DIVIDEND DISCOUNT

MODELS

Agenda

Perpetual dividends model.

Two-phase growth model.
The H model
Three stage growth model.
Relative Valuation.
Asset based model.

 Calculate the value of non-callable

fixed-rate perpetual preferred stock
given the stocks annual dividend ( 2
USD) and the discount rate. The riskfree rate (3 percent),beta (1.20) times
the equity risk premium (6 percent).
Find the value of the preferred
stock..

Calculating the Implied Growth

Rate Using the Gordon Growth
model

Using the previous common stock

example and the current stock price
of $24, what is the implied growth
rate?

$2.00(1 g )
$24
0.102 g
2.448 24 g 2.00(1 g )
26 g 0.448
g 1.72%

the value of a common stock

using the Gordon growth
model
Risk-free rate
3.0%
Equity risk
premium
Beta
Current dividend
Dividend growth
rate
Current stock
price

6.0%
1.20
$2.00
5.0%
$24 .00

The resulting valuation of $40.38 is greater than the current

market stock price of $24, which would indicate that the stock is
undervalued in the market

Example: Calculating the Implied

Required Return Using the Gordon
Growth Model

Using the previous common stock

example and the current stock price

of $24, what is the implied required
return?

D1
r
g
P0
2.10
r
0.05
24
r 8.75% 5% 13.75%
the market is placing too high a required return on
the stock relative to the CAPM required return,
which is why the stock is currently undervalued in
the market.

Issues Using the Gordon

Growth Model

Choice of Discounted Cash

Flow Models

General Two-Stage DDM

V0

D0 1 g S

t 1

1 r

D0 1 g S 1 g L
n

1 r

r gL

Example: General TwoStage DDM

Current dividend = $2.00
Growth Current dividend = $2.00
Growth for next three years = 15
percent
Long-term growth = 4 percent
Required return = 10 percent
for next three years = 15 percent
Long-term growth = 4 percent
Required return = 10 percent

Example: General TwoStage

DDM
Step 1: Calculate the first three dividends:
D1 = $2.00 x (1.15) = $2.30
D2 = $2.30 x (1.15) = $2.6450
D3 = $2.6450 x (1.15) = $3.0418
Step 2: Calculate the year 4 dividend:
D4 = $3.0418 x (1.04) = $3.1634
Step 3: Calculate the value of the constant growth
dividends:
V3 = $3.1634 / (0.10 0.04) = $52.7237

Example: General TwoStage DDM

$2.30 $2.6450 $3.0418 $52.7237
V0

1.10
1.102
1.103
1.103
V0 $46.17

Example: General TwoStage

DDM
Using the previous
example,
now well use the

trailing P/E to determine the terminal value

The D4 is $3.1634
Assume also that the projected P/E is 13.0 in year
4 and that the firm will pay out 60 percent of
earnings as dividends
Year 4 earnings are then $3.1634 / 0.60 =
$5.2724
The stock price in year 4 is then $5.2724 13 =
$68.54

Example: General TwoStage DDM

$2.30 $2.6450 $3.0418 $3.1634 $68.54
V0

1.10
1.102
1.103
1.103
V0 $55.54

Two-Stage H-Model
D0 1 g L D0 H g S g L
V0
r gL

Example: Two-Stage HModel

Current dividend
gs

$3.00
20%

gL
6%
H
5
Required return on stock
10%
Current stock price
$120

Example: Two-Stage HModel

D0 1 g L D0 H g S g L
V0
r gL
$3 1 0.06 $3 5 0.20 0.06

V0
0.10 0.06
V0 $79.50 $52.50 $132.00

Solving for the Required Return

Using
the Two-Stage H-Model
D0

r 1 g L H g S g L g L
P0

1 0.06 5 0.20 0.06 0.06 10.40%

r

120

Example: Three-Stage
Model
Firm pays a current dividend of $1.00
Growth rate is 20 percent for next two
years
Growth then declines over six years to
stable rate of 5 percent
Required return is 10 percent
Current stock price is $50

Three-Stage Model
Assumes three distinct growth stages:
First stage of growth
Second stage of growth
Stable-growth phase
H-model can be used for last two stages if
growth declines linearly

