Price and Value: A Guide to Equity Market Valuation Metrics

412 Pages·2020·19.697 MB·English

by  George Calhoun

Price and Value
A Guide to Equity Market
Valuation Metrics
George Calhoun
Price and Value: A Guide to Equity Market Valuation Metrics
George Calhoun
Jersey City, NJ, USA
ISBN-13 (pbk): 978-1-4842-5551-3 ISBN-13 (electronic): 978-1-4842-5552-0
https://doi.org/10.1007/978-1-4842-5552-0
Copyright © 2020 by George Calhoun
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“Measuring the price of something and measuring its value …
are two different tasks.”
—The Economist magazine (2019)
“Price and value… Find the disconnect.”
—Forbes magazine (2018)
“Price is what you pay. Value is what you get.”
—Warren Buffett (2008)
“Nowadays people know the price of everything and
the value of nothing.”
—Oscar Wilde (1890)
Table of Contents
About the Author �����������������������������������������������������������������������������������������������������xi
About the Technical Reviewer �������������������������������������������������������������������������������xiii
Acknowledgments ���������������������������������������������������������������������������������������������������xv
Preface ������������������������������������������������������������������������������������������������������������������xvii
Introduction ����������������������������������������������������������������������������������������������������������xxiii
Chapter 1: The Ford Dollar: The Mysterious Multiple �����������������������������������������������1
1.1 P/E As a Measure of How “Expensive” a Company Is .............................................................4
1.2 P/E As a Predictor of Future Share Price .................................................................................6
1.3 P/E As a Predictor of Future Returns .......................................................................................9
1.4 The Mysterious Multiple ........................................................................................................16
Chapter 2: The Value Triangle ���������������������������������������������������������������������������������19
2.1 Accounting Valuations: The Limitations of “Book Value” .......................................................20
2.2 The Shortcomings of Financial Models .................................................................................25
2.3 The Pros and Cons of Market-Based Valuation Metrics ........................................................30
2.3.1 Disney vs. Netflix ..........................................................................................................31
2.3.2 Ford vs. Tesla ................................................................................................................33
2.4 Triangulating Intrinsic Value: The Use of Valuation Ratios .....................................................36
2.4.1 Price-to-Book ...............................................................................................................37
2.4.2 Return-on-Assets .........................................................................................................38
2.4.3 Price-to-Earnings .........................................................................................................39
2.5 Summary...............................................................................................................................40
v
Table of ConTenTs
Chapter 3: Valuation Ratios ������������������������������������������������������������������������������������41
3.1 Trailing P/E, or P/E ..............................................................................................................42
ttm
3.2 Forward P/E ..........................................................................................................................44
3.2.1 PER (Relative P/E) .........................................................................................................49
3.2.2 Normalized P/E .............................................................................................................49
3.2.3 Improving on P/E? ........................................................................................................50
3.3 Price-to-Operating Earnings .................................................................................................50
3.3.1 Pro Forma Earnings ......................................................................................................54
3.3.2 Core Earnings ...............................................................................................................57
3.4 D ividends ..............................................................................................................................59
3.4.1 Dividend Ratios: Significance and Trends .....................................................................60
3.5 P rice-to-Sales .......................................................................................................................65
3.6 Metrics Based on Cash Flow .................................................................................................74
3.6.1 EBITDA and EV/EBITDA .................................................................................................75
3.6.2 Free Cash Flow .............................................................................................................76
3.6.3 Do Cash Flow Metrics Improve Upon Earnings-Based Multiples? ................................78
3.7 P rice-to-Book ........................................................................................................................83
3.8 T obin’s Q ................................................................................................................................86
3.9 R eturn-on-Assets ..................................................................................................................88
3.10 Adjustments to the Denominator: Cyclically Adjusted P/E (CAPE ) ......................................90
1
3.10.1 Critics and Critiques ...................................................................................................94
3.10.2 CAPE Performance .....................................................................................................96
3.10.3 CAPE: An Assessment ...............................................................................................107
3.11 Adjustments to the Numerator: Cash-Adjusted P/E (CAPE ) .............................................113
2
3.12 What About the PEG Ratio? ...............................................................................................120
3.13 Composite P/E Ratios ........................................................................................................123
3.14 Summary...........................................................................................................................126
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Table of ConTenTs
Chapter 4: Interpretations: P/E As a Dependent Variable �������������������������������������131
4.1 What Does the P/E Really Measure? ...................................................................................132
4.2 Firm-Level Drivers ..............................................................................................................135
4.2.1 Growth ........................................................................................................................135
4.2.2 Profitability, and “Quality” ..........................................................................................146
4.2.3 Size .............................................................................................................................156
4.2.4 “Risk” and Cost of Capital ..........................................................................................159
4.2.5 Shareholder Return ....................................................................................................162
4.2.6 Strategy and Business Model Issues ..........................................................................168
4.2.7 Earnings Volatility .......................................................................................................185
4.2.8 Share Price Volatility (Beta) ........................................................................................188
4.2.9 L everage .....................................................................................................................194
4.2.10 A ccounting Issues.....................................................................................................201
4.2.11 G overnance...............................................................................................................202
4.3 Sector-Level and Market- Level Drivers ...............................................................................207
4.3.1 Sentiment (“Animal Spirits”) ......................................................................................207
4.3.2 Sector Discounts and Premiums ................................................................................212
4.3.3 R egulation ..................................................................................................................219
