Equity Valuation【Reading 41】Sample average, selling, industry

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Shares of TKR Construction (TKR) are selling for $50. Earnings for the last 12 months were $4.00 per share. The average trailing P/E ratio for firms in TKR’s industry is 15. The appropriate WACC is 12%, and the risk-free rate is 8%. Assume a growth rate of 0%. Using the method of comparables, what price is indicated for TKR?

A) $33.33.

B) $50.00.

C) $60.00.

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Using the method of comparables, TKR should be priced as (15 × 4) = $60.00.

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An analyst begins an equity analysis of Company A by noting the following ratios from three companies in the same industry:

	EPS	PE
Company A	$1.60	10.0
Company B	$2.10	12.5
Company C	$5.80	13.0

This analyst is most likely using:

A) the method of forecasted fundamentals.

B) the method of comparables.

C) technical analysis.

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The analysis is comparing ratios of three companies in the same industry. The Law of One Price states that similar assets should have comparable prices.

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Lucas Davenport, CFA, has been assigned the task of doing a valuation analysis of Sanford Systems Inc. Sanford is currently trading at $15 per share. Exhibits 1 and 2 present a summary of Sanford’s financial statements for 2007 and 2008.
Davenport has previously completed a FCFE valuation, which yielded a value of $11.18 per share based on FCFE per common share in 2008 of $0.85.
Exhibit 1: Sanford Systems Balance Sheets as of 12/31/2008 (in US$ millions)

<P > td [td=1,1,81]2007	2008
Cash and equivalents	$325	450
Accounts receivable	850	870
Inventory	1,000	1,050
Total current assets	$2,175	$2,370
Gross fixed assets	13,600	15,900
Accumulated depreciation	2,300	2,900
Net fixed assets	11,300	13,000
Total assets	$13,475	$15,370
Accounts payable	$1,500	$1,520
Notes payable	300	550
Accrued taxes and expenses	--------	--------
Total current liabilities	$1,800	$2,070
Long-term debt	$5,575	$6,111
Common stock	100	100
Additional paid-in capital	--------	--------
Retained earnings	6,000	7,089
Total shareholders' equity	$6,100	$7,189
Total liabilities and shareholders' equity	$13,475	$15,370

Exhibit 2: Sanford Systems Income Statements for 2007 and 2008 (in US$ millions)

<P > td [td=1,1,84]2007	2008
Total revenues	$12,000	$13,100
Operating costs and expenses	9,400	9,600
EBITDA	$2,600	$3,500
Depreciation and amortization	500	600
EBIT	$2,100	$2,900
Interest expense	500	585
Income before taxes	$1,600	$2,315
Taxes (40%)	640	926
Net income	$960	$1,389
Dividends	$280	$300
Change in retained earnings	$680	$1,089
EPS	$1.92	$2.78
DPS	$0.56	$0.60
# of shares outstanding (millions)	500	500

Davenport determines that the company follows IFRS rules, and compiles the following industry price-to-adjusted (per share) CFO data, where adjusted CFO is equal to cash flow from operations from the statement of cash flows plus after-tax cash interest expense.

Exhibit 3: Industry Data

[td=1,1,189] Trailing P/Adjusted CFO per share	Beta	Consensus 5-Year Earnings Growth
Industry Median	2.0x	1.20	9.9%
Sanford	[td=1,1,60] 1.25	9.2%

Davenport would also like to make international price multiple comparisons and is contemplating using one or more of the following ratios: price-to-sales, price-to-earnings, price-to-book, price-to-adjusted cash flow from operations, and enterprise value-to-EBITDA.
Davenport decides to use a single-stage residual income model to estimate the value of Sanford, in addition to the FCFE framework he used earlier. He estimates Sanford’s long-term perpetual growth rate in residual income at 5 percent, its return on new investments to be 20 percent, weighted average cost of capital to be 10.4 percent based on the target debt-to-asset ratio, and the required return on equity to be 14 percent.
Finally, Davenport solves the following equation for T, given the other inputs (where the index is the S&P 500), and determines that T = 3.6.
Sanford’s economic value added (EVA®) for 2008 is closest to:

A) $567.80

B) $1,383.20

C) $356.80

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EVA is equal to net operating profit after tax (NOPAT) minus the dollar weighted average cost of capital ($WACC).
NOPAT = EBIT(1 + t) = $2,900(1 − 0.4) = $1,740
Invested capital = LTD + SH equity = $6,111 + $7,189 = $13,300
$WACC = $13,300 × 0.104 = $1,383.20
EVA = $1,740 − $1,383.20 = $356.80
(Study Session 12, LOS 42.a)

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Based on a comparison of the actual trailing P/FCFE ratio compared to the justified trailing P/FCFE ratio (based on Davenport’s FCFE valuation model) for 2008, Sanford is:

A) undervalued because the actual P/FCFE ratio is less than the justified P/FCFE ratio for 2008.

B) overvalued because the actual P/FCFE ratio is greater than the justified P/FCFE ratio for 2008.

C) correctly valued because the actual P/FCFE ratio is equal to the justified P/FCFE ratio for 2008.

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Sanford’s actual P/FCFE ratio is the current market price of $15 divided by FCFE for 2008:

The justified P/FCFE ratio is the value derived from the FCFE valuation model ($11.18) divided by FCFE for 2008:

Based on this analysis, Sanford is overvalued on an absolute basis (NOT relative to the industry benchmark) because the actual P/FCFE ratio is greater than the justified P/FCFE ratio. (Study Session 12, LOS 41.b)

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Based on a comparison of the actual trailing P/adjusted CFO ratio compared to the industry median trailing P/adjusted CFO per share ratio for 2008, Sanford:

A) is overvalued relative to the industry benchmark because Sanford’s P/adjusted CFO ratio is higher than the industry median, despite slightly higher systematic risk and lower 5-year earnings growth.