THREE-STAGE MODEL EXAMPLE

V0

$1 1.20
1.101

$1 1.20
2

$1 1.20

1.10
6 0.20 0.05

2
2

1.10 0.10 0.05

$1 1.20 1.05
2

1.10 0.10 0.05

V0 $1.09 $1.19 $10.71 $24.99 $37.98

Estimating the Growth Rate

The Sustainable Growth

Rate

The DuPont Model

Net income
ROE =

Total assets

Total assets

Shareholders' equity

Sales
Total assets
Net income

Sales
Total
assets
Shareholders'
equity

ROE =

Net income Dividends

Net
income

Total assets
Sales
Net income

Sales
Equity

Total assets

Example: DuPont Model

Net profit margin

.
00
5%

Total asset turnover

1.5

Equity multiplier

2.0

Retention ratio

60%

Example: DuPont Model

Net income Dividends
g

Net
income

g 0.60 5% 1.5 2.0

g 9.0%

Total assets
Sales
Net income

Total assets
Sales
Equity

Summary

Summary

Summary

Using Multiples for Valuation

Why Use Multiples?

A careful multiples analysiscomparing a companys multiples versus
those of comparable companiescan be useful in improving
cashflow forecasts and testing the credibility of DCF-based
valuations.
Multiples address three important issues:
1. How plausible are forecasted cash flows?
2. Why is one companys valuation higher or lower than its
competitors?
3. Is the company strategically positioned to create more
value than its peers?
Multiple analysis is only useful when performed
accurately. Poorly performed multiple analysis can
lead to misleading conclusions.

What
Are
Multiples?
Multiples such as the Price-to-Earnings Ratio (P/E) and EnterpriseValue-to-EBITA are used to compare companies. Multiples
normalize market values by profits, book values, or nonfinancial
statistics.
Lets examine a standard multiples analysis of Home Depot and
Estimated
ForwardMarket
Lowes:
Earnings per
looking
Stock
price
Company
July 23,
Home Depot 2004
$33.00

capitalizati
share (EPS)
on
2004
2005
$ Million
$74,250
$2.18
$2.48

7.1

13.3

Lowes

$39,075

7.3

14.4

$48.39

$2.86

$3.36

multiples,
EBITDA
P/E
2004

To find Home Depots P/E ratio (13.3x), divide the companys end of
week closing price of $33 by projected 2005 EPS of $2.48. Since
EPS is based on a forward-looking estimate, this multiple is known
as a forward multiple.
But which multiple is best and why are some multiples misleading?

Key Issues
To address these questions, we will
1. Investigate what drives multiples and how to build a
multiple that focuses on the operations of the business
Enterprise value multiples are driven by the drivers of free cash
flow: return on invested capital and growth.
To analyze an industry, use an enterprise-value multiple of
forward-looking EBIT, adjusting for non-operating items such
as operating leases and excess cash.
2. Demonstrate why using the often-computed Price-toEarnings ratio can be misleading
The P/E ratio is not a clean measure of operating
performance. The ratio commingles operating, nonoperating, and financing activities
3. Examine the benefits and drawbacks to alternative
multiples

Back to Basics What Drives Company

Value?
To better understand what drives a multiple, lets derive the
enterprise value to EBIT multiple using the key value driver
formula.
g

NOPLAT 1

Start with the key value

ROIC

Value
driver formula.
WACC g

Substitute EBIT(1-T)
for NOPLAT

Divide both sides by

EBIT to develop the
enterprise value
multiple.

EBIT(1 - T) 1

ROIC

Value
WACC g

(1 T) 1

Value
ROIC

EBIT
WACC g

The enterprise value

multiple is driven
by:

(1) return on new

invested capital,
(2) growth,
(3) the operating
cash tax rate, and
(4) the weighted
average cost of
capital

Back to Basics What Drives Company

Value?
Lets use the formula to predict the multiple for a company with the
following financial characteristics.
Consider a company growing at 5% per year and generating a 15%
return on invested capital. If the company has an operating cash
tax rate at 30% and a 9% cost of capital, what multiple of EBIT
should it trade at?

