Aswath Damodaran 12

Price Earnings Ratio: Denition

PE = Market Price per Share / Earnings per Share
! There are a number of variants on the basic PE ratio in use. They are based upon how
the price and the earnings are dened.
! Price:
is usually the current price (though some like to use average price over last 6
months or year)
EPS:
Time variants: EPS in most recent nancial year (current), EPS in most recent four
quarters (trailing), EPS expected in next scal year or next four quartes (both called
forward) or EPS in some future year
Primary, diluted or partially diluted
Before or after extraordinary items
Measured using different accounting rules (options expensed or not, pension fund
income counted or not)
Aswath Damodaran 13
Characteristic 1: Skewed Distributions
PE ratios for US companies in January 2012
Aswath Damodaran 14
Characteristic 2: Biased Samples
PE ratios in January 2012
Aswath Damodaran 15
Characteristic 3: Across Markets
PE Ratios: US, Europe, Japan and Emerging Markets
January 2012
Aswath Damodaran 16
PE Ratio: Understanding the Fundamentals
! To understand the fundamentals, start with a basic equity discounted cash ow
model. With a stable growth dividend discount model:


! Dividing both sides by the current earnings per share or forward EPS:
Current EPS Forward EPS


! If this had been a FCFE Model,

P
0
=
DPS
1
r ! g
n
P
0
EPS
0
= PE=
Payout Ratio * (1 + g
n
)
r-g
n
P
0
=
FCFE
1
r ! g
n
!
P
0
EPS
0
= PE =
(FCFE/Earnings) *(1+ g
n
)
r-g
n
!
P
0
EPS
1
= PE =
Payout Ratio
r-g
n
Aswath Damodaran 17
PE Ratio and Fundamentals
! Proposition: Other things held equal, higher growth rms will have
higher PE ratios than lower growth rms.
! Proposition: Other things held equal, higher risk rms will have lower PE
ratios than lower risk rms
! Proposition: Other things held equal, rms with lower reinvestment needs
will have higher PE ratios than rms with higher reinvestment rates.
! Of course, other things are difcult to hold equal since high growth rms, tend
to have risk and high reinvestment rats.
Aswath Damodaran 18
Using the Fundamental Model to Estimate PE For a High
Growth Firm
! The price-earnings ratio for a high growth rm can also be related to
fundamentals. In the special case of the two-stage dividend discount model,
this relationship can be made explicit fairly simply:



For a rm that does not pay what it can afford to in dividends, substitute FCFE/
Earnings for the payout ratio.
! Dividing both sides by the earnings per share:
P
0
=
EPS
0
* Payout Ratio*(1+ g)* 1 !
(1+ g)
n
(1+ r)
n
"
#
$
%
&
r - g
+
EPS
0
* Payout Ratio
n
*(1+ g)
n
*(1+ g
n
)
(r -g
n
)(1+ r)
n
P
0
EPS
0
=
Payout Ratio * (1 + g) * 1 !
(1 + g)
n
(1+ r)
n
"
#
$
%
&
'
r - g
+
Payout Ratio
n
*(1+ g)
n
* (1 + g
n
)
(r - g
n
)(1+ r)
n
Aswath Damodaran 19
Expanding the Model
! In this model, the PE ratio for a high growth rm is a function of growth, risk
and payout, exactly the same variables that it was a function of for the stable
growth rm.
! The only difference is that these inputs have to be estimated for two phases -
the high growth phase and the stable growth phase.
! Expanding to more than two phases, say the three stage model, will mean that
risk, growth and cash ow patterns in each stage.
Aswath Damodaran 20
A Simple Example
! Assume that you have been asked to estimate the PE ratio for a rm which has
the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
! Riskfree rate = T.Bond Rate = 6%
! Required rate of return = 6% + 1(5.5%)= 11.5%
Aswath Damodaran 21
PE and Growth: Firm grows at x% for 5 years, 8% thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios
0
20
40
60
80
100
120
140
160
180
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate
P
E

R
a
t
i
o
r =4%
r =6%
r =8%
r=10%
Aswath Damodaran 22
PE Ratios and Length of High Growth: 25% growth for n
years; 8% thereafter
Aswath Damodaran 23
PE and Risk: Effects of Changing Betas on PE Ratio:
Firm with x% growth for 5 years; 8% thereafter
PE Ratios and Beta: Growth Scenarios
0
5
10
15
20
25
30
35
40
45
50
0.75 1.00 1.25 1.50 1.75 2.00
Beta
P
E

