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Financial Statement Analysis & Valuation Third Edition

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## Financial Statement Analysis & Valuation Third Edition

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**Financial Statement**Analysis & Valuation Third Edition Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang**Valuation Model Using Market Multiples**• Used as a shortcut valuation method • Popular due to simplicity • Does not rely on subjective forecasts of future performance • Also referred to as the method of comparables**Company or Equity Value?**Depends on whether the output is company or equity value If an equity performance measure is selected Output will be an equity value Examples: earnings, book value Most Common If a company performance measure is selected Output will be a company value Examples: NOPAT, NOA**Using the Valuation Model**Step 1 Select a relevant summary performance measure from financial statements Identify companies that are comparable to the target company on relevant dimensions Step 2 Compute the market multiple using the average of the market value ratio to the performance measure for each company compared Step 3 Multiply the summary measure by the market multiple to get the target company’s value Step 4 If equity performance, divide by outstanding shares. If company performance, subtract net nonoperating obligations before dividing by outstanding shares Step 5**Weaknesses of the Market Multiple Model**• No ‘right’ measure to use • Because company value depends on future performance • No ‘right’ companies to use for comparison • Could be over or undervalued • No ‘right’ way to combine comparable company data to produce a multiple • Median, equal-weighted average, value-weighted average, or other average**Valuation Using Balance Sheet Multiples**This data will be used to estimate the intrinsic value of Family Dollar’s equity.**Valuation Using a Net Operating Asset (NOA) Multiple**Determine the market multiple for each company: Dollar General = $12,499 ÷ $6,854 = 1.82 NOA market multiple = [1.82 + 2.84] ÷ 2 = 2.33 Company intrinsic value = Net operating assets × NOA market multiple**Valuation Using a Net Operating Asset Multiple**Family Dollar’s intrinsic value = Net operating assets × NOA market multiple = $1,021 × 2.33 = $2,379 Family Dollar’s Equity intrinsic value = Company intrinsic value – Net nonoperating obligations = $2,379 – $(401) = $2,780 Family Dollar’s Equity intrinsic value per share Equity intrinsic value = = = $21.30 Common shares outstanding $2,780 130.5 shares**Valuation Using a Book Value (BV) Multiple**• Yields the intrinsic value for equity, not for the entire company This data will be used to estimate the intrinsic value of Family Dollar’s equity.**Valuation Using a Book Value Multiple**Family Dollar’s Equity intrinsic value = Book value of equity x BV Market multiple = $1,422 x 2.44 = $3,470 Family Dollar’s Equity intrinsic value per share Equity intrinsic value = = = $26.59 Common shares outstanding Because Family Dollar’s actual stock price at year end was $43.34, its stock is markedly overvalued. $3,470 130.5 shares**Assessing Quality of Value Estimates**• Careful selection of companies • Such as similar capital structures • Operating in the same industry • Must control for • Profitability • Growth • Risk**Valuation Using Earnings**• Most commonly used performance measure for estimating company value with market multiples • Intuition • Dividends are paid out of earnings, and potential dividend payouts are the basis for company value • Higher earnings should warrant higher payment for stock**Valuation Using NOPAT Multiple**NOPAT intrinsic value for Family Dollar: Company intrinsic value Net operating profit after tax NOPAT market multiple = x Family Dollar’s intrinsic value = $366 × 12.50 = $4,575 million**Valuation Using NOPAT Multiple**Equity intrinsic value for Family Dollar: Equity intrinsic value Company intrinsic value Net nonoperating obligations = – Family Dollar’s equity intrinsic value per share $4,575 – $(401) 130.5 shares = $38.13 =**Valuation Using Net Income (NI) Multiple**Net income intrinsic