Price to earnings: determining earnings.

This subject is for LOS 41.d-n.

Arguments for P/E ratios:

According to security analysts, earnings continue to be the primary driver of investment value.

P/E is widely recognized and used by investors.

Differences in price/earnings ratios may be related to differences in long-run average returns,

according to empirical research.

Arguments against P/E ratios:

P/E does not make economic sense with a negative EPS. As a result, only companies with positive
earnings can be ranked according to their P/E ratios and a number of companies with negative
earnings have to be excluded from this analysis.

Volatile, transitory portion of earnings makes it difficult to calculate P/E, because only permanent or
recurring income can be a determinant of the company's value. Splitting a company's earnings into
recurring and period-specific elements is difficult.

Management discretion in choice of accounting methods reduces comparability. For example,

management may pursue income-smoothing policy which can significantly distort a company's net
income and lead to inaccurate valuation of the company's stock if P/E is used.

In calculating a P/E ratio, the current price for publicly traded companies is generally easily obtained and
unambiguous. Determining the earnings figure to be used in the denominator, however, is not as
straightforward. Two issues are:

The time horizon over which earnings are measured, which results in two chief alternative definitions of
the price/earnings ratio; and

Adjustments to accounting earnings that the analyst may make so that P/Es are comparable across
companies.

Alternative Definitions of P/E

The two alternative definitions of P/E are trailing P/E and leading P/E.

A trailing P/E (also current P/E) is a price multiple comparing the stock's current market price to the
company's earnings during the last four fiscal quarters. The EPS in such calculations are sometimes
referred to as trailing twelve months (TTM) EPS. Trailing P/E is the price/earnings ratio published in
stock listings of financial newspapers.

A leading P/E (also forward P/E or prospective P/E) is a price multiple comparing the stock's current

market valuation with the company's forecasted earnings for the next full fiscal year or for the next four
quarters.
Example
2009 earnings = $25 million
Forecasted EPS over the next 12 months = $0.60
50 million shares outstanding
Market price = $16.00
Calculate trailing and leading P/E ratios.
EPS2009 = $25,000,000 / 50,000,000 = $0.50.
Trailing P/E = $16 / $0.50 = 32.
Leading P/E = $16 / $0.60 = 26.7, which is significantly lower than the trailing multiple.
Trailing P/E
When calculating a P/E ratio using trailing earnings, care must be taken in determining the EPS number. The
issues include:

Transitory, nonrecurring components of earnings that are company-specific;

Transitory components of earnings due to cyclicality (business or industry cyclicality);

Differences in accounting methods; and

Potential dilution of earnings per share.

Underlying earnings are earnings excluding nonrecurring components such as:

Gains/losses on asset sales.

Asset write-downs of impaired assets.

Loss provisions, corporate restructurings, divestitures of business segments.

Extraordinary losses from repurchase of the company's debt prior to maturity.

Changes in accounting estimates.

Example
2009 EPS = $8.00 Gain on asset sale = $1.40 Gain from change in accounting estimate = $0.75 Underlying

earnings = $8.00 - $1.40 - $0.75 = $5.85.

Normalized EPS - Adjusting EPS to remove cyclical component of earnings
Earnings of many big companies such as those in automobile manufacturing, residential construction and air
travel industries significantly depend on the aggregate demand in the economy, and earnings trends of them
approximate the direction of general economic cycle. Because of cyclic effects, the most recent four quarters of
earnings may not accurately reflect the average or long-term earnings power of the business.
Analysts address the problem of cyclicality by normalizing EPS - calculating the level of EPS that the business
could achieve currently under mid-cyclical conditions (normal EPS).
Two normalization methods:

The method of average return on equity:

Normal EPS = Average Historical ROE x Current BV per share
The averaging period for historical ROE calculation should encompass full previous economic cycle.

The method of historical average EPS

Mean EPS during the most recent cycle may be a good indicator of the normal level of earnings per
share.

Example

Average return on equity method:

Average ROE = (0.15 + 0.15 + 0.21 + 0.16) / 4 = 0.1675.
Average ROE x BVPS2004 = 0.1675 x $28.00 = $4.69.
Historical average EPS method:
Average EPS = (4.00 + 3.80 + 5.25 + 4.5) / 4 = $4.39.
Earnings Yield
P/E multiple is meaningless if the earnings is negative. An analyst should use earnings yield (E/P: the reciprocal
of the P/E multiple) for the ranking purposes.

It can be used to rank stocks from low E/P to high E/P:

High E/P: under-priced.

