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DICK SMITH HOLDINGS (ASX: DSH)

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A wise broker once said the difference between a hand grenade and a company float is that the average investor has enough sense to throw the hand grenade
away.

BACKGROUND
Dick Smith Holdings Limited is a leading retailer of consumer electronics products in Australia and New Zealand.
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Dick Smith was founded in 1968 by Australian entrepreneur Richard Dick Smith, starting as a single store car radio
installation business in the Sydney suburb of Artarmon. It was partially purchased by Woolworths Limited
(ASX:WOW) in 1981, at which time there were 20 stores, before Woolworths took complete ownership in 1983. In
2001, Woolworths acquired Tandy, rebranding the majority of these stores as Dick Smith, and by 2005 it was
generating $1bn in sales. Though Dick Smith was a highly regarded and well-known brand across Australia, intense
competitive pressures and a failed restructuring of the brand by Woolworths in 2008 (Dick Smith Talk to the
Techxperts) led to Woolworths trying to offload the brand in 2012. Woolworths own strategic review concluded
that the Dick Smith business was not core to its future plans due to its size and business model. As a result,
Woolworths divested Dick Smith and it was ultimately picked up by Anchorage Capital Partners (Anchorage) in
November 2012 for $94m. Anchorage is an Australian based turnaround-focused private equity firm with
approximately $450m in funds under management. Following a 12-month restructuring, Dick Smith Holdings listed
on the 4
th
December 2013, raising $520m (at $2.20 per share) in the process. The IPO returned Anchorage a four-
fold return on its $94m investment, which was predominately prescribed to by institutional investors.
Commenting on the significant twelve month turnaround, Clime Asset Managements John Abernethy, quoted in the
Australian on the 30
th
November 2013, was quite sceptical about the value of the float (at 13 times earnings).
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Asking
the question so many value investors were thinking at the time - Was Woolworths management really so naive as to
sell Dick Smith at a significant discount to fair value? Or was it that the new investors (i.e. those that would
participate in the float) were the gormless ones by believing that the company could be turned around (in a
sustainable manner) in just under a year. If Dick Smith was so strong, why is it that the private equity players were
taking out $405m of the $418 million raised? Actions such as these evoke memories of the Myer float in 2009 (for
those unlucky enough to participate in the float at $4 when private equity owners TPG got out fast, four years later
the stock is trading at $2.25).
Despite these concerns, the recent wave of listings, and the ability of these new stocks to hold their ground has given
fund managers confidence that markets are not set for a repeat of 2007 when investors were overrun with floats
before the financial crisis hit. Most recently Dick Smith Holdings was trading at $2.25 (a slight premium to the listing
price). Key dates and information regarding the IPO can be found in Exhibit 1 and 2 located in the Appendix.

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This case study has been prepared by Dr Angelo Aspris for FINC3015: Valuations: A Case Study Approach. It has been constructed using a mix of both real
(publicly available sources identified) and fictional data. There is sufficient information within the bounds of this case study to use as a basis for your assumptions,
eliminating the need for external research. All mistakes are those of the author. No part of this publication may be reproduced without the permission of the
author.
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Dick Smith is the largest consumer electronics retailer in Australia and New Zealand by total number of stores and is one of the largest by total retail sales value.
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Down to Earth Approach to Floats (30 November 2013, The Australian, James Kirby)
Market Cap
$532m
Shares Outstanding
$236.5