(1 T) 1

Value
ROIC

EBIT
WACC g
5%

(1 .30) 1

Value
15%

11.7

EBIT
9% 5%

How ROIC and Growth Drive

Multiples
To demonstrate how different
values of ROIC and growth will
generate different multiples, consider a set of hypothetical
multiples for a company whose cash tax rate equals 30% and cost
of capital equals 9%.
Enterprise value to
EBITA*
Long-term
growth
rate
4.0%
Increasing
Growth
Rate

Increasin
g
ROIC
Return on invested
capital
6%

9%

15%

20%

25%

4.7

7.8

10.3

11.2

11.8

4.5%

3.9

7.8

10.9

12.1

12.8

5.0%

2.9

7.8

11.7

13.1

14.0

5.5%

1.7

7.8

12.7

14.5

15.6

6.0%

n/a

7.8

14.0

16.3

17.7

When ROIC > WACC, higher

growth leads to higher
EV/EBITA Ratio

Note how
different
combinations of
growth and
ROIC can lead
to the same
multiple!

Building
Effective
Multiples
A well-designed, accurate multiples analysis can provide valuable
insights about a company and its competitors. Conversely, a poor
analysis can result in confusion. To apply multiples properly, use the
following four best practices:
Choose
comparables
with similar
prospects
Step 1
To analyze a
company using
comparables, you
must first create
an appropriate
peer group.

Use
enterprise
value
multiples
Step 2
Use an enterprise
value multiple to
eliminate effects
from changes in
capital structure
and one time gains
and losses

Use multiples
based on
forward looking
data
Step 3
When building a
multiple, the
denominator
should use a
forecast of profits,
rather than
historical profits

Eliminate nonoperating
items
Step 4
Enterprise-value
multiples must be
adjusted for non
operating items
hidden within
enterprise value
and reported EBITA

Step 1: Choosing Comparables

To create and analyze an appropriate peer group:
1.

Start by examining other companies in the targets industry. But

how do you define an industry?
Potential resources include the annual report, the companys Standard Industry
Classification Code (SIC) or Global Industry Classification (GIC)

2.

Once a preliminary screen is conducted, the real digging begins.

You must answer a series of strategic questions.
Why are the multiples different across the peer group?
Do certain companies in the group have superior products, better access to
customers, recurring revenues, or economies of scale?

3.

If necessary, compute the median and harmonic mean for sample

Multiples are best used to examine valuation differences across companies. If
you must compute a representative multiple, use median or harmonic
mean.
Harmonic mean: Compute the EBITA/Value ratio for each company and average
across companies. Take the reciprocal of the average.

Step 2: Use Enterprise-Value-to-EBITA

Multiple
A cross-company multiples analysis should highlight differences in
performance, such as differences in ROIC and growth, not
differences in capital structure.
Although no multiple is completely independent of capital
structure, an enterprise value multiple is less susceptible to
distortions caused by the companys debt-to-equity choice. The
Enterprise
multiple is calculated
as Value
follows: MV Debt MV Equity

EBITA

EBITA

Consider a company that swaps debt for equity (i.e. raises debt to
repurchase equity).
EBITA is computed pre-interest, so it remains unchanged as
debt is swapped for equity.
Swapping debt for equity will keep the numerator unchanged as
well. Note however, that EV may change due to the second
order effects of signaling, increased tax shields, or higher

Step 2: Use Enterprise Value

Multiples
Why is the P/E Ratio misleading?
Conversely, the P/E Ratio can be artificially impacted by a change in
capital structure, even when there is no change in enterprise
value.
It can be shown, that in a world without taxes, the price to earnings
ratio is a function of the unlevered price to earnings ratio, the cost
of debt, and the debt to value ratio:
The price to earnings
ratio of an all-equity
company

K - PE u
P
1
K
where K
E
kd
D

k
PE

d
u
V

Market-based
debt to value
ratio

The cost of
debt

Price-to-Earnings Ratio: Why can it be

Misleading?
An Example:
Before we use the formula to test the impact of capital structure on
the P/E ratio, lets try an example.
Consider an all-equity company whose P/E ratio is 15x.
The companys management is considering a move to 20% debt
to value, through borrowings at 5%. Assuming no taxes, what
would happen to the P/E ratio?

K - PE u
P
1
K
where K
E
kd
D

k
PE

d
u
V

P
20 - 15
20
14.1
.20 .0515 1
E

The P/E
ratio would
fall!

Price-to-Earnings Ratio: Why can it be

Misleading?

