IV. Shareholder Value Analysis - Preliminaries
A. Definition of Shareholder Value Analysis (SVA)
B. Definitions of Equity Value Not Used in SVA
1. Intrinsic Value
2. Market Value
C. Definitions of Equity Value Used in SVA
1. Book Value
2. Liquidation Value
3. Value Based on Multiples
4. Value Based on Discounted Cash Flows
D. How financial leverage affects discount rates and valuation
1. Business risk and Financial risk
2. Unlevering and Relevering a Firm’s Stock Beta
3. Assumptions in Unlevering/relevering Stock Beta
4. Adjusted Present Value (APV) Approach to Valuation
A. Definition of Shareholder Value Analysis
Shareholder Value Analysis (SVA) uses the expected effect on shareholders’ value (equity value or stock price per share) as the performance measure when making strategic decisions.
According to this analysis, if the strategic decision will lead to an increase in stock price then it is a good strategy and if not then it is not a good strategy.
Note that this analysis is perfectly consistent with the corporate objective of maximizing shareholder value.
Problems or Weakness: The difficulty in estimating the value of equity or the expected change in the value of equity due to a strategic decision.
B. Definitions of Equity Value Not Used in SVA
1. Intrinsic or "True" Value
The intrinsic value is often described as the “true” value of equity. However, there is no way of knowing what the intrinsic or "true" value of a share of stock is.
2. Market Value
The market value is the value one would receive if a share of stock is sold in the market place. It is usually estimated by the price of the last shares of stock traded.
If you believe the market is "efficient" then the market price is a good estimate of the intrinsic value.
Why are Market Values not useful in evaluating different strategic alternatives?
C. Definitions of Equity Value That Can be Used in SVA
1. Book Value
Book Value represents the value of the stock when it was issued
plus the additional capital that has been reinvested in the firm
(retained earnings).
For Weyerhaeuser at the end of 2006 ($ millions):
Number of Shares 219.2 mill
Treasury Shares 16.2 mill
Common Stock 6,832
Preferred Stock 0
TOTAL EQUITY 6,832
Book Value per Share = T. Equity/NSO = ______/______=
$______/share
2. Liquidation Value or Break-up Value:
Liquidation value of the firm's equity is estimated by the marketvalue of all the individual assets (or business units) minus themarket value of the firm's liabilities.
Liquidation Value/share = MV(assets) - MV(liabilities)
# of shares outstanding
If liquidation value > market value, what should occur?
Why does this not usually happen?
3. Multiples Based Valuation:
General Method:
Multiple of Comparable / Industry / Sector / Market firms x firm-specific variable
e.g.
PE of comparables x EPS of firm to be valued
Is multiple based valuation relative or absolute valuation?
What method would give you absolute valuation?
e.g. when all internet stocks are bid up, relative valuation is higher but absolute valuation (DCF) may not yield higher value. Multiples capture the current mood of the market
Pitfalls of multiples based valuation:
· Risk, growth, cash flows are ignored
· Over/undervaluation occurs if market/comparables is temporarily inflated/deflated
· Scope of bias in choosing comparables so that any valuation can be justified without explicitly accounting for the underlying assumptions about CF, risk, growth – lack of transparency
Types of multiples used:
· Earnings: EPS, EBITDA
· Book value or replacement value multiples: Price-to-Book, Tobin’s Q
· Revenue multiples: Price-Sales, Value-Sales
· Sector-specific: Value / # of web hits; Value / # of e-customers; very dangerous, and difficult to come up with industry/market benchmarks
Four Steps for multiples valuation
· Make sure multiple is defined consistently: numerator/denominator consistency as well as consistency across firms
· Be aware of the cross sectional distribution of the multiple across sector and market
· Analyze the fundamentals affecting the multiple
· Find the right set of comparables
Consistency check:
Consistent:
· Price-to-Earnings – both numerator and denominator are equity based
· Firm Value-to-EBITDA – both on firm level basis
Inconsistent:
· Price- to-EBITDA: price is equity-based, EBITDA is firm based
· Implication: Different capital structures can cause substantial difference:
Q: Is firm with higher debt under or over valued using Price-to-EBITDA?
3. Value Based on Multiples:
The most common multiple used to value stock is the P/E multiple. The estimate of the intrinsic value of stock using P/E multiple model equals the forecasted EPS next period times the firm's intrinsic P/E multiple:
Intrinsic value/share0 = EPS1 * P/E ratio
Example:
If Ford's earnings per share at the end of 2007 is expected to equal
$2.50/share and the typical P/E ratio in the automobile industry is
20 to 1, then an estimate of the intrinsic value of Ford's stock is
$2.50 x 20 = $50/share.