Low E/P: over-priced.

Price multiple valuation methods.

This subject is for LOS 41.a.b.c.
Types of Valuation Indicators
A price multiple is a ratio of a stock's price to a measure of value per share such as earnings, assets, sales or
cash flows. To tie up a company's performance with its market valuation, an analyst needs to evaluate what a
dollar of share price can "buy" in terms of the company's earnings, sales, cash flow or assets. For example, an
analyst can estimate that each dollar invested in the company generates $1.5 of sales. Using this information,
the analyst can evaluate the attractiveness of investing in the company's stock at the current market price per
share.
An enterprise value multiple is also a ratio used to determine the value of a company. It relates the enterprise
value of a company to a measure of value (e.g. EBITDA).
Momentum indicators relate either price or a fundamental (such as earnings) to the time series of their own
past values, or in some cases to their expected value.
All price multiples can be applied to equity valuation in two different ways: the method of comparables and the
method based on forecasted fundamentals.
The Method of Comparables

Price multiples are price scaled by a measure of value, which provides the basis
for the method of comparables. The method involves the comparison of a
company's actual price multiple to some benchmark value to evaluate if an
asset is relatively fairly priced, relatively undervalued, or relatively overvalued.
The economic rationale is the law of one price - similar assets should sell at
approximately equal prices. That is, if two companies are identical in all
respects, their shares should be quoted at the same price in an efficient market.
Some of the most widely used benchmarks involve the multiple of a closely matched individual stock, the
average or median value of the multiple for the stock's company or industry peer group.
The method is the most popular application of price multiples. It allows investors to determine the stock's
relative valuation as compared to the benchmark. For example, many analysts point out that even after the

technology market crash of 2000-2001, some technology stock still remain overvalued on the basis of P/E
multiple compared to the normal historical valuations.
By its nature the method of comparables allows analysts to value investments only on a relative basis, i.e. only
in comparison to the benchmark value of multiple. It cannot be used for absolute valuation of stocks, since the
benchmark itself may as well depart from its fair value. Although Sun Microsystems seems to be undervalued
comparing to other storage hardware companies, an analyst would needs some more information to
recommend purchase of its stocks, since the entire storage industry may currently be overvalued and primed for
decline.
The Method Based on Forecasted Fundamentals
This method is based on the assumption that fundamentals - characteristics of a business related to profitability
or financial strength, such as current level of assets, sales and earnings - drive cash flows. The price multiple of
an asset should be related to the prospective cash flows from holding it.
To perform this analysis, an analyst should first calculate the present value of the complete stream of forecasted
future cash flows. Any DCF model can be used for this purpose. Then the analyst should divide the present
value of cash flows by a selected fundamental value, such as earnings per share or sales per share to obtain a
price multiple justified by fundamentals.
A justified price multiple is an analyst's estimated fair or appropriate price multiple. This multiple will likely
represent a combination of comparables to other traded securities as well as forecasted company
fundamentals.

Method of comparables: Justified P/E = average P/E of firms in biotech industry.

Forecasted fundamentals: Justified P/E = value from DCF model.

If the justified price multiple differs from the actual multiple, then the analyst is signaling that the security may be
currently over or undervalued. Consequently, the analyst's support and justification for this multiple will be
closely scrutinized as it suggests that the market is not currently incorporating all of the information as the
analyst deems appropriate.

FCFF and FCFE valuation approaches.

This subject is for LOS 40.a.b.
Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital
investment, and WC investment.
Free Cash Flow to Equity (FCFE): Cash available to stockholders after payments to and inflows from
bondholders. It is the cash flow from operations net of capital expenditures and debt payments (including both
interest and repayment of principal).

Free cash flow models belong to the group of discounted cash flow valuation models. They are quite similar to
another DCF model - the dividend discount model. The main difference is the definition of cash flows. It is also
very important to use the correct rate for discounting free cash flows in the two models. The discounting rate is
the average cost of capital supplied by the parties that have claims on the cash flow. Consequently, we use
WACC for discounting FCFF and cost of equity for discounting FCFE.
Present value of FCFF
Firm value = FCFF discounted at the WACC.
Firm value = [FCFFt / (1 + WACC)t)]
: t = 1 to infinite.
Equity value = firm value - debt value.
Equity value = Firm value - MVd
MVd: the market value of debt.
Dividing the total value of equity by the number of outstanding shares gives the value per share.
WACC can be either based on the current market weights of equity and debt or target weights. In case of
market weights-based WACC, the formula is
WACC = MVd / [MVd + MVe] x rd (1 - T) + MVe / [MVd + MVe] x re
Where

MVd is the market value of debt.

