Mentorship Session III
Will Showers – Director of Mentorship Welcome Back
What we covered last time Modern Portfolio Theory Diversification Risk aversion Systematic vs company-specific risk Capital Asset Pricing Model Market Beta Accounting Fundamentals The three Financial Statements Major line-items How the three statements work together
Mentorship || Session 3 Today’s Topics
Efficient Market Hypothesis Is the listed price of a security its “true” price? How does public information become factored into asset prices? Arbitrage Valuation Multiples Relative Valuation Intrinsic Valuation
Mentorship || Session 3 Efficient Market Hypothesis
True prices, mispricing, and public vs private information
Mentorship || Session 3 Efficient Market Hypothesis Investment theory that states that all existing asset prices reflect all relevant information This implies that investors cannot “beat” the market If EMH holds, risk is the only factors driving the magnitude of returns Do we believe this though? 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”
Mentorship || Session 3 Efficient Market Hypothesis
Three different levels of “efficiency” exist in academia Weak Form Prices only reflect past publically available information Semi-strong Form Prices reflect past publically available information and prices instantly change to reflect new public information Strong Form Prices instantly reflect both public and private information Think insider trading
Mentorship || Session 3 Efficient Market Hypothesis
Popular view among institutional investors: 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: Small firm effect (Fama-French Model) Value effect (Fama-French, Ben Graham, Warren Buffet) Mean reversion Overreaction / Underreaction The Human Element
Mentorship || Session 3 Beating the Market Beating the market doesn’t just mean having higher returns than the average market return We must adjust for risk Example: 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? 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.
Mentorship || Session 3 Alpha
Alpha is a measurement of performance on a risk- adjusted basis The realized returns in excess of the expected return of an investment a = Returns Realized – E(Returns) Example: 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?
Mentorship || Session 3 Sharpe Ratio
Sharpe Ratio is another way to compare risk adjusted returns 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
Mentorship || Session 3 Valuation
Relative and intrinsic valuation, and using multiples
Mentorship || Session 3 Valuation
Despite which investment philosophy you are using, valuation is crucial Growth How much growth has already been factored into an asset’s price? Momentum If this stock is “hot”, how far above its true value will it go before investors sell off? Value Is the market wrong in pricing certain assets? The only way to know is to conduct valuation
Mentorship || Session 3 Valuation
Two main types of valuation Relative Valuation 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 Example: If Exxon is mispriced significantly, it’s unlikely that ConocoPhillips, BP, Chevron, and Total are mispriced as well Intrinsic Valuation Determining the actual value of an asset based on its fundamentals and without any reference to its market value
Mentorship || Session 3 Valuation Trading at a discount When an asset is being bought and sold for a price lower than what similar assets are being traded for Trading at a premium 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: 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 If it doesn’t, it is likely that you are dealing with a mispriced asset
Mentorship || Session 3 Relative Valuation
Use market prices of comparable transactions to impute the value of your firm Relative valuation is commonly used in real estate 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
Mentorship || Session 3 Relative Valuation Step 1 – Find comparable companies Step 2 – Using comps, calculate a valuation metric which is a ratio of value to some attribute Price to Earnings Enterprise Value to EBITDA Step 3 – Calculate the initial value estimate using this average ratio 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 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)
Mentorship || Session 3 Relative Valuation Real Estate Example
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
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
Mentorship || Session 3 Relative Valuation Example
However, your house has a better lot and also has a swimming pool, while the other houses don’t 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
Mentorship || Session 3 Relative Valuation Example
These types of differences are even more stark when comparing entire companies E.g., the management makes a huge difference in the value of a company, and that isn’t fully reflected in the comps’ EBITDA- ratios 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!
Mentorship || Session 3 Relative Valuation Example
This simple example teaches us the following: 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
Mentorship || Session 3 Step 1 - Comp Selection
“Garbage in, garbage out” Looking for companies with similar fundamentals Industry, Geography, Market Cap, etc. On Bloomberg, preset comps are a good place to start 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 This method often gives you enough companies to work with and can take as little as 5 minutes
Mentorship || Session 3 Step 2 - Valuation Multiples
We cannot simply compare line items across different companies 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: Price / Earnings per share Price / Revenue Enterprise Value / EBITDA
Mentorship || Session 3 Valuation Multiples – P/E
Price / Earnings, “P/E” Market Capitalization / Net Income OR Share Price / EPS Essentially demonstrates how much you are paying per dollar of earnings as a potential investor E.g. A P/E of 12.0 means you are paying $12 for every $1 of earnings P/E ratios tend to indicate growth expectations of a company A higher P/E means investors expect earnings to increase quickly relative to other companies Trailing P/E Uses current share price divided by earnings per share from the most recent four historical fiscal quarters (year) Forward P/E Uses current share price divided by the expected earnings per share from the next four fiscal quarters (year)