To show that the P/E ratio can be artificially impacted by a change in

the companys capital structure, we use the formula to compute
multiples for companies with varying leverage ratios.
Price to
earnings
multiple*

Price to earnings for an all-equity

company
40x
10x
15x
20x
25x
10%

9.5

14.6

20.0

25.7

45.0

20%
Increasing
Debt to
30%
Value
40%

8.9

14.1

20.0

26.7

53.3

8.2

13.5

20.0

28.0

70.0

7.5

12.9

20.0

30.0

120.0

50%

6.7

12.0

20.0

33.3

n/m

P/E Ratio
decreases as
leverage increases
*

P/E Ratio increases

as leverage
increases

Assumes a cost of debt equal to 5% and no taxes: Therefore, 1/kd equals 20x.

Price-to-Earnings Ratio: Why can it be

Misleading?
Issue 2:
The second problem with the P/E ratio is that it commingles
operating and non-operating performance. Each source can
have vastly different financial characteristics.
Excess cash has a very high
P/E ratio (because of
extremely low earnings).
Mixing excess cash with
income from operations
usually raises the P/E ratio.
One time non-operating
gains and losses such as
restructuring costs and
other writeoffs will also
temporarily raise or lower
earnings, raising the P/E
ratio. Most analysts
recognize this problem and

Step 3: Use Forward Looking

When building a multiple,Multiples
the denominator should use a forecast of
profits, rather than historical profits.
Unlike backward-looking multiples, forward-looking multiples are
consistent with the principles of valuationin particular, that a
companys value equals the present value of future cash flow, not
past profits and sunk costs.
Enterprise Value
EBITA

Enterprise Value = Present value of FUTURE

cashflows
therefore
EBITA = should represent FUTURE profit

Research by Kim and Ritter (1999) and Lio, Nissim, and Thomas
(2002) documents that forward looking multiples increase
predictive accuracy and decrease variance of multiples within an
industry.

Step 4: Adjust for Non-Operating

Items
Even the enterprise value-to-EBITA multiple commingles operating
and nonoperating items. Therefore, further adjustments must be
made.

1.Excess cash and other non-operating assets have very

different financial characteristics from the core business, exclude
their
value Value
from enterprise
value
when
comparing
tong
EBITA.
Enterprise
Debt Equity
Excess
Cash
NonOperati
Assets

EBITA
EBITA
2. The use of operating leases leads to artificially low enterprise
value (missing debt) and EBITA (lease interest is subtracted preEBITA). Although operating leases affect both the numerator
and denominator in the same direction, each adjustment is of
different magnitude.
Enterprise Value
Debt PV(Operating Leases) Equity

EBITA
EBITA Implied Lease Interest

Step 4: Adjust for Non-Operating

Items
3.

When companies fail to expense employee stock options,

reported EBITA will be artificially high. Enterprise value should
also be adjusted upwards by the present value of outstanding
stock options.
Enterprise Value
Debt Equity PV(All Outstanding Options)

EBITA
EBITA Newly Issued Options

4.

To adjust enterprise value for pensions, add the present value

of unfunded pension liabilities to debt plus equity. To remove
gains and losses related to plan assets, start with EBITA, add the
pension interest expense, and deduct the recognized returns on
plan assets.
Enterprise Value
Debt Equity Unfunded Pension Liabilities

EBITA
EBITA - Recognized Net Pension Gains

Building a Clean Multiple: An

Example
Home
Depot
1,365

Lowes

Market value of equity

74,250

39,075

Enterprise value

75,615

42,830

6,554

2,762

Excess cash

(1,609)

(1,033)

Adjusted enterprise value

80,560

44,559

8,691

4,589

340

154

9,031

4,743

$ Million

Lets adjust the

enterprise multiples of
Home Depot and
Lowes for excess cash
and operating leases.
Before adjustments,
Home Depots forward
looking enterprisevalue multiple is within
7 percent of that for
Lowes. After
adjustments, the
difference drops to 5
percent.

