scenarios C and D) and the di scount rate (12% in Scenarios A and C ,
and 10% in Scenarios Band D) , and then solve for Limited Brands ' implied growth rate. Results
show that to support an 18.2 PB ratio, we require a high implied growth rate , ranging from 6 .7%
to 11.2%, which is high ; remember that this rate is assumed to exist in perpetuity.

Case 2 Case 2 assumes that we know the market's expectation for ROE (67 .5 % in Scenarios A
and B , and 26.4% in Scenarios C and D) and the growth rate (5 % in Scenarios A and C , and 4%
in Scenarios Band D), and then we solve for Limited Brands ' implied discount rate. Results show
that to support an 18 .2 PB ratio, we require a discount rate between 5.2% and 8.4%.

+ Present value of expected RI

OE

unlikely sustainable without the result of leverage. (Limited Brands has substantial debt, so its
RNOA is much lower than the 67 .5 % trailing ROE.) Looking at the most recent quarter, ROE is
26.4%, which suggests a level closer to normal (the difference could also result from seasonality
in Limited Brands' sales .)
To help us assess market expectations for Limited Brands we use the above PB formula to
investigate scenarios using different combinations of expected ROE, growth rates, and discount
rates that would justify a PB ratio of over 18 for Limited Brands. Exhibit 15.14 presents the
results of one such process of reverse engineering. The results are organized into three cases,
linked to a variation in one of the three parameters, and four scenarios A through D.

$11,396
$ 625
67.5%
26.4%

The PB ratio for Limited Brands is 18.2, computed as $11 ,396/$625 , which is extremely high.
A PB ratio of l implies no future residual income and, as such , it is clear that the market expects
Limited Brands to generate substantial future residual income . Looking at Limited Brands' current performance, ROE on a trailing four quarter basis is 67.5% , which is also extremely high and

Reverse Engineering of PB Ratio for Limited Brands

Scenario A

Scenario B

Scenario C

Scenario D

PB* (equals PB ratio observed - 1). . . . . . . . . . . . .

17 .2

17 .2

17 .2

17 .2

Case 1: Solve for implied growth rate


Assumed parameters
ROE ... . . . . . . . . . .. . .. . . . . .. . . . ... .. ...
Discount rate, r ... . .... .. . . . . .. .. . . . .. . ..
Implied parameter
Growth rate, (r8 + [PB* x r0 ] - ROE)/PB* . . .. . .

67.5 %
12.0%

67.5%
10.0%

26.4%
12.0%

26.4%
10.0%

8.8 %

6.7%

11 .2%

9.0 %

Case 2: Solve for implied discount rate


Assumed parameters
ROE .... . ..... . ... . ... .. .. . . . . . . . .. . . . .
Growth rate, g . . . . . .. .. .. . .. . . . ... . . .... .
Implied parameter
Discount rate, (ROE + [PB* x g])/(1 + PB*) ... . .

67.5%
5.0%

67.5%
4.0%

26.4%
5.0%

26.4%
4.0%

8.4%

7.5%

6.2 %

5.2%

Case 3: Solve for implied future ROE


Assumed parameters
Discount rate, r . . . . .. . . .. . .. . .. .... . .... .
Growth rate, g .. .. . . .. . . . . . . . . ..... . .... .
Implied parameter
ROE, (PB* x [r. - g]) + r8

10.0%
7.0%

10.0%
6.0%

9.0%
7.0 %

9.0%
6.0%

61.6%

78.8%

43.4%

60.6 %

Interpreting and Reverse Engineering the PE Ratio


Reverse engineering of the PE ratio can also be applied to infer the market's expectations about
future earnings , but it is not nearly as tractable as the PB ratio . For the PE ratio, recall that:

15-20

15-21

Module 15 I Market-Based Valuation

PE = ( 1

Module 15 I Market-Based Valuation

+ re) x (1 + [Present value of exp~cted changes in RI l)


r.
Earmngs

where:
Residual income (RI )
OEbeg
re

= NI

- (OEBeg X re)

= Owners' equity at beginning of the period

= Cost of equity capital

This formula shows that the PE ratio approximates the capitalization factor ([l + re]/re), plus an
adjustment for expected increases or decreases in future residual income. To illustrate , let's assume
a 10% equity cost of capital , which implies a capitalization factor of LI . If investors do not expect
residual income to change, then the PE ratio should approxi mate 11 . More precisely, investors can
expect income to increase , but only at a rate equal to the change in book value times the 10% cost
of equity capital. Further, if investors expect income to increase at a rate higher than 10% times the
change in book value, then the PE ratio is predicted to be higher than 11 ; and vice versa if investors
expect income to increase at a rate lower that 10% times the change in book value.
We can use the PE valuation formula and reverse engineer the market's expectations about
its valuation parameters and future earnings as we did for PB ratios. However, the results when
reverse engineering the PE ratio are not usually intuitive or useful. Still, we often use the PE
valuation formula to help us understand why PE ratios differ among industries and companies.

RESEARCH INSIGHT Fischer Black and the Magic In Earnings


Fischer Black argued in an article, The Magic in Earnings (1980), that investors want an earnings
number that they can use to determine value. He provocatively proposed that accountants adopt
as their main objective the creation of an earnings number that can be multiplied by a constant
(such as 10) to yield value. This accounting model would render the balance sheet superfluous to
investors. He suggested that accountants were surprisingly close to producing such a number,
as evidenced by the relatively low variance in PE ratios. Whatever you believe the merits of his
suggestion, recent actions by the FASB to move from historical cost accounting toward fair value
accounting inverts FiscMr Black's suggestion in that the FASB moves the balance sheet closer to
the primary indicator of company value and the income statement toward superfluous status.

MODULE-END REVIEW
Joh~son ~ ~ohnson's (JNJ) current market cap is $191 billion , its book value of equity is $39 .3 billion,

and its trailmg four quarters ROE is about 26%, with an average 13% ROE for seven health care peers.
JNJ's five-year average sales growth is 10%, with an average of 13% for its peer group; and , its fiveyear average EPS growth is 14%, with an average of 5% for its peer group.

Perspective on Valuation Multiples and Fundamental Analysis


We conclude thi s module with some perspecti ve on us ing valuation multiples to value a target
company. We also offer some advice on the implementation of valuation multiples.

Process of Fundamental Analysis


This module and the prior three introduced us to four different methods of valuing securities:
discounted dividends, di scounted cash flow s, the residual operating income model , and valuation
by market multiples. The first three methods require explicit modeling of a company's future
performance, and the use of these forecasts for valuation. The resulting valuation can contain
error because the forecasts are wrong, or because the discount rate is wrong, but not because of
an inherent problem with the valuation model .
In the case of the fourth method , an investor cannot have the same assurance if market multiples are used as the valuation technique . The method does have some intuitive appeal (and it is
easy!) but it does not have rigorous theoretical underpinnings. Many errors can arise. For example , the selection of comparables might not yield peers that are similar on profitability, growth,
and risk. Also, the performance metric (earnings or book values) might be unstable over time
and be a poor basis for assessing relative value. In addition, the market might be inefficient, so
that using prices of comparables to infer the value of a target company simply compounds error.
Nonetheless, market multiples are widely used and, if applied with discretion , are sometimes
useful for our analysi s.

Scenario A

Scenario B

ScenarfoC

Scenario D

PB* (equals PB ratio observed - 1) . ... . . ... . ...

3.9

3.9

3.9

3.9

Case 1: Solve for implied growth rate


Assumed parameters
ROE .. . . . . .... ........ . . .... . ..........
Discount rate, r .. .......... . . . ....... . . ..
Implied parameter
Growth rate, (r0 + [PB* x r0 ] - ROE)/PB* ......

26.0%
7.0%

13.0%
7.0%

26.0%
9.0%

13.0%
9.0%

Case 2: Solve for implied discount rate


Assumed parameters
ROE ......... ... . ....... . . .. . ...... . . ..
Growth rate, g ......... .. ... . . . . ... . ....
Implied parameter
Discount rate, (ROE + [PB* x g])/(1 + PB*) .. . ..

26.0%
3.0 %

13.0%
3.0%

26.0%
5.0%

13.0%
5.0%

Case 3: Solve for implied future ROE


Assumed parameters
Discount rate, r0 . .
Growth rate, g . ..... . . . .. ...... .. .. . .. .. .
Implied parameter
ROE, (PB* x (r0 - g]) + r0 . .

7.0%
3.0%

9.0%
3.0%

7.0%
5.0%

9.0%
5.0%

Implementation of Valuation Multiples


If we use market multiples for company valuation, there are at least three steps we should take in
implementing this method . First, whenever possible , use forward-looking performance measures
to compute the market multiples for comparable companies. Prices are forward-looking and
reflect expected future performance of a company, not past performance. Further, use an estimate
of the target company ' s future performance to multiply by the forward-looking market multiple.
Forward-looking estimates are especially important for earnings multiples as earnings are more
volatile than book values. Second, select comparable companies with care so as to match them
on profitability, growth, and risk profiles to those of our target company. Third, use both incomestatement-based and balance-sheet-based valuation multiples, and possibly consider industrybased multiples. This might induce greater variance in the estimated value of our target company.
However, as unsettling as this can be , it requires us to directly consider the reliability of those
estimates and the inputs underlying them.

