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Relative Valuations: Tips on How You Can Perform Your Analysis Better

June 19, 2014 | About:

What are Relative Valuations?

You may be asking yourself, “What is a relative valuation?” Well, it is not a method of evaluating family members (pun intended). A Relative Valuation is a method to value a company based on multiples such as Price-to-Earnings (P/E), Price-to-Book (P/B), Price-to-Sales (P/S), Price-to-Cash Flow, Dividend Yield, and Enterprise Value-to-Earnings Before Interest, Taxes, Depreciation & Amortization (EV/EBITDA). There are two basic categories of Relative Valuations, which are: 1) compared to other companies, industry, or sector (Comparables) and 2) compared to the company itself called Justified Ratios that is based on the company’s internal growth rate, Dividend Payout Ratio, Required Rate of Return, Net Profit Margin, and Cash Flow. One of the best way to learn is through examples. Therefore, I will start off by defining some terms/formulas and then provide an example of a Comparable Analysis along with a Justified Ratios Analysis.

Terms and Definitions:

P/E = Price / Earnings

PEG = P/E/g

 

P/B = Price / Book Value

P/S = Price / Sales

P/CF = Price / Cash Flow

EV/EBITDA = Enterprise Value / Earnings Before Interest, Taxes, Depreciation & Amortization

D/P = Dividend Yield = Dividend / Price

re = Required Rate of Return

g = Growth = ROE * rr

ROE = Return on Equity = Net Income / Equity

rr = Retention Ratio = 1 - Dividend Payout Ratio = sometime referred also as "b"

(1 - b) = Dividend Payout Ratio = Dividends / Net Income

NPM = Net Profit Margin = Net Income / Sales

BV = Book Value = Total Assets - Total Liabilities = Shareholders' Equity

EPS = Earnings per Share

FCFE = Free Cash Flow For Equity = Net Income + Depreciation - Fixed Capital Expenditures

 

- Change in Working Capital + Net Borrowings

EV = Market Value of Common Stock + Market Value of Debt + Market Value of Preferred Stock

 

- Cash & Investments

Actual = Justified: Properly Valued

Actual < Justified: Undervalued

Actual > Justified: Overvalued

   

P/E:

Trailing P0/E0 = Market Price per Share / EPS last 12 months

 

Leading P0/E1 = Market Price per Share / Forecast EPS next 12 months

 

Justified Trailing P0/E0 = (1 - b) * (1 + g) / (re - g)

 

Justified Leading P0/E1 = (1 - b) / (re - g)

   

PEG:

Compare PEG Ratios with comparables to determine relative value;

 

Don't assume PEG < 1 = Buy and PEG > 1 = Sell.

   

P/B:

Justified P/B = (ROE - g) / (re - g)

   

P/S:

Justified P/S = NPM * (1 - b) * (1 + g) / (re - g)

   

P/CF:

V0 = FCFE0 * (1 + g) / (re - g)

 

Justified P/CF = V0 / CF

   

EV/EBITDA:

Firm EV/EBITDA < Benchmark: Undervalued

 

Firm EV/EBITDA > Benchmark: Overvalued

   

D/P:

Justified D0/P0 = (re - g) / (1 + g)

Comparable Analysis for Campbell’s Soup (CPB):

Dated: 6/13/14

 

Campbell's Soup (CPB)

Previous Close

45.32

Trailing P/E

27.37

Trailing EPS

1.66

Dividend

1.25

Dividend Yield

2.70%

Sales

25.92

Book Value

5.14

Free Cash Flow

0.84

EV/EBITDA

12.72

EBITDA

1,410,000,000.00

MV Equity

14,230,000,000.00

MV Debt

2,247,000,000.00

MV Preferred

-

Cash & Cash Equivalents

333,000,000.00

Shares Outstanding

313,989,408.65

Operating Margin

14.82%

Net Profit Margin

6.43%

Inventory Turnover

6.27

Asset Turnover

0.97

ROE

48.62%

rr

24.70%

Growth Rate

12.01%

I included Operating Margin, Net Profit Margin, Inventory Turnover, and Asset Turnover in the following analysis because these ratios provide insights into the kind of companies Warren Buffett (Trades, Portfolio) likes.

  • Warren thinks that the best kind of business to own is one with high profit margins and high turnover.
  • Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.
  • Warren is not interested in owning a business with both low profit margins and low turnover.

When comparing the companies, ask yourself:

  • How are the Margins?
  • How does the Turnover compare to the other companies?
  • Which company has the highest ROE?
  • What are the companies’ growth rates?
 

General Mills, Inc. (GIS)

Kraft Foods Group, Inc. (KRFT)

ConAgra Foods. Inc. (CAG)

Average

Price

54.31

59.01

32.50

 

Trailing EPS

2.73

4.60

1.92

 

Book Value

10.24

8.91

13.36

 

Sales

28.32

30.37

42.58

 

Free Cash Flow

1.44

0.48

1.17

 

Dividend

1.64

2.10

1.00

 

