Chapter 2
VALUATION
Behavioral Corporate Finance
by Hersh Shefrin
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuation Heuristics
 P/E heuristic


P0 = P0/E1 x E1
Target price P1 = P1/E2 x E2
 PEG Heuristic


P0 = PEG x E1 x G,
where G is 100 x growth rate
 Price-to-sales Heuristic

P0 = P0/S1 x S1, where S stands for sales
1
Behavioral Pitfalls:
Judging the Value of eBay
 On May 20, 2003 eBay’s P/E ratio was
66.2, while Wal-Mart’s P/E was 22.7.

eBay appeared to be over twice as
expensive as War-Mart.
 Analysts were expecting eBay to grow by
42.5%, while they were only expecting
Wal-Mart to grow by 14%.

eBay’s PEG was 1.56, which was actually
lower than Wal-Mart’s PEG of 1.62.
2
Behavioral Pitfalls:
Wall-Marting of the Web
 Mary Meeker, “Queen of the Internet.”
 Just as the traditional retailer Wal-Mart
came to dominate the retail sector, webbased counterparts would emerge and
dominate Internet commerce.

Mary Meeker described the phenomenon as
the “Wal-Marting of the Web.”
3
Mary Meeker’s
Target Prices for eBay
Technique
Downside
$74
$45
$97
P/E
PEG
Price-to-sales
Discounted cash flow
Average
Upside adjusted average
Upside
$111
$91
$210
Base
$84
$68
$147
$117
$104
$106
Exhibit 2.1
4
Methodology
Year
EPS at 32% growth
EPS at 38% growth
GMS/share at 38% growth
P/E
P/E
PEG
Price-to-sales
2002
$0.86
$0.86
$39.53
103
2003E
$1.14
$1.19
$54.55
63
2004E
$1.50
$1.64
$75.27
47
Price-toSales
P/E ratio PEG ratio
ratio
40
1.5
1.5
2005E
$1.98
$2.26
$103.88
33
EPS
$2.26
$1.50
$2.26
Growth
GMS
Sales per
Share
32
$103.88
Target
Target
Price
Price
Dec 2004 (Discounted)
$90
$84
$72
$68
$156
$147
Exhibit 2.2
5
Free Cash Flow
Computation
($ Thousands)
EBITDA
Taxes
Change in Working Capital
Capital Expenditures
Free Cash Flow
2000
84,072
(47,582)
49,753
(13,263)
2001
229,438
(41,091)
57,420
130,927
Target Price -- Dec 31, 2003
Present Value eBay FCFs $36,478,759
Less Debt
$79,592
Plus Cash
$2,280,857
eBay's Full Value
$38,680,023
Shares Outstanding ('000)
330,259
Discount Rate
12%
Future Growth Rate
7%
DCF Per Share Value
$117
2002
444,614
39,232
138,670
345,176
2003E
723,735
(26,792)
188,908
508,035
2004E
2005E
2006E
2007E
2008E
2009E
1,005,276 1,401,682 1,853,230 2,426,297 3,110,990 3,985,085
140,168
370,646
849,204 1,088,846 1,394,780
6,849
(58,695)
9,709
(52,096)
7,375
(53,278)
190,000
190,000
190,000
190,000
190,000
190,000
822,125 1,012,819 1,302,292 1,334,997 1,839,519 2,347,027
2010E
4,982,032
1,743,711
4,105
190,000
3,052,426
2011E on
65,321,907
Exhibit 2.3
Meeker forecasted that free cash flows in
2011 will be $3,266,096 = 1.07 x
$3,052,426.
She then applied the perpetuity formula
PV = $3,266,096 / (0.12-0.07)
= $65,321,907
6
Biases
 Discount rate, 12%, fair expected return.
 Target price of $106 implies expected
return exceeds 12%.
 PEG and P/E target prices imply returns
below 12%, even negative.
 FCF and price-to-sales target prices
imply returns above 12%.
7
Biased Free Cash Flows
($millions)
Sources of Free Cash Flow
Net Income (adjusted for cash flow from other income)
Depreciation
Interest
-Change in Net Working Capital - Change in Short-term Debt
-Investment
Free Cash Flow
Uses of Free Cash Flow
Interest
Dividends
-Change in Long-term Debt - Change in Short-term Debt
-Stock Issue - Other Financing
Free Cash Flow
eBay's Statement
of Cash Flows
Mary Meeker's
Report
206.6
86.6
2.2
-363.2
-29.8
-97.6
140.6
86.6
2.2
-41.1
-57.4
130.9
2.2
0.3
21.9
-122.0
-97.6
Differences?
 EBITDA
 working
capital
 investment
Note: Meeker uses EBITDA of $229.4 in her report, which is very close to the income statement item
"Operating Income Before Depreciation." The sum of the first three items in the column above that
displays Meeker's figures sum to $229.4. Her report provides tha aggregate figure, but not the
decomposition.
Exhibit 2.4
8
Textbook Style Valuation
Year
2002
2003E
2004E
2005E
2006E
2007E
2008E
2009E
2010E
2011E
Earnings
($millions)
$250
$345
$476
$657
$854
$1,110
$1,423
$1,823
$2,279
$2,849
Growth
Rate
38%
38%
38%
30%
30%
28%
28%
25%
25%
Present
Value ($millions)
$9,589
$10,740
$12,029
$13,472
$15,089
$16,899
$18,927
$21,199
$23,742
Exhibit 2.5
 $23,742 = E2011/r = $2,849/0.12
 Because eBay pays no dividends before 2010, the $23,742 would
be worth $21,199 at the end of 2009, $21,199= $23,742/1.12.
 Discounting back to mid-2004 would lead to a value of $11,366
(=$12,029/1.120.5) at that time.
9
Mistaking Growth for
Growth Opportunities
 Mary Meeker titled her April 2003 report
on eBay “Tales of a Growth Machine.”
 Analysts are inclined to mistake growth
in EPS for growth opportunities
Growth opportunity features ROE > r.
 From the time that eBay went public, through
June 2004, eBay's ROE < its r of 12%.

10
Intrinsic PEG?
 PEG heuristic effectively assumes P/E is
proportional to g.
 When the plowback ratio is 0, g = 0.
 When the plowback ratio is 1, g = ROE.
 Regardless of whether g is equal to 0 or equal
to the ROE, P/E is 1/r for a firm with zero
growth opportunities.
 Therefore, P/E does not vary in proportion to g.
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1/n Heuristic
 The 1/n heuristic is a rule of thumb that
assigns the same weight to each technique, as
if they are all equally valid.
 Very wide dispersion in values associated with
P/E, PEG, price-to-sales, and DCF.
 Meeker averaged the numbers, which in her
words, “combine to an average fair value of
about $106.”
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Excessive Optimism
 On April 23, 2003 The Wall Street Journal
suggested that analysts' revenue forecasts
were excessively optimistic.

The article singled out Mary Meeker and Safa
Rashtchy from U.S. Bancorp Piper Jaffray.
 On January 20, 2005 Safa Rashtchy
downgraded his recommendation on eBay
from “outperform” to “market perform,” stating
that the stock was priced for perfection.
13
Agency Conflicts
 Managers of firms prefer favorable coverage
from analysts to unfavorable coverage.
 Analysts whose firms seek to do business with
companies have an incentive to generate
favorable (optimistic) reports.
 Agency conflict might induce analysts to view
valuation heuristics as instruments to provide
numbers they want to deliver.
14