Required
a. Using the assumptions in Case l, compute the growth rate implied by JNJ's PB ratio for each
Scenario A through D .
b. Using the assumptions in Case 2, compute the discount rate implied by JNJ's PB ratio for each
Scenario A through D.
c. Using the assumptions in Case 3, compute the ROE implied by JNJ's PB ratio for each Scenario
A through D .
d. Based on your analysis in parts a, band c, do you believe the current PB ratio for JNJ reflects
reasonable expectations about its future performance?

The solution is on page 15-38.

15-22

15-23

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

M15-12. Determining PB Ratio for Companies with Different Returns

15-24

(L03)

Assume that the present value ~f expected ROPI follows a perpetuity with growth g (Value = Amount/
[r - g]). Determine the theoretically correct PB ratio for each of the following companies A and B.
You Are an Entrepreneur You should point out that Oracle and SAP are more mature companies and probably
have lower expected growth than your firm . You could find some publicly-traded start-up software firms that have
also experienced losses and suggest using those as comparables. Alternatively, you could suggested a valuation
based on discounted cash flows or residual income. You might also suggest that part of the buyout price be contigent on the future performance of your firm .

Company
A .......... .. ...

B .. .. ......... . .

Net operating
assets

Equity

RNOA

ROE

Weighted average
cost of capital

Growth rate
lnROPl

$100
$100

$100
$100

18%
11%

18%
11%

10%
10%

2%
2%

M15-13. Determining PB Ratio for Companies with Different Returns and Growth
Q15-1.

Identify the advantages of valuation using market multiples compared to valuation using discounted
cash flow s or discounted residual operating income.

Q15-2.

Identify the disadvantages of valuation using market multiples compared to valuation using discounted
cash flows or discounted residual operating income .

Q15-3.

This module referred to the residual operating income model described in Module 14. Explain what a
company-value-to-net-operating-assets ratio equal to I implies about future residual operating income.

Q15-4.

Describe the factors that should be considered in choosing comparable companies for computation of
the market multiples company-value-to-net-operating-assets and the price-to-book-value.

Q15-5.

The " E" in the PE ratio can be determined in several ways . Identify at least three different variations
in meas uring earnings for the PE ratio .

Q15-6.

Referring to residual income , PE can be expressed in terms of cost of equity capital, the present value
of expected changes in residual income, dividends, and earnings. Explain what a PE ratio of 11 implies
about market gro wth expectations for a company with a cost of equity capital equal to 10%. Do the
same analysis for a PE greater than 11 and less than l l.

QlS-7.

Company
A . . . . ... . .......

B .... . . ... . .. ...

Net operating
assets

Equity

RNOA

ROE

Weighted average
cost of capital

Growth rate
lnROPl

$100
$100

$100
$100

18%
11%

18%
11%

10%
10%

2%
4%

M15-14. Determining PB Ratio for Companies with Different Returns and Cost of Capital (L03)
Assume that the present value of expected ROPI follows a perpetuity with growth g (Value = Amount/
[r - g]). Determine the theoretically correct PB ratio for each of the following companies A and B.

Company
A .. . .....
B . . . ... ........ .

Net operating
assets

Equity

RNOA

ROE

Weighted average
cost of capital

Growth rate
lnROPl

$100
$100

$100
$100

18%
11%

18%
11%

15%
10%

2%
2%

Barron 's Online posted the following headline in early October 2007: "Cisco: Goldman Ups Target On
'Stronger Multiple Outlook '." Explain what this headline means.

M15-15. Determining PB Ratio for Companies with Different Capitalization


Assignments with the ~ logo in the margin are available in an online homework system.
See the Preface of the book for details.

Burger King Corporation reports total book value of $796 million and common shares outstanding of
135 .7 million. The average PB ratio for restaurant companies is 7 . I. Using the industry average PB ratio,
estimate the intrinsic value of Burger King 's equity.

BURGER KINI:
CORPORATION
(BKC)

M15-9.

BUILll-A-llEAll
WORKSHOP
(BBW)

Valuation using a Balance Sheet Multiple (L01)

Valuation using a Balance Sheet Multiple (l01)


Build-a-Bear Workshop, Inc. , reports a book value per share of $9.55 . The industry average PB ratio
for toy and hobby stores is 2.3. Using the industry average PB ratio, estimate the intrinsic value of
Build-a-Bear's equity per share.

M15-10. Valuation using an Income Statement Multiple

IAKKS PAl:IFll:
(JAKK)

(L02)

JAKKS Pacific, Inc. , a toy manufacturer, reports net income for the recent twelve months of $90 million . JAKKS ' has 28.6 million shares outstanding. The industry average PE (using the trailing twelve
months earnings) for its competitors is 14.25. Using this industry average PE , estimate the intrinsic
value of Jakk Pacific 's equity.

M15-11. Valuation using an Income Statement Multiple (L02)

MOTOlllJLA, INI:.
(MOT)

Motorola, Inc. , was trading at $9.65 per share. Earnings estimates for the next 12 months were $0.62 per
share. The industry average forward PE ratio is 10.4. Using the industry average forward PE, estimate
the intrinsic value of Motorola 's equity per share .

(L03)

Assume that the present value of expected ROPI fo llows a perpetuity with growth g (Value = Amount/
[r - g]). Determine the theoretically correct PB ratio for each of the following companies A and B.

Company

M15-8.

(L03)

Assume that the present value of expected ROPI follows a perpetuity with growth g (Value = Amount/
[r - g]). Determine the theoretically correct PB ratio for each of the following companies A and B.

A ... . . . . ..
B .. ..... .......

Net
operating
assets

Debt
(6% rate)

$100
$100

$ 0
$60

Ml5-16. Identifying Comparables for Valuation

Equity
$100
$ 40

RNOA

ROE

Weighted
average cost
of capital

11%
11%

11.0%
18.5%

10%
10%

""'

Growth
rate In
ROPI
0%
0%

(L03)

Which would be a better comparable to use in valuing Chiquita Brands using a PB ratio-based multiple:
Fresh Del Monte Produce or Lancaster Colony? Explain your answer without reference to the actual
PB ratios .

Company
Chiquita Brands Intl .............
Fresh Del Monte Produce ........
Lancaster Colony ..... . .........

5-Year Historical
EPS Growth Rate

ROET4Q

Debt-to-Equity
Last Qtr

PB Current

(0.26)

(0.06)

0.89

1.05

(0.07)
(0.02)

(0.03)
0.10

0.33
0.12

1.96
2.71

l:HIOUITA BRANDS
(CQB)

FRESH llELMIJNTE
PRODUCE
(FDP)

LANl:ASTEll
COLONY
(LANC)

15-25

Module 15 I Market-Based Valuation

SYNUTRA
INTERNATIONAL
(SYUT)

SARA LEE
CllRPllRATlllN
(SLE)

WIMM-BILL-UANN
FlllJUS
(WBD)

HEllSHEY
COMPANY
(HSY)

Module 15 I Market-Based Valuation

MlS-17 . Identifying Comparables for Valuation

(L03)

Which wou ld be a better comparable to use in valuing Synutra International using a PE ratio-based
multiple: Sara Lee Corporation , Wimm-Bill-Dann Foods, or Hershey Company? Explain your answer
without reference to the actual PE ratios .

ROE

Debt-toEquity

Synutra International ...... .. . . ...... . ..

0.39

0.34

0.24

42 .94

Sara Lee Corporation . .. . . . ...... ... ...

0.1 9

0.23

0.80

13.49

Wimm-Bill-Dann Foods .. . .... .... ......


Hershey Company ... . ........ . . . .. . . . .

0.42
(0.11)

0.23
0.36

0.24
2. 16

32.23
19.88

Estimated

(PNRA)

ElS-21. Valuation Using Price-to-NOA Multiple

(L01)

The fo llowing table provides summary data for Cerner Corporation and its competitors, Eclipsys Corporation and McKesson Corporation .

Earnings Growth

Company

MlS-18. Identifying Comparables and Valuation using PB and PE

PANERA UllEAll
COMPANY

(in millions)

Company assu med val ue . ........... . ......... .. . .


Equity assumed value . .... . . .. . .. ...... . .. ...... .
Net operating assets .. . .. ................. . .... . .
Book value of equity ......... . ....... ... .... ..... .
Net nonoperating obligations (assets) .. . .. . . . ... . .. . .
Common shares outstanding .. . . .. ........ . ... . . .. .

(L01, 2, 3)

$2.02. T he followi ng information is also avai lable for Panera and a peer group of companies (identified
by ticker symbol) from the restaurant sector.

cap
Ticker

($mil.)

