Market-Based Valuation: Price and Enterprise Value Multiples
Earnings power is the primary determinant of investment value. Both remaining factors reduce the usefulness of the P/E approach.
Question #10 of 140
Question ID:463344MarginandSalesTrade-offforCVR,Inc.and Home,Inc.,forNextYear
ᅞ B)
MarginandSalesTrade-offforCVR,Inc.and Home,Inc.,forNextYear
Question #1
8
of 140
Question ID: 463347Question #2
8
of 140
Question ID:415433ᅚ B)
ᅞ C)
Questions #52-57 of 140
dividendyield. price/book ratio.
Explanation
Ofalltheprice ratios, theprice/freecash flow toequity ratioistheleastaffectedbyinternationalaccounting differences.However, the dividendyieldisnotaffectedbysuch accounting differencesatall, and representsa goodstarting point. Residual-income modelsand price/book ratiosare verysensitivetoaccounting issues. (Study Session12, LOS 37.o)
Robin Alberts, CFA, isthe headof research for Worth Brothers, alargeinvestmentcompanybasedin New York. Next week, a groupof analysts who have justcompletedthe Worth Brothers' managementtraining program willbegin rotating throughoutthe various
departmentsandtrading desksatthefirm.Thetrainees willbesplitintosmall groups, andeach group willspendfour weeksineach area tolearnthebasicoperationsofeach departmentthrough "handson" experience. Also, inthattimeperiod, each department headis expectedtofullyevaluateeach candidateinorder todeterminetheir futureplacement withinthefirm.
Albertsdecidesthatsheshouldbeginevery rotationinthe research departmentby giving each candidateabrief review exam totesttheir
knowledgeofthe generalprinciplesofcreditanalysis. Sheaskseach candidatetoanalyzethefollowing threescenariosandtoanswer
two questionsoneach scenario.
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ᅞ A)
net of capital expenditures needed to keep the business productive.
ᅞ A)
It assumes that cash flows are related to fundamentals.
Questions #107-112 of 140
Lucas Davenport, CFA, hasbeenassignedthetaskofdoing a valuationanalysisof Sanford Systems Inc. Sanfordiscurrentlytrading at
$15 per share.Exhibits1and2presentasummaryof Sanford'sfinancialstatementsfor 2007and2008.
Davenport haspreviouslycompleteda FCFE valuation, which yieldeda valueof $11.18 per sharebasedon FCFEper commonsharein 2008 of $0.85.
Exhibit 1: Sanford Systems Balance Sheets as of 12/31/2008(in US$ millions)
2007 2008
Cash andequivalents $325 450
Accounts receivable 850 870
Inventory 1,000 1,050
Totalcurrentassets $2,175 $2,370
Grossfixedassets 13,600 15,900
Accumulateddepreciation 2,300 2,900
Netfixedassets 11,300 13,000
Totalassets $13,475 $15,370
Accountspayable $1,500 $1,520
Notespayable 300 550
Accruedtaxesandexpenses ---
---Totalcurrentliabilities $1,800 $2,070
Long-term debt $5,575 $6,111
Commonstock 100 100
Additionalpaid-incapital ---
---Retainedearnings 6,000 7,089
Totalshareholders' equity $6,100 $7,189
Totalliabilitiesandshareholders' equity $13,475 $15,370
Exhibit 2: Sanford Systems Income Statements for 2007 and 2008(in US$ millions)
Total revenues $12,000 $13,100
Operating costsandexpenses 9,400 9,600
EBITDA $2,600 $3,500
Depreciationandamortization 500 600
EBIT $2,100 $2,900
Interestexpense 500 585
Incomebeforetaxes $1,600 $2,315
Taxes (40%) 640 926
Netincome $960 $1,389
Dividends $280 $300
Changein retainedearnings $680 $1,089
EPS $1.92 $2.78
DPS $0.56 $0.60
#ofsharesoutstanding (millions) 500 500
Davenportdeterminesthatthecompanyfollows IFRS rules, andcompilesthefollowing industryprice-to-adjusted (per share)CFO data, whereadjustedCFO isequaltocash flow from operationsfrom thestatementofcash flowsplusafter-tax cash interestexpense.