Operating Margin

16.07%

26.92%

9.55%

17.51%

Net Profit Margin

9.90%

15.34%

4.58%

9.94%

Inventory Turnover

7.51

6.43

5.60

6.51

Asset Turnover

0.78

0.79

0.76

0.78

ROE

22.46%

61.27%

15.08%

32.94%

rr

39.93%

54.35%

47.92%

47.40%

Growth Rate

8.97%

33.30%

7.23%

16.50%

P/E

19.89

12.83

16.93

16.55

PEG

2.22

0.39

2.34

1.65

P/B

5.30

6.62

2.43

4.79

P/S

1.92

1.94

0.76

1.54

P/CF

37.72

122.94

27.78

62.81

Dividend Yield

3.02%

3.56%

3.08%

3.22%

EV/EBITDA

11.86

8.31

9.95

10.04

We take the average ratios and use them to estimate the approximate value for Campbell’s soup. The Value column below contains the values for Earnings, Book Value, Sales, Free Cash Flow, Dividend, etc. When we multiply the value by the average ratios (Average Factor column), we obtain a relative value based on that metric. For example, when we multiply Campbell’s Earnings (Value) times the average P/E of the comparable companies (Average Factor) we obtain the Relative Value. As a result, you have a number of relative value estimates based on the average comparable ratios. You can then weight the values (i.e. If you prefer P/S then weight that more heavily).

Campbell's Soup (CPB)

 

Value

Average Factor

Relative Value

Weights

Weighted Relative Value

Earnings

1.66

16.55

27.47

20.0%

5.49

Book Value

5.14

4.79

24.60

10.0%

2.46

Sales

25.92

1.54

39.95

20.0%

7.99

Free Cash Flow

0.84

62.81

52.76

20.0%

10.55

Dividend

1.25

3.22%

38.84

10.0%

3.88

EBITDA

1,410,000,000.00

10.04

14,156,400,000.00

   

MV Debt

2,247,000,000.00

 

2,247,000,000.00

   

MV Preferred

-

 

-

   

Cash & Cash Equivalents

333,000,000.00

 

333,000,000.00

   

Shares Outstanding

313,989,408.65

 

313,989,408.65

   

Estimated Equity Value

   

11,909,400,000.00

   

Estimated Equity Value per Share

 

37.93

20.0%

7.59

       

100.0%

37.97

Justified Ratios Analysis

Based on the Justified Ratio Formula as defined in the Terms section of this article, you can calculate the Justified Ratios and its implied Relative Value (i.e. current Earnings TTM (Value) * Justified Ratio = Relative Value for that metric). You can then value the company based on your own weighting for preferred ratios (i.e. base 20% of your Justified Ratios Analysis Valuation on 10% of P/S Relative Value). For the following, I assumed a required rate of return of 16% just for illustration purposes.

Campbell's Soup (CPB)

 

Value

Current Ratio

Justified Ratio

Relative Value

Weights

Weighted Relative Value

Earnings TTM

1.66

27.37

21.13

35.08

20.0%

7.02

Earnings Forward

2.60

17.43

18.87

49.05

20.0%

9.81

Book Value

5.14

8.82

9.17

47.15

10.0%

4.71

Sales

25.92

1.75

1.36

35.22

20.0%

7.04

Free Cash Flow

0.84

53.95

28.06

23.57

20.0%

4.71

Dividend

1.25

2.70%

3.56%

35.08

10.0%

3.51

         

100.0%

36.81

The final concept I want to discuss is normalizing the data for better results. To do this, gather the several years’ worth of data like in the following Campbell’s Soup Normalized Table below. Use your personal judgment to identify trends.

Campbell's Soup (CPB): Normalizing

 

28-Jul-13

29-Jul-12

31-Jul-11

Average

Normalized

Net Profit Margin

5.69%

10.79%

11.27%

9.25%

9.25%

ROE

37.63%

86.19%

73.99%

65.94%

48.00%

rr

19.87%

51.81%

53.04%

41.57%

25.00%

Growth Rate

7.48%

44.65%

39.25%

30.46%

12.00%

Earnings TTM

1.46

2.43

2.44

2.11

1.70

Earnings Forward

     

N/A

1.90

Book Value

3.88

2.83

3.34

3.35

5.14

Sales

25.65

22.86

22.75

23.75

25.92

Free Cash Flow

0.78

1.33

1.50

1.20

0.80

Dividend

1.16

1.16

1.15

1.16

1.25

Take your normalized results to calculate normalized justified ratios. In addition, you may want to normalize the values if for example sales should be adjusted up or down based on your analysis. As result, you can obtain a normalized justified relative valuation for Campbell’s Soup.

Campbell's Soup (CPB): Normalized Valuation

 

Normalized Value

Current Ratio

Normalized Justified Ratio

Relative Value

Weights

Weighted Relative Value

Earnings TTM

1.70

27.37

21.00

35.70

20.0%

7.14

Earnings Forward

1.90

17.43

18.75

35.70

20.0%

7.14

Book Value

5.14

8.82

9.00

46.26

10.0%

4.63

Sales

25.92

1.75

1.94

50.35

20.0%

10.07

Free Cash Flow

0.80

53.95

28.00

22.40

20.0%

4.48

Dividend

1.25

0.03

3.57%

35.00

10.0%

3.50

Projected Justified Value

     

100.0%

36.96

PLEASE NOTE: This Relative Valuation sample is for illustrative purposes only. I did not spend time analyzing the appropriate discount rate, which could dramatically alter estimated values. However, you can use this method of Relative Valuation to be approximately correct rather than as Buffett says absolutely wrong. In addition, please apply the Margin of Safety principle when purchasing a security as taught by Benjamin Graham.

About the author:

Nelson Nguyen
Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance experience and a 2014 Level II Candidate in the CFA Program.

Visit Nelson Nguyen's Website


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