PNRA . . . .. .. . .. ...
PFCB . ... .. . .. .... $ 689.2
416.0
BWLD . ...........
702.2
PZZA .. . ..........
CPKI .... . . .. .. . ..
379.3
320.6
PEET . . . . ... ......
1,264.2
SONC . .. ...... .. .
TXRH . ... . . . ......
717.6
RRGB . ......... . .
609.7

PB
Current
2.3
2.9
5.5
1.7
2.2
(12.4)
2.0
2.1

EPS5-Year

(FY1)

Growth Rate

er 4Q)

Debt-to-Equltil
(Prior Y9811

21.3
17.8
14.4
23.6
28.8
19.0
17.1
16.9

15.3%
6.1%
21.5%
(1 5.8)%
(7.3)%
11 .7%
(3.3)%
(2 0.6)%
19. 0%

13.3%
10.2%
15.2%
23.8%
6.8%
6. 1%
(102.3)%
11.4%
11.7%

0.17
0.32
0.00
1.06
0.00
0.00
(7.33)
0.18
0.50

Hlstortcal

ROE

b.

c.

(L04)

The PB , trai ling PE, and forward PE data fo llow for four companies. Determine the current ROE for
each company. Which company do you believe the market expects to have the highest future ROE?
Explain .
Company

PB

Trailing PE

Forward PE

Apple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Autozone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Coinstar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Schwab .. . ..... . ...... . . ..... . . .. .. . . . ....... . . ..... ..

11
45
2. 4
2.1

48
14
42
11

30
11
35
21

MlS-20. Determining ROE and Assessing Market Expectations

(ECLP)

Ml: KESSON
COllPOllATlllN
(MCK)

ElS-22. Valuation Using the PB Multiple

(L01)

Refer to information in El5-21 to complete the requirements.


Required

a.
b.

Compute the PB ratio for both Eclipsys and McKesson.


Use Eclipsys and McKesson as comparables, along with the PB ratios from part b, and then estimate for Cerner its equity intrinsic val ue and its equity intrinsic value per share.

ElS-23. Valuation Using Price-to-NOPAT Multiple

(L02)

The follow ing table prov ides summary data for Applied Materials and its competitors , KLA Tencor
Corporation and Lam Research Corporation .

APPLIED
MATElllALS
(AMAT)

Identify a set of three compan ies from this list to use as com parables for estimating the equity
intrinsic value of Panera using the market multiples approach.
Assume that you use as comparables the following set of companies: PFCB , BWLD , and RRGB.
Estimate Panera 's equity intri nsic value per share us ing the PB ratio from these peer companies.
Use the same comparables as in part band estimate Panera's equity intrinsic value per share using
the PE ratio from these peer companies.

MlS-19 . Determining ROE and Assessing Market Expectations

ECLIPSYS
t:llllPlll\ATlllN

Compute the price to net operating assets ratio for both Eclipsys and McKesson.
Use Eclipsys and McKesson as comparables, along wit h the price to NOA ratios from part a, and
then estimate for Cerner its company intrinsic value , its equity intrinsic value , and its equity intrinsic value per share.

Required

a.

54. 0 shares

$17,519
$15,570
$ 8,454
$ 6,505
$ 1,949
288.8 shares

Required

a.
b.

Forward
PE

$1,328
$1, 132
$ 192
80.4 shares

$1,120
$1,120
$ 258
$ 258

l:EllNEll
l:llllPllllA TlllN
(CERN)

Ecllpsys

Panera Bread Company's book value per share is $14.17 and its forward earnings estimate per share is

Market

15-26

(L04)

Refer to the information in M IS-19 . Which company do you believe the market expects to experience
a decline in earni ngs? Explain .

(In mllllons)

Company assumed value ...... . .. ......... ... .... .


Equity assumed value ............. . . .. .... . . .... .
NOPAT ...... . . ... . .. . .... . . . . .. . . .... . ....... .
Net income . .... ... .. . ..... . .... ... . ... . ...... . .
Net nonoperating obligations (assets) ...... . . . . . ... . .
Common shares outstanding ....... . .. ... . ..... . . . .

Applied
Materials

KLA
Tencor

R....at

$1 ,591
$1,570
$ 205
1,350 shares

$6,890
$6,890
$474.2
$474.2
$
0
180.1 shares

$5,720
$5,370
$647.3
$637.7
$ 350
135.1 shares

Lam

KLA TENCllll
l:llllPOllA TlllN
(KLAC)

LAM llESEAlll:H
(LRCX)

Required

a.
b.

Compute the price to NOPAT ratio for both KLA Tencor Corporation and Lam Research
Corporation .
Use KLA Tencor Corporation and Lam Research Corporation as comparables, along with the price
to NOPAT ratios from part a, and then estimate for Applied Materials its company intrinsic value,
its equity intrinsic val ue, and its equity intrins ic value per share.

ElS-24. Valuation Using the PE Multiple

(L01)

Refer to information in E IS-23 to complete the requirements.


Required

a.

Compute the price to net income ratio for both KLA Tencor Corporation and Lam Research
Corporation .

b.

Use KLA Tencor Corporation and Lam Research Corporation as comparables , along with the price
to net income ratios from part a, and then estimate for Applied Materials its equity intrinsic value
and its equity intrinsic va lue per share .

KLA TENl:Oll
(KLAC)

LAM llESEAlll:H
(LRCX)

APPLIED
MATElllALS
(AMAT)

Module 15 I Market-Based Valuation

15-27

Module 15 I Market-Based Valuation

ElS-25. Valuation Using the PE Multiple

(L01)
Nokia, Inc. , recentl y traded at $5 .66 per share. At that time , earnings per share estimates for the next 12
months were $0.36. In addition , Motorola Mobility and L.M . Ericsson had forward PE rat ios of 28.03
and 14 .64 , respecti vely.

NOKIA, INC.
(NOK)

MOTOROLA
MOBILITY

Requ ire d
Using Motorola and Eri csson as comparables, estimate the intrin sic value of Noki a 's equity per
share .
b. Does the estimate in part a suggest that Noki a is undervalued or overvalued ? Expla in .

(MM!)

a.

L. M. ERICSSON
(ERIC)

continued from prior page

TWB . . ...
CBK . . . . .
FINL . ... .
551 . .. . . .
DBRN

(L01, 3)
Ass ume that you w ish to estimate the equity intrinsic value of McCormick & Company using PB ratios
for comparable companies . The fo llow ing onl ine data are ava il able fro m companies .

b.

(MKC)
Company

ROE

PB
Current

EPS 5-Year Historical


Growth Rate

{T4Q)

Debt-to-Equity
(Prior Q)

4.20
5.84
1.24
3.47

0.09
0.08
(0.06)
0.20

0.23
0.25
0.05
0.15

0.53
0.35
0.54
0.04

McCormick & Co Inc . . ..


Wm Wrigley Jr Co .... . . .
Tyson Foods Inc .. . . ....
Flowers Foods Inc .. . ...

Required
a . Identify two of the th ree companies as better comparables fo r use in valuati on of McCormick.
Ex plain yo ur reasoning. (Hint: Consider each company o n the bas is of profitability, growth , and
fin ancial ri sk.)
b. Ex pl ain your rati onale fo r e liminatin g the third company in part a .

ElS-27. Identifying Comparables and Estimating Equity Value using PE

(L01, 3)
Ass ume that you w ish to estimate the equity intrinsic va lue of Kellogg Company using PE ratios for
comparable companies . The fo llowing online data are ava il able from companies.

KELLOGG l:llMPANY
(K)

Company
Kellogg Co . .. .. .. .... .. .. ..
Bunge Limited .. ... . . . . . . . . .
General Mills Inc .. ... .. .. ...
Hormel Foods Corporation . . .
Ralcorp Holdings, Inc . . . ... ..

Forward
PE

Estimated Earnings
Growth

ROE

Debt-to-Equity

16.80
13.81
16.61
17.31
15.26

0.09
0.04
0.10
0.11
0.07

0.47
0.14
0.22
0.16
0.14

1.30
0.52
0.63
0.19
1.37

Required
Identify two of the fo ur companies as better comparables fo r use in valuation of Ke llogg . Explain
your reasoning. (Hint: Consider each company on the bas is of profit ability, growth , and fi nancial
risk .)
b. Explain your reasoning fo r e liminatin g the two companies in part a .

a.

ElS-28. Identifying Comparables and Valuation using PB and PE

(l01, 2, 3)
Hot Topic, lnc.'s book value of equity is $235 million and its fo rward earnin gs estimate per share is
$0 .38 , or $ 16.7 million in total earnin gs. The fo llow ing info rmati on is also avail able fo r Hot Topic and
a peer group of companies (identified by ti cker sy mbol) from the specialty reta il sector.

HOT TOPIC, INC.


(HOTT)

Ticker
HOTT . ...
PLCE . . . .
J05B . . . .
ZUMZ . . .
GYMB . . .
MW ... . .

Market
Cap ($mil.)
$ 595.1
439.5
492 .5
1,126.3
1,217.0

PB
Current
1.1
1.9
3.2
5.7
1.5

Forward PE
(FY1)
14.7
9.1
18.5
13.0
11.8

EPS 5-Year Hlstorlcal


Growth Rate
(21 .2) %
11.8%
14.4%
27.4%
28.5 %
28.6%

ROE

er 40>
5.9%
8.4%
22.5%
19.8%
33.5%
23.5%

437.4
375.7
289.2
515.0
751.6

2.5
1.6
0.7
1.0
1.5

9.2
17.4
16.3
11.9
11.4

c.

