Will you get your money's worth?
Price-to-earnings (P/E) ratios, discount rates and the weighted average cost of capital are valuation terms that often mystify rather than clarify concepts that are critical to users of business and security valuations. What are they? How are they similar? How are they different? And how can financial executives who are considering acquisition and divestiture opportunities, or even simply analyzing corporate performance and shareholder value, better use them?
THE P/E RATIO: A VALUABLE BENCHMARK
Over the last 20 years, the evolution of academic research, computer spreadsheets and capital markets has done much to advance the level of sophistication and supportability associated with the valuation process. Nevertheless, a time-tested resource, the P/E ratio, remains a valuable benchmark for estimating the fair market value of a business or security interest. Typically, you can estimate the value of a firm or corporate division's capital by using various earning multiples observed for similar public companies. To use market multiples meaningfully, however, involves much more than gathering market data and multiplying. While a relatively simple calculation, P/E multiples can be improperly used in the valuation process.
Generally, a P/E ratio refers to the price of a common stock divided by the net income per share generated by a business over a 12-month period. A common share, in a corporation that earned $2 per share of net income, is trading at a P/E of 10 when its market price is $20. This is the P/E found in most daily newspapers. While there are many types of P/E ratios that can be used for a variety of purposes, there are two basic market multiple categories: common equity and invested capital multiples.
Common equity multiples are calculated by dividing the stock price by various equity-specific earning levels. Equity earning levels such as net income, cash flow (net income plus depreciation and amortization) and equity book value represent funds available for distribution to common equity investors. When used in a valuation, net income, cash flow and book value multiples can provide indications of common equity value.
Invested capital multiples are calculated by dividing the market value of invested capital (i.e., interest-bearing debt and equity) by various invested capital-oriented earning levels. Invested capital earning levels such as earnings before interest and taxes ("EBIT"), revenues, and earnings before depreciation/amortization, interest and taxes ("EBDIT") represent funds available to both debt and common equity investors. Invested capital multiples provide indications of a firm's total capital value, from which debt is subtracted to obtain the value of equity.
There must be consistency in the computation of the numerator and denominator of the P/E ratio. Where the numerator measures the price of the total invested capital of the business, the denominator must measure the earning level available to the providers of both debt and equity funding. Where the numerator considers only the price of equity, the denominator should consider the financial benefit attributable to equity.
Invested capital earning levels are representative of the operating results available to compensate both debt holders (through interest) and equity investors. Invested capital multiples can be useful in many valuation situations, because differences associated with varying debt levels are minimized. Also, by adding current liabilities to the indicated market value of invested capital, you can estimate the economic market value of a firm's total assets, both tangible and intangible. As with all business valuations, however, you should consider control and marketability issues and make appropriate adjustments.
Look at the table below that shows the current market data for three public drug retailers. This type of market data can be helpful when you're estimating the value of a private drug store chain, for instance.
While extensive analysis is required in a formal valuation, the data you find in the table reveals much about the three retailers. You see that, while Walgreen and Rite Aid trade at different P/Es, investors appear to have a common risk assessment of the companies, as indicated by the implied equity return of 18.7 percent. Perry Drug, on the other TABULAR DATA OMITTED hand, is trading at a much lower P/E and appears to be viewed by the market as being a riskier investment. Analysis of Perry, relative to Walgreen and Rite Aid, reveals that it's substantially more leveraged and has experienced revenue declines over the last five years.
When valuing businesses using market multiples, however, you should avoid simplistic reliance on averages. A private drug retailer, for example, may review the data in the table and conclude that its common stock should be valued at 16 times net income, the indicated average. But it's important to understand that such a valuation inherently presumes that the financial condition, growth prospects and overall investment risks are identical to the average condition of the three guideline companies. Such an assumption may not be supported by a comparative analysis of the valuation subject relative to the public guideline companies.
Analyzing the common equity multiples and growth prospects for these three drug retailers can give you insight into the rate of return shareholders require. The equity rate of return refers to both a return on and of the shareholders' investment. Many factors, such as management depth, diversification, debt levels and profitability, influence the return demanded by equity investors. All else being the same, however, expectations of earnings growth can provide keen insight into why the common stocks of similar companies trade at different multiples.
Using Perry's current P/E ratio and the Institutional Brokers Estimate System ("I/B/E/S") estimates of expected net income growth, you can calculate a rough estimate of the equity return expected by its shareholders. Perry common stock is trading at 11.6 times its latest 12-month net income. A net income multiple of 11.6 implies a capitalization rate of 8.6 percent (i.e., 1 divided by 11.6 equals 0.086). Thus, Perry's net income per share divided by 8.6 percent results in the current market price for its stock.
A capitalization rate has two basic components: the equity return requirement and earnings growth expectations. Given the I/B/E/S net income growth (5-year) estimate of 13 percent per year, and assuming Perry's net cash flow (i.e., net funds available for distribution to shareholders) is similarly expected to grow at a 13-percent annual rate into perpetuity, the indicated equity return requirement being demanded by its shareholders approximates 21.6 percent (i.e., 8.6-percent capitalization rate plus 13-percent earnings growth equals 21.6 percent). Given the assumptions made, the typical shareholder investing in Perry common stock today expects dividends and capital gains to yield an average annual return of 21.6 percent on the initial investment. Of course, Perry's actual performance, alternative investment opportunities and other types of information provided to the market on a daily basis will cause a constant reassessment of risk and, therefore, the equity return expectation.