R
a
t
i
o
g=25%
g=20%
g=15%
g=8%
Aswath Damodaran 24
PE and Payout/ ROE
Aswath Damodaran 25
The perfect under valued company
! If you were looking for the perfect undervalued asset, it would be one
With a low PE ratio (it is cheap)
With high expected growth in earnings
With low risk (and a low cost of equity)
And with high ROE
In other words, it would be cheap with no good reason for being cheap.
! In the real world, most assets that look cheap on a multiple of earnings basis
deserve to be cheap. In other words, one or more of these variables works
against the company (It has low growth, high risk or a low ROE).
! When presented with a cheap stock (low PE), here are the key questions:
What is the expected growth in earnings?
What is the risk in the stock?
How efciently does this company generate its growth?
Aswath Damodaran 26
I. Comparing PE ratios across Emerging Markets
Aswath Damodaran 27
II. An Old Example with Emerging Markets: June 2000
Country PE Ratio Interest
Rates
GDP Real
Growth
Country
Risk
Argentina 14 18.00% 2.50% 45
Brazil 21 14.00% 4.80% 35
Chile 25 9.50% 5.50% 15
Hong Kong 20 8.00% 6.00% 15
India 17 11.48% 4.20% 25
Indonesia 15 21.00% 4.00% 50
Malaysia 14 5.67% 3.00% 40
Mexico 19 11.50% 5.50% 30
Pakistan 14 19.00% 3.00% 45
Peru 15 18.00% 4.90% 50
Phillipines 15 17.00% 3.80% 45
Singapore 24 6.50% 5.20% 5
South Korea 21 10.00% 4.80% 25
Thailand 21 12.75% 5.50% 25
Turkey 12 25.00% 2.00% 35
Venezuela 20 15.00% 3.50% 45
Aswath Damodaran 28
Regression Results
! The regression of PE ratios on these variables provides the following
PE = 16.16 - 7.94 Interest Rates
+ 154.40 Growth in GDP
- 0.1116 Country Risk
R Squared = 73%
Aswath Damodaran 29
Predicted PE Ratios
Country PE Ratio Interest
Rates
GDP Real
Growth
Country
Risk
Predicted PE
Argentina 14 18.00% 2.50% 45
13.57
Brazil 21 14.00% 4.80% 35
18.55
Chile 25 9.50% 5.50% 15
22.22
Hong Kong 20 8.00% 6.00% 15
23.11
India 17 11.48% 4.20% 25
18.94
Indonesia 15 21.00% 4.00% 50
15.09
Malaysia 14 5.67% 3.00% 40
15.87
Mexico 19 11.50% 5.50% 30
20.39
Pakistan 14 19.00% 3.00% 45
14.26
Peru 15 18.00% 4.90% 50
16.71
Phillipines 15 17.00% 3.80% 45
15.65
Singapore 24 6.50% 5.20% 5
23.11
South Korea 21 10.00% 4.80% 25
19.98
Thailand 21 12.75% 5.50% 25
20.85
Turkey 12 25.00% 2.00% 35
13.35
Venezuela 20 15.00% 3.50% 45
15.35
Aswath Damodaran 30
III. Comparisons of PE across time: PE Ratio for the S&P
500
Aswath Damodaran 31
Is low (high) PE cheap (expensive)?
! A market strategist argues that stocks are cheap because the PE ratio today is
low relative to the average PE ratio across time. Do you agree?
! Yes
! No
! If you do not agree, what factors might explain the lower PE ratio today?
Aswath Damodaran 32
E/P Ratios , T.Bond Rates and Term Structure
Aswath Damodaran 33
Regression Results
! There is a strong positive relationship between E/P ratios and T.Bond rates, as
evidenced by the correlation of 0.69 between the two variables.,
! In addition, there is evidence that the term structure also affects the PE ratio.
! In the following regression, using 1960-2011 data, we regress E/P ratios
against the level of T.Bond rates and a term structure variable (T.Bond - T.Bill
rate)
E/P = 3.16% + 0.597 T.Bond Rate 0.213 (T.Bond Rate-T.Bill Rate)
(3.98) (5.71) (-0.92)
R squared = 40.92%