Exhibit 3: Industry Data
Trailing
P/AdjustedCFO pershare
Beta Consensus5-Year
Earnings Growth
IndustryMedian 2.0x 1.20 9.9%
Sanford 1.25 9.2%
Davenport wouldalsoliketo makeinternationalprice multiplecomparisonsandiscontemplating using oneor moreofthefollowing ratios: price-to-sales, price-to-earnings, price-to-book, price-to-adjustedcash flow from operations, andenterprise value-to-EBITDA.
Davenportdecidestouseasingle-stage residualincome modeltoestimatethe valueof Sanford, inadditiontothe FCFEframework he usedearlier.Heestimates Sanford'slong-term perpetual growth ratein residualincomeat 5 percent, its returnonnew investmentstobe 20percent, weightedaveragecostofcapitaltobe10.4percentbasedonthetargetdebt-to-asset ratio, andthe required returnonequityto be14percent.
Question #107 of 140
Question ID: 463324ᅚ A)
ᅞ B)
ᅞ C)
Question #108 of 140
Question ID: 463325ᅚ A)
ᅞ B)
ᅞ C)
Question #109 of 140
Question ID: 463326Sanford'seconomic valueadded (EVA®)for 2008 isclosestto:
$356.80
$567.80
$1,383.20
Explanation
EVA isequaltonetoperating profitafter tax (NOPAT) minusthedollar weightedaveragecostofcapital ($WACC).
NOPAT = EBIT(1 + t) = $2,900(1 − 0.4) = $1,740
Investedcapital = LTD + SHequity = $6,111 + $7,189 = $13,300
$WACC = $13,300 × 0.104 = $1,383.20
EVA = $1,740 − $1,383.20 = $356.80
(Study Session12, LOS 38.a)
Basedonacomparisonoftheactualtrailing P/FCFE ratiocomparedtothe justifiedtrailing P/FCFE ratio (basedon Davenport's FCFE
valuation model)for 2008, Sanfordis:
overvalued because the actual P/FCFE ratio is greater than the justified P/FCFE ratio for 2008.
undervaluedbecausetheactualP/FCFE ratioislessthanthe justifiedP/FCFE ratiofor 2008. correctly valuedbecausetheactualP/FCFE ratioisequaltothe justifiedP/FCFE ratiofor
2008.
Explanation
Sanford'sactualP/FCFE ratioisthecurrent marketpriceof $15 dividedby FCFEfor 2008:
The justifiedP/FCFE ratioisthe valuederivedfrom the FCFE valuation model ($11.18)dividedby FCFEfor 2008:
Basedonthisanalysis, Sanfordisovervaluedonanabsolutebasis (NOT relativetotheindustrybenchmark)becausetheactualP/FCFE
ratiois greater thanthe justifiedP/FCFE ratio. (Study Session10, LOS 31.b)
Basedonacomparisonoftheactualtrailing P/adjustedCFO ratiocomparedtotheindustry mediantrailing P/adjustedCFO per share
ᅞ C)
Question #112 of 140
Question ID: 463329ᅞ A)
ᅞ B)
ᅚ C)
Question #113 of 140
Question ID: 463396ᅞ A)
ᅚ B)
ᅞ C)
$22.44.
Explanation
Book valueper sharefor 2008 is:
The valueofthecommonequityaccording tothesingle-stage residualincome modelis:
(Study Session12, LOS 38.f)
For purposesofthis questiononly, assume Sanford's ROEis20%, itscurrent marketpriceis $25, andthecostofequityis14%.
Sanford'simplied growth ratein residualincomeisclosestto:
5.23%.
5.11%.
5.88%.
