Mentorship Session III
Will Showers – Director of Mentorship
Welcome Back
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What we covered last time
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Modern Portfolio Theory
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Diversification
Risk aversion
Systematic vs company-specific risk
Capital Asset Pricing Model
Market Beta
Accounting Fundamentals
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The three Financial Statements
Major line-items
How the three statements work together
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Today’s Topics
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Efficient Market Hypothesis
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Is the listed price of a security its “true” price?
How does public information become factored into asset
prices?
Arbitrage
Valuation
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Multiples
Relative Valuation
Intrinsic Valuation
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Efficient Market Hypothesis
True prices, mispricing, and public vs private information
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Efficient Market Hypothesis
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Investment theory that states that all existing asset
prices reflect all relevant information
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Do we believe this though?
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This implies that investors cannot “beat” the market
If EMH holds, risk is the only factors driving the
magnitude of returns
Institutional investors don’t
If Beta was the only determinant of expected returns
(think CAPM), then investment research and due
diligence would be pointless
“Since markets are efficient, attempts to outperform
the market are essentially a game of chance
(speculation) rather than one of skill”
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Efficient Market Hypothesis
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Three different levels of “efficiency” exist in
academia
Weak Form
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Semi-strong Form
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Prices only reflect past publically available information
Prices reflect past publically available information and
prices instantly change to reflect new public information
Strong Form
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Prices instantly reflect both public and private
information
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Think insider trading
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Efficient Market Hypothesis
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Popular view among institutional investors:
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Market efficiency lies somewhere between weak form
and semi-strong form
This means that it is possible to beat the market
Body of evidence to support this:
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Small firm effect (Fama-French Model)
Value effect (Fama-French, Ben Graham, Warren Buffet)
Mean reversion
Overreaction / Underreaction
The Human Element
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Beating the Market
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Beating the market doesn’t just mean having higher
returns than the average market return
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We must adjust for risk
Example:
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The S&P 500 (proxy for market average) has a beta of 1.0,
and Ralph Lauren has a beta of 1.3. You decide to invest
in Ralph Lauren for one year. If the S&P 500 had an
annual return of 10% and your investment in Ralph
Lauren had a return of 12%, did you beat the market?
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No! With a Beta of 1.3, Ralph Lauren is bearing more
systematic risk than the average company. As such, it should
have higher returns than the S&P 500 by a factor of 1.3! If not,
you have underperformed because you received less
compensation for your level of risk than you expected.
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Alpha
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Alpha is a measurement of performance on a riskadjusted basis
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The realized returns in excess of the expected return of an
investment
a = Returns Realized – E(Returns)
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Example:
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You hold 1 share of Amazon Inc’s stock which has a Beta
of 1.5. After one year, that share increased in value by
25%. The S&P 500 increased in value by 10%. How much
Alpha did you generate with your investment?
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Sharpe Ratio
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Sharpe Ratio is another way to compare risk adjusted
returns
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Measures returns for each additional unit of risk
The higher it is, the less risk you assume for a given level
of returns
Commonly used to compare funds
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Valuation
Relative and intrinsic valuation, and using multiples
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Valuation
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Despite which investment philosophy you are using,
valuation is crucial
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Growth
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Momentum
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How much growth has already been factored into an asset’s
price?
If this stock is “hot”, how far above its true value will it go before
investors sell off?