Given the treasury bond rate and treasury bill rate today, is the market under or
over valued today?
Aswath Damodaran 34
IV. Valuing one company relative to others
Relative valuation with comparables
! Ideally, you would like to nd lots of publicly traded rms that look just like
your rm, in terms of fundamentals, and compare the pricing of your rm to
the pricing of these other publicly traded rms. Since, they are all just like
your rm, there will be no need to control for differences.
! In practice, it is very difcult (and perhaps impossible) to nd rms that share
the same risk, growth and cash ow characteristics of your rm. Even if you
are able to nd such rms, they will very few in number. The trade off then
becomes:
Small sample of
firms that are
just like your
firm
Large sample
of firms that are
similar in some
dimensions but
different on
others
Aswath Damodaran 35
Techniques for comparing across rms
! Direct comparisons: If the comparable rms are just like your rm, you can compare
multiples directly across the rms and conclude that your rm is expensive (cheap) if it
trades at a multiple higher (lower) than the other rms.
! Story telling: If there is a key dimension on which the rms vary, you can tell a story
based upon your understanding of how value varies on that dimension.
An example: This company trades at 12 times earnings, whereas the rest of the
sector trades at 10 times earnings, but I think it is cheap because it has a much
higher growth rate than the rest of the sector.
! Modied multiple: You can modify the multiple to incorporate the dimension on which
there are differences across rms.
! Statistical techniques: If your rms vary on more than one dimension, you can try using
multiple regressions (or variants thereof) to arrive at a controlled estimate for your
rm.
Aswath Damodaran 36
Example 1: Lets try some story telling
Comparing PE ratios across rms in a sector
Company Name Trailing PE Expected Growth Standard Dev
Coca-Cola Bottling 29.18 9.50% 20.58%
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88%
Anheuser-Busch 24.31 11.00% 22.92%
Corby Distilleries Ltd. 16.24 7.50% 23.66%
Chalone Wine Group Ltd. 21.76 14.00% 24.08%
Andres Wines Ltd. 'A' 8.96 3.50% 24.70%
Todhunter Int'l 8.94 3.00% 25.74%
Brown-Forman 'B' 10.07 11.50% 29.43%
Coors (Adolph) 'B' 23.02 10.00% 29.52%
PepsiCo, Inc. 33.00 10.50% 31.35%
Coca-Cola 44.33 19.00% 35.51%
Boston Beer 'A' 10.59 17.13% 39.58%
Whitman Corp. 25.19 11.50% 44.26%
Mondavi (Robert) 'A' 16.47 14.00% 45.84%
Coca-Cola Enterprises 37.14 27.00% 51.34%
Hansen Natural Corp 9.70 17.00% 62.45%

Aswath Damodaran 37
A Question
You are reading an equity research report on this sector, and the analyst claims
that Andres Wine and Hansen Natural are under valued because they have low
PE ratios. Would you agree?
" Yes
" No
! Why or why not?
Aswath Damodaran 38
Example 2: The limits of story telling
Telecom ADRs in 1999
Company Name PE Growth
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44
Aswath Damodaran 39
PE, Growth and Risk
Dependent variable is: PE

R squared = 66.2% R squared (adjusted) = 63.1%

Variable Coefcient SE t-ratio prob
Constant 13.1151 3.471 3.78 0.0010
Growth rate 1.21223 19.27 6.29 # 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not
Aswath Damodaran 40
Is Telebras under valued?
! Predicted PE = 13.12 + 1.2122 (7.5) - 13.85 (1) = 8.35
! At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued.
Aswath Damodaran 41
Relative to the entire market
Extending your sample
! If you can control for differences in risk, growth and cash ows, you can
expand your list of comparable rms signicantly. In fact, there is no reason
why you cannot bring every rm in the market into your comparable rm list.
! The simplest way of controlling for differences is with a multiple regression,
with the multiple (PE, EV/EBITDA etc) as the dependent variable, and proxies
for risk, growth and payout forming the independent variables.
! When you make this comparison, you are estimating the value of your
company relative to the entire market (rather than just a sector).
Aswath Damodaran 42
PE versus Expected EPS Growth: January 2012






