KN

Lecture 23: Stocks (Pt. 5)

Valuation Based on Comparable Firms

  • Method of Comparables:
    • Estimates a firm's value based on other similar firms or investments expected to generate identical future cash flows.
    • Based on the Valuation Principle: Identical cash flows should equate to the same price.
    • Market value of existing firms can guide the valuation of new firms, adjusted for differences using valuation multiples.

Valuation Multiples

  • Definition: Ratio of a firm's value to a measure of its scale or cash flow.
  • Common Types:
    • Price-Earnings ratio (P/E)
    • Enterprise Value Multiples
    • Other common multiples:
    • Multiples of sales
    • Price-to-book value
    • Industry-specific ratios

Price-Earnings (P/E) Ratio

  • Most widely used valuation multiple.
  • Calculated as:
    P/E = \frac{\text{Share Price}}{\text{Earnings per Share}}
  • Computed using:
    • Trailing Earnings: Earnings over the last 12 months.
    • Forward Earnings: Anticipated earnings for the next 12 months.
  • Different forms:
    • Trailing P/E
    • Forward P/E (preferred for future projection).

Related Valuation Techniques

  • P/E ratio relation to other valuation techniques:
    • Example: In constant dividend growth, the formula connects P/E with dividend payouts.
    • \frac{D1}{E1} = \frac{P}{E} = \frac{D_1}{E} \cdot \frac{1}{r-g} where
    • $D_1$: Expected dividends,
    • $E_1$: Earnings,
    • $r$: required return,
    • $g$: growth rate.

Enterprise Value Multiples

  • Concept: Extend valuation by incorporating debt impact.
  • Utilize earnings measures like EBIT, EBITDA, or free cash flow.
  • Commonly use EV/EBITDA multiples due to fluctuating capital expenditures.
  • Constant free cash flow growth equation using EV/EBITDA:
    V = \frac{FCF}{wacc - g}
    where wacc = weighted average cost of capital.

Practical Valuation Example

  • Westcoast Port, Inc.:
    • Given financials: EBITDA=$50M, Cash=$20M, Debt=$100M, Shares=10M.
    • Industry EV/EBITDA ratio = 8.5.
    • Estimate Enterprise Value:
    • \text{EV} = EBITDA \times ext{EV/EBITDA} = 50M \times 8.5 = 425M .
    • Equity Value:
    • \text{Equity Value} = EV - Debt + Cash = 425M - 100M + 20M = 345M .
    • Stock Price:
    • \text{Stock Price} = \frac{Equity Value}{Shares Outstanding} = \frac{345M}{10M} = 34.50.

Limitations of Multiples

  • Differential Firms:
    • Unique factors cause variations in multiples:
    • Growth rate differences.
    • Risk and cost of capital dissimilarities.
    • Accounting practices variations.
  • Market Behavior: Does not reflect whether the entire industry is overvalued; reliance on historical comparisons.

Discounted Cash Flow Comparison

  • Unlike multiples, DCF methods incorporate detailed factors affecting firms such as:
    • Management quality.
    • Production efficiency.
    • Intellectual property.
  • DCF potentially provides a more accurate valuation by factoring in specifics about cost of capital and growth.

Stock Valuation Techniques Summary

  • No singular method guarantees an accurate valuation; a mix of techniques is preferred for reliability.
  • Consistent validation across multiple methods enhances confidence in valuations.

Information, Competition, and Stock Prices

  • Market price often reflects accurate assessments of a publicly traded firm’s intrinsic value.
  • Efficient Markets Hypothesis: Implies securities are valued based on all available information.
  • Information types:
    • Public data: news, financial statements, announcements.
    • Private information can create investor speculation and impact stock price differently.
  • Example of market reaction to marked announcements, such as drug approvals or declines in expected cash flows, can highlight significant stock price shifts.

Behavioral Aspects of Trading

  • Overconfidence Effect: Investors may trade excessively, stemming from overestimating their stock-picking capabilities, leading to losses after accounting for trading costs.
  • Disposition Effect: Investors often retain losing shares and sell winners, driven by a reluctance to accept losses despite these stocks historically underperforming.

Investor Psychology

  • Various factors affect investor behavior:
    • Media exposure and news influence trader actions.
    • Emotional states can skew investment decisions, e.g., trading on sunny vs. cloudy days.
  • Investors’ past experiences significantly shape current behaviors and market participation.

Key Questions to Consider

  • Distinguish between preferred and common stock characteristics.
  • Understand discount rates used in stock cash flow assessments.
  • Explore strategies for enhancing future dividends.
  • Analyze limitations within different valuation models, such as dividend-discount and total payout models.