MVe is the market value of equity.

rd is the pre-tax cost of debt.

re is the cost of equity.

T is the tax rate.

The cost of debt can be obtained directly from the market as the yield to maturity on the company's debt or
comparable companies' debt. To calculate the cost of equity we can use methods such as CAPM, APT or cost
of debt plus risk premium.
If FCFF is growing at a constant rate g, the value of the firm is:
Firm value = FCFF1/(WACC - g) = FCFF0(1 + g) / (WACC - g)

Present value of FCFE

Equity value = FCFE discounted at the required return on equity (r).
These cash flows belong to the stockholders only. Therefore, the present value of FCFE stream gives us the
intrinsic value of a company:
Equity value = [FCFEt / (1 + re)t]
: t = 1 to infinite.
Similarly, if FCFE is growing at a constant rate g, the value of the equity is:
Equity value = FCFE1/(r - g) = FCFE0(1 + g) / (r - g)
Strengths and limitations of the FCFE model.
Advantages:

Wide applicability for different dividend and financing policies.

Free cash flow always reflects the capital that can potentially be paid out to shareholders,
notwithstanding the dividend policy. This model is preferable to DDM models, when actual dividends
differ significantly from FCFE.

In contrast to dividends, a record of free cash flows is observable for any company.

Since FCF model is based on the capital exceeding operational needs, it is useful for valuation of
control ownership that allows investors to redeploy this capital.

Disadvantages:

If FCF < 0 due to capital demands.

Many companies have negative free cash flow for years due to large capital demands. Since prediction
of free cash flow far in the future would be imprecise, FCF model cannot be used for growth
companies.

The implicit ownership perspective

FCF models are useful for control perspective. Acquirer can change the firm's dividend policy.
FCFE represents cash flow that can be redeployed outside the company without affecting the
company's capital investments. A controlling equity interest can affect such a redeployment. If an
investor can take control of a company, dividends can be changed substantially, possibly coming

closer to the company's capacity to pay dividends. Consequently, historical dividend patterns may not
necessarily be a good basis for valuation of control ownership interest in a company. Since free cash
flow to equity is a measure of potential dividend payments, it is a more relevant indicator for valuation
of company control.

Dividend discount models are useful for minority shareholder perspective with no control over dividend
policy.

Computing FCFF and FCFE from net income, EBIT, EBITDA, or CFO.
This subject is for LOS 40.c.d.
Computing FCFF from net income
FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

NI: Net income available to common shareholders. It is the company's earnings after interest, taxes
and preferred dividends.

NCC: Net noncash charges. They represent depreciation and other non-cash charges minus non-cash
gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major
part of total expenses for most companies.

Int (1 - Tax rate): After-tax interest expense.

We add this back to net income because
o

FCFF is the cash flow available for distribution among all suppliers of capital, including the
debt-holders, and

Interest expense net of the related tax savings was deducted in arriving at net income.

The add-back is after-tax, because the discount rate in FCFF model (WACC) is also calculated on the
after-tax basis.

FCInv: Investment in fixed capital. It equals to capital expenditures for PP&E minus sales of fixed
assets.

WCInv: Investment in working capital. It equals to the increase in short-term operating assets net of
operating liabilities.
Note that working capital for cash flow and valuation purposes is defined to exclude cash and shortterm debt (which includes notes payable and the current portion of long-term debt).
o

Cash and cash equivalents are not taken into consideration, because it is the change in this

account that is explained by FCFF.

o

Notes payable and the current portion of long-term debt are also ignored, because these
accounts pertain to financing decisions, and FCFF describes operating and investing
activities only.

Example
Quinton is evaluating Proust Company for the year of 2004. Quinton has gathered the following information (in
millions):

Net income: $250.

Interest expense: $50.

Depreciation: $130.

Investment in working capital: $20.

Investment in fixed capital: $100.

Tax rate: 30%.

Net borrowing: $180.

Proust has launched a new product in the market. It has capitalized $200 as intangible asset out of
product launch expense of $240.

During the year, Proust has written down restructuring non-cash charges amounting to $30.