Outstanding debt

Capitalized operating leases

2005 EBITA
Implied interest from leases
Adjusted 2005 EBITA

3,755

Home Depot Lowes

8.7

9.3

Adjusted enterprise value multiple

8.9

9.4

Raw enterprise value multiple

An Examination of Alternative
Multiples
Although we have so far focused on enterprise-value multiples based
on EBITA , other multiples can prove helpful in certain situations.
Price-to-Sales Multiple. An enterprise-value-to-sales multiple
imposes an additional important restriction beyond the EV/EBITA
multiple: similar operating margins on the companys existing
business. For most industries, this restriction is overly
burdensome.
Price Earnings Growth (PEG) Ratio. Whereas a price-to-sales
ratio further restricts the enterprise-to-EBITA multiple, the PEG
ratio is more flexible than the enterprise multiple, because it
allows expected growth to vary across companies.
EV/EBITDA vs. EV/EBIT multiples. EBITDA is popular because the
statistic is closer to cashflow than EBIT, but fails to measure
reinvestment, or capture differences in equipment outsourcing.
Multiples of operational data. When financial data is sparse,
compute non-financial multiples, which compare enterprise value
to one or more operating statistics, such as Web site hits, unique

Alternate Multiples: Price-to-Sales

Multiple
An enterprise-value-to-sales multiple imposes an additional important
restriction: similar operating margins on the companys existing
business. For most industries, this restriction is overly burdensome.
To see this, consider the following analysis:
Circui
t City

Linens
n
things

Best
Buy

Home
Depot Lowes

Bed Bath
&
Beyond

Enterprise/Sal
es
Enterprise/EBIT
A
Price/Earning
s

Home Depot estimated share price*

Applying the enterprise value to sales multiple from various retailers

to Home Depot revenue would estimate its fair stock price
somewhere between $4 and $60, too wide to be helpful.

Alternate Multiples: PEG Ratios

Whereas a price-to-sales ratio further restricts the enterprise-to-EBITA

multiple, the Price-Earnings-Growth (PEG) ratio is more flexible,
because it allows expected profit growth to vary across companies.
We measure the PEG ratio as the enterprise value multiple divided
by expected EBITA growth.
Expecte
d profit
growth

Enterpris
Hardline retailing e
multiple
Home
improvement
Home Depot
7.1

11.8

0.60

Lowes

7.3

17.2

0.42

Bed Bath & Beyond

9.9

16.1

0.61

Linens n Things

5.1

15.4

0.33

Enterpris
e PEG
ratio

Home furnishing

To calculate Home Depots

adjusted PEG ratio, divide
forward looking enterprise
multiple (7.1x) by its EBITA
growth rate (11.8%).

Based on the enterprise-based

PEG ratio, Bed Bath & Beyond
trades at a significant
premium to Linens n Things.

Alternate Multiples: PEG Ratios

There are two major drawbacks to using a PEG ratio:
1. There is no standard time frame for measuring the growth in profits.
The valuation analyst must decide to use one year, two year or long
termPEG
growth.
2. The
ratio incorrectly
assumes a linear
relationship between
multiples and growth
Consider company
valuations presented in
the graph (the dotted
line). As growth
declines, the enterprise
value multiple also
drops, but by a declining
rate.
A low growth company,

Enterprise value to EBITA

Comparing Multiples to Growth Rates

Long-term growth rate

Percent

Alternative
Multiples:
EV
to
Many financial analysts use multiples of EBITDA, rather than EBITA,
because depreciation is a EBITDA
noncash expense, reflecting sunk costs,
not future investment.
But EBITDA multiples have their own drawbacks. To see this, consider
two companies, who differ only in outsourcing policies. Because
they produce identical products at the same costs, their valuations
are identical ($150).
What is each companies EV to EBITDA multiple and why are they
different?
Company A
manufactures
product with
their own
equipment
Incurs
depreciation
cost directly

Revenues
Raw materials
Operating costs
EBITDA

Depreciation
EBITA

Comp
A
10
0
(10
)
(40
)
50

(30
)
20

Comp B
10
0
(35
)
(40
)
25

(5
)
2
0

Company B
outsources
manufacturing to
another company
Incurs depreciation
cost indirectly
through an increase
in the cost of raw
material)

Alternative Multiples: EV to
Because both companies EBITDA
produce identical products at the same
costs, their valuations are identical ($150). Yet, there EV/EBITDA
ratios differ. Company A trades at 3x EBITDA (150/50), while
Company B trades at 6x EBITDA (150/25).

Multiples

Comp
A

Enterprise value ($
150.0
Million)
Enterprise value/EBITDA
3.0
Enterprise value/EBITA

7.5

Comp B
150.
0
6.0
7.5

When computing the enterprise-value-to-EBITDA multiple, we failed

to recognize that Company A (the company that owns its
equipment) will have to expend cash to replace aging equipment.
Since capital expenditures are recorded as an investing cash flow
they do not appear on the income statement, causing the
discrepancy.