1.02
0.00
0.00
0.20
0.28

Identify a set of three companies from thi s list to use as comparables fo r estimatin g th e equity
in trinsit; value of Hot Topic using the market multiples approach .
Ass ume that you use as comparables the fo llowing set of companies: CBK , FINL , and SSI. Estimate Hot Topic 's equity intrinsic value using the PB rati o from these peer companies .
Use the same comparables as in part band estimate Hot Topic's equity intrinsic va lue using the PE
rati o from these peer companies .

(L01, 2, 3)
Fossil, lnc.'s book value of equity is $772 mi ll ion and its forward earnings estimate per share is $2 .14 ,
or $ 147 m illion in total. The fo llowing information is also available fo r Foss il and a peer group of companies (identified by ti cker symbol) from the specia lty retail sector.

Ticker
F05L . . . ..
DECK . .. . .
K5W5 . .. .
MOV . . .. ..
ZQK . .. .. .
5KX .. . . . .
PERY . . .. .
UNF . . . . ..
WWW ... . .
MFB . ... . .
VLCM .. . . .

Market
Cap($ mil.)

PB
Current

Forward PE
(FY1)

$1,449.4
554.0
361.2
1,223.6
81 3.1
31 3.0
865.7
1,476.3
368.9
475.1

4.9
1.4
0.8
1.4
1.3
1.2
1.7
3.1
3.7
2.7

14.5
18.2
55.3
11.2
17.0
9.3
10.8
14.8
15.6
11.1
12.9

EPS 5-Year Historical


Growth Rate
7.0%
71.5%
(12 .6)%
9.2%
(24.7)%
6.7%
5.7%
11 .3%
8.1%
33.4%
16.8%

ROE
{T4Q)

Debt-to-Equity
(Prior Year)

18.4%
27.5%
10.6%
15.0%
(1 5.9)%
13.2%
11.4%
9.8%
19.2%
37.6%
22.0%

0.01
0.00
0.00
0. 11
0.85
0.03
0.74
0.45
0.00
0.89
0.00

Requ ired
Identify a set of three companies from thi s li st to use as comparabl es fo r estimatin g the equity
intrinsic value of Fossil using the market multiples app roac h.
b. Ass ume th at you use as comparables the fo llowing set of companies: MOY, SKX , and WWW.
Estimate Foss il 's equi ty intrinsic va lue using the PB rati o from these peer companies .
c. Use the same comparables as in part band estimate Fossil's equity intrinsic value using the PE ratio
from these peer companies .

a.

ElS-30. Theoretical PE for Companies with Zero Expected Growth in Residual Income

(L03)
The cost of equity capital fo llows fo r each of fi ve companies . For each company th e ex pected growth
in res idual income is zero .
Company
A . .. ... . . .. . . .

B . . . . . .. .. .. . .
C . ... . .. . . . . . .
D . . .. . . . ... . . .
E . ... . . . . ... . .

continued

17.3%
11 .8%
(0.1)%
11.0%
16.9%

ElS-29. Identifying Comparables and Valuation using PB and PE

Debt-to-Equity
(Prior Year)
0.00
0.00
0.00
0.00
0.00
0.11

4.6%
(11 .6)%
(7.7)%
(7. 1)%
(0.7)%

Required

a.

ElS-26. Identifying Comparables and Estimating Equity Value using PB

MCCORMICK &
COMPANY

15-28

a.
b.

Cost of equity capital


6%
9%
12%
15%
18%

Determine the theoreti call y correct PE rati o fo r each of the companies A th rough E.
In late 2007 , approximate ly one-half of the companies on the New York Stock Exc hange had a PE
ratio between 12 and 48 . Do you believe th e range of those PE rati os is primaril y related to di ffe rences in the cost of equity capital or to differences in ex pectati ons about future residual income?
Ex plain.

FUSSIL INC.
(FOSL)

15-29

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

ElS-31. Determining ROE to Yield Projected PB

t:OOCLE
(GOOG)

YAHllll
(YHOO)

EBAY
(EBAY)

(L04)

Google recently had a market cap of $ 194 bi ll ion , total equity of $46.2 billion , and 321 million shares
outstanding . At about the same time , the PB of Yahoo and eBay were 1.73 and 2.4 , respecti vely. Assume

that we desire a minimum 12% annual return on our investments, and that we believe Google will sell
at 2. 1 times book value five years from now. What must Google earn (ROE) on average over the next 5
years to make it a worthwhile investment? (Assume that Google pays no dividends.)

a.
b.
c.
d.

15-30

Common shares outstanding .


Total book value of equity.
Trailing fo ur quarters earnings per share (EPS).
Trai ling four quarters return on equity (RO E).

ElS-32 . Explaining Prices relative to NOA and RNOA (L03, 4)


Summary information for RNOA , NOA growth , price per NOA do llar for a sample of 300 companies
fo llows. Can you explain the behavior in companies ' prices fro m the data provided?

Number of companies

Median RNOA from

Median % growth In NOA

year t-1 to year t

from year t-1 to year t

Price per dollar of


NOA at end of year t

20%
20%

(5)%
34%

1.80
2.10

150 . . . . . . .. .. . . . .... . .
150 .. . .. . ... ... . . . . .. .

Identifying Comparables and Estimating Equity Value using PB

(L01, 3)

A s~ u m e

that your superiot req~c sts that you estimate the equity intri nsic value of ValueClick 's using PB
ratios f~r comparable compames-ValueCl ick is one of the world 's largest online marketing services
compames. The fo llowing data are available on companies fro m the Web.

VALUECLICK
(VCLK)

c::-

($mlL)

PB
CUrrent

$ 5,898 .8
2,014.3
53,115.5
229.2
724.7
1,426.2
913.9
431 .9
1,066.3
38,003.0

4.8
3.0
4.6
1.0
4.1
2.7
4.8
2.7
2.9
4.2

MmketCap

Ticker

ElS-33. Linking PB and PE Ratios to ROE (L03)


The fo llow ing graphic plots the PE and PB ratio combinations for each of five separate companies
A th rough E . Identify the company with the fo llowing description of its current and expected future
performance .
I . High current profitabil ity, earni ngs expected to decl ine but profitabi lity wi ll remain high
_ _2. Average current profitability, earni ngs and profitabi lity expected to remai n at the average
_ _3. Low current profitability, earn ings expected to increase but future profitability will be about
average
_ _ 4 . High current profitabil ity, profitability wi ll remain high
_ _ 5 . High current profitability, earnings expected to decline marked ly and profitabi lity will be low

VCLK . . . . . . . .. . . .. . .
AKAM .... .. . . .... . .
ORIV . . . . . .. . . .. . . . .
EBAY . . . . . . . . . .. . . ..
JUPM . ... .. .. . . . . . ..
KNOT . .. . . . ... . . . . ..
OTEX ... . . .. ...... . .
RATE .. . . . . . . . .. ....
SRVY . . . ..... . .. . . ..
UNTO .. . . . . . . . . . . ...
YHOO ... . .. . . . . . . . .

EPS 5-Y... Hlstortcal

ROE

Debt-to-Equity

GrowthRate

(T4Q)

(PrlorQ)

65.4%
102.5%
45.6 %
44.9%
44.1%
114.2%
19.8%
24.1 %
11.6%
23.8%
44.1%

11 .7%
7.9 %
11 .0%
12.4%
0.5 %
15.9%
4.5%
9.2%
7.0 %
13.5%
8.4%

0.0%
16.3%
29.0%
0.0%
20.0%
0.0%
70.0%
0.0%
0.0%
0.0%
0.0%

Required
Trailing PB and PE ratios

45

_/

.... c (1.5, 40)


-.

_V
40
_V
35
30
.2
(6 25
a:
w 20
a..

5
0

b.
c.

_V

lde ~tify the ~et o.f _


c ompanies you plan to use as com parables . (Hint: Consider each company on the
basis of prof1tab1hty, growth , and fi nancial risk .)
Estimate the equity intrinsic value of ValueClick. It has a current book value of $707 mill ion.
Prepare a memorandum to your superior identifying any issues that you believe should be considered before using the equity intrinsic value fro m part b for business decisions.

PlS-36. Identifying Comparables and Estimating Equity Value using PE (L02, 3)

__V

A s ~ um e

_V
_V
15
10

a.

+B-

that your superior requests that you estimate the equity intrinsic value of ValueClick 's using PE
ratios f~r comparable ~o mpa n_i es-ValueC li c k is one of the world 's largest online marketing services
compames. The fo llow ing online data are available fro m various companies.

u::i
' v/

B (1 .5, 12)

_1/1
__V

E (5 , 3)

A (0.7, 3)

-/
I

7
I

-1

L_

7
6

PB Ratio

ElS-34. Computing Key Metrics from Financial Data

(L03)

For each of the fo llowing company stocks , listed amo ng the Dow Jones Industrials , use the info rmation
provided to compute the measures a th rough d.

