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

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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.

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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.

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An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:

A) price/book ratio.

B) price/sales ratio.

C) dividend yield.

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The price/book ratio is a preferred tool for valuing financial stocks.

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At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio (g) of 40% and cost of equity (k) of 12%. Xanedu's P/E ratio will also decrease by 0.5%. Is Chan correct?

A) Yes, Xanedu's P/E ratio will increase by approximately 0.5%.

B) No, Xanedu's P/E ratio will decrease by approximately 7.8%.

C) No, Xanedu's P/E ratio will increase by approximately 7.8%.

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Chan is not correct. P/E_Xanedu = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.40 / (0.12 - 0.06) = 6.67
When the expected dividend growth is 5.5%, P/E = 0.40 / (0.12 - 0.055) = 6.15
The percentage change is (6.15 / 6.67) - 1 = -7.80%, representing a 7.80% decrease.

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At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?

A) No, ZEI's P/E ratio will decrease by approximately 14.32%.

B) Yes, ZEI's P/E ratio will increase by approximately 0.5%.

C) No, ZEI's P/E ratio will increase by approximately 14.32%.

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Caza is not correct. P/E_ZEI = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.50 / (0.10 - 0.06) = 12.50
When the expected dividend growth is 6.5%, P/E = 0.50 / (0.10 - 0.065) = 14.29
The percentage change is (14.29 / 12.50) - 1 = 14.32%, representing a 14.32% increase.

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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.

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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.

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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

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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.

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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.

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

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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.

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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.

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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.

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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.

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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.

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