Value
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Is the market wrong in pricing certain assets? The only way to
know is to conduct valuation
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Valuation
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Two main types of valuation
Relative Valuation
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A model in which a company’s value is determined by
comparing it to a group of similar companies
It is highly unlikely that the market will misprice (at least
consistently) an entire sub-industry in the market
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Example: If Exxon is mispriced significantly, it’s unlikely that
ConocoPhillips, BP, Chevron, and Total are mispriced as well
Intrinsic Valuation
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Determining the actual value of an asset based on its
fundamentals and without any reference to its market
value
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Valuation
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Trading at a discount
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Trading at a premium
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When an asset is being bought and sold for a price lower
than what similar assets are being traded for
When an asset is being bought and sold for a price
higher than what similar assets are being traded for
Valuation will give you the following:
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It will tell you if a company is trading at a discount or
premium
It will tell you why the company may be trading at a
discount or premium
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If it doesn’t, it is likely that you are dealing with a mispriced
asset
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Relative Valuation
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Use market prices of comparable transactions to
impute the value of your firm
Relative valuation is commonly used in real estate
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A good estimate of your home’s value on a price/sq-foot
basis is in the last sale on your street
The same logic can be applied to value a firm,
replacing price/sq-foot with the appropriate value
drivers
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Relative Valuation
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Step 1 – Find comparable companies
Step 2 – Using comps, calculate a valuation metric which
is a ratio of value to some attribute
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Step 3 – Calculate the initial value estimate using this
average ratio
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Price to Earnings
Enterprise Value to EBITDA
Multiply the Price to Earnings ratio you selected by the
Earnings of your stock’s price
Multiply the EBITDA multiple you selected by your firm’s
EBITDA to obtain an estimate of value
Step 4 – Refine the initial value estimate
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A comp’s EBITDA in one particular year could be higher or
lower than its usual EBITDA for a number of reasons (e.g.
billion dollar lawsuit)
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Relative Valuation Real Estate Example
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These are two deals that have recently been done in a
neighborhood
Sale price
$330,000 $323,000
Average
Square-footage
3,556
4,143
3849
Price/sq-ft
$92.80
$77.96
$85.38
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Let’s say your house is 3750 square feet
Value
Comp #1
Comp #2
Average
Comparable price/sq-ft
$92.80
$77.96
$85.38
Sq-ft of your house
3,556
4,143
3750
Estimated value
$330,000
$323,000
$320,175
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Relative Valuation Example
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However, your house has a better lot and also has a
swimming pool, while the other houses don’t
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We must adjust for these premiums
Let’s say the lot premium is $10,000
And the pool premium is $20,000
Then, the value is ~$350k, and has increased ~10%
for two items
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Relative Valuation Example
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These types of differences are even more stark when
comparing entire companies
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E.g., the management makes a huge difference in the value of a
company, and that isn’t fully reflected in the comps’ EBITDAratios
Or, the company may have growth opportunities that are
incomparable
These things might be somewhat reflected but not fully
The point is – you can see how quickly this gets complicated!
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Relative Valuation Example
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This simple example teaches us the following:
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Finding good “comps” is crucial
The initial estimate isn’t perfect but can be refined to
some extent as per the unique attributes of your firm
Depending on the firm/project, you can use different
valuation ratios
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Step 1 - Comp Selection
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“Garbage in, garbage out”
Looking for companies with similar fundamentals
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Industry, Geography, Market Cap, etc.
On Bloomberg, preset comps are a good place to start
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Read business descriptions of automatic comps to make
sure they match your business
Take a look at market cap and geography to make sure
they are truly comparable
Look through the automatic comps of your first set of
automatic comps to cast a wider net
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This method often gives you enough companies to work with
and can take as little as 5 minutes
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Step 2 - Valuation Multiples
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We cannot simply compare line items across
different companies
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How would we account for size?
What about conglomerates who operate in multiple
spaces in the market?
To overcome this, we “normalize” the information
available to us through multiples
Examples:
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Price / Earnings per share
Price / Revenue
Enterprise Value / EBITDA
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Valuation Multiples – P/E
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Price / Earnings, “P/E”
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Market Capitalization / Net Income OR Share Price / EPS
Essentially demonstrates how much you are paying per dollar
of earnings as a potential investor
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P/E ratios tend to indicate growth expectations of a company
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A higher P/E means investors expect earnings to increase quickly
relative to other companies
Trailing P/E
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E.g. A P/E of 12.0 means you are paying $12 for every $1 of
earnings
Uses current share price divided by earnings per share from the
most recent four historical fiscal quarters (year)
Forward P/E
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Uses current share price divided by the expected earnings per
share from the next four fiscal quarters (year)
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Valuation Multiples – PEG
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Price / Earnings / Growth
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Essentially a P/E ratio divided by the company’s earnings
growth rate
A measure of whether a company’s P/E ratio is “justified”
The growth component is usually a 5-year CAGR
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Either historical, projected, or a hybrid (3 historical years, 2
projected years)
PEG ratios tend to be close to 1.00
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Valuation Multiples – EV/EBITDA
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Enterprise Value
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EV = Market Capitalization + Debt – Cash
The amount that you would be required to buy the entire
company
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EV/EBITDA
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Pay for the shares, pay off the debt, and pocket the cash
In theory, it is also the present value of all future free cash
flows the company will receive
One of the most popular valuation multiples and is used in
many other valuation applications
Great comparative metric
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Does not take into account differences in tax rates, capital
structure (interest), or non cash expenses
(Depreciation/Amortization)
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Other Valuation Multiples
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EV/Revenue
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Price/Sales
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Not extremely popular, but remember that “Cash is King”
EV/EBITDAR
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Used for companies with negative earnings
Price/Free Cash Flow
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Measurement of top-line performance
The R stands for “rent”
Used for firms that either pay or receive a significant
amount of rent (e.g. real estate firms, airlines, etc.)