Company
Alcoa . . .. . . . . . . . .. ... . ....... . .
Boeing . . . . .. . .. . .. .. . . .. . . .. . . .
Citigroup . . . . . . . .. . . . .. . . .. . .. . .
Coca- Cola . .. . . . . ... . .... . . . . . .
McOonalds .. . . . . . . .. . . . .... . .. .
3M . . . . .. . ... . . . . . . . .. . . ... . . . .
Wal-Mart . . . . . . . . . . . . . .. . . . . ....
Exxon Mobil . . . . . .. . .. . . .. . . . . ..

($ml.)

Forward
PE

EPS s-v... Hlstorical


Growth Rate

ROE
(T4Q)

Debt-to-Equity
(PrlorQ)

$ 5,898.8
2,014.3
53,1 15.5
229.2
724.7
1,426.2
913.9
431.9
1,066.3
38,003.0

21.8
15.3
20.0
32.5
30.5
15.4
24.4
24.1
10.7
43.9

65.4%
102.5%
45.6 %
44.9 %
44.1%
114.2%
19.8%
24.1%
11.6%
23.8%
44.1 %

11 .7%
7.9%
11 .0%
12.4%
0.5 %
15.9%
4.5 %
9.2 %
7.0%
13.5%
8.4%

0.0%
16.3 %
29.0%
0.0%
20.0%
0.0%
70.0%
0.0%
0.0%
0.0%
0.0%

Market Cap

Ticker

Market Cap

Stock

PB

BVper

lhllllng

($mlL)

Price

Current

Share

4-Quarter PE

$ 30,016
67,578
148,886
143,928
69,534
60,261
191,630
503 ,364

$35.39
87 .19
29.89
62.28
58.79
84.49
47.85
92 .13

1.89
10.55
1.17
7.32
4.65
5.49
3.04
4.24

$18.34
8.44
25.86
8.51
12.63
15.35
15.57
21 .68

11 .88
16.80
8.03
23 .59
21.22
17.24
15.90
13.47

VCLK . . . . .... . . . .. .
AKAM . . ... . . . . . . ..
ORIV ... .. . .. . . . ...
EBAY . . . . . . . .. . ....
JUPM . . . ... .. . . ... .
KNOT .... . . ... .....
OTEX . . . . . .. .. . ... .
RATE ... .. . ...... . .
SRVY . . . . . . ... .. . ..
UNTO .. .. .. . . . . .. . .
YHOO . . . . .. . . . .. . .

Required

a.

b.
c.

ld e~tify

the ~et o_f_co mpanies you plan to use as comparables . (Hint: Consider each company on the
basis of prof1tab1hty, growth , and fi nancial risk .)
Estimate the equity intrinsic value of ValueClick . Its earnings estimate is $81.5 million.
Prepare a memorandum to your superior identify ing any issues that you believe should be considered before usi ng the equity intrinsic value from part b for business decisions.

VALUECLll:K
(VCLK)

Module 15 I Market-Based Valuation

b.

TARl:ET
(TGT)

KllllL'S
(KSS)

WAL-MAllT
(WMT)

(In mllllons)

Company assumed value ......... . ... . .


Equity assumed value . . . . ..... . .. . .... . ..
Net operating assets . .. . .. . ... . .. . . . . . . .
Book value of equity .... . . .. .. . . . . .. . . .
Net nonoperating obligations (assets) ... . . .. . . . . .. . ..
Common shares outstanding . . . ..... . .. . . . . . . .

Target

Kohl's

Wal-Mart

$25,652
$15,633
$10,109
860 shares

$23,098
$22,470
$ 6,231
$ 5,603
$ 628
321 shares

$237,306
$1 98,288
$100,591
$ 61,573
$ 39,01 8
41 shares

Required
.
,
Compute the price to net o perating assets rat io for both Kohl s and Wal-Mart.
a. Use Ko hl's and Wal-Mart as com parables, along with the price to NOA rati os
part_a ,
b. estimate for Target its company intrinsic va lue , its equity intrinsic value , and its equity 111tnns1c
value per share .
.
c. Compute the PB rati o fo r both Kohl's and Wal-Mart .
d . Use Ko hl 's and Wal-Mart a comparables , along with the PB ratios from part c, and th en estimate
fo r Target its equity intrinsic va lue and its equity intrin sic va lue per share .

fr~m

PlS-38. Valuation Using Income Statement Multiples

TAlll:ET
(TGT)

KllllL'S
(KSS)

WAL-MAllT
(WMT)

(L02)

Target

Company assumed value . . .. . .. . . . . . .. . . . . ..


Equity assumed value . . . .. . .. .. ... . . ..
$ 3,159
NOPAT .. . . . . . . ..... . . . . . . . . . .
$ 2,787
Net income . ......... . .. . . .. .. .. ... .
$10,109
Net nonoperating obligations (assets) ...... . . . .. . . . ..
Common s hares outstanding .. .. . . . . . . ... . .. . . . . . . . 860 s hares

Kohl's

Wal-Mart

$23,098
$22,470
$ 1,152
$ 1,109
$ 628
321 shares

$237,306
$198,288
$ 13,354
$ 12,178
$ 39,018
41 s hares

Required
Compute the price to NOPAT rati o for both Ko hl's and Wal-Mart .
Use Kohl 's and Wa l-M art as comparables, along .w it.h t~e comp~ n y va l_ue ~o . 0'.AT rati os from
part a , and then estimate fo r Target its company 111tnns1c value , its equ ity 111tnns1c va lue , and its
equity intrinsic value per share.
Compute the price to net income rati o for both Kohl 's and Wa l-Mart .
Use Kohl 's and Wal-Mart as comparables, along wi th the eq uity. to _net_income rati os from part c,
and then estimate fo r Target its equity intrin ic value and its equity 111tnns1c value per share.

~:

PIS-39. Identifying Comparables and Valuation using PB and PE


(HZO)

(L01, 2, 3)

Marinemax Inc. 's equity book value per share is $20 . 11 and its forward eam111gs estimate per s h ~re
is 0 .7 1. The fo llowing info rmati on is also ava ilable for Marin emax and a peer group of companies
(identified by ti cker symbo l) from the leisure goods sector.

Ticker

Market Cap
($mil.)

Current

Forward
PE (FY1)

$ 180.2
825.0
951 .1
359.8
153.6
1,395.3

2.2
1.2
4.6
0.9
2.0
8.1

34.8
20.0
9.9
14.8
10.1
20.9
12.5

PB

HZO .. . . ..

SHFL .. . ..
JAKK .. .. .
POOL. .. . .
RCRC ... .
RGR . .. . . .
Pll. . ... . ..

EPS 5-Year Historical

Growth Rate
(11 .1)%
(15.6)%
11 .7%
(3.2)%
5.4%
(3.8)%
(7.4)%

ROE
(T4Q)

Debt-to-Equity
(Prior Y)

4.8%
19.0%
14.2%
28.6%
4.9%
10.9%
61.5 %

0.07
2.89
0.14
1.34
0.00
0.00
1.16

Required

h
t Identify a set of two companies from thi s list t~ use as comparables fo r est1matm g t e equity 111 nn
sic value of Marinemax using the market multiples approac h.

a.

(L04}

The foll owing table provides summary data fo r Wolverine World Wide (in millio ns). An alys ts will often
use the observed PB rati o to infer market ex pectations regardin g a company's future performance under
various ass umptions.

WOLVERINE
WllllLO WIDE
(WWW)

Market value of equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


Book value of equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ROE (based on trailing 4 quarters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
EPS Growth (based on traili ng 4 quarters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,490
$ 505
17.8 %
16.0%

Requ ired

a.
b.

Ass ume th at th e market's ex pectati ons of future ROE and the di scount rate are 18% and 8% ,
res pecti vely. So lve fo r the implied gro wth rate .
Ass ume that the market 's ex pectati ons of future RO E and the growth rate are 18% and 3%, res pecti vely. So lve fo r the implied discount rate .

c.

Ass ume th at th e market 's expectations of the discount rate and the growth rate are 8% and 3%,
res pecti vely. So lve fo r th e implied future RO E.

d.

Do the market ex pectati ons implied from the res ults o f parts a th rough c seem reasonable? Ex pl ain .

The fo llowing table prov ides summary data for Target and its competito rs, Kohls and Wal-Mart .
(In mllllons)

As ume that you use as co mparables the fo llowing set of companies: RCRC and RGR . Estimate
Marinemax 's equity intrinsic value per share using the PB ratio from th ese peer companies .
Use the same comparables as in part b and estimate Marin emax 's equity intrinsic va lue per share
using the PE rati o from these peer companies.

PlS-40. Reverse Engineering with the PB Ra tio

~nd _th~n

a.
b.

MAHI EMAX, INC.

c.

15-32

PIS-41. Reverse Engineering with the PB Ra tio

(L04)

The fo llowing table prov ides summary data for Family Dollar, Inc. (in mjJ lio ns). Analysts will often
use th e observed PB rati o to infer market ex pectati ons regarding a company's future performance under
va ri ous ass umptions.

FAMILY lllJLLAll,
INC.
(FAMILY

Market val ue of equ ity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,000


Book value of equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32 ,000
ROE (based on traili ng 4 quarters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11 %
EPS Growth (based on trail ing 4 quarters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
18%

DOLLAR)

Required

a.
b.

c.