The tax treatment of all non-cash items is the same as that of other items in the books. There are no
differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution
NCC = Depreciation + non-cash restructuring charges - Cash expense during the year in which they are
capitalized = 130 + 30 - 200 = -$40 million.
FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv = 250 + (-40) + 50 (1 - 0.3) - 20 - 100 = $125 million.
Computing FCFF from the statement of cash flows

FCFF = CFO + Int (1 - Tax rate) - FCInv

CFO: Cash flow from operations.

Int (1 - Tax rate): After-tax interest expense is added back because interest expense is considered an
operating cash flow under US GAAP. Note that the adjustment may be unnecessary under the
Internationals Accounting Standards, where interest expense can be treated as either operating or
financing cash flow.

FCInv: Investment in fixed assets. It equals to capital expenditures for PP&E minus sales of fixed
assets.

The convenience of this approach to calculation of FCFF is that CFO is already adjusted for non-cash charges
and changes in working capital accounts.
Example
Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).

CFO: $250.

Depreciation: $80.

Interest expense: $50.

Tax rate: 30%.

Investment in working capital: $60.

Investment in fixed capital: $240.

Net borrowing: $180.

Calculate the FCFF for the company for the year.

Solution
FCFF = CFO + Int (1 - tax rate) - Investment in fixed capital = 250 + 50 (1 - 0.3) - 240 = $45 million.
As CFO is given, information on WCInv and non-cash charges is not required.
Noncash charges
If an analyst wants to use an add-back method, the analyst must be careful to add back only non-cash
component of such charges. As one example, restructuring charges can involve cash expenditures and

noncash charges. For example, severance expense, which is incurred in the same year, should not be added
back to net income, because it is a cash charge. On the other hand, a write-down in the value of assets as part
of a restructuring charge is a noncash item.
Sometimes non-cash items should be subtracted from, instead of being added back to, net income. Examples
are non-cash gains on sale of assets, or reversal of previous restructuring charges.
Particular diligence should be exercised in determining effect of deferred taxes and tax benefits of employee
stock plans on FCFF. Deferred taxes generate cash flows only if they are expected to reverse in the future,
otherwise they should be added back to net income in calculation of FCFF.
Conversely, employee stock ownership plans generate cash flows only if they are not reversed in the future.
Consequently, benefits associated with employee options should be subtracted from net income for the purpose
of FCFF forecasting, if their reversal is expected in the near future.
We summarize the common noncash charges that impact net income and indicate for each item whether to add
it or subtract it from net income in arriving at FCFF:

Computing FCFE from FCFF

FCFE is the cash flow available to common stockholders.
FCFE = FCFF + Net borrowing - Int ( 1- Tax rate)

Net borrowing: Borrowing of new debt minus repayment of old debt.

Int (1- Tax rate): Net distributions to debt-holders need to be subtracted from FCFF to calculate FCFE.

FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv.
Then:
FCFE = NI + NCC + Net borrowing - FCInv - WCInv

FCFE can be calculated from CFO. Recall that FCFF = CFO + Int (1 - Tax rate) - FCInv. Then:
FCFE = CFO + Net borrowing - FCInv
Finding FCFF and FCFE from EBIT or EBITDA
We know that:

Net income = (EBIT - Interest expense) (1 -Tax rate) = EBIT(1 - Tax rate) - Interest expense (1 - Tax
rate)

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv.

If we assume that the only noncash charge (NCC) is depreciation (Dep), it's easy to show the relationship
between FCFF from EBIT.
FCFF = EBIT (1 - Tax rate) + Dep - FCInv - WCInv
Similarly, we can show that:
FCFF = EBITDA (1 - Tax rate) + Dep (Tax rate) - FCInv - WCInv
It's also possible to calculate FCFE (instead of FCFF) from EBIT or EBITDA by using FCFE = FCFF - Int (1 Tax rate) + Net borrowing.

FCFE = EBIT (1 - Tax rate) - Int (1 - Tax rate) + Dep - FCInv - WCInv + Net borrowing

FCFE = EBITDA (1 - Tax rate) + Dep (Tax rate) - Int (1 - Tax rate) - FCInv - WCInv + Net borrowing

Example
Watson is planning to value Alcan, Inc. The financial information Watson has assembled for his valuation is as
follows (unit: million $. Year: 2004):

EBIT: 400.

Interest expense: 150.

Depreciation: 120.

Income tax rate: 30%.

Investment in working capital: 60.

Investment in fixed capital: 300.

Calculate FCFF for the company.

Solution
FCFF = EBIT (1 - Tax rate) + Dep - FCInv - WCInv = 400 x (1 - 0.30) + 120 - 60 - 300 = 40.