4.3.4 Monetary Policy ..........................................................................................................222
4.3.5 Fiscal Policy ................................................................................................................226
4.3.6 I nflation ......................................................................................................................228
4.3.7 Interest Rates and Bond Yields ...................................................................................233
4.3.8 International Differences ............................................................................................240
4.4 S ummary.............................................................................................................................245
Chapter 5: Applications: P/E As an Independent Variable ������������������������������������249
5.1 Using Multiples to Forecast Stock Prices ............................................................................250
5.1.1 The General Case: P/E As a Contrarian Indicator ........................................................250
5.2 Screening for “Value” .........................................................................................................256
5.2.1 Evidence for the Value Anomaly .................................................................................257
5.2.2 Explanations of the Value Anomaly .............................................................................261
5.2.3 Comparing Multiples As Value Screens ......................................................................273
vii
Table of ConTenTs
5.3 Index Construction ..............................................................................................................286
5.4 Factor Models and “Smart Beta” ........................................................................................288
5.4.1 The Proliferation of Factors ........................................................................................290
5.4.2 The “Value” Cornerstone ............................................................................................292
5.5 Valuing Corporate Transactions ...........................................................................................293
5.5.1 Deal Pricing ................................................................................................................293
5.5.2 Sum-of-the-Parts Analyses (the Conglomerate Discount) ..........................................296
5.6 Diagnosing Market Regimes ...............................................................................................299
5.6.1 Monetary Policy Impact ..............................................................................................300
5.6.2 Bubble Detection ........................................................................................................304
5.6.3 Illuminating the “Fine Structure” of Market Regimes ................................................308
5.7 S ummary.............................................................................................................................314
Chapter 6: Assessments and Qualifications ���������������������������������������������������������317
6.1 The Best Metric Today (2019): The P/E ................................................................................317
6.1.1 P/E Tends to Prevail (but Not Always), and It Only Explains So Much .........................319
6.1.2 Substituting Earnings Measures Other Than GAAP-Compliant Net Earnings
Does Not Reliably Improve Performance (Yet) ............................................................320
6.1.3 The Performance of All Multiples Is Highly Dependent on the Market Regime ..........320
6.1.4 The Performance of Some Multiples Has Diminished Significantly over Time ...........321
6.1.5 Sensitivity Varies, but Favors P/E ...............................................................................321
6.1.6 A Future Orientation Tends to Improve Short-Term Performance,
but Only So Much .......................................................................................................322
6.1.7 Prediction Tends to Improve Significantly as the Holding Period Increases ...............323
6.1.8 Cash Flow Multiples Are Less Reliable .......................................................................323
6.1.9 Averaging (Trend-Smoothing) Multiples: An Under-explored Concept ........................324
6.1.10 P/E Wins the Industry Popularity Contest .................................................................324
6.2 Shifting Definitions ..............................................................................................................326
6.2.1 GAAP, Non-GAAP, Core, and So On: The Validity Problem for “Earnings” .....................327
6.2.2 Street Earnings ...........................................................................................................328
6.2.3 IFRS vs. GAAP .............................................................................................................331
6.2.4 Changing Accounting Standards ................................................................................332
6.2.5 Earnings Management 1: Gaming the Numbers .........................................................334
viii
Table of ConTenTs
6.2.6 Earnings Management 2: Buybacks and EPS Enhancement ......................................336
6.2.7 Cash Dilution (“Nonoperating Financial Assets”) .......................................................340
6.2.8 Taxes ...........................................................................................................................341
6.2.9 The Effect of Asset-Light Business Models ................................................................343
6.2.10 The Effect of Alternate Growth Strategies: Acquisition vs. Internal Development ....347
6.3 Problems with Price-to- Book ..............................................................................................349
6.4 ROA: An Incomplete Picture ................................................................................................352
6.5 Concluding Comments: The Uncertainty Principle(s) in Finance .........................................355
6.5.1 The Academic Confusion Factor .................................................................................355
6.5.2 Reflexivity and the “Human Uncertainty Principle” ....................................................357
6.5.3 Fischer Black’s Proposition ........................................................................................360
6.5.4 Price-Insensitive Markets ...........................................................................................363
Appendix A: A Critical Examination of Discounted Cash Flow
Valuation Methods ������������������������������������������������������������������������������������������������365
The End of Book Value ..............................................................................................................365
Discounted Cash Flow Modeling: A Critical Assessment ...........................................................369
The DCF Best Case ..............................................................................................................370
What Is DCF, Really? ............................................................................................................371
Uncertainties, Compounded ................................................................................................372
DCF Manipulation ................................................................................................................376
Is DCF Actually Used by Market Practitioners? ....................................................................377
DCF: Assessments ...............................................................................................................378
Afterword: Fair Price, True Value ��������������������������������������������������������������������������381
Index ���������������������������������������������������������������������������������������������������������������������385
ix
About the Author
George Calhoun
• Professor and Founding Director of the Quan-
titative Finance Program – Stevens Institute of
Technology
• Executive Director of the Hanlon Financial
Systems Center, at Stevens
• Area Coordinator for graduate and undergraduate
finance programs, at Stevens
• Series Editor for the Stevens Series in Quantitative
Finance and Data Sciences, a book series
launched in 2014 with Springer/Apress
• PhD from the Wharton School
• 30 years of experience in the technology industry,
in executive and board-level positions at several
public companies, including as Chief Executive
Officer (CEO), Chairman of the Board (two
companies), and Audit Committee Chairman
(four companies)
• Extensive experience in capital acquisition
through public offerings (five), convertible and
straight debt offerings, private placements, joint
ventures, and venture capital transactions
• Author of three books on advanced signal
processing technology and applications to the
telecommunications field
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