Ass ume th at the market 's expectati ons of future ROE and the di scount rate are 11 % and 9% ,
respecti vely. Solve fo r the implied growth rate .
Ass ume th at the mark et 's ex pectati ons of future ROE and th e growth rate are 11 % and 4 % , respecti vely. So lve fo r the implied di scount rate.
Ass ume th at the market' ex pectati ons of th e di scount rate and the growth rate are 9% and 4 % ,
re pecti vely. So lve fo r the imp lied future ROE.

d. Do the market ex pectati ons implied from th e res ults of parts a through c seem reasonable? Ex pl ain .
PIS-42. Reverse Engineering a nd Interpreting the PB Ratio (L04)
The mid-201 I market capita lizati o n fo r Google was $ 163 billio n , its book va lue o f equity was $52
billio n , and its trailing fo ur-qu arte rs ROE was 19% (w hile th e ave rage for th e " Intern et" industry was
15%). Its hi stori ca l fi ve-yea r average sa les g rowth was 37% (average for th e industry was 2 1%) , its
hi stori ca l fiv e-yea r ave ra ge EPS growth was 25 % (average fo r th e industry was 35 %), and ana lysts
were fo recastin g a 2 1% annua l earnin gs grow th rate fo r industry over th e next fi ve years. Fo llo wing
are three di ffe rent cases to he lp inte rpret and re ve rse e ngineer its PB ratio, incl ud ing some unkn own
va lues.
PB* (equals PB ratio observed - 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Case 1: Solve for implied growth rate


Ass umed parameters
ROE .. . .. . ... . ........ . . . ... . . ..... . . . . . . .. . . . ... . . .. . ..... . . . . . .... .. . . . ...
Discount rate, r0 .
Implied parameter
Growth rate, (r0 + [PB* x r0 )

ROE)/ PB* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18 %
10%
?

continued

1:011m
(GOOG)

15-33

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

15-34

continued from prior page

Case 2: Solve for implied discount rate


Assumed parameters
ROE . .. ..... ....... . . . .. . .. ... .. . . ..... ........ . .. .. .. . . . . . . .... . .. . ..... . . .
Growth rate, g ......... ....... . . .... . .. . .. .... . .. .. . . ..... .. .. .. ....... .. . . .. .
Implied parameter
Discount rate, (ROE + [PB* x g])/(1 + PB*) . . . .. .. . . . .... .. . .. .. .. . . ... . . .. . . . . .. ... .

18%
15%

Company a~s umed value . . .. .. . . . . .... . . ... . . . ... .


Equity assumed value . . . . .. . . . . . . . .. . . .... . . ... . .
Net operating assets .. ... . .. . ... ... . . .. ..... . . . . .
Book value of equity ... . ... .. ..... . . . . . .. . . ..... . .
Net nonoperating obligations (assets) . . . . . ... ... . . . . .
Common shares outstanding .. .. .. . . . .. .. . .. .. .. . . .

16%
15%
?

(L01, 2, 3, 4)

Refer to the fo llowing excerpts from an analysts ' report coveri ng The Walt Disney Company to complete the followi ng requirements.

December 8, 2011
Company Report

The Walt Disney Company (DIS)


ANALYSIS

Stock Type

Last Close Price

Fair Value Est

Classic Growth

$35.92 (12/8/2011)

$45.00

Our fair value estimate for Disney is $45 per share, which implies forward price/
earnings of 16 times, enterprise value/ EBITDA of 8.9, and a free cash-flow yield
of6 %.
We expect annual top-line growth of about 5% through fiscal 2016 , including
5% sales growth in fiscal 2012. We forecast 5% annual sales growth from the
media networks (7% for cable networks and 1% for ABC broadcasting), driven by
affiliate fee and advertising growth. We project 65% average annual sales growth
during the next five years for parks and resorts; however this segment is the most
sensitive to macroeconomic headwinds. We have modeled modest 1 % average
annual growth assumptions for the filmed entertainment segment and 5% growth
for consumer products, which should benefit from continued global growth of key
Disney brands. We believe the interactive segment will continue to be a money
loser, albeit a very small piece of the overall Disney pie.

Valuation
Fair Value Estimate

$45.00

Stock Price
.
.
Consider Buying
Consider Selling
U-n-certainty Risk
..
Economic Moat
Stewardship Grade

$36.61
31 .50

BEBE STIJRES

Umlted Brands

Bebe Stores

Gap

$4,985
$2,077
$2 ,908
354 shares

$1,020
$1 ,020
$ 478
$ 478
$
0
88 shares

$14,948
$14,760
$ 4,798
$ 4,610
$ 188
745 shares

(BEBE)

CAI'
(GPS)

Required
Compute the price to net operati ng assets ratio for both Bebe Stores and Gap .
b. Use Bebe Stores and Gap as comparables, along with the price to NOA ratios from part a , and then
estimate for Limited Brands its company intrinsic value , its equity intrinsic value, and its equity
intrinsic value per share .
c. Compute the PB ratio for both Bebe Stores and Gap.
d . Use Bebe Stores and Gap as comparables, along with the PB ratios from part c, and then estimate
for Limited Brands its equ ity intrinsic value and its equ ity intrinsic value per share.

a.

DlS-45. Valuation Using Income Statement Multiples

(DIS)

LIMITED BRANDS
(LTD)

(In mlUions)

Required
a. For Case I , compute the growth rate implied by Google 's PB ratio .
b. For Case 2 , compute the discoun t rate implied by Google 's PB rat io.
c. For Case 3, compute the ROE implied by Google's PB ratio .
d. Based on your resu lts in parts a throu gh c, do you believe Google 's observed PB ratio impl ies
reasonable expectations about its future performance? Explain .

THE WALT UISNEY


CUMl'ANY

(L01)

The followin g table provides summary data for Limited Brands and its competitors, Bebe Stores and
Gap.

Case 3: Solve for implied future ROE


Assumed parameters
Discount rate, r ... .. .. ... ... . .. . ..... . ..... . ....... .. ... . .. . .... . . . . . ... . . . .. .
Growth rate, g .. .. . .. . . . . .. .. . . . .. . . . . . . . . ... . . .... . . .... . . . ..... . . . .. ....... .
Implied parameter
ROE, (PB* x [r0 - g]) + r0 . . .

PlS-43. Interpreting Analysts Reports that use Valuation with Multiples

DlS-44. Valuation Using Balance Sheet Multiples

(L02)

The follow ing table provides summary data for Limited Brands and its competitors, Bebe Stores and
Gap .

LIMITED BRANDS
(LTD)

(In mllllons)

Company assumed value .. . . . . . .. . . . . . . .. .. .. .. . . .


Equity assumed value .. ... .. .. . . ... . . .. . . . .. . ... .
Net operating profit after tax ... . . ... . . .. .. . .. . .. .. .
Net income . .. .. .... . . .. .... .... . . . . . . ... .. . .. . .
Net nonoperating obligations (assets) ............... .
Common shares outstanding .. . .. .... . ... . ... . . . . . .

BEBE STORES

Umlted Brands

Bebe Stores

Gap

$ 742
$ 676
$2,908
354 shares

$1 ,020
$1 ,020
$ 77
$ 77
$
0
88 shares

$14,948
$14,760
$ 805
$ 778
$ 188
745 shares

(BEBE)

CAI'
(GPS)

60.80
Avg
Wide
B

We project Disney's overall operating margin to average 20% during the next
fi ve years, which is a bit higher than the recent peak margins of 19.4% in fiscal
2008. We think some additional profit expansion is reasonable, as the highest
margin segment, cable networks, will grow at a faster clip than the overall firm .
However, we believe operating margins at the cable networks wi ll hover around
40 % during the next fi ve years as affiliate fee growth offsets sports programming
cost inflation. We're expecting the parks and resorts segment margins to average
13.5% by 2013, still below fiscal 2008 levels of 16.5% . With the addition of
Marvel and cost improvements at the Disney stores , we think consumer products
margins will average 32 % during the next five years, higher than the 27 % margin
generated in fiscal 2011 .

Required
a. Compute the price to NOPAT ratio for both Bebe Stores and Gap.
b. Use Bebe Stores and Gap as comparables, along with the price to NOPAT rati os from part a, and
then estimate for Limited Brands its company intrinsic value, its equity intrinsic value , and its
equity intrinsic value per share.
c. Compute the price to net income ratio for both Bebe Stores and Gap.
d. Use Bebe Stores and Gap as com parables, along with the price to net income ratios from part c, and
then estimate for Limited Brands its equity intrinsic value and its equity intrinsic value per share.

DlS-46. Assessment of Comparables, Multiples, and Observed PB


Required

a.
b.

Required
a . What market-based valuation multiples does this analyst reference with regard to Disney?
b. What is this analyst's price target for Disney? If Disney ach ieves that target in the ne xt twelve
months , what would be an investor's return? Exp lain .
c. Describe how this analyst justifies the price target .
d. Comment on the analysis used in this excerpt. Why is this a potentially useful way to value Disney?

(L03, 4)

Refer to the information in Dl5-44 and Dl5 -45.

c.