Aswath Damodaran 43
PE Ratio: Standard Regression for US stocks - January 2012
Aswath Damodaran 44
Problems with the regression methodology
! The basic regression assumes a linear relationship between PE ratios and the
nancial proxies, and that might not be appropriate.
! The basic relationship between PE ratios and nancial variables itself might
not be stable, and if it shifts from year to year, the predictions from the model
may not be reliable.
! The independent variables are correlated with each other. For example, high
growth rms tend to have high risk. This multi-collinearity makes the
coefcients of the regressions unreliable and may explain the large changes in
these coefcients from period to period.
Aswath Damodaran 45
The Multicollinearity Problem
Aswath Damodaran 46
Using the PE ratio regression
! Assume that you were given the following information for Dell. The rm has
an expected growth rate of 10%, a beta of 1.20 and pays no dividends. Based
upon the regression, estimate the predicted PE ratio for Dell.
Predicted PE =
! Dell is actually trading at 18 times earnings. What does the predicted PE tell
you?
Aswath Damodaran 47
The value of growth
Time Period PE Value of extra 1% of growth Equity Risk Premium
January 2012 0.408 6.04%
January 2011 0.836 5.20%
January 2010 0.550 4.36%
January 2009 0.780 6.43%
January 2008 1.427 4.37%
January 2007 1.178 4.16%
January 2006 1.131 4.07%
January 2005 0.914 3.65%
January 2004 0.812 3.69%
January 2003 2.621 4.10%
January 2002 1.003 3.62%
January 2001 1.457 2.75%
January 2000 2.105 2.05%
Aswath Damodaran 48
Fundamentals in other markets: PE regressions across
markets
Region Regression January 2012 R squared
Europe PE = 19.57 - 2.91 Payout - 3.67 Beta 6.9%
Japan PE = 21.69 - 0.31 Expected Growth -4.12 Beta 5.3%
Emerging
Markets
PE = 15.48+ 9.03 ROE - 2.77 Beta + 2.91 Payout 4.3%
Aswath Damodaran 49
Investment Strategies that compare PE to the expected
growth rate
! If we assume that all rms within a sector have similar growth rates and risk, a
strategy of picking the lowest PE ratio stock in each sector will yield
undervalued stocks.
! Portfolio managers and analysts sometimes compare PE ratios to the expected
growth rate to identify under and overvalued stocks.
In the simplest form of this approach, rms with PE ratios less than their expected
growth rate are viewed as undervalued.
In its more general form, the ratio of PE ratio to growth is used as a measure of
relative value.
Aswath Damodaran 50
Problems with comparing PE ratios to expected growth
! In its simple form, there is no basis for believing that a rm is undervalued just
because it has a PE ratio less than expected growth.
! This relationship may be consistent with a fairly valued or even an overvalued
rm, if interest rates are high, or if a rm is high risk.
! As interest rates decrease (increase), fewer (more) stocks will emerge as
undervalued using this approach.
Aswath Damodaran 51
PEG Ratio: Denition
! The PEG ratio is the ratio of price earnings to expected growth in earnings per
share.
PEG = PE / Expected Growth Rate in Earnings
! Denitional tests:
Is the growth rate used to compute the PEG ratio
on the same base? (base year EPS)
over the same period?(2 years, 5 years)
from the same source? (analyst projections, consensus estimates..)
Is the earnings used to compute the PE ratio consistent with the growth rate
estimate?
No double counting: If the estimate of growth in earnings per share is from the current
year, it would be a mistake to use forward EPS in computing PE
If looking at foreign stocks or ADRs, is the earnings used for the PE ratio consistent with
the growth rate estimate? (US analysts use the ADR EPS)
Aswath Damodaran 52
PEG Ratio: Distribution US stocks
Aswath Damodaran 53
PEG Ratios: The Beverage Sector
Company Name Trailing PE Growth Std Dev PEG
Coca-Cola Bottling 29.18 9.50% 20.58% 3.07
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82
Anheuser-Busch 24.31 11.00% 22.92% 2.21
Corby Distilleries Ltd. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55
Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56
Todhunter Int'l 8.94 3.00% 25.74% 2.98
Brown-Forman 'B' 10.07 11.50% 29.43% 0.88
Coors (Adolph) 'B' 23.02 10.00% 29.52% 2.30
PepsiCo, Inc. 33.00 10.50% 31.35% 3.14
Coca-Cola 44.33 19.00% 35.51% 2.33
Boston Beer 'A' 10.59 17.13% 39.58% 0.62
Whitman Corp. 25.19 11.50% 44.26% 2.19
Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18
Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38
Hansen Natural Corp 9.70 17.00% 62.45% 0.57
Average 22.66 13.00% 33.00% 2.00
Aswath Damodaran 54
PEG Ratio: Reading the Numbers
! The average PEG ratio for the beverage sector is 2.00. The lowest PEG ratio in
the group belongs to Hansen Natural, which has a PEG ratio of 0.57. Using
this measure of value, Hansen Natural is
" the most under valued stock in the group
" the most over valued stock in the group
! What other explanation could there be for Hansens low PEG ratio?
Aswath Damodaran 55
PEG Ratio: Analysis
! To understand the fundamentals that determine PEG ratios, let us return again
to a 2-stage equity discounted cash ow model



