Some notes on relative valuation

Earnings for which period should we use?

Two basic types of ratios:  Trailing ratios. Using trailing earnings (NI or EBITDA), i.e. over the prior 12 months.

 Forward ratios. Using expected earnings over the coming 12 months Other periods can be more reasonable (imagine cyclical industry with a 3 years cycle – better take average earnings over the last 3 years)

Example: why we should be careful when using comparables

Forward P/E = P 0 /EPS 1 = (Div 1 /(r E -g))/EPS 1 Dividend Payout Rate/(r E -g), where g – earnings growth rate = What if r E is different?

What if g is different?

What if the payout rate is different?

Note: chapters in BD: 9 and 19

Initial Public Offerings (BD, ch. 23)

Private and Public companies:     Private (privately held) companies have fewer shareholders and their shares are NOT traded on a stock exchange Public (publicly held) companies have their shares traded publicly on a stock exchange without restrictions, they have large number of shareholders Private companies are usually smaller (but think of IKEA, Mittal Steel (Ispat International) until 1997) Public companies are subject to much stricter rules and regulations (e.g. disclosure, financial reporting) IPO is the first sale of stock by a company to the public.

UPDATE: in 2006 US$227 billion raised in 1559 new deals

2005 global IPO activity by countries

(note: activity is assigned to the domicile of the listing company) Source: Ernst&Young/Thomson Financial UPDATE: China and Russia in 2006! (see next slide)

Largest IPOs in 2005

In 2006 we had:    China's ICBC: $22 billion (Hong Kong exchange) Bank of China Ltd: $11 billion (Hong Kong exchange) Rosneft: $10.4 billion (London exchange)

Russia’s IPOs

1996-2003: only 6 deals 2004: US$600 million, 7 deals 2005: US$4 billion, 8 deals 2006: US$20 billion, 20 deals Largest IPOs:  Rosneft, 2006, US$10.4 billion (LSE and Russia)     AFK Sistema, 2005, US$1.5 billion (LSE) Comstar-UTS, 2006, US$1 billion (LSE) Severstal, 2006, US$1 billion (LSE) Novatek, 2005, US$1 billion (LSE)

Reasons for Going Public

New Finance   Direct. Funds raised at IPO Indirect. Helps to raise funds in the future Due to reduction in leverage. But why not private placement?  Increase in liquidity of stock.

 Liquidity is valuable per se, but in addition it helps to raise funds in the future (more precise information about a firm’s value helps to attract finance) Increased competition among suppliers of finance (i.e. lower cost of capital)

Reasons for Going Public (cont-d)

Liquidity and possibility for diversification Cashing in ( Владимир Лисин?) Issuing new stock for future M&A transactions (liquid shares are valued more, easier to get an estimate for a firm’s value) Greater dispersion of ownership mitigates the problem of excessive monitoring of managers by shareholders Enhanced company image and publicity  Visibility of the company and its products Motivating management and employees  E.g. through conditioning compensation on the stock price (stock-based compensation) Exploiting mispricing  Timing issues to take advantage of swings in investor sentiment

Costs of Going Public

Direct costs (underwriting, auditing and legal fees, effort) Cost of information disclosure вознаграждение директоров, структура бизнеса, планы) (отчетность, Underpricing Cost of constraining business decisions (asking approval by the board, shareholder meeting) Tax implications  Greater transparency of accounts may lead to more taxes paid Danger of loss of control (through hostile takeover) Fiduciary duty (to shareholders) risk

Underpricing at IPO

Widely documented phenomenon: offering price is typically lower than the market price of the shares right

after

the IPO Ritter and Welch (2002), US data (but the same is true for other countries too):  In the sample of 6,249 IPOs from 1980 to 2001 the average first-day return is 18.8 percent.

 About 70 percent of the IPOs end the first day of trading at a closing price greater than the offer price and about 16 percent have a first-day return of zero.

First day IPO returns

Some Theories of Underpricing

Theories based on asymmetric information  Issuer is better informed than investors – signaling by underpricing as a response to the lemons problem Good firms separate themselves from bad ones by offering underpriced stock  Winner’s Curse (Berk-DeMarzo, p. 767): if the deal is overpriced you get your full order and bear the losses in full if the deal is underpriced you are rationed – have to share the benefits of underpricing with other investors

Some Theories of Underpricing (cont-d)

Some other theories:  Avoiding legal liabilities (more relevant for the US).

Drops in prices may trigger lawsuits. So it’s better to have a lower price from the start.

 Achieving greater liquidity through greater ownership dispersion NOTE: in the long run IPOs are shown to

underperform

the market

Mergers & Acquisitions (BD ch. 28)

Ten Largest Merger Transactions, 1995-2005

World M&A market in 2006: about US$3.8 trillion Russia’s M&A market in 2006: roughly US$50 billion Growing both in the world and in Russia In Russia: share of cross boarder transactions is increasing (e.g. Vimpelcom-Turkcel, Evraz-Oregon Steel, RusAl+ SUAL+Glencore, Lukoil-Nelson Resources)

Merger waves. Percentage of Public Companies Taken Over Each Quarter, 1926 –2005

Reasons for a merger

Synergies   Operational synergies Economies of scale and scope (e.g. reduction of marketing costs or expenses on distribution) Increase in market power Vertical integration (e.g. control over suppliers) Diversification (benefit those who cannot diversify themselves, reduces bankruptcy risk) Efficiency gains due to the change in management Empire building (is not efficiency-driven)

Who gains from a merger?

Friendly and hostile takeovers

Friendly: the target’s board supports the merger and recommends the shareholders to sell their shares (then the shareholders vote) Hostile: the board opposes the takeover and does not recommend the shareholders to sell at the price offered by the raider. It also uses all kinds of protective measures (takeover defenses).