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Relative Valuations: Tips on How You Can Perform Your Analysis Better
Posted by: Nelson Nguyen (IP Logged)
Date: June 19, 2014 09:52AM

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.

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