! Dividing both sides of the equation by the earnings gives us the equation for
the PE ratio. Dividing it again by the expected growth g

P
0
=
EPS
0
* Payout Ratio*(1+ g)* 1 !
(1+ g)
n
(1+ r)
n
"
#
$
%
&
r - g
+
EPS
0
* Payout Ratio
n
*(1+ g)
n
*(1+ g
n
)
(r -g
n
)(1+ r)
n
PEG =
Payout Ratio*(1 + g) * 1 !
(1+ g)
n
(1 + r)
n
"
#
$
%
&
g(r - g)
+
Payout Ratio
n
* (1+ g)
n
* (1+ g
n
)
g(r - g
n
)(1 + r)
n
Aswath Damodaran 56
PEG Ratios and Fundamentals
! Risk and payout, which affect PE ratios, continue to affect PEG ratios as well.
Implication: When comparing PEG ratios across companies, we are making
implicit or explicit assumptions about these variables.
! Dividing PE by expected growth does not neutralize the effects of expected
growth, since the relationship between growth and value is not linear and
fairly complex (even in a 2-stage model)
Aswath Damodaran 57
A Simple Example
! Assume that you have been asked to estimate the PEG ratio for a rm which
has the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
! Riskfree rate = T.Bond Rate = 6%
! Required rate of return = 6% + 1(5.5%)= 11.5%
! The PEG ratio for this rm can be estimated as follows:
!
PEG =
0.2 * (1.25) * 1"
(1.25)
5
(1.115)
5
#
$
%
&
'
(
.25(.115 - .25)
+
0.5 * (1.25)
5
*(1.08)
.25(.115 - .08) (1.115)
5
= 115 or 1.15
Aswath Damodaran 58
PEG Ratios and Risk
Aswath Damodaran 59
PEG Ratios and Quality of Growth
Aswath Damodaran 60
PE Ratios and Expected Growth
Aswath Damodaran 61
PEG Ratios and Fundamentals: Propositions
! Proposition 1: High risk companies will trade at much lower PEG ratios than
low risk companies with the same expected growth rate.
Corollary 1: The company that looks most under valued on a PEG ratio basis in a
sector may be the riskiest rm in the sector
! Proposition 2: Companies that can attain growth more efciently by investing
less in better return projects will have higher PEG ratios than companies that
grow at the same rate less efciently.
Corollary 2: Companies that look cheap on a PEG ratio basis may be companies
with high reinvestment rates and poor project returns.
! Proposition 3: Companies with very low or very high growth rates will tend to
have higher PEG ratios than rms with average growth rates. This bias is
worse for low growth stocks.
Corollary 3: PEG ratios do not neutralize the growth effect.
Aswath Damodaran 62
PE, PEG Ratios and Risk
0
5
10
15
20
25
30
35
40
45
Lowest 2 3 4 Highest
0
0.5
1
1.5
2
2.5
PE
PEG Ratio
Risk classes
Aswath Damodaran 63
PEG Ratio: Returning to the Beverage Sector
Company Name Trailing PE Growth Std Dev PEG
Coca-Cola Bottling 29.18 9.50% 20.58% 3.07
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88% 2.82
Anheuser-Busch 24.31 11.00% 22.92% 2.21
Corby Distilleries Ltd. 16.24 7.50% 23.66% 2.16
Chalone Wine Group Ltd. 21.76 14.00% 24.08% 1.55
Andres Wines Ltd. 'A' 8.96 3.50% 24.70% 2.56
Todhunter Int'l 8.94 3.00% 25.74% 2.98
Brown-Forman 'B' 10.07 11.50% 29.43% 0.88
Coors (Adolph) 'B' 23.02 10.00% 29.52% 2.30
PepsiCo, Inc. 33.00 10.50% 31.35% 3.14
Coca-Cola 44.33 19.00% 35.51% 2.33
Boston Beer 'A' 10.59 17.13% 39.58% 0.62
Whitman Corp. 25.19 11.50% 44.26% 2.19
Mondavi (Robert) 'A' 16.47 14.00% 45.84% 1.18
Coca-Cola Enterprises 37.14 27.00% 51.34% 1.38
Hansen Natural Corp 9.70 17.00% 62.45% 0.57
Average 22.66 13.00% 33.00% 2.00
Aswath Damodaran 64
Analyzing PE/Growth
! Given that the PEG ratio is still determined by the expected growth rates, risk
and cash ow patterns, it is necessary that we control for differences in these
variables.
! Regressing PEG against risk and a measure of the growth dispersion, we get:
PEG = 3.61 -.0286 (Expected Growth) - .0375 (Std Deviation in Prices)
R Squared = 44.75%
! In other words,
PEG ratios will be lower for high growth companies
PEG ratios will be lower for high risk companies
! We also ran the regression using the deviation of the actual growth rate from
the industry-average growth rate as the independent variable, with mixed
results.
Aswath Damodaran 65
Estimating the PEG Ratio for Hansen
! Applying this regression to Hansen, the predicted PEG ratio for the rm can
be estimated using Hansens measures for the independent variables:
Expected Growth Rate = 17.00%
Standard Deviation in Stock Prices = 62.45%
! Plugging in,
Expected PEG Ratio for Hansen = 3.61 - .0286 (17) - .0375 (62.45)
= 0.78
! With its actual PEG ratio of 0.57, Hansen looks undervalued, notwithstanding
its high risk.
Aswath Damodaran 66
Extending the Comparables
! This analysis, which is restricted to rms in the software sector, can be
expanded to include all rms in the rm, as long as we control for differences
in risk, growth and payout.
! To look at the cross sectional relationship, we rst plotted PEG ratios against
expected growth rates.
Aswath Damodaran 67
PEG versus Growth January 2012
Aswath Damodaran 68
Analyzing the Relationship
! The relationship in not linear. In fact, the smallest rms seem to have the
highest PEG ratios and PEG ratios become relatively stable at higher growth
rates.
! To make the relationship more linear, we converted the expected growth rates
in ln(expected growth rate). The relationship between PEG ratios and
ln(expected growth rate) was then plotted.
Aswath Damodaran 69
PEG versus ln(Expected Growth) January 2012
Aswath Damodaran 70
PEG Ratio Regression - US stocks
January 2012
Aswath Damodaran 71
Negative interceptsand problem forecasts..
! When the intercept in a multiples regression is negative, there is the possibility
that forecasted values can be negative as well. One way (albeit imperfect) is to
re-run the regression without an intercept.
Aswath Damodaran 72
Applying the PEG ratio regression
! Consider Dell again. The stock has an expected growth rate of 10%, a beta of
1.20 and pays out no dividends. What should its PEG ratio be?
! If the stocks actual PE ratio is 18, what does this analysis tell you about the
stock?
Aswath Damodaran 73
A Variant on PEG Ratio: The PEGY ratio
! The PEG ratio is biased against low growth rms because the relationship
between value and growth is non-linear. One variant that has been devised to
consolidate the growth rate and the expected dividend yield:
PEGY = PE / (Expected Growth Rate + Dividend Yield)
! As an example, Con Ed has a PE ratio of 16, an expected growth rate of 5% in
earnings and a dividend yield of 4.5%.
PEG = 16/ 5 = 3.2
PEGY = 16/(5+4.5) = 1.7
Aswath Damodaran 74
Value/Earnings and Value/Cashow Ratios
! While Price earnings ratios look at the market value of equity relative to
earnings to equity investors, Value earnings ratios look at the market value of
the operating assets of the rm (Enterprise value or EV) relative to operating
earnings or cash ows.
EV = Market value of equity + Debt Cash
! The form of value to cash ow ratios that has the closest parallels in DCF
valuation is the ratio of Firm value to Free Cash Flow to the Firm.
FCFF = EBIT (1-t) - Net Cap Ex - Change in WC
! In practice, what we observe more commonly are rm values as multiples of
operating income (EBIT), after-tax operating income (EBIT (1-t)) or EBITDA.
Aswath Damodaran 75
Value/FCFF Multiples and the Alternatives
! Assume that you have computed the value of a rm, using discounted cash
ow models. Rank the following multiples in the order of magnitude from
lowest to highest?
" EV/EBIT
" EV/EBIT(1-t)
" EV/FCFF
" EV/EBITDA
! What assumption(s) would you need to make for the Value/EBIT(1-t) ratio to
be equal to the Value/FCFF multiple?
Aswath Damodaran 76
EV/FCFF: Determinants
! Reverting back to a two-stage FCFF DCF model, we get:



FCFF
0
= Free Cashow to the rm in current year
g = Expected growth rate in FCFF in extraordinary growth period (rst n years)
WACC = Weighted average cost of capital
g
n
= Expected growth rate in FCFF in stable growth period (after n years)\
! Dividing both sides by the FCFF
V
0
=
FCFF
0
(1 + g) 1-
(1 + g)
n
(1+ WACC)
n
!
"
#
$
%
&
WACC- g
+
FCFF
0
(1+ g)
n
(1+ g
n
)
(WACC- g
n
)(1 + WACC)
n
V
0
FCFF
0
=
(1 + g) 1-
(1 + g)
n
(1 + WACC)
n
!
"
#
$
%
WACC- g
+
(1+ g)
n
(1+ g
n
)
(WACC- g
n
)(1 + WACC)
n
Aswath Damodaran 77
Illustration: Using Value/FCFF Approaches to value a rm:
MCI Communications
! MCI Communications had earnings before interest and taxes of $3356 million
in 1994 (Its net income after taxes was $855 million).
! It had capital expenditures of $2500 million in 1994 and depreciation of $1100
million; Working capital increased by $250 million.
! It expects free cashows to the rm to grow 15% a year for the next ve years
and 5% a year after that.
! The cost of capital is 10.50% for the next ve years and 10% after that.
! The company faces a tax rate of 36%.
V
0
FCFF
0
=
(1.15) 1 -
(1.15)
5
(1.105)5
!
"
#
$
%
.105 - .15
+
(1.15)
5
(1.05)
(.10 - .05)(1.105)
5
= 3 1 . 2 8
Aswath Damodaran 78
Multiple Magic
! In this case of MCI there is a big difference between the FCFF and short cut
measures. For instance the following table illustrates the appropriate multiple
using short cut measures, and the amount you would overpay by if you used
the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885
Aswath Damodaran 79
Reasons for Increased Use of Value/EBITDA
1. The multiple can be computed even for rms that are reporting net losses, since
earnings before interest, taxes and depreciation are usually positive.
2. For rms in certain industries, such as cellular, which require a substantial
investment in infrastructure and long gestation periods, this multiple seems to
be more appropriate than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the rm prior to
all discretionary expenditures, the EBITDA is the measure of cash ows from
operations that can be used to support debt payment at least in the short term.
4. By looking at cashows prior to capital expenditures, it may provide a better
estimate of optimal value, especially if the capital expenditures are unwise
or earn substandard returns.
5. By looking at the value of the rm and cashows to the rm it allows for
comparisons across rms with different nancial leverage.
Aswath Damodaran 80
Enterprise Value/EBITDA Multiple
! The Classic Denition



