Session 17: Book Value Multiples

Introduction

The speaker introduces the concept of book value and market value, and how they are used to estimate a company's worth.

Book Value vs Market Value

• Accountants estimate a company's book value, which is the estimated equity and overall capital.

• The market attaches values to these numbers to determine a company's market value of equity and enterprise value.

• Some companies trade below book value, some close to it, and others above it.

Understanding Price-to-Book Ratio

The speaker explains what drives the price-to-book ratio and how it can be used to evaluate a company's worth.

Price-to-Book Ratio

• There are two multiples that flow directly from the relationship between market value of equity and book value: price-to-book ratio and enterprise multiple.

• Price-to-book ratio is calculated by dividing market value of equity by book value of equity.

• A more expansive measure is enterprise multiple, which divides (market value of equity + market value of debt) by (book value of equity + book value of debt).

Market Valuation for Companies

The speaker discusses how markets estimate values for companies using measures such as market value of equity and price-to-book ratios.

Estimating Company Values

• Markets estimate values for companies using measures such as market value of equity and price-to-book ratios.

• Accountants also estimate values for businesses, spending a lot on getting this number right.

Relationship Between Market Value & Book Value

The speaker explores the relationship between a company's market value and its book value.

Multiples Derived from Market Value & Book Value Relationship

• Two multiples are derived from this relationship: price-to-book ratio & enterprise multiple.

• Numerator and denominator of these multiples must be internally consistent.

Global Distribution of Price-to-Book Ratio

The speaker shows the global distribution of price-to-book ratios to illustrate how much in common companies have.

Global Distribution

• The global distribution of price-to-book ratios has a peak to the left and a tail to the right.

• Differences exist across markets, with the US having the highest price-to-book ratio and Japan having the lowest.

Driver Variables for Price-to-Book Ratio

The speaker explains what drives differences in price-to-book ratios across markets and within companies.

Understanding Driver Variables

• Return on equity is the driver variable for price-to-book ratio.

• Companies with high price-to-book ratios generally have high return on equity, while those with low ratios have low return on equity.

• Growth rates also matter because they can be written as a function of retention ratio (1 - payout ratio) and return on equity.

Stable Growth Dividend Discount Model

The speaker uses a stable growth dividend discount model to back out variables that drive the price-to-book ratio.

Stable Growth Dividend Discount Model

• A stable growth dividend discount model is used to back out variables that drive the price-to-book ratio.

• The equation for this model includes four variables: cost of equity, expected growth rate in earnings, return on equity, and payout ratio.

• Return on equity is the one variable that pops up when introducing price-to-book ratios.

Simplified Version of Price-To-Book Ratio

The speaker provides an intuitive version of a simplified stable company's price-to-book ratio.

Intuitive Version

• For a stable company, the price-to-book ratio is a function of two things: excess returns (return on equity minus cost of equity) and growth rate.

• Companies that trade at roughly the cost of equity should trade at roughly book value.

• Companies traded well above book value usually have returns in equity that exceed the cost of equity, while those traded below book value usually have return on equity less than the cost of equity.

Finding Cheap Companies

In this section, the speaker discusses how to find cheap companies with high returns and low risk. The speaker uses the example of financial services sector and explains how price-to-book ratio is used to find cheap banks.

Using Median Values

• Financial services are well-suited for using price-to-book ratio.

• Banks have a mark-to-market rule in accounting which means that book value of equity should be updated.

• Mismatches can be found by comparing median values for price-to-book, return on equity, and risk measure (standard deviation).

• To find undervalued companies, look for banks trading below median price-to-book ratio with above-median return on equity and standard deviation below the median.

Regression Analysis

• Regression analysis can also be used to explain price-to-book ratio.

• Higher return on equity leads to higher price-to-book ratio while higher risk leads to lower price-to-book ratio.

• Predicted value takes into account the risk and return in equity of each bank.

• Banks trading below predicted price-to-book are considered cheap while those trading above their own predicted price-to-book are expensive.

Scatter Plots

• Interesting companies are those that fall off quadrants with low price-to-book and high return on equity or high price-to-book and low return on equity.

• A scatter plot of 100 largest market cap stocks in the US is used to identify undervalued or overvalued companies based on their position relative to regression line and confidence intervals.

Book Value Multiples and Relative Valuation

In this section, the speaker discusses book value multiples and relative valuation. He explains how to use these concepts to find cheap companies and shares his thoughts on Nokia as a potentially interesting stock.

Book Value Multiples

• Companies with high growth rates may appear expensive when looking at price-to-book ratios without considering growth.

• Return on equity is an important factor in determining the relationship between market value of equity and book value.

• The speaker advises keeping the companion variable rule in mind when looking at multiples.

Relative Valuation

• Relative valuation can be used to find cheap companies by comparing them to others in the same industry or sector.

• The speaker uses Nokia as an example of a company he finds interesting and plans to do a full-fledged intrinsic valuation on.

• Regression analysis can also be used for relative valuation by finding the ten cheapest and most expensive stocks among a group of 100 largest market cap companies.