value for Family Dollar: Equity intrinsic value NI market multiple Net income = – Family Dollar’s equity intrinsic value per share = $35.63 = $358 x 12.99 130.5 shares**Selecting Comparables for Market Multiples**• Companies should be selected based on similar profitability, growth, and risk • Common multiples • Price-to-Book • Price-to-Earnings**Residual Operating Income Model**Includes parameters for • Residual operating income • Expected growth rate in residual operating income • Weighted average cost of capital • Leverage Present value of expected ROPI, discounted using rw Price-to-Book = 1 + OE ROPI = NOPAT – (NOAbeg × rw)**PB Ratios in Relation to Profitability**Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $150 $100 = 2.5 Company A Price-to-Book = 1 + PV of $50 $100 = 1.5 Company B Price-to-Book = 1 +**PB Ratios in Relation to Growth**Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $200 $100 = 3.0 Company C Price-to-Book = 1 + PV of $120 $100 = 2.2 Company D Price-to-Book = 1 +**PB Ratios in Relation to Company Operating Risk**Model assumes that residual operating income grows at a constant rate, g, in perpetuity Present value of expected ROPI Expected ROPI Rw - g = PV of $46.7 $100 = 1.47 Company E Price-to-Book = 1 + PV of $120 $100 = 2.2 Company F Price-to-Book = 1 +**PB Ratios in Relation to Company Leverage**PV of $120 $100 = 2.2 Company G Price-to-NOA = 1 + PV of $120 $100 = 2.2 Company H Price-to-NOA = 1 + PV of $120 $100 = 2.2 Company G Price-to-Book = 1 + PV of $120 $40 = 4.0 Company H Price-to-Book = 1 +**Residual Operating Income Model**PE ratio equals the total of • The capitalized value of current income • Normal income and residual income • Capitalized present value of changes in future residual income Present value of expected changes in RI Earnings 1 + re re x 1 + PE ≈**PE Ratios in Relation to Profitability, Growth, and Risk**• Growth and risk affect PE • Profitability has no effect on PE • Unaffected by RNOA • Expected growth in residual income leads to higher PE ratios • Higher cost of equity capital leads to lower PE ratios Consider expected earnings, growth, and risk when selecting comparables to use for valuing a firm based on earnings multiples.**Reverse Engineering**• Process of observing market price metrics such as the PB and PE ratio, and • Assessing the quality of the underlying expectations supporting the observed stock price Expected ROE – re re - g PB = 1 + $11,396 million $625 million = 18.2 1 + Limited Brand’s PB =**Reverse Engineering of PB Ratio for Limited Brands**Case 1 Assumes we know the market’s expectation for ROE and the discount rate To support an 18.2 PB ratio, a high implied growth rate (6.7% to 11.2%) is required.**Reverse Engineering of PB Ratio for Limited Brands**Case 2 Assumes we know the market’s expectation for ROE and the discount rate To support an 18.2 PB ratio, a discount rate between 5.2% and 8.4% is required.**Reverse Engineering of PB Ratio for Limited Brands**Case 3 Assumes we know the market’s expectation for ROE and the discount rate To justify the 18.2 PB ratio, profitability in perpetuity from 43.4% to 78.8% is required.**Present value of expected changes in RI**Earnings 1 + re re 1 + Interpreting the PE Ratio • PE approximates the capitalization factor of [1 + re] ÷ re x PE ≈ • Example: A company has a 10% equity cost of capital, which implies a capitalization factor of 11. • If investors think residual income will change, PE ratio ≈ 11 • If investors think residual income will increase more than 10% times the change in book value, PE ratio > 11**Process of Fundamental Analysis**• Models requiring explicit modeling of a company’s future performance using forecast for valuation • Discounted dividends • Discounted cash flows • Residual operating income model • Lack of assurance using market multiples • Valuation by market multiples**Implementing Valuation Multiples**Step 1: Use forward-looking performance measures to compute the market multiples for comparable companies Step 2: Select comparable companies with care so as to match them on profitability, growth, and risk Step 3: Use both income-statement-based and balance-sheet-based valuation multiples