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1.

market multiples based on balance

sheet measures. (p. 15-5)

3.

for use in company valuation with

market multiples. (p. 15-12)

2.

market multiples based on income

statement measures. (p. 15-8)

4.

multiples to assess the reliability of

market expectations. (p. 15-19)

c.. )>

:o

~z

"'

G>

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.

15-2

15-3

03:,

Market-Based Valuation

1-~T ;

::D 0

c

> c:

z r- m

N

C>

>

....

0

..,.,.,.,,.

--

....

Valuation Model

Application Using a

NOA Multiple

Multiple

Selecting Comparables

for Market Multiples

Statement Multiples

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

Engineering Market

....

.llliillll

PB Ratios and

Profitability, Growth ,

and Risk

~

Interpreting and

Reverse Engineering the

PB Ratio

ROPI Model

Interpreting and

Reverse Engineering the

PE Ratio

Multiples

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 using market multiples is popular chiefly beca~se

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.

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

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

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

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.

'

Big Lots

Company assumed value . . . . . .

Equity assumed value

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

Net nonoperating obligations (assets) . . . . . . : : : : : : : :

Common shares outstanding ... . . ... . .. ..

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

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

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

~""""

w:

.

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

$2,:379

=

$1,021

x

2.33

~~~~~~~~__J

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

d .

..

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

Then ,

3.55

L01 Explain

company valuation

using market multiples

based on balance

sheet measures.

130.5 shares

$ 4,054

$ 2,800

341.5 shares

~ {:~;)

$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

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.

1 021

$

$12,499

$ 9,699

$ 6,854

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

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

Big Lots

$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

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

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

$1,422

$9,699

$2,351

$4,054

$ 947

~?~'.1:1?~. ~.~~~~-~ -~~-t-~~~~.~~~~ : :.: :. : :.:: ...::. ::. ::. ::.::.: :. ::. ::.:.... ~.~~ ..~ .~~.~~~-~ .... -~~~ :~. ~.~~.r~~ ..... .'.~:~ .~~.~~~~..

BV market multiple . .. ...... ..... ... . .... . ... .

2.44

$3,470

$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:

$3,470

$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 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

(In millions)

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.

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

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

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

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:

$4,575

$366

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 .

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

Net income .... . .. . . .... . . ......... . .. . .. . .. . . . ... .

Common shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 358

$ 628

130.5 shares

341.5 shares

$2,351

$ 223

73.9 shares

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:

= $358 x

12.99

$4,650

Estimating Intrinsic Value Using a Net Operating Profit after Tax Multiple

Family Dollar Dollar General

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:

=

$4,575

$(401)

$4,976

Then,

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 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

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.

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

(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

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

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

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

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 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 .

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 .

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.

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

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

$26.59

$38.13

$35.63

$38.98

$34.83

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.

15-13

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 )

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

OE

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

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

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.

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

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

Value

Weighted

average cost

~ROPI

Reelduel

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 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

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 .

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

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 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

Burger King Holdings . .... . .. . .. . . . ... . . . . ... ... . .

Cabelas .. .... ... .. . . . ... . . . . ... . ... .. . . . ..... .

ConAgra Food ....... .. .. . . . . . . .. . . .. ..... . . . .. .

Ruddick Corporation ... .. . . .. . ... . . . . .. .. . ..... .

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.

Dow Jones & Company .... . . .... . ..... . . .. ..... .

lconix Brand Group .. .. . . .... . . ..... .... . ....... .

Oxford Industries . ... ... .. . .... . . ...... ... . .. .. . .

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.

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

Earmngs

15-16

15-17

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.,., =

= NI - (OEBeg

r.)

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

~

~

_._

......., '

....

-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

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

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

Equity value

= 1

OE

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%.

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

Scenario A

Scenario B

Scenario C

Scenario D

17 .2

17 .2

17 .2

17 .2

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 %

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%

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 %

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

PE = ( 1

r.

Earmngs

where:

Residual income (RI )

OEbeg

re

= NI

- (OEBeg X re)

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.

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.

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.

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