Multiples on Non-Financial (Operational)

Data

Multiples based on nonfinancial (i.e. operational) data can be

computed for new companies with unstable financials or negative
profitability. But to use an operational multiple, it must be a
reasonable predictor of future value creation, and thus somehow
tied to ROIC and growth.
Many analysts used operational multiple to value young Internet
companies at the beginning of the Internet boom. Examples of
Enterprise
Enterprise Value
Enterprise
these multiples included:
Value
Number of
Value
Unique
Subscribers
Website Hits
Visitors
A few cautionary notes:
1. Non-financial multiples should be used only when they
provide incremental explanatory power above financial
multiples.
2. Non-financial multiples, like all multiples, are relative
valuation tools. They do not measure absolute valuation
levels.

Closing Thoughts

A multiples analysis that is careful and well reasoned will not only
provide a useful check of your DCF forecasts but will also provides
critical insights into what drives value in a given industry. A few
closing thoughts about multiples:
1. Similar to DCF, enterprise value multiples are driven by the key
value drivers, return on invested capital and growth. A company
with good prospects for profitability and growth should trade at a
higher multiple than its peers.
2. A well designed multiples analysis will focus on operations, will
use forecasted profits (versus historical profits), and will
concentrate on a peer group with similar prospects.
P/E ratios are problematic, as they commingle operating, nonoperating, and financing activities which lead to misused and
misapplied multiples.
3. In limited situations, alternative multiples can provide useful

Valuation Ratios versus

DCF
Do both
Both entail use of value estimates, professional
judgment, quality of information and purpose of
valuation.
Acquisition of specific, known asset or
company, and good data, Comps may be
better.
Acquisition of general, non-specific or
unknown asset or company, DCF may be
better.
See Titman, Valuation-The Art and Science of Corporate Investment Decisions, 2011, pgs. 291-2.

58

Market-Based Methods: Comparable Company Example

Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MV C/VIC):
Comparable Company

Trailing
P/E1
Col. 1

Forward
P/E2

Price/Sales

Price/Book

Col. 2

Col. 3

Col. 4

11.25

8.73

1.17

3.71

9.18

7.68

0.69

2.17

10.79

8.05

0.91

2.54

7.36

8.35

0.61

1.86

11.92

6.89

0.77

1.59

Total SA (TOT)

8.75

8.73

0.80

2.53

Eni SpA (E)

3.17

7.91

0.36

0.81

11.96

10.75

1.75

2.10

9.30

8.39

0.88

2.16

$4.38

$3.27

$92.66

$26.49

$40.72

$27.42

$81.77

$57.32

Exxon Mobil Corp (XOM)

British Petroleum (BP)
Chevron Corp (CVX)
Royal Dutch Shell (RDS-B)
ConocoPhillips (COP)

PetroChina Co. (PTR)

Average Multiple (MVC/VIC) Times
Repsol YPF Projections (VIT)3
Equals Estimated Value of Target
1

Average
Col. 1-4

$51.81

Trailing or Current 52 week average. 2Projected 52 week average. 3Billions of Dollars.

59

Valuation ExxonMobil
Chemical
ExxonMobil, 3rd largest following BASF &
DuPont
Division earned $3.428 Billion
Hypothetical assume spin off of division.
What is the baseline valuation? (Next slide 60)
Modify baseline to adjust for relative size.
(Slide 61)
Consider growth factors (Slide 62)

60

Equity Valuation Using PE Ratios

Chemical Company P/E Ratios
Share Price

P/E Ratio

$ 70.47

$ 5.243

13.44

Bayer

35.64

1.511

23.59

Dow Chemical

47.40

4.401

10.77

DuPont

41.00

2.572

15.94

Eastman
Chemical

51.69

5.75

8.99

FMC

59.52

5.729

10.39

Rohm & Hass

45.02

2.678

16.81

BASF

EPS

14.28
Average

61

Market Cap and PE Ratios

P/E Ratio

Market Cap
(Billions)

BASF

13.44

$ 38.25

Bayer

23.59

25.63

Dow Chemical

10.77

45.25

DuPont

15.94

40.61

8.99

4.10

FMC *

10.39

2.20

Rohm & Hass *

16.81

10.01

Average (Big
4)