! The No-Cash Version

!
Value
EBITDA
=
Market Value of Equity + Market Value of Debt
Earnings before Interest, Taxes and Depreciation
!
Enterprise Value
EBITDA
=
Market Value of Equity + Market Value of Debt - Cash
Earnings before Interest, Taxes and Depreciation
Aswath Damodaran 81
Enterprise Value/EBITDA Distribution US
Aswath Damodaran 82
Enterprise Value/EBITDA : Global Data
6 times EBITDA may seem like a good rule of thumb..
Aswath Damodaran 83
But not in early 2009
Aswath Damodaran 84
The Determinants of Value/EBITDA Multiples: Linkage to
DCF Valuation
! The value of the operating assets of a rm can be written as:



! The numerator can be written as follows:
FCFF = EBIT (1-t) - (Cex - Depr) - & Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) - & Working Capital
= EBITDA (1-t) + Depr (t) - Cex - & Working Capital
!
EV
0
=
FCFF
1

WACC- g

Aswath Damodaran 85
From Firm Value to EBITDA Multiples
! Now the value of the rm can be rewritten as,

! Dividing both sides of the equation by EBITDA,

! Since Reinvestment = (CEx Depreciation + & Working Capital), the
determinants of EV/EBITDA are:
The cost of capital
Expected growth rate
Tax rate
Reinvestment rate (or ROC)

!
EV =
EBITDA (1- t) + Depr (t) - Cex - " Working Capital
WACC- g

!
EV
EBITDA
=
(1- t)
WACC- g
+
Depr (t)/EBITDA
WACC- g
-
CEx/EBITDA
WACC- g
-
" Working Capital/EBITDA
WACC- g
Aswath Damodaran 86
A Simple Example
! Consider a rm with the following characteristics:
Tax Rate = 36%
Capital Expenditures/EBITDA = 30%
Depreciation/EBITDA = 20%
Cost of Capital = 10%
The rm has no working capital requirements
The rm is in stable growth and is expected to grow 5% a year forever.
Aswath Damodaran 87
Calculating Value/EBITDA Multiple
! In this case, the Value/EBITDA multiple for this rm can be estimated as
follows:
Value
EBITDA
=
(1- .36)
.10 -.05
+
(0.2)(.36)
.10 -.05
-
0.3
.10 - .05
-
0
.10 - .05
= 8.24
Aswath Damodaran 88
The Determinants of EV/EBITDA
!
Tax
Rates
Reinvestment
Needs
Excess
Returns
Aswath Damodaran 89
Is this stock cheap?
! Assume that I am trying to convince you to buy a company, because it trades
at 5 times EBITDA. What are some of the questions you would ask me as a
potential buyer?
! Following through, what combination of fundamentals would make for a
cheap company on an EV/EBITDA basis:
Tax rate
Growth
Return on capital
Cost of capital/Risk