3.9

3.9

3.9

3.9

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%

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%

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%

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?

15-22

15-23

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

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.

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)

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.

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.

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

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

SYNUTRA

INTERNATIONAL

(SYUT)

SARA LEE

CllRPllRATlllN

(SLE)

WIMM-BILL-UANN

FlllJUS

(WBD)

HEllSHEY

COMPANY

(HSY)

(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

0.39

0.34

0.24

42 .94

0.1 9

0.23

0.80

13.49

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

0.42

(0.11)

0.23

0.36

0.24

2. 16

32.23

19.88

Estimated

(PNRA)

(L01)

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

Earnings Growth

Company

PANERA UllEAll

COMPANY

(in millions)

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

(ECLP)

Ml: KESSON

COllPOllATlllN

(MCK)

(L01)

Required

a.

b.

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.

(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.

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)

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.

(L01)

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)

15-27

(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)

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

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

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 .

(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.

(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.

(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

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

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%

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.

MCCORMICK &

COMPANY

15-28

a.

b.

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

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

Total book value of equity.

Trailing fo ur quarters earnings per share (EPS).

Trai ling four quarters return on equity (RO E).

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

NOA at end of year t

20%

20%

(5)%

34%

1.80

2.10

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

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

(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

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

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

_/

-.

_V

40

_V

35

30

.2

(6 25

a:

w 20

a..

5

0

b.

c.

_V

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.

__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

(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

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)

b.

TARl:ET

(TGT)

KllllL'S

(KSS)

WAL-MAllT

(WMT)

(In mllllons)

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

TAlll:ET

(TGT)

KllllL'S

(KSS)

WAL-MAllT

(WMT)

(L02)

Target

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.

~:

(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. . ... . ..

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)

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.

~nd _th~n

a.

b.

c.

15-32

(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

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) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

15-34

Assumed parameters

ROE . .. ..... ....... . . . .. . .. ... .. . . ..... ........ . .. .. .. . . . . . . .... . .. . ..... . . .

Growth rate, g ......... ....... . . .... . .. . .. .... . .. .. . . ..... .. .. .. ....... .. . . .. .

Implied parameter

Discount rate, (ROE + [PB* x g])/(1 + PB*) . . . .. .. . . . .... .. . .. .. .. . . ... . . .. . . . . .. ... .

18%

15%

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

ANALYSIS

Stock Type

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.

(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 .

CUMl'ANY

(L01)

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

Gap.

Assumed parameters

Discount rate, r ... .. .. ... ... . .. . ..... . ..... . ....... .. ... . .. . .... . . . . . ... . . . .. .

Growth rate, g .. .. . .. . . . . .. .. . . . .. . . . . . . . . ... . . .... . . .... . . . ..... . . . .. ....... .

Implied parameter

ROE, (PB* x [r0 - g]) + r0 . . .

(L02)

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

Gap .

LIMITED BRANDS

(LTD)

(In mllllons)

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.

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)

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

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

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.

Case 1: Solve for implied growth rate

Assumed parameters

ROE . ... . . . .. . . ... .. ..... . . . ... . ... . ........ . .. . .... .. ..... . . . .... . .... .

Discount rate, re. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Implied parameter

Growth rate, (r. + [PB* x r. J - ROE)/PB*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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.

?%

Assumed parameters

Discount rate, re. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Growth rate, g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Implied parameter

ROE, (PB* x [r0 - g]) + r0 . .

10%

8%

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

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)

esti mate estimate Cash ($M )

~1 )

EBITOA

EV/E BtTDA

($M J

Company Name

Ticker

Price

DECK

$ t 26.46

1642.6

$6.34

19.95

168.09

0.00

1474.50

93.33

15.80

6. 14

Debt~\1 )

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

WWW

S26.7 t

t4 t0. 3

$ 1.87

14.28

76.09

t0.73

t344.93

t53.7

8.75

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:

? %

R&D Expense

BBY

GS

HD

JPM

KR

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

Company Report

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

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.

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 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

Company A:

ROPI:

PYofROPI

Value of equity

PB ratio

$75 = $6/(10% - 2%)

$175 = $100 + $75

1.75

10%)

Company B:

ROPJ:

PVofROPI

Value of equity

PB ratio

$25 = $2/(10% - 2%)

$125 = $100 + $25

1.25

10%)

Company C:

ROPI:

PV ofROPI

Value of equity

PB ratio

$6 = $6/(10% - 4%)

$200 = $100 + $100

2.00

10%)

Company D:

ROPI:

PYofROPI

Value of equity

PB ratio

$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

rt

(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

$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

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

respectively.

o,

o, an

d 8 om

. 70,

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

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