Explanation
BVPS = 7,189 / 500 = $14.38
Theimplied growth ratecanbecalculatedas:
(Study Session12, LOS 38.g)
Whatisthe justifiedleading price-to-earnings (P/E) multipleofastockthat hasa retention ratioof 60% iftheshareholders requirea return of16% ontheir investmentandtheexpected growth rateindividendsis 6%?
6.36.
4.00.
4.24.
Explanation
Question #118 of 140
Question ID: 463322ᅞ A)
ᅚ B)
ᅞ C)
Questions #119-124 of 140
Explanation
Theaverage returnonequitynormalization methodnormalizesEPS astheaverage ROEover the most recentfullcycle multipliedby book valueper share.
AnanalystbeginsanequityanalysisofCompany A bynoting thefollowing ratiosfrom threecompaniesinthesameindustry:
EPS PE
CompanyA $1.60 10.0
CompanyB $2.10 12.5
CompanyC $5.80 13.0
Thisanalystismost likelyusing:
the method of forecasted fundamentals.
the methodofcomparables.
technicalanalysis.
Explanation
Theanalysisiscomparing ratiosofthreecompaniesinthesameindustry.The Law of OnePricestatesthatsimilar assetsshould have comparableprices.
Beachwood Builders merged with CountryPointHomeson December 31, 2003. Both companies werebuildersof mid-scaleandluxury
homesintheir respective markets. On December 31, 2013, becauseoftax considerationsandtheneedtosegmentthebusinesses between mid-scaleandluxury homes, Beachwooddecidedtospin-offCountryPoint, itsluxury homesubsidiary, toitscommon shareholders. Beachwood retained Bernheim Securitiesto valuethespin-offofCountryPointtoitsshareholders.
Thefollowing informationisavailableto Bernheim'sinvestmentbankers:
CountryPoint'sallocatedcommonequity was $55.6 millionasof December 31, 2013.
Beachwoodpaidnodividendsand hasnopreferredshareholders. CountryPoint'sfreecash flow (FCF)isexpectedto grow 7% after 2017. Thecurrent risk-free rateis 6%.The market riskpremium is11%.
Beachwood Builders had 5 millioncommonsharesasof December 31, 2013.
CountryPoint'scostofcapitalisequaltoits returnonequityatyear-end (roundedtothenearestpercentagepoint). CountryPointdidnot haveanylong-term debtallocatedfrom Beachwood.
Thefollowing datafor CountryPointisalsoavailablefor analysis
ᅞ A)
ᅞ B)
ᅚ C)
Question #140 of 140
Question ID: 463446ᅚ A)
ᅞ B)
ᅞ C)
0.109.
0.037.
0.114.
Explanation
ProfitMargin = EPS / Salesper share = 1.75 / 150 = 0.01167or 1.167%. Payout ratio = 1 − (g / ROE) = 1 − (0.04 / 0.16) = 0.75 or 75%.
P / S = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.01167 × 0.75 × 1.04] / (0.12 − 0.04) = 0.11375.
Ananalyst gatheredthefollowing datafor TRK Construction [allamountsin Swissfrancs (Sf)]:
Recentshareprice Sf22.00
Sharesoutstanding 40 million
Market valueofdebt Sf140 million
Cash and marketablesecurities Sf 55 million
Investments Sf 300 million
Netincome Sf140 million
Interestexpense Sf7 million
Depreciationandamortization Sf10 million
Taxes Sf 56 million
TheEV/EBITDA ratiofor TRK Constructionisclosestto:
3.12x.
2.52x.
3.49x.
Explanation
EBITDA = (netincome + interest + taxes + depreciation / amortization)
EV = (market valueofcommonstock + market valueofdebt-cash andinvestments)
EBITDA = 140 + 7 + 10 + 56 = Sf213 million EV = (22 × 40) + 140- 55 - 300 = Sf 665 million EV / EBITDA = 3.12
