Relative valuation and Technical Analysis

Relative valuation and

Technical Analysis

Relative vs. fundamental

valuation

• The DCF model is a method of

fundamental valuation.

– Value of equity is the present value of future cash flows.

– Ignores the current level of the stock market. – Appropriate for comparing investments across

different asset classes

– In the long run, fundamental valuation is the

Relative vs. fundamental

valuation

• Relative valuation is based on P/E ratios

and a host of other “multiples”

– Popular with the press, stock brokers,

– Used to value one stock against another.

– Cannot compare values across different asset classes

Prices can be standardized using a common

variable such as earnings, cashflows,

Multiples

• Relative valuation relies on the use of

multiples and a little algebra.

• For example: house prices..

House Price Sq ft. Price /sq ft

A $ 629,500 4,032 $ 156.13 B $ 595,000 3,621 $ 164.32 C $ 545,000 3,400 $ 160.29 D $ 499,000 3,400 $ 146.76 E $ 439,000 3,000 $ 146.33 Average $ 154.77

What is the price of a 4,000 sq ft house? Answer: 154.77*4,000 = $619,080

Multiples can be misleading

• To use a multiple intelligently you must:

• Know what the fundamentals are that determine the multiple. • Know how changes in these fundamentals change the

multiple.

• Know what the distribution of the multiple looks like.

• Ensure that both the denominator and numerator represents claims to the same group

– OK: P/E Price => Equityholders, EPS => Equityholders – Not OK: P/EBIT Price =>Equity, EBIT => all

claimholders

Price Earnings Ratios

PE = Market Price per Share / Earnings per Share

• There are a number of variants on the basic PE ratio in use. They are based upon how the price and the

earnings are defined. • Price:

– current price

– or average price for the year • EPS:

– most recent financial year

– trailing 12 months (Trailing PE) – forecasted eps (Forward PE)

PE Ratio: Understanding the

Fundamentals

• To understand the fundamentals, start with a basic equity discounted cash flow model.

• With the constant growth dividend discount model,

• Dividing both sides by the (forecasted) earnings per share,

g k

D V₀ 1

− = ROE(g) -k b -1 = PE E V 1 0 =

PE Ratio: Understanding the

Fundamentals

• Holding all else equal:

– higher growth firms – higher risk firms

– firms with lower reinvestment needs

• Of course, other things are difficult to hold

equal since high growth firms, tend to

Example: Valuing a firm using

P/E ratios

• In an industry we identify 4 stocks that are similar to the stock we wish to value.

• The average P/E =

• Our firm has EPS of $2.10

PE=21 Stock D

PE=24 Stock C

PE=18 Stock B

PE=14 Stock A

Value/??

• Variants:

– Free cash flow to the firm or FCFF

– after-tax operating income or EBIT(1-t) – pre-tax operating income or EBIT

– EBITDA, which is earnings before interest, taxes, depreciation and amortization.

EBITDA

Debt

MV

Equity

MV

EBITDA

Value

+

Value/EBITDA Multiple

• The No-Cash Version

• When cash and marketable securities are netted out of value, none of the income from the cash and securities should be reflected in the

denominator.

• The no-cash version is also called “Enterprise

Value” on Depreciati and Taxes Interest, before Earnings Cash Debt of Value Market + Equity of Value Market EBITDA EV ₌

Enterprise value

•

EV =Market value of equity+debt-cash

Reasons for Increased Use of

Value/EBITDA

1.

The multiple can be computed even for

firms that are reporting net losses, since

EBITDA is usually positive.

2. More appropriate than the price/earnings

ratio for high growth firms.

3 Allows for comparisons across firms with

different financial leverage.

Price (market) to Book Value

Ratio

• Ratio of the market value of equity to the

book value of equity, i.e., the measure of

shareholders’ equity in the balance sheet.

In 2004 the average Price/book for US

firms was a little less than 4.

Equity of

Value Book

Equity of

Value Market

B P ₌

Market to Book Ratio: Stable

Growth Firm

• If the return on equity is based upon expected earnings in the next time period, this can be simplified to, g -k g) (1 * Ratio Payout * ROE = PBV BV P 0

0 = +

g -k Ratio Payout * ROE = PBV BV P 0 0 =

Market to Book Ratio: Stable Growth

Firm

•

by relating growth to the return on equity:

g = (1 Payout ratio) * ROE=> payout ratio = 1 -g/ROE

• Substituting back into the P/BV equation,

g -k g -ROE g -k ROE g ROE PBV BV P 0

0 ⎥⎦ =

⎤ ⎢⎣ ⎡ − = = 1

Price to Sales Ratio

• The price/sales ratio is the ratio of the market value of equity to the sales.

Revenues

Total

Equity

MV

S

P

=

Price Sales Ratios and Profit

Margins

• A key determinant of price-sales ratios is the profit margin.

Choosing Between the Multiples

• There are dozens of multiples.

• The multiple that is used can be chosen in

one of two ways:

– Use the multiple that best fits your objective. Thus, if you want the company to be

undervalued, you pick the multiple that yields the highest value.

– Use the multiple that seems to make the most sense for that sector, given how value is

Daily fluctuations

are

essentially noise and

are of no real importance.

Dow Theory

The primary direction is either bullish or bearish, and reflects the long-run direction of the market.

Secondary trends are temporary departures from

the primary direction.

Corrections are reversions back

to the primary direction. Time Prices

DJIA

DJTA

If a departure in one is

followed by a departure in the other, then this is viewed as a confirmation

Support and Resistance Levels

•

Support level

•

Resistance level

• Resistance and support areas are usually

viewed as psychological barriers - bargain

hunters help “support” the lower level,

Technical Indicators—Sentiment

• trin

• Odd-lot trading • Confidence index • Put/call ratio

Technical Indicators

• Flow of Funds

– Short interest

– Credit balances in brokerage accounts

• Market Structure

– Moving averages – Breadth