Aswath Damodaran 90
Value/EBITDA Multiple: Trucking Companies:
Is Ryder cheap?
Company Name Value EBITDA Value/EBITDA
KLLM Trans. Svcs. 114.32 $ 48.81 $ 2.34
Ryder System 5,158.04 $ 1,838.26 $ 2.81
Rollins Truck Leasing 1,368.35 $ 447.67 $ 3.06
Cannon Express Inc. 83.57 $ 27.05 $ 3.09
Hunt (J.B.) 982.67 $ 310.22 $ 3.17
Yellow Corp. 931.47 $ 292.82 $ 3.18
Roadway Express 554.96 $ 169.38 $ 3.28
Marten Transport Ltd. 116.93 $ 35.62 $ 3.28
Kenan Transport Co. 67.66 $ 19.44 $ 3.48
M.S. Carriers 344.93 $ 97.85 $ 3.53
Old Dominion Freight 170.42 $ 45.13 $ 3.78
Trimac Ltd 661.18 $ 174.28 $ 3.79
Matlack Systems 112.42 $ 28.94 $ 3.88
XTRA Corp. 1,708.57 $ 427.30 $ 4.00
Covenant Transport Inc 259.16 $ 64.35 $ 4.03
Builders Transport 221.09 $ 51.44 $ 4.30
Werner Enterprises 844.39 $ 196.15 $ 4.30
Landstar Sys. 422.79 $ 95.20 $ 4.44
AMERCO 1,632.30 $ 345.78 $ 4.72
USA Truck 141.77 $ 29.93 $ 4.74
Frozen Food Express 164.17 $ 34.10 $ 4.81
Arnold Inds. 472.27 $ 96.88 $ 4.87
Greyhound Lines Inc. 437.71 $ 89.61 $ 4.88
USFreightways 983.86 $ 198.91 $ 4.95
Golden Eagle Group Inc. 12.50 $ 2.33 $ 5.37
Arkansas Best 578.78 $ 107.15 $ 5.40
Airlease Ltd. 73.64 $ 13.48 $ 5.46
Celadon Group 182.30 $ 32.72 $ 5.57
Amer. Freightways 716.15 $ 120.94 $ 5.92
Transfinancial Holdings 56.92 $ 8.79 $ 6.47
Vitran Corp. 'A' 140.68 $ 21.51 $ 6.54
Interpool Inc. 1,002.20 $ 151.18 $ 6.63
Intrenet Inc. 70.23 $ 10.38 $ 6.77
Swift Transportation 835.58 $ 121.34 $ 6.89
Landair Services 212.95 $ 30.38 $ 7.01
CNF Transportation 2,700.69 $ 366.99 $ 7.36
Budget Group Inc 1,247.30 $ 166.71 $ 7.48
Caliber System 2,514.99 $ 333.13 $ 7.55
Knight Transportation Inc 269.01 $ 28.20 $ 9.54
Heartland Express 727.50 $ 64.62 $ 11.26
Greyhound CDA Transn Corp 83.25 $ 6.99 $ 11.91
Mark VII 160.45 $ 12.96 $ 12.38
Coach USA Inc 678.38 $ 51.76 $ 13.11
US 1 Inds Inc. 5.60 $ (0.17) $ NA
Average 5. 61
Aswath Damodaran 91
Extending to the market
US Market: January 2012
Aswath Damodaran 92
EBITDA regressions across markets
January 2012
Region Regression January 2011 R squared
Europe EV/EBITDA= 12.47 $$$$$+0.02 Interest Coverage
Ratio - 11.50 Tax Rate$ -3.31 Reinvestment Rate$$
8.9%
Japan EV/EBITDA= 3.70 $$$$$-0.01 Interest Coverage
Ratio + 8.00 Tax Rate + 3.05 Reinvestment Rate
6.6%
Emerging
Markets
EV/EBITDA= 15.01$$$- 10.70 Tax Rate$$$$$-3.04
Reinvestment Rate
2.2%