B) may be undervalued relative to the industry benchmark because Sanford’s P/adjusted CFO ratio is higher than the industry median, despite slightly higher systematic risk and lower 5-year earnings growth.

C) is correctly valued relative to the industry benchmark because Sanford’s P/adjusted CFO ratio is equal to the industry median, despite slightly higher systematic risk and lower 5-year earnings growth.

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Sanford’s adjusted CFO is equal to net income plus depreciation minus the increase in net working capital (excluding cash and notes payable) plus after-tax interest expense:

Sanford is overvalued relative to the industry benchmark because its P/adjusted CFO ratio is higher than the industry median of 2.0, despite slightly higher systematic risk (as measured by beta) and a lower 5-year earnings growth forecast. (Study Session 12, LOS 41.m)

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Which of the following market multiples is most appropriate for Davenport to use in international valuation comparisons?

A) Price-to-sales.

B) Price-to-adjusted CFO.

C) Enterprise value-to-EBITDA.

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Using relative valuation methods that require the use of comparable firms is challenging in an international context due to differences in accounting methods, cultures, risk, and growth opportunities. Further, benchmarking is difficult because price multiples for individual firms in the same industry vary widely internationally, and country market price multiples can vary significantly. Common differences in international accounting treatment fall into several categories: goodwill, deferred income taxes, foreign exchange adjustments, R&D, pension expense, and tangible asset revaluations.
The usefulness of all price multiples is affected to some degree by differences in international accounting standards. The least affected are price-to-cash flow ratios (including P/adjusted CFO), while P/B, P/E, P/S, P/EBITDA, and EV/EBITDA will be more seriously affected because they are more affected by management’s choice of accounting methods and estimates. (Study Session 12, LOS 41.o)

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The value per share of Sanford’s common equity, based on a single-stage residual income model, is closest to:

A) $23.96.

B) $22.44.

C) $21.24.

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Book value per share for 2008 is:

The value of the common equity according to the single-stage residual income model is:

(Study Session 12, LOS 42.f)

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For purposes of this question only, assume Sanford’s ROE is 20%, its current market price is $25, and the cost of equity is 14%. Sanford’s implied growth rate in residual income is closest to:

A) 5.11%.

B) 5.88%.

C) 5.23%.

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BVPS = 7,189 / 500 = $14.38
The implied growth rate can be calculated as:

(Study Session 12, LOS 42.g)

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An analyst begins an equity analysis of Company A by estimating future cash flows, discounting them back to the present, and dividing the result by the outstanding number of shares. This analyst is most likely using the:

A) the method of comparables.

B) the method of forecasted fundamentals.

C) technical analysis.

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This analysis is comparing forecasted discounted cash flows (DCF) to a fundamental variable (shares). This suggests the method for forecasted fundamentals.

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Which of the following valuation approaches is based on the rationale that stock values differ due to differences in the expected values of variables such as sales, earnings, or related growth rates?

A) Method of comparables.

B) Free cash flow to the firm.

C) Method of forecasted fundamentals.

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The method of forecasted fundamentals is based on the rationale that stock values differ due to differences in the expected values of fundamentals such as sales, earnings, or related growth rates.

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Which of the following statements about the method of comparables in price multiple valuation is CORRECT?

A) It relates multiples to company fundamentals using a discounted cash flow (DCF) model.

B) It values an asset relative to a benchmark value of the multiple.

C) It assumes that cash flows are related to fundamentals.

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The method of comparables involves using a price multiple to evaluate whether an asset is valued properly relative to a benchmark value of the multiple. It makes no explicit assumptions about fundamentals and does not rely on a DCF model.

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Which of the following statements about the method of forecasted fundamentals in price multiple valuation is most accurate?

A) It relates multiples to company fundamentals using a discounted cash flow (DCF) model.

B) It values an asset relative to a benchmark value of the multiple.

C) It relies on the Law of One Price.

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The method of forecasted fundamentals relates multiples to company fundamentals using a DCF method. It does not explicitly rely on the Law of One Price. Further, it does not typically focus on benchmarks.

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P/E multiples are often computed using the average of the multiples of comparable firms, because:

A) it provides the most accurate results.

B) it is very easy to find comparable firms that have the same business mix and risk and growth profiles.

C) it is conceptually very straightforward.

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The use of comparable firms is quite common, because it is conceptually very straightforward. Also, it does not require the analyst to make specific assumptions regarding growth, risk, and other variables. However, it is often difficult to find comparable firms, since even within the same industry different firms can have different business mixes and risk and growth profiles.

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The value of a firm, calculated using the discounted cash flow (DCF) method, will be closest to the valuation using P/E multiples when P/E multiples are estimated using:

A) P/E multiples of comparable firms.

B) historical P/E multiples.

C) fundamental data.

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In the DCF valuation method, an analyst makes specific assumptions about each variable, such as growth, risk, payout, etc. The valuation using P/E multiples will be closest to the one obtained using the DCF approach when fundamental data -- for growth, risk, payout, etc. -- is used to estimate P/E multiples.

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A justified price multiple is the:

A) multiple implied by historical growth.

B) warranted or intrinsic price multiple.

C) multiple implied by the market price.

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