Historically your firm trades at a P/E ratio of 15 to 1 and you
expect earnings per share to equal $4.40/share this year, therefore
if your stock is trading below $66/share you would conclude that the
stock is undervalued.
Weyerhaeuser's Annual Ave. P/E Ratios:
Weyerhaeuser Co.:
Price/Earnings – Current 14.446
Dec96 / 17.708Dec97 / 11.698
Dec98 / NM
Dec99 / 20.150
Dec00 / 17.297
Dec01 / 13.112
Dec02 / 11.005
Dec03 / 20.246
Dec04 / 28.524
Dec05 / 34.333
Dec06 / 24.018
Historic Ave. 19.81
Peer Group Comparison P/E Ratio at the end of 2006
P/E ratio = Price (12/31/2006) / Forecast(EPS in 2007):
ABITIBI CONSOLIDATED INC / 12.70KIMBERLY-CLARK CORP / 29.70
LOUISIANA-PACIFIC CORP / 12.70
MEAD CORP / 15.10
UNIVERSAL FOREST PRODS INC / 10.70
WESTVACO CORP / 12.70
WILLAMETTE INDUSTRIES / 14.80
Peer Group Average 15.48
Estimating the Value of Weyerhaeuser’s Stock (Assume Valuation Date: December, 2006)
Price/share (12/31/06) = P/E ratio x EPS2007
Price/share (6/30/07) = (P/E ratio x EPS2007 ) x (1+ke).5
Or
Price/share (6/30/06) = (P/E ratio x EPS2007 ) / (1+ke).5
1. Using Historical Average P/E Ratio:
Assume ke = .1220
Price/share (6/30/07) = 19.81 x ($840/219.2) x (1+.1220).5
Price/share (6/30/07) = 19.81 x ($3.83) x (1+.1220).5 = $______/share
2. Using Industry Average P/E Ratio:
Price/share = 14.5 x ($3.83) x (1+.1220).5 = $______/share
Q: Which PE ratio is ‘better’?
What do P/E ratios measure?
We can understand the factors underlying a P/E ratio by exploring its link with constant growth dividend discount model:
Therefore,
Where b = a firm’s retention ratio
and hence
(1-b) = payout ratio = dividends per share / earnings per share
From above, we can see that a firm’s P/E ratio is higher if:
And therefore, P/E ratios fundamentally reflect a firm’s:
Another Example: Alpha and Gamma Cos. Stock both have required returns of 9%, Alpha has investment opportunities which earn a 12% return and Gamma has investment opportunities which earn a 7% return. Both firms expect earnings to be $2 per share for the coming year and both expect to retain no earnings.
If both firms retains no earnings
ð Dividend = Earnings = $2
ð
check:
If firms retain 70% of earnings:
Check:
Check:
Note: in this case, differences in P/E due only to differences in investment opportunities
Cautions about P/E multiple valuation:
1. Valuation requires ‘forward-looking’ P/E ratio,
Forward looking P/E ratios are based on future expected EPS, i.e., , and not , based on actual realized EPS. Most reported P/E ratios are backward looking P/E ratios.
2. “Chicken and Egg” Problem:
Fundamentally, a stock’s value is the present value of all future expected dividends. Without understanding a firm’s growth and risk characteristics, it is difficult to choose an appropriate P/E multiple.
Any multiple based valuation hides detail about a firm’s characteristics.
3. Unsustainable future expected earnings:
Expected earnings (EPS1) which are too low or too high, and which in the long run are unsustainable, give misleading valuation.
4. P/E ratios usually calculated with accounting earnings rather than “economic” earnings
ð Sensitive to accounting rules
5. P/E ratios affected by temporary swings in earnings
ð Temporary downturn in earnings will decrease price some, but not by as much as earnings have declined
ð P/E will actually rise if earnings decline seen as temporary
Alternative multiples used:
Price-to-book (of equity):
Price per share / Book Value of Equity per share
Or
Total Market Value of Equity/ Total Book Value of Equity
Intrinsic value/share = BV equity/share * P/B ratio
Which fundamentals affect Price-to-Book ratio?
Sales Multiple
Intrinsic value/share = sales/share * P/sales ratio
Which fundamentals affect Price-to-Sales ratio?