Comment on the reasonableness of using Bebe Stores and Gap as comparables in valuing Limited
Brands.
Assume that you are a staff analyst at a major analyst firm . Write a memorandum to your sen ior
analyst identifying any issues you believe should be cons idered before using the value estimates
from D 15-44 and D 15-45 .
Analysts' average 5-year earnings growth forecast for Limited Brands is 13% . Which of the firms
in the table below do you believe would be best for valuing Limited Brand using comparab le PE
ratios? Ex pla in

LIMITED BllANDS
(LTD)

BEBE STORES
(BEBE)

l:AP
(GPS)

15-35

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

Company

Analysts' 5-Year
Earnings Forecasts

Debt-toEquity

Forward

PB

ROE

PE

Current

22%
16%
13%
11 %
14%
17%
17%
14%
15%
13%
14%
24%
16%

1.13
0.05
0.10
0.65
0.00
0.11
0.00
0.77
0.06
0.40
0.54
0.00
0.35

2.94
(0.05)
0.04
0.19
0.29
0.24
0.39
0.11
0.19
0.30
(0.03)
0.20
0.20

24.03
23.54
14.59
14.85
9.90
10.75
15.84
10.41
11.46
14.52
26.81
25.93
12.43

24.86
1.74
0.77
2.56
2.61
1.35
6.90
1.19
1.52
6.61
0.82
6.36
2.24

J Crew Group Inc ...... .. . . .


Pacific Sunwear ..... . ..... .
Foot Locker Inc ...... . ......
Home Depot Inc .... . .......
American Eagle Outfitters ....
Mens Wearhouse .. . ... . . . ..
Aeropostale Inc . . ..... . ... . .
Cabelas Inc . .. . . . .... . .....
Dress Barn Inc . . .. . .. . . .. . ..
TJX Companies Inc .. . .. . . . .
Talbots Inc .. . .. . . .. ....... .
Urban Outfitters Inc .........
Kohl's Corp ...... . .... . .. ..

d.

c.

PB* (equals PB ratio observed - 1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


Case 1: Solve for implied growth rate
Assumed parameters
ROE . ... . . . .. . . ... .. ..... . . . ... . ... . ........ . .. . .... .. ..... . . . .... . .... .
Discount rate, re. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Implied parameter
Growth rate, (r. + [PB* x r. J - ROE)/PB*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

POWERFUL 04 LED BY UGG - STRONG BUT


CONSERVATIVE OUTLOOl'I - MUCH UPSIDE
Based on the strong Q407 (EPS of $2.69 and Revenue of
$ 194 mi llion, up 48% and 56%, respecti ve ly, over Q406)
res ults and strong FY08 g uidance o f a 25% increase in
revenue and 20% increase in EPS to $561 million and
$6.09, respecti ve ly, over FY07, we are maintain ing our
BUY ra1ing and our $ 175 pri ce 1arge1.
We are s li gh1 ly rais ing our revenue estimates for FYOS to
$579 mi ll ion, a 29% increase over FY07 and th e
compan y' s guidance of a 25% revenu e increase due 10
our perception (based on recem channel chec ks) tha1 1he
momemum in UGG brand continues to increase, the
Simple brand sho uld exceed ex pec1a1ions, and TEVA
rebirth as an outdoor brand meets wi1h success.
We are mainl ain ing our $6.34 EPS es1ima1e for FY08
whi ch reflects a 25% increase ove r FY07 and above the
company's guidance for a 20% grow1h in EPS. We are
comfortabl e with o ur num bers, and conli nue to see
upside due to Decker 's track record o f beatin g guidance:
o In Q4 of 2005. the company guided FY06 to
revenue of $270 million, and EPS of $2. 15. FY
2006 resulted in revenue of $304 milli on and
EPS of $3. 20. a guidance beat of 12.6% and
48.9%. respectively.
o In Q4 of 2006, the company guided FY07
revenue to $349 mill ion and EPS to $3.36. FY07
res ult ed in revenue o f $449 million and EPS of
$5.06. a guidance beat of 28.7% and 50.5%,
respectively.

?%

Case 3: Solve for implied future ROE


Assumed parameters
Discount rate, re. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Growth rate, g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Implied parameter
ROE, (PB* x [r0 - g]) + r0 . .

10%
8%

DlS-47. Estimating Equity Value using Industry-Based Multiples

ln conjunction with the a fore mentioned conservative


guidance, DECK has al so histori ca ll y overestimated
the EPS impact of their proposed additional SG&A
spending, as we expect they have done on yesterday 's
ca ll.
We also believe 1he guidance 10 a 45% gross margin for
FY08 is conservati ve. DECK apparen1l y reserves some
marg in doll ars if perfo rmance weakens. We are
comfortabl e tha1 such reserves were in thei r guidance
over lhe pas! 2 years, and are baked into the FYOS
guidance as well. Based on 1hc streng1h and momemum
of th e UGG and Simple brands, and the higher gross
margins in the TEVA brand , we see ups ide 10 gross
margin s in 2008.

Buy
$126.46
$175
$62.11-$166.50
$1 ,642
13.0
$370 .63
0%
26.1%
$22.70

FYE Dec
P/E Ratio:

2008E
19.9

Revenue (M) :

01
02
03
04
Full
Year

EPS:

01
02
03
04
Full
Year

$72.6
$52.7
$129.4
$194.2

$91.4
$67.3
$169.4
$250.7

$448.9

$578.8

$0.73
$0.17
$1 .47
$2 .69

$0 .75
$0.25
$2.09
$3.21

$5.06

$6.34

2009E
16.8

$7.51

Company Description: Deckers Outdoor Corporation is a


designer, producer, and brand manager of footwear for
outdoor activities and casual lifestyles. It sells its
products directly to consumers, through retailers in the
United States, and through distributors in a number of
international countries . It markets its products under the
brand names Teva, UGG, and Simple.

VALUATION T A BLE

(L02, 3)

Markel Cap EPS 2008 2008 PIE


esti mate estimate Cash ($M )
~1 )

EBITOA

EV/E BtTDA
($M J

Company Name

Ticker

Price

Deckers Outd oor

DECK

$ t 26.46

1642.6

$6.34

19.95

168.09

0.00

1474.50

93.33

15.80
6. 14

Debt~\1 )

EV (SM J ($M, ttm l

Columbia Spons wear

COLM

$43.27

t 555 .9

$3 .52

t 2.29

t9 1.95

2 1.05

1384.96

225.65

C ROCS lnc.

C ROX

S25. t 3

2049.2

$2.69

9 .34

36.33

7. t2

20 t9.98

228.95

8.82

LaCross Footwear

BOOT

$ t6.99

t03.8

$ 1.27

t3 .38

t5.39

0.39

88.83

t 2.74

6.97

Rocky Brands

RC KY

$5 .79

3 1.8

S0.78

7.42

6.54

t03.55

t2 8.77

17.66

7.29

Timberland

TBL

$ t5.6 1

957 .7

$0.9t

t7. t5

43.95

46.60

960.35

t34 .04

7. 16

Wolverine World Wide

WWW

S26.7 t

t4 t0. 3

$ 1.87

14.28

76.09

t0.73

t344.93

t53.7

8.75

Average (excl. DECK)

T he li st of companies you curre ntly follow is:


Pfizer . .... . . .. ...... . . ... .... . ....
P.F. Chang 's China Bistro . . . . . . . . . . . . . .
Procter & Gamble. . . . . . . . . . . . . . . . . . . .
Wal -Mart Stores . . . . . . . . . . . . . . . . . . . . .
Walt-Disney Company . . . . . . . . . . . . . . . .

-Enda Dec
Rating:
Price:
Price Target:
52wk Range:
Markel Capitalization (M) :
Shares Outstanding (M) :
Assets (M):
Debt/Equity:
ROE (TTM) :
Book Va lue/Share:

? %

Price - Book Value


R&D Expense

BBY
GS
HD
JPM
KR

FOOTWEAR & APPAREL

Keeping in min? that DECK has a history of beatin.g even the .high end of guidance, our FY08 projection s are sl ightly
above company s guidance. Our revenue prOJeC tJOn JS $57 8.8 m1ll1on and our EPS target is $6.34. Our FY09 projections
are $668 million in revenue and EPS of $7.51.

Assume that your superior requests that you apply the fo llowing mu ltiple to value the set of compani es
you are curren tly assigned to fo llow.

Best Buy . . . . . . . . . . . . . . . . . . . . . . . . . . .
Goldman Sachs Group ................
Home Depot . . . . . . . . . . . . . . . . . . . . . . . .
JP Morgan Chase .......... . ........ .
Kroger ... . . . . . . . ..... . .. . . .. . . .. . . .

February 29, 2008


Company Report

DECKERS OUTDOOR CORP. (NNM: DECK)

25%
10%

25%
12%

(L01, 2, 3, 4)

Refer to the foll owing excerpts from an analysts' report (5 pages total) covering Deckers Outdoor
Corporation to complete the fo llowing requirements.

1. 7

Case 2: Solve for implied discount rate


Assumed parameters
ROE .... . .. . ....... . . .. . ... ... ..... . . . ... . . . . . ... .. . . . . .. . .. . . ..........
Growth rate, g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Implied parameter
Discount rate, (ROE + [PB* x g])/(1 + PB*). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Prepare a memorandum to the superior i dentifyi ng any concerns in using the above multiple m
estimati ng equity intr i nsic value.

