Some notes on relative valuation
Earnings for which period should we use?
Two basic types of ratios:
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Trailing ratios. Using trailing earnings (NI or EBITDA),
i.e. over the prior 12 months.
Forward ratios. Using expected earnings over the
coming 12 months
Other periods can be more reasonable (imagine
cyclical industry with a 3 years cycle – better
take average earnings over the last 3 years)
Example: why we should be careful
when using comparables
Forward P/E = P0/EPS1 = (Div1/(rE-g))/EPS1 =
Dividend Payout Rate/(rE-g),
where g – earnings growth rate
What if rE is different?
What if g is different?
What if the payout rate is different?
Note: chapters in BD: 9 and 19
Initial Public Offerings (BD, ch. 23)
Private and Public companies:



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Private (privately held) companies have fewer shareholders and
their shares are NOT traded on a stock exchange
Public (publicly held) companies have their shares traded
publicly on a stock exchange without restrictions, they have large
number of shareholders
Private companies are usually smaller (but think of IKEA, Mittal
Steel (Ispat International) until 1997)
Public companies are subject to much stricter rules and
regulations (e.g. disclosure, financial reporting)
IPO is the first sale of stock by a company to the public.
UPDATE: in 2006 US$227 billion raised in 1559 new deals
2005 global IPO activity by countries
(note: activity is assigned to the domicile of the listing company)
Source: Ernst&Young/Thomson Financial
UPDATE: China and Russia in 2006! (see next slide)
Largest IPOs in 2005
In 2006 we had:
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China's ICBC: $22 billion (Hong Kong exchange)
Bank of China Ltd: $11 billion (Hong Kong exchange)
Rosneft: $10.4 billion (London exchange)
Russia’s IPOs
1996-2003: only 6 deals
2004: US$600 million, 7 deals
2005: US$4 billion, 8 deals
2006: US$20 billion, 20 deals
Largest IPOs:

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Rosneft, 2006, US$10.4 billion (LSE and Russia)
AFK Sistema, 2005, US$1.5 billion (LSE)
Comstar-UTS, 2006, US$1 billion (LSE)
Severstal, 2006, US$1 billion (LSE)
Novatek, 2005, US$1 billion (LSE)
Reasons for Going Public
New Finance


Direct. Funds raised at IPO
Indirect. Helps to raise funds in the future
Due to reduction in leverage. But why not private
placement? 
Increase in liquidity of stock.

Liquidity is valuable per se, but in addition it helps to
raise funds in the future (more precise information about
a firm’s value helps to attract finance)
Increased competition among suppliers of finance
(i.e. lower cost of capital)
Reasons for Going Public (cont-d)
Liquidity and possibility for diversification
Cashing in (Владимир Лисин?)
Issuing new stock for future M&A transactions (liquid
shares are valued more, easier to get an estimate for a
firm’s value)
Greater dispersion of ownership mitigates the problem of
excessive monitoring of managers by shareholders
Enhanced company image and publicity

Visibility of the company and its products
Motivating management and employees

E.g. through conditioning compensation on the stock price
(stock-based compensation)
Exploiting mispricing

Timing issues to take advantage of swings in investor sentiment
Costs of Going Public
Direct costs (underwriting, auditing and legal fees, effort)
Cost of information disclosure (отчетность,
вознаграждение директоров, структура бизнеса,
планы)
Underpricing
Cost of constraining business decisions (asking approval
by the board, shareholder meeting)
Tax implications

Greater transparency of accounts may lead to more taxes paid
Danger of loss of control (through hostile takeover)
Fiduciary duty (to shareholders) risk
Underpricing at IPO
Widely documented phenomenon: offering price
is typically lower than the market price of the
shares right after the IPO
Ritter and Welch (2002), US data (but the same
is true for other countries too):
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In the sample of 6,249 IPOs from 1980 to 2001 the
average first-day return is 18.8 percent.
About 70 percent of the IPOs end the first day of
trading at a closing price greater than the offer price
and about 16 percent have a first-day return of zero.
First day IPO returns
Some Theories of Underpricing
Theories based on asymmetric information

Issuer is better informed than investors – signaling by
underpricing as a response to the lemons problem
Good firms separate themselves from bad ones by offering
underpriced stock

Winner’s Curse (Berk-DeMarzo, p. 767):
if the deal is overpriced you get your full order and bear the
losses in full
if the deal is underpriced you are rationed – have to share
the benefits of underpricing with other investors
Some Theories of Underpricing
(cont-d)
Some other theories:


Avoiding legal liabilities (more relevant for the US).
Drops in prices may trigger lawsuits. So it’s better to
have a lower price from the start.
Achieving greater liquidity through greater ownership
dispersion
NOTE: in the long run IPOs are shown to
underperform the market
Mergers & Acquisitions (BD ch. 28)
Ten Largest Merger Transactions, 1995-2005
World M&A market in 2006: about US$3.8
trillion
Russia’s M&A market in 2006: roughly
US$50 billion
Growing both in the world and in Russia
In Russia: share of cross boarder
transactions is increasing (e.g.
Vimpelcom-Turkcel, Evraz-Oregon Steel,
RusAl+ SUAL+Glencore, Lukoil-Nelson
Resources)
Merger waves. Percentage of Public Companies
Taken Over Each Quarter, 1926–2005
Reasons for a merger
Synergies

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Operational synergies
Economies of scale and scope (e.g. reduction of
marketing costs or expenses on distribution)
Increase in market power
Vertical integration (e.g. control over suppliers)
Diversification (benefit those who cannot
diversify themselves, reduces bankruptcy risk)
Efficiency gains due to the change in
management
Empire building (is not efficiency-driven)
Who gains from a merger?
Friendly and hostile takeovers
Friendly: the target’s board supports the
merger and recommends the shareholders
to sell their shares (then the shareholders
vote)
Hostile: the board opposes the takeover
and does not recommend the
shareholders to sell at the price offered by
the raider. It also uses all kinds of
protective measures (takeover defenses).