Mentorship || Session 3 Valuation Multiples – PEG
Price / Earnings / Growth 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 Either historical, projected, or a hybrid (3 historical years, 2 projected years) PEG ratios tend to be close to 1.00
Mentorship || Session 3 Valuation Multiples – EV/EBITDA
Enterprise Value EV = Market Capitalization + Debt – Cash The amount that you would be required to buy the entire company 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 EV/EBITDA One of the most popular valuation multiples and is used in many other valuation applications Great comparative metric Does not take into account differences in tax rates, capital structure (interest), or non cash expenses (Depreciation/Amortization)
Mentorship || Session 3 Other Valuation Multiples EV/Revenue Measurement of top-line performance Price/Sales Used for companies with negative earnings Price/Free Cash Flow Not extremely popular, but remember that “Cash is King” EV/EBITDAR 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 Used for software companies
Mentorship || Session 3 Levered vs Unlevered Multiples
Whether a multiple is levered or not is a very important distinction 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 This is why you should always look at both levered and unlevered multiples to see the whole picture
Mentorship || Session 3 Levered vs Unlevered Multiples
So how do we know which multiples are levered? 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 As such, anything EBIT and above is considered unlevered Anything below EBIT is considered levered as interest expenses are accounted for in the multiple
Mentorship || Session 3 Levered vs Unlevered Multiples
There is one other important distinction Market prices (market capitalization & price per share) are levered as the market will always account for capital structure when pricing assets Enterprise Value EV = Market Capitalization + Debt – Cash More importantly though… EV = NPV of all future unlevered free cash flows It is the sum of all cash available to the firm before paying back creditors As such, it is unlevered
Mentorship || Session 3 Levered vs Unlevered Multiples
Levered Price/Earnings PEG Price/Book Price/Free Cash Flow Unlevered EV/EBITDA EV/Revenue EV/Page Views EV/Unlevered Free Cash Flow
Mentorship || Session 3 Operating Metrics 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% 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 Rev. Growth (3-5 year CAGR) EPS Growth (3-5 year CAGR) Gross Margin % Profit Margin % FCF Margin %
Mentorship || Session 3 Relative Valuation Example Type in company ticker Select ‘Relative Valuation’
Mentorship || Session 3 Relative Valuation Example
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
Mentorship || Session 3 Relative Valuation
Refine list to closest set of comps Look for 4-6 comps
Mentorship || Session 3 Relative Valuation Example Go to ‘Custom’ tab to add valuation multiples and operating metrics Copy/Paste results in Excel
Mentorship || Session 3 Relative Valuation Example
Highlight highs and lows to make conclusions on value
Valuation: Share EV/EBITDA P/E P/E/G P/S P/FCF EV/SALES Company Name Price Marathon Petroleum $ 55.97 5.0 x 8.8 x N/A 0.4 x 16.2 x 0.5 x Phillips 66 $ 92.75 9.1 x 10.3 x 2.4 x 0.5 x 71.7 x 0.6 x Tesoro $ 113.69 5.2 x 8.2 x 0.5 x 0.4 x 11.4 x 0.6 x Valero $ 71.95 3.9 x 6.9 x 3.3 x 0.3 x 7.9 x 0.4 x
Maximum 9.1 x 10.3 x 3.3 x 0.5 x 71.7 x 0.6 x 75th Percentile 6.1 x 9.1 x 2.9 x 0.4 x 30.1 x 0.6 x Median 5.1 x 8.5 x 2.4 x 0.4 x 13.8 x 0.5 x 25th Percentile 4.7 x 7.9 x 1.4 x 0.4 x 10.5 x 0.5 x Minimum 3.9 x 6.9 x 0.5 x 0.3 x 7.9 x 0.4 x
Performance: Share Rev. Growth Profit Growth EBIT Margin EBITDA Margin FCF Margin Profit Margin ROA ROE Company Name Price 3-5 year CAGR 3-5 year CAGR Marathon Petroleum $ 55.97 2.83% 26.78% 7.60% 9.85% 2.59% 4.88% 11.20% 29.95% Phillips 66 $ 92.75 N/A N/A 8.21% 9.42% -0.17% 4.82% 9.54% 21.02% Tesoro $ 113.69 7.80% 57.96% 16.69% 19.17% 1.67% 5.28% 10.58% 32.71% Valero $ 71.95 1.45% 34.05% 9.47% 11.61% 1.60% 5.00% 9.57% 21.74%
Maximum 7.80% 57.96% 16.69% 19.17% 2.59% 5.28% 11.20% 32.71% 75th Percentile 5.32% 46.01% 11.28% 13.50% 1.90% 5.07% 10.74% 30.64% Median 2.83% 34.05% 8.84% 10.73% 1.64% 4.94% 10.08% 25.85% 25th Percentile 2.14% 30.42% 8.06% 9.74% 1.16% 4.87% 9.56% 21.56% Minimum 1.45% 26.78% 7.60% 9.42% -0.17% 4.82% 9.54% 21.02%
Mentorship || Session 3 Sensitivity Analysis
How does sensitivity analysis relate to Relative Valuation? 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’ E.g. a fair value range from a P/E of 10.0 – 14.0 (+/- 16%)
Mentorship || Session 3 What does RV output tell us?
First, look at a company’s multiples relative to its peers Then, see if the operating metrics support your findings 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?
Mentorship || Session 3 Constructing a fair value range Remember that we cannot be 100% confident about the fair value of a company Hence the usefulness of sensitivity analysis Fair value range “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 We know that it should be trading less than Company B but more than Company C But by how much? The level of confidence in a valuation is evident in how wide the fair value range is
Mentorship || Session 3 Putting it all together… “Buy low, sell high” Just like buying a house, you want to find the cheapest price for its square footage (in a certain condition, of course) The same thought process should apply to investing! You can achieve similar returns or exploit a trend similarly through multiple investment avenues You want to find the cheapest option as it will maximize your upside! Lower multiples implies that an investment is “cheaper” 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
Mentorship || Session 3 What we have learned so far
Efficient Market Hypothesis Alpha and Risk-adjusted Returns Importance of Valuation Valuation Multiples Sensitivity Analysis
Session 3 Quiz A link will be sent out shortly after the meeting Please complete it by Thursday!
Mentorship || Session 3 Next Time
Currencies The Fed Intrinsic Valuation Free Cash Flow WACC DCF
Questions? Email: [email protected] Hang around after
Mentorship || Session 3