EV/Page Views
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Used for software companies
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Levered vs Unlevered Multiples
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Whether a multiple is levered or not is a very
important distinction
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Levered means that it takes into account the company’s
capital structure (remember, leverage = debt)
Sometimes we want to consider these differences as
capital structure can imply additional risk
But capital structure does not necessarily influence
operating performance or future growth
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This is why you should always look at both levered and
unlevered multiples to see the whole picture
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Levered vs Unlevered Multiples
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So how do we know which multiples are levered?
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Check the income statement!
Revenues
(Cost of Goods Sold)
= Gross Profit
(Operating Expenses)
= Operating Income (EBIT)
*(Interest Expense)*
= Pre-tax Income
(Income Taxes)
= Net Income
Remember that leverage is related to debt and is accounted for on
the income statement as interest expense
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As such, anything EBIT and above is considered unlevered
Anything below EBIT is considered levered as interest expenses are
accounted for in the multiple
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Levered vs Unlevered Multiples
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There is one other important distinction
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Market prices (market capitalization & price per share)
are levered as the market will always account for capital
structure when pricing assets
Enterprise Value
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EV = Market Capitalization + Debt – Cash
More importantly though…
EV = NPV of all future unlevered free cash flows
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It is the sum of all cash available to the firm before paying back
creditors
As such, it is unlevered
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Levered vs Unlevered Multiples
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Levered
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Price/Earnings
PEG
Price/Book
Price/Free Cash Flow
Unlevered
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EV/EBITDA
EV/Revenue
EV/Page Views
EV/Unlevered Free Cash Flow
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Operating Metrics
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Performance metrics are just as important as
valuation multiples when determining if a company is
undervalued
Let’s say Company A and Company B are exactly the
same except for their revenue growth rates. A grows at
10% and B grows at 15%
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Which should have a higher P/E ratio?
If a company is valued less than its comps and has lesser
growth and margins, that’s probably why
Performance metric examples
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Rev. Growth (3-5 year CAGR)
EPS Growth (3-5 year CAGR)
Gross Margin %
Profit Margin %
FCF Margin %
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Relative Valuation Example
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Type in company ticker
Select ‘Relative Valuation’
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Relative Valuation Example
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Initial comp screen has companies Bloomberg thinks are comparable
Read through business descriptions to see if companies are comparable
Look through comps of these comps
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Relative Valuation
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Refine list to closest set of comps
Look for 4-6 comps
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Relative Valuation Example
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Go to ‘Custom’ tab to add valuation multiples and operating metrics
Copy/Paste results in Excel
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Relative Valuation Example
Highlight highs and lows to make conclusions on value
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Valuation:
Company Name
Marathon Petroleum
Phillips 66
Tesoro
Valero
$
$
$
$
Share
Price
55.97
92.75
113.69
71.95
EV/EBITDA
Maximum
75th Percentile
Median
25th Percentile
Minimum
P/E
P/E/G
P/S
P/FCF
EV/SALES
5.0 x
9.1 x
5.2 x
3.9 x
8.8 x
10.3 x
8.2 x
6.9 x
N/A
2.4 x
0.5 x
3.3 x
0.4 x
0.5 x
0.4 x
0.3 x
16.2 x
71.7 x
11.4 x
7.9 x
0.5 x
0.6 x
0.6 x
0.4 x
9.1 x
6.1 x
5.1 x
4.7 x
3.9 x
10.3 x
9.1 x
8.5 x
