Reading 42: Market-Based Valuation: Price and Enterprise Val 2010, face, valuation, multiple, discuss

土豆妮

Session 12: Equity Investments: Valuation Models
Reading 42: Market-Based Valuation: Price and Enterprise Value Multiples

LOS c: Describe a justified price multiple and discuss rationales for each price multiple and dividend yield in valuation.

 

 

 

The multiple indicated by applying the discounted cash flow (DCF) model to a firm’s fundamentals is necessarily the:

A) same as the average industry multiple.

B) justified price multiple.

C) result of calculating retention/(required rate of return - growth) for the overall market.

---

 

A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple. The question is limited to an individual firm and does not necessarily apply to the market or an industry.

土豆妮

The warranted or intrinsic price multiple is called the:

A) multiple implied by the market price.

B) justified price multiple.

C) multiple implied by historical growth.

---

A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple.

土豆妮

A justified price multiple is the:

A) warranted or intrinsic price multiple.

B) multiple implied by historical growth.

C) multiple implied by the market price.

---

A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple.

土豆妮

For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities?

Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm B: Expected dividend growth = ?6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.

A) Firm C.

B) Firm A.

C) Firm B.

---

The formula for the PEG ratio is: PEG = (P/E) / g. It measures the tradeoff between P/E and expected dividend growth (g). For traditional growth firms, PEG ratios fall between 1 and 2. The general rule is that PEG ratios above 2 are indicative of overvalued firms (expensive), and PEG ratios below 1 are indicative of firms that are undervalued (cheap).

Firm A:	PEG = 2, indicating a stock that is appropriately priced.
Firm B:	The PEG ratio of firms with negative expected dividend growth is negative, which is meaningless. For Firm B, PEG = -2.
Firm C:	Firms with very low expected dividend growth are likely to have PEG ratios that unrealistically indicate overvalued stocks. For Firm C, PEG = 12.

土豆妮

An argument against using the price-to-earnings (P/E) valuation approach is that:

A) research shows that P/E differences are significantly related to long-run average stock returns.

B) earnings power is the primary determinant of investment value.

C) earnings can be negative.

---

Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.

土豆妮

An argument for using the price-to-earnings (P/E) valuation approach is that:

A) earnings volatility facilitates interpretation.

B) research shows that P/E differences are significantly related to long-run average stock returns.

C) earnings can be negative.

---

Research shows that P/E differences are significantly related to long-run average stock returns. Both remaining factors reduce the usefulness of the P/E approach.

土豆妮

An argument for using the price-to-earnings (P/E) valuation approach is that:

A) earnings power is the primary determinant of investment value.

B) earnings can be negative.

C) management discretion increases the reliability of the ratio.

---

Earnings power is the primary determinant of investment value. Both remaining factors reduce the usefulness of the P/E approach.

土豆妮

A firm is better valued using the discounted cash flow approach than the P/E multiples approach when:

A) earnings per share are negative.

B) expected growth rate is very high.

C) dividend payout is low.

---

P/E multiples are not meaningful when the earnings per share are negative. While this problem can be partially offset by using normalized or average earnings per share, the problem cannot be eliminated.

土豆妮

Analyst Ariel Cunningham likes using the price/earnings ratio for valuation purposes because studies have shown it is very effective at identifying undervalued stocks. However, she has one main problem with the statistic – it doesn’t work when a company loses money. So Cunningham is considering switching to a different core valuation metric. Given Cunningham’s rationale for using the price/earnings ratio, which option would be her best alternative?

A) Price/sales.

B) Price/book.

C) Price/cash flow.

---

Book value is usually positive, but not always. Cash flow is often negative. If the reason Cunningham wants to stop using the P/E ratio is that it does not work for unprofitable companies, her best option is a ratio base on sales, which are positive in all but the rarest of instances.

土豆妮

Bill Whelan and Chad Delft are arguing about the relative merits of valuation metrics.

Whelan: “My ratio is less volatile than most, and it works particularly well when I look at stocks in cyclical industries.”

Delft: “The problem with your ratio is that it doesn’t reflect differences in the cost structures of companies in different industries. I like to use a metric that strips out all the fluff that distorts true company performance.”

Whelan: “People can’t even agree how to calculate your ratio.”

Which valuation metric do the analysts most likely prefer?

Whelan

Delft

A) Price/book EV/EBITDA

B) Price/cash flow Price/book

C) Price/sales Price/cash flow

---

The price/sales ratio is not very volatile, and it is of particular value when dealing with cyclical companies. The price/cash flow ratio considers the stock price relative to cash flows, ignoring the noncash gains and losses that can skew earnings. A major weakness of the price/cash flow ratio is the fact that there are different ways of calculating it, making comparisons difficult at times.