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Chapter 2

Chapter 2. VALUATION Behavioral Corporate Finance by Hersh Shefrin. Valuation Heuristics. P/E heuristic P 0 = P 0 /E 1 x E 1 Target price P 1 = P 1 /E 2 x E 2 PEG Heuristic P 0 = PEG x E 1 x G , where G is 100 x growth rate Price-to-sales Heuristic

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Chapter 2

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  1. Chapter 2 VALUATION Behavioral Corporate Finance by Hersh Shefrin

  2. Valuation Heuristics • P/E heuristic • P0 = P0/E1 x E1 • Target price P1 = P1/E2 x E2 • PEG Heuristic • P0 = PEG x E1 x G, • where G is 100 x growth rate • Price-to-sales Heuristic • P0 = P0/S1 x S1, where S stands for sales

  3. Behavioral Pitfalls: Judging the Value of eBay • On May 20, 2003 eBay’s P/E ratio was 66.2, while Wal-Mart’s P/E was 22.7. • eBay appeared to be over twice as expensive as War-Mart. • Analysts were expecting eBay to grow by 42.5%, while they were only expecting Wal-Mart to grow by 14%. • eBay’s PEG was 1.56, which was actually lower than Wal-Mart’s PEG of 1.62.

  4. Behavioral Pitfalls: Wall-Marting of the Web • Mary Meeker, “Queen of the Internet.” • Just as the traditional retailer Wal-Mart came to dominate the retail sector, web-based counterparts would emerge and dominate Internet commerce. • Mary Meeker described the phenomenon as the “Wal-Marting of the Web.”

  5. Mary Meeker’s Target Prices for eBay Exhibit 2.1

  6. Methodology Exhibit 2.2

  7. Free Cash Flow Computation Meeker forecasted that free cash flows in 2011 will be $3,266,096 = 1.07 x $3,052,426. She then applied the perpetuity formula PV = $3,266,096 / (0.12-0.07) = $65,321,907 Exhibit 2.3

  8. Biases • Discount rate, 12%, fair expected return. • Target price of $106 implies expected return exceeds 12%. • PEG and P/E target prices imply returns below 12%, even negative. • FCF and price-to-sales target prices imply returns above 12%.

  9. Biased Free Cash Flows Differences? • EBITDA • working capital • investment Exhibit 2.4

  10. Textbook Style Valuation • $23,742 = E2011/r = $2,849/0.12 • Because eBay pays no dividends before 2010, the $23,742 would be worth $21,199 at the end of 2009, $21,199= $23,742/1.12. • Discounting back to mid-2004 would lead to a value of $11,366 (=$12,029/1.120.5) at that time. Exhibit 2.5

  11. Mistaking Growth for Growth Opportunities • Mary Meeker titled her April 2003 report on eBay “Tales of a Growth Machine.” • Analysts are inclined to mistake growth in EPS for growth opportunities • Growth opportunity features ROE > r. • From the time that eBay went public, through June 2004, eBay's ROE < its r of 12%.

  12. Intrinsic PEG? • PEG heuristic effectively assumes P/E is proportional to g. • When the plowback ratio is 0, g = 0. • When the plowback ratio is 1, g = ROE. • Regardless of whether g is equal to 0 or equal to the ROE, P/E is 1/r for a firm with zero growth opportunities. • Therefore, P/E does not vary in proportion to g.

  13. 1/n Heuristic • The 1/n heuristic is a rule of thumb that assigns the same weight to each technique, as if they are all equally valid. • Very wide dispersion in values associated with P/E, PEG, price-to-sales, and DCF. • Meeker averaged the numbers, which in her words, “combine to an average fair value of about $106.”

  14. Excessive Optimism • On April 23, 2003 The Wall Street Journal suggested that analysts' revenue forecasts were excessively optimistic. • The article singled out Mary Meeker and Safa Rashtchy from U.S. Bancorp Piper Jaffray. • On January 20, 2005 Safa Rashtchy downgraded his recommendation on eBay from “outperform” to “market perform,” stating that the stock was priced for perfection.

  15. Agency Conflicts • Managers of firms prefer favorable coverage from analysts to unfavorable coverage. • Analysts whose firms seek to do business with companies have an incentive to generate favorable (optimistic) reports. • Agency conflict might induce analysts to view valuation heuristics as instruments to provide numbers they want to deliver.

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