15.94

$37.44

Average (Small 3)*

12.06

5.44

Eastman Chemical *

62

Variation of PE Ratio
Share
Price
BASF

Current
EPS

Current/
Trailing
P/E Ratio

Forecast
EPS

Forward
P/E Ratio

$ 70.47

$ 5.243

13.44

$ 7.27

9.69

Bayer

35.64

1.511

23.59

2.69

13.27

Dow

47.40

4.401

10.77

5.71

8.30

DuPont

41.00

2.572

15.94

3.04

13.48

Eastman

51.69

5.75

8.99

5.93

8.71

FMC

59.52

5.729

10.39

5.66

10.51

Rohm &
Hass

45.02

2.678

16.81

3.12

14.44

Average

14.28

11.20

63

Valuation of ExxonMobil
Baseline valuation
Earnings $3.428B X P/E Ratio 14.28 = $48.94
B

Modification to reflect relative size

Earnings $3.428B X P/E Ratio 15.94 = $54.63
B

Further modification
Substantial dispersion (10.77 23.59) in P/E
Ratios even among top 4 firms indicate risk
and growth potential must be considered.
64

Market-Based Methods:
Same or Comparable Industry Method

Multiply targets earnings or revenues by

market value to earnings or revenue
ratios for the average firm in targets
industry or a comparable industry.
Primary advantage is the ease of use
and availability of data.
Disadvantages include presumption
industry multiples are actually
comparable and analysts projections
are unbiased.
65

PEG Ratio = PE Ratio/Earnings Growth

Used to adjust relative valuation methods for differences in growth

rates among comparable firms.
Many current models assumes zero or minimal growth
BES/CPS example: BES/CPS 15 & 9% respectively vs industry
12.4 & 11%.
Helpful in determining which of a number of different firms in same
industry exhibiting different growth rates may be the most
attractive.
(MVT/VIT) = A and
VITGR

Where A
of
MVT
VIT
VITGR

MVT = A x VITGR x VIT

= Market price to value indicator relative to the growth rate
value indicator (e.g., (P/E)/ EPS growth rate)
= Market value of target
= Value indicator for target (e.g., EPS)
= Projected growth rate in value indicator (e.g., EPS)
66

Applying the PEG Ratio

An analyst is asked to determine whether Basic Energy Service

(BES) or Composite Production Services (CPS) is more attractive
as an acquisition target. Both firms provide engineering,
construction, and specialty services to the oil, gas, refinery, and
petrochemical industries.
BES and CPS have projected annual earnings per share growth
rates of 15 percent and 9 percent, respectively. BES and CPS
current earnings per share are $2.05 and $3.15, respectively. The
current share prices as of June 25, 2008 for BES is $31.48 and
for CPX is $26. The industry average price-to-earnings ratio and
growth rate are 12.4 and 11 percent, respectively. Based on
this information, which firm is a more attractive takeover target
as of the point in time the firms are being compared?

67

Industry average PEG ratio: 12.4 (PE

Ratio) /.11 (Growth rate of earnings) =
112.73
BES: Implied share price = 112.73 x .15 x
$2.05 = $34.66
10.1% undervalued
CPX: Implied share price = 112.73 x .09 x
$3.15 = $31.96
22.9% undervalued
Answer: The difference between the implied
and actual share prices for BES and CPX is
$3.18 (i.e., $34.66 - $31.48) and $5.96
($31.96 - $26.00), respectively.
CPX is
more undervalued than BES at that
moment in time.

Asset-Based Methods:
Tangible Book Value
Tangible book value (TBV) = (total assets total liabilities - goodwill)
Targets estimated value = Targets TBV x
[(industry average or comparable firm
market value) / (industry or comparable firm
TBV)].
Often used for valuing
Financial services firms where tangible
book value is primarily cash or liquid assets
Distribution firms where current assets
constitute a large percentage of total
assets
69

Valuing Companies Using Asset Based

Methods
Ingram Micro distributes information technology products worldwide. The firms share
price on 8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and the
firms beta is .89. Shareholders equity is $3.4 billion and goodwill is $.7 billion. Ingram
has 172 million (.172 billion) shares outstanding. The following firms represent Ingrams
primary competitors.
Market Value/
Tangible Book Value

Beta

Projected 5-Year
Net Income Growth
Rate (%)