Interpreting Analysts Reports that use Valuation with Multiples

T he PB ratio fo r L imited Brands is 2 .7, its trai li ng four-q uarters ROE is 33 % (w ith an industry
average of 18%), its histori cal five-year average EPS growth is 15% (with an industry average of
16%), and analysts forecast a 14 % earnings growth rate for the industry over the next five years.
Usi ng this i nformation, reverse engineer the expectat ions implied by Limited 's PB ratio.

9.22

7.52

We und~rstand t~at our valu~tion is hi gh in the c urren t env ironment , but we v iew DECK as an except ion to the ru le, as the
~pul.anty of their product lines and their propensity for beating numbers justifi es the hi gh va luat ion. We be lie ve there is

PFE
PFCB
PG
WMT
DIS

std! s1grnf1ca.nt growth ahead for UGG and that the TEVA and Simple brand s are improving as well. Therefore, we view
our PIE multiple of 27.6x our 2008 EPS estimate of $6.34 to reach our $ 175 pri ce target as appropri ate. DECK has traded
at a tralimg t wel ve month PE of 3 l .8x over the last three months.

Required
Required
a. D iscuss w hat is measured by the above multi ple. W hy might it be especially appropriate for certain
i ndustri es?
b. Identify a set of companies from th e li st above for w hich th is mu ltiple i s likely better in estimating
equity val ue.

a.
b.

c.
d.

15-36

W hat method is thi s analyst usi ng to value D eckers?


W hat is this analyst's price target for D eckers? I f Deck ers achieves th at target in the next twel ve
months, what would be an in vestor 's return ? Ex plain .
Describe how thi s analyst justifies the price target.
I s there any other informati on in these excerpts th at you might use to value D eckers? Expl ain.

DECKERS llUTDUOR

l:llllPllllA THIN
(DECK)

15-37

Module 15 I Market-Based Valuation

Module 15 I Market-Based Valuation

Company A:

ROPI:
PYofROPI
Value of equity
PB ratio

$6 = ($100 x 16%) - ($100


$75 = $6/(10% - 2%)
$175 = $100 + $75
1.75

10%)

Company B:

ROPJ:
PVofROPI
Value of equity
PB ratio

$2 = ($100 x 12%) - ($100


$25 = $2/(10% - 2%)
$125 = $100 + $25
1.25

10%)

Company C:

ROPI:
PV ofROPI
Value of equity
PB ratio

$6 = ($100 x 16%) - ($100


$6 = $6/(10% - 4%)
$200 = $100 + $100
2.00

10%)

Company D:

ROPI:
PYofROPI
Value of equity
PB ratio

$4 = ($100 x 16%) - ($100 x 12%)


$40 = $4/(12% - 2%)
$140 = $100 + $40
1.40

Mid-Module Review 1
Solution

a. Our estimate of the net operating assets market multiple for Procter & Gamble and Merck is 2.3 and
7 .2, respectively; computed as company assumed value divided by net operating assets for each. The
NOA market multiple is the average of the two ratios, or 4.8, computed as (2.3+7 .2)/2. We could weight
one of the two companies more heavily if we believe its ratio is more relevant for valuing Johnson &
Johnson.
b. Johnson & Johnson's estimated company intrinsic value is $220,291 million, computed as $45,894
in NOA multiplied by the 4.8 NOA market multiple. Its estimated equity intrinsic value is $213,715,
computed as $220,291 company intrinsic value less $6,576 in net nonoperating obligations. Its estimated
equity intrinsic value per share is $73.87, computed as $213,715 in equity intrinsic value divided by
2,893 of common shares.
c. The book value multiple (price-to-book) for Procter & Gamble and Merck are 3.0 and 5.9, respectively;
computed as equity assumed value divided by the book value of equity for each. The BY market multiple is the average of the two ratios, or 4.5 , computed as (3.0 + 5.9)/2. We could weight one of the
two companies more heavily if we believe its ratio is more relevant for valuing Johnson & Johnson .
d. Johnson & Johnson's estimated equity intrinsic value is $176,931, computed as $39,318 in book value
of equity multiplied by the 4.5 BY market multiple. Its estimated equity intrinsic value per share is
$61.16, computed as $176,931 in equity intrinsic value divided by 2,893 of common shares.

Mid-Module Review 2
Solution

a. Our estimate of the NOPAT market multiple for Procter & Gamble and Merck is 21.3 and 23.8 , respectively; computed as company assumed value divided by net operating profit after tax for each. The NO PAT
market multiple is the average of the two ratios, or 22.6, computed as (21.3 + 23.8)/2. We could weight
one of the two companies more heavily if we believe its multiple is more reliable for valuing JNJ.
b. JN J's estimated company intrinsic value is $238,724 million, computed as $10,563 in NO PAT multiplied by
the 22.6 NOPAT market multiple. Its estimated equity intrinsic value is $232,148, computed as $238 ,724
company intrinsic value less $6,576 in net nonoperating obligations. Its estimated equity intrinsic value
per share is $80 .24, computed as $232,148 in equity intrinsic value divided by 2,893 of common shares.
c. The net income multiple for Procter & Gamble and Merck is 19.66 and 23.30, respectively; computed as equity assumed value divided by net income for each. The NI market multiple is the
average of the two ratios, or 21.48, computed as (19.66 + 23.30)/2. We could weight one of the
two companies more heavily if we believe its ratio is more relevant for valuing JNJ.
d. JNJ's estimated equity intrinsic value is $237 ,418, computed as $11,053 in net income multiplied by
the 21.48 NI market multiple. Its estimated equity intrinsic value per share is $82.07, computed as
$237 ,418 in equity intrinsic value divided by 2,893 of common shares.

a. The following tables reports ROPI, present value of ROPI, company value, and equity value of Companies A through E (computations follow the table).

A ... ... .

B ...... .

c ...... .
D .. .....
E .......

......
$100
$100
$100
$100
$100

rate)

$ 0
$ 0
$ 0
$ 0
$60

equity

$100
$100
$100
$100
$ 40

RNOA

16%
12%
16%
16%
16%

Mid-Module Review 4
Solution

a. T_here is more than one reasonable answer to this requirement The im

rt

~:'m~;~t":ii:i::'~~ ri::'~~;,} ;,~~~;h(~i~~3~~~~~~i~~~~;~,:t~i~:i~~

(tw? low~st 5-y~ar growth rates) on the basis of growth, and CAT and DE (high debt/ )
h
basis of nsk. This would leave VOLVY PH PCAR ETN DHR d IR
o eqmty on t e
b Th
b
'
'

an
as comparables
.
.e.compara Jes have an aver~ge p~ ratio of 3.03. Multiplying CMI 's equity book vaiue of 3 l 95
by the 3.03 market multiple yields an estimate of CMI's equity intrinsic value of $9 68l 1 10
c.
e comparable~ ?ave an average forward PE ratio of 15.7 . Multiplying CMI's forw d '
~
mate of $932 million by the 15 7 market multi l . Id
.
ar earnmgs esti$14,632 million.
.
p e yie s as estimate ofCMI's equity intrinsic value of

;.ll.

~~Ilion

Solution

Solution

Comp9l1J

$6 = ($100 x 16%) - ($100 x 10%)


$75 = $6/(10% - 2%)
Value of company
$175 = $100 + $75
$115 = $175 - $60
Value of equity
PB ratio
2.88
b. PB rat~o .increases with profitability-compare A and B.
PB rat~o increases with expected growth-compare A and c.
PB ratio decrea.se~ as .operating risk increases-compare A and D.
Levered PB ratio is h1gher than unlevered PB ratio-compare A and E.

Module-End Review

Mid-Module Review 3

Debt
Net
operating (6% Owners'

~~~~ ROPI

Company E:

Cost of RMldual
Weighted
average cost equity operating
capital
Income
of capita!
ROE

16%
12%
16%
16%
31%

10%
10%
10%
12%
10%

10%
10%
10%
12%
12.1%

$6
$2
$6
$4
$6

Growlh Pl'9Mnt value


rate In of expected Yalueof
ROPI ROPI U8lng r. company

2%
2%
4%
2%
2%

$ 75
$ 25
$100
$ 40
$ 75

$175
$125
$200
$140
$175

Velue
of
equity

$175
$1 25
$200
$140
$115

a. For Ca.se 1, the growth rate implied by Scenarios A through D is 2 1% 5 5% 4 6%


respectively.

o,

o, an

d 8 om
. 70,

b. For Ca.se 2, the discount rate implied by Scenarios A through D is 7 7% 5 0% 9 3%


d 6 601.
respectively.
o, o, an
. 70,

c. For Ca~e 3, the future ROE implied by Scenarios A through Dis 22.6% 32 4% 14 8% and 24 601.
respective1y.

'

70 ,

d. ~:e:~o~~~ .not ~r~w any definitive concl~sion~ from these reverse engineering exercises. With that
,
IIDP 1e parameters are not entirely 1IDplausible.

15-38