7.9 x
6.9 x
3.3 x
2.9 x
2.4 x
1.4 x
0.5 x
0.5 x
0.4 x
0.4 x
0.4 x
0.3 x
71.7 x
30.1 x
13.8 x
10.5 x
7.9 x
0.6 x
0.6 x
0.5 x
0.5 x
0.4 x
Performance:
Company Name
Marathon Petroleum
Phillips 66
Tesoro
Valero
Maximum
75th Percentile
Median
25th Percentile
Minimum
$
$
$
$
Share
Price
55.97
92.75
113.69
71.95
Rev. Growth
3-5 year CAGR
2.83%
N/A
7.80%
1.45%
Profit Growth
3-5 year CAGR
26.78%
N/A
57.96%
34.05%
7.80%
5.32%
2.83%
2.14%
1.45%
57.96%
46.01%
34.05%
30.42%
26.78%
EBIT Margin
EBITDA Margin
FCF Margin
Profit Margin
ROA
ROE
7.60%
8.21%
16.69%
9.47%
9.85%
9.42%
19.17%
11.61%
2.59%
-0.17%
1.67%
1.60%
4.88%
4.82%
5.28%
5.00%
11.20%
9.54%
10.58%
9.57%
29.95%
21.02%
32.71%
21.74%
16.69%
11.28%
8.84%
8.06%
7.60%
19.17%
13.50%
10.73%
9.74%
9.42%
2.59%
1.90%
1.64%
1.16%
-0.17%
5.28%
5.07%
4.94%
4.87%
4.82%
11.20%
10.74%
10.08%
9.56%
9.54%
32.71%
30.64%
25.85%
21.56%
21.02%
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Sensitivity Analysis
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How does sensitivity analysis relate to Relative
Valuation?
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Let’s say that we determine a company should be trading
at a slight discount to the peer group mean of a 12.0 P/E
ratio. So we decide that the company’s true P/E ratio
should be 11.0. The company currently has EPS of $4.00.
As such, we believe the company should be valued at
$44/share.
If we are not 100% confident about our choice of 11.0 as
the company’s true P/E ratio, we can create a range of
values and assume that any P/E ratio within that range
would be ‘fair value’
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E.g. a fair value range from a P/E of 10.0 – 14.0 (+/- 16%)
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What does RV output tell us?
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First, look at a company’s multiples relative to its
peers
Then, see if the operating metrics support your
findings
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E.g. If the target company is trading at a discount on
multiples, you would expect their margins and EPS
growth rate to be lower than their peers to justify it
How do we use this information to compute a fair
value for the target company?
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Constructing a fair value range
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Remember that we cannot be 100% confident about
the fair value of a company
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Hence the usefulness of sensitivity analysis
Fair value range
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“Company A’s fair per share price lies somewhere
between $35 and $55”
It is much easier to determine upper and lower bounds
using relative valuation
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We know that it should be trading less than Company B but
more than Company C
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But by how much?
The level of confidence in a valuation is evident in
how wide the fair value range is
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Putting it all together…
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“Buy low, sell high”
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Just like buying a house, you want to find the cheapest
price for its square footage (in a certain condition, of
course)
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The same thought process should apply to investing!
You can achieve similar returns or exploit a trend similarly
through multiple investment avenues
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You want to find the cheapest option as it will maximize your
upside!
Lower multiples implies that an investment is
“cheaper”
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BUT it can also indicate that an investment is relatively
less desirable to other investors AND/OR that something
is fundamentally wrong with the company
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What we have learned so far
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Efficient Market Hypothesis
Alpha and Risk-adjusted Returns
Importance of Valuation
Valuation Multiples
Sensitivity Analysis
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Session 3 Quiz
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A link will be sent out shortly after the meeting
Please complete it by Thursday!
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Next Time
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Currencies
The Fed
Intrinsic Valuation
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Free Cash Flow
WACC
DCF
Questions?
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Email: [email protected]
Hang around after
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