Tech Data

.91

.90

11.6

Synnex
Corporation

.70

.40

6.9

Avnet

1.01

1.09

12.1

Arrow

.93

.97

13.2

Based on this information, what is Ingrams tangible book value per share (VIT)? What is
the appropriate industry average market value to tangible book value ratio (MV IND/VIIND)?
Estimate the implied market value per share for Ingram (MVT) using tangible book value
as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to
its 8/21/08 share price?
Note both Beta and 5 Year Growth Rate used to cull out irrelevant Company.
70

Solution to Ingram Problem

Ingrams net tangible book value per share (VI T) = ($3.4 -$.7)/.172 =
$15.70

Based on risk as measured by the firm beta and the 5-year projected
earnings growth rate, Synnex is believed to exhibit significantly
different risk and growth characteristics and is excluded from the
calculation of the industry average market value to tangible book
value ratio. Therefore, the appropriate industry average ratio is as follows:
MVIND/VIIND = .95 [i.e., (.91+1.01+.93)/3]

Ingrams implied value per share = MV T = (MVIND/VIIND) x VIT = .95 x $15.70

= $14.92

Based on the implied value per share, Ingram was over-valued on 8/21/08
when its share price was $19.30

Note, we are deriving tangible book value by assuming it equals equity less intangible assets
(goodwill).

71

Asset-Based Methods: Liquidation

Method
Value assets as if sold in an orderly fashion (e.g., 9-12
months) and deduct value of liabilities and expenses
associated with asset disposition. Used in Chapter 7/11
Bankruptcy Cases in US.
While varies with industry,
Receivables often sold for 80-90% of book value
Inventories might realize 80-90% of book value
depending on degree of obsolescence and condition
Equipment values vary widely depending on age
and condition and purpose (e.g., special
purpose)
Book value of land may understate market value
Prepaid assets such as insurance can be liquidated
with a portion of the premium recovered.

72

Asset-Based Methods:
Liquidation Method
Nortel Networks Canadian Company
July 1, 2011 pursuant to Bankruptcy
Sold 6,000 patents for $4.5 Billion at
auction to Rockstar Bidco.
Consortium Apple, EMC, Microsoft, RIM &
Sony
Google defensive, stalking horse bid to
discourage suits over Android & Chrome.
Intel early bidder but teamed with Google
73

Asset-Based Method: Break-Up Value

Target viewed as series of independent operating
units, whose income, cash flow, and balance sheet
statements reflect intra-company sales, fully-allocated
costs, and operating liabilities specific to each unit
After-tax cash flows are valued using market-based
multiples or discounted cash flows analysis to
determine operating units current market value
The units equity value is determined by deducting
operating liabilities from current market value Mkt.
Cap
Aggregate equity value of the business is determined
by summing equity value of each operating unit less
unallocated liabilities and break-up costs
May be used by private equity/hedge and LBO
deals.

74

McGraw Hill Spin Off ?

August 2011 Publisher & S&P owner
Pressure from activist hedge fund Jana
Partners and Ontario Teachers Pension Plan.
Meetings between MH (Goldman) & Jana
MH mini conglomerate of non related
information businesses. Education capital
intensive and plodding growth?
Lazard & JPMorgan Chase breakup value
$55 per share versus $41 current price.
See website, McGraw Hill Faces Breakup Pressures, Business Week, August 2,
2011

75

Replacement Cost Method

All target operating assets are assigned a
value based on what it would cost to
replace them.
Each asset is treated as if no additional
value is created by operating the assets as
part of a going concern.
Each assets value is summed to determine
the aggregate value of the business.
This approach is limited if the firm is
highly profitable (suggesting a high
going concern value) or if many of the
firms assets are intangible.
76

Weighted Average Valuation

Method
An analyst has estimated the value
of a company using multiple
valuation methodologies. The
discounted cash flow value is
$220 million, comparable
transactions value is $234
million, the P/E-based value is
$224 million and the liquidation
value is $150 million. The
analyst has greater confidence
in certain methodologies than
others. Estimate the weighted
average value of the firm using
all valuation methodologies and
the weights or relative
importance the analyst gives to
each methodology.

Estimated
Value ($M)

Relative
Weight

Weighted
Avg. ($M)

220

.30

66.0

234

.40

93.6

224

.20

44.8

150

.10

15.0

1.00

219.4

77