The relationship between risk, growth expectations and P/E ratios helps to explain why the common stock of otherwise similar companies trades at different multiples. It also helps explain why "high-growth" stocks tend to trade at P/Es above the market averages. In the business valuation process, the market multiples of guideline companies, combined with meaningful analysis, can give you useful insights about private companies and divisional businesses. And, by using invested capital multiples, you can estimate the market value of a firm's total assets from the perspective of noncontrolling minority shareholders. Finally, you can conduct comparative analysis of the equity return requirements that shareholders of similar companies demand.
THEN THERE'S DISCOUNTED CASH FLOW
Another way to value common stock is known as the discounted cash flow ("DCF") method. Under this income approach, you forecast the net cash flow available for distribution to common shareholders and discount it to present value. In addition to requiring future earnings projections, applying a DCF analysis requires you to estimate an appropriate equity rate of return or discount rate.
When using the DCF method, it's imperative that the discount rate and net cash flow being discounted are consistent. That is, if the objective of the analysis is to estimate the value of common equity, you must discount only those funds that are available to common shareholders at an equity rate of return. The net cash flow available for distribution to common shareholders is typically calculated as follows:
After-tax net income plus depreciation and amortization equals operating cash flow plus additions of debt principal less working capital additions, capital expenditures, reductions of debt principal, and preferred stock dividends equals net cash flow available to common shareholders.
As discussed, there's a direct relationship between P/E ratios and discount rates since each reflects risk and growth expectations. Equity return requirements (discount rates) tend to be measured in relative terms. That is, the return required of and on an investment in a common stock is often measured against a relatively risk-free investment alternative, such as Treasury bonds. Assuming expected returns on equity investments will resemble actual returns earned historically, many owners of closely held firms may be surprised by the equity return required to attract investment in their businesses' common stock.
TABULAR DATA OMITTED
Based on 65 years of historical investment return data, as recorded in Ibbotson Associates' Stocks, Bonds, Bills and Inflation 1992 Yearbook, common stocks of large firms have averaged an annual return of between 12 percent and 13 percent, while the yield on long-term Treasuries has averaged 5 percent. Thus, the total return on these common stocks has historically been at a 7-percent to 8-percent premium above the risk-free rate. Based upon current data, this relationship suggests that the market is currently demanding a total equity return of approximately 15 percent for an investment in these larger (i.e., S&P 500) companies' common stock.
Of particular interest is the historical return obtained by investors in "small" capitalization stocks. The historical relationship between small (i.e., average capitalization of approximately $20 million in 1991 dollars) and large (i.e., S&P 500) stock returns indicates that investors have achieved a premium of 5 percent (over the general market return) as compensation for the added risk of an investment in these smaller companies. Current risk-free rates, combined with the historical data, suggest that today's equity return on small-company stocks approximates 20 percent per year.
Historical equity return data helps to explain relatively high P/E multiples for small, publicly traded companies. Assuming a P/E ratio of 20 and an equity return requirement of 20 percent, investors in these small stocks appear to be expecting earnings growth of approximately 15 percent per year. In the current low-interest rate, recessionary economy, high P/E ratios tend to imply an expectation of material earnings growth over the foreseeable future.
Like P/E ratios, there are two distinct types of discount rates. Discount rates can reflect equity return requirements or they can account for the return on both debt and equity capital utilized in a business. Typically referred to as the weighted average cost of capital ("WACC"), this blended rate of return is used in the DCF process when the objective is to estimate the value of a firm's total invested capital. This analysis is especially useful if you want to estimate the economic value of a firm's tangible and intangible assets.
It's imperative, however, that the WACC discount rate be properly matched with the cash flows being forecast. Since the WACC accounts for returns to both debt and equity investors, through interest and dividends, the cash flow used must also represent funds available to both investors. As such, forecast cash flow shouldn't include a reduction for either interest expense or changes in interest-bearing debt balances. This type of cash flow is commonly referred to as "debt free."
Under the assumptions that: a firm's assets are financed 50 percent with debt and 50 percent with equity capital; the after-tax borrowing cost (i.e., interest) is 6 percent; and the cost of equity capital is 20 percent, a WACC of 13 percent is indicated |(50 percent weight x 20 percent equity cost) plus (50 percent weight x 6 percent debt cost) equals 13 percent WACC~. To the extent discounting forecast debt-free net cash flow at the WACC results in a value indication of $25 million, and non-debt current liabilities represent $5 million, an indicated value of the firm's tangible and intangible assets is $30 million.
The table on page 57 illustrates how to apply the DCF model in the process of estimating invested capital and total asset values.
PLENTY OF FACTS, NO SIMPLISTIC DATA
The process of valuing companies and their securities should reflect financial theory and market data. While the scientific art of business valuation requires experience and judgment, there's a surprising amount of factual data that directly influences the valuation process. However, you shouldn't use this data simplistically. You must carefully consider differences between the valuation subject and the guideline companies.
The tables I've included illustrate the relationships between various P/E ratios and the discount rates that reflect returns required by investors. Of particular significance in these relationships is the impact of growth expectations and the alternative returns available to common stock investors in the marketplace. For many privately held firms, market data suggests that a return in excess of 20 percent is currently required to attract equity capital. Attracting investment in higher-risk, start-up or speculative ventures would likely require higher returns.
Mr. Maxson is a director with the Valuation and Realty Consulting Group of Deloitte & Touche in San Francisco, California.
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|Title Annotation:||Mergers & Acquisitions; business and stock valuations|
|Author:||Maxson, Mark J.|
|Date:||May 1, 1993|
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