Valuation Methods

Methods of Corporate
Valuation
Asset-Based

Methods
Using Comparables
Free Cash Flow Methods
Option-Based Valuation

Asset-Based Methods
Balance

sheet approach:

Cash and working capital (book value close to its

realizable value)
Property, Equipment, and Land (appraisal value)
Intangibles.

Book

value of equity vs market value of

equity

Relative Valuation
What

is relative valuation?
What is the logic underlying relative
valuation?
Using comparables

What is relative valuation?

Relative

to revenues or cash flows

Relative to Earnings
Relative to the Book Value of Equity

Relative to Revenue
Price/Sales (PS)
Value/Sales (VS)
Usually used in valuing retailing firms

Relative to Earnings
Price/Earnings

Ratio (PE)
Trailing Price/Earnings Ratio (trailing PE)

A trailing PE is a price-earnings ratio based on the

most recent 12 months' results. U.S. companies report
quarterly, so a trailing PE is computed based on the
most recent four quarters.

Forward

Price/Earnings Ratio (forward PE)

Also called estimated PE. Forward PE divides a stock's

current price by its estimated future earnings per share.
Forward PE is often used to compare a company's
current earnings to its estimated future earnings.

Relative to the Book Value of

Equity
Price/Book

Value (PBV)
Market to book Value (MB)

Advantages to using multiples

in valuation analysis
Require

fewer explicit assumptions than

DCF
Easy to compute and dont require
forecasting
Commonly quoted and used by
management and press

Disadvantages to using
multiples in valuation analysis
Require

more implicit assumptions than

DCF
Logic behind valuation analysis is often
misunderstood
Identification of comparable firms is
subjective

What is logic underlying

relative valuation? P/E ratio
Think

about a basic DCF model (Gordons

Growth Model)
DPS1
Value of Equity P0
re g n

Divide

both sides by earnings per share

P0
DPS1 1

PE
EPS0 EPS 0 re g n
P0
1
(Payout Ratio) 1+g n
PE
EPS0
re g n

Comparing two PE ratios

across firms assumes
Identical

payout ratio
Identical cost or equity
Identical expected stable-growth rate

What is logic underlying relative

valuation? Price to book value
DPS1
Value of Equity P0
re g n
Divide

both sides by book value of equity

P0
DPS1 1

PBV
BV0
BV0 re g n
P0
EPS1 DPS1 1

PBV
BV0
BV0 EPS1 re g n

P0
1
ROE0 (Payout Ratio) 1+g n
PBV
BV0
re g n

Comparing two PE ratios

across firms assumes
Identical

payout ratio
Identical cost or equity
Identical expected stable-growth rate
Identical ROE

What is logic underlying relative

valuation? Price to sales
DPS1
Value of Equity P0
re g n
Divide

both sides by sales

P0
DPS1
1

PS
Sales0 Sales0 re g n
P0
EPS1 DPS1 1

PS
Sales0 Sales0 EPS1 re g n
P0
1
Gross Profit Margin 0 (Payout Ratio) 1+g n
PS
Sales0
re g n

Comparing two PE ratios

across firms assumes
Identical

payout ratio
Identical cost or equity
Identical expected stable-growth rate
Identical Gross profit margin

Using comparables
Construct

the multiple for the set of comparable

firms
Average the multiple across the set of
comparable firms
Compare individual firm to this average
Differences may be attributed to differences in
underlying logic of multiple
Differences may be attributed to inefficient
markets (price)

Remember to control for

differences between firms
Growth
Payout
Risk
ROE
Profit

Margin

Ways to control for differences between firms

Sample firms and sort according to attributes (Growth,

Payout, Risk, ROE, Profit)

Modify the multiples to make them more comparable

Requires a large number of potential comparables

Compare your firm to subset of comparables with similar
attributes
Divide the PE ratio by the expected growth rate in EPS (PEG
Ratio)
Divide PBV ratio by the ROE (Value Ratio)
This assumes firms are comparable on all other attributes

Run regression of multiples on attributes

PE 0 1 growth 2 payout 3risk

Use coefficient values from regression and attributes for the firm
to predict the correct multiple for the firm.

Regression-based multiple
analysis

Damodaran ran regressions on 2,475 firms using data from

1998

PE=291.27*Growth+37.74*Payout+21.62*Beta
PBV=3.99*Payout-0.79*Beta+60.65*growth+31.56*ROE
PS=11.56*Growth+1.41*Payout-1.42*Beta+11.93*Margin

Free cash flow method

Free

cash flows to equity

Free cash flows to firm

Basic case
Firms with insufficient valuation data
Acquisition valuation

Option base valuation

Real

option approach in valuing firm