Last Close
$2.25
GICS Sector
Consumer Discretionary
GICS Industry
Retailing


Your job is to provide an assessment of the listing price as at the date of listing (i.e. the IPO price as at 4
th
December, 2013). Does it
represent fair value for its long term investors? Use the provided qualitative and quantitative data to form your assessment.
1 INDUSTRY ANALYSIS
Dick Smith operates in the consumer electronics retail sector in Australia and New Zealand, which is estimated to be
an $11 to $12bn market. This sector involves the retail of consumer electronics products and related items including:
computers, including desktop computers, ultrabooks, laptops, notebooks, e-readers, tablets and other
portable computers, and peripherals, including monitors, printers, inks and scanners;
home video, including televisions (e.g. plasma and LED-LCD), visual components (e.g. DVD, Blu-ray and
media players and HD recorders), and audio products (e.g. hi-fi and home theatre, speakers and docks);
mobile phones, including mobile handsets and telephone service agreements (both pre-paid and post-paid);
portable entertainment devices, including portable audio and digital radios, MP3 players and headphones;
imaging devices, including digital cameras (e.g. compact, SLR and video), gaming (e.g. consoles and games),
movies (e.g. DVD and Blu-ray) plus related accessories;
security device products, including surveillance cameras, smoke alarms, travel security, and baby monitors;
and related accessories, including adapters, bags, batteries, cables, cases, memory cards and travel
accessories, as well as in-store services, product installation, warranties and insurance.
Dick Smiths range covers most of these product categories, with an emphasis on office (e.g. computers ~54%) and
mobility products (e.g. mobile phones ~14%) and associated accessories, as well as entertainment (e.g. televisions
~30%).
In Australia and New Zealand, consumer electronics products are sold through a number of different retail formats.
These include:
specialty consumer electronics retailers (with physical stores and online channels), such as Dick Smith, JB
Hi-Fi, Harvey Norman, The Good Guys, Noel Leeming and other independent consumer electronics
retailers;
department stores, such as Myer and David Jones;
discount department stores, such as Big W, Kmart, Target and The Warehouse Group; and
online pure-play retailers, such as Appliances Online, Amazon, eBay and Kogan.



The key drivers of the consumer electronics industry are:
1) Technological change New products continue to be the largest driver of volume growth in the
consumer electronics industry.
2) Pricing trends in key categories A constant feature of the consumer electronics industry has been
price deflation. Over the last five years, average selling prices for the total consumer electronics industry
have fallen by 3% p.a. This has been primarily led by the computers and peripherals category. Price deflation
is principally being driven by aggressive market share tactics and the strong Australian dollar.
3) Industry competitive dynamics Given testing trading conditions, the Australian and New Zealand
consumer electronics market has been consolidating over the past five years. The combined market share of
the top 3 consumer electronics retailers (Dick Smith, Harvey Norman, and JB Hi-Fi) has grown over the
past five years (to ~ 54% market share) as their network size and scale, brand awareness, and strong product
offerings have driven market share gains. With largely homogenised products, often easily transported, the
consumer electronics industry has been transformed by online retailing. Despite its increasing presence,
however, the penetration of online retailing in the Australian consumer and electronics market has risen
from 6% in 2008 to 10% in 2012.
4) General consumer spending environment Consumer electronics is largely considered to consist of
discretionary spend products and therefore, the consumer electronics retail market is influenced by external
factors such as consumer sentiment, household disposable income, savings rate, interest rates, exchange
rates and inflation.
Consensus forecasts suggest that Australian demand for consumer electronics will grow by around 3% in the
foreseeable future. The following SWOT analysis has been prepared for the Consumer Electronics Industry in
Australia for the 4
th
Quarter, 2013 (www.businessmonitor.com).


Strengths
* Digitially literature nation with high penetration levels of products like
computers (90%) and digital cameras (75%).
* The Australian market offers continued growth potential in key products
groups such as notebook computers and flat-screen TV sets.
*High incomes, with GDP per capita $67,035 USD (Estimate: Wolrd Bank,
2013)

Weaknesses
* Australia is a mature market wwith relatively slow growth rates.
* Australia is sensitive to a volatile global economy.
* Mobile growth will be slower than previous expectations due to a
saturation of mobile subscriptions.
Opportunities
* PC sales fuelled by government programmes and National Broadband
Network project, with volume sales predicted to rise to more than six million
units by 2016.
* The government's 'Computer for Schools' programme will fuel sales.
* 3D, 4K, Smart and Ultra-large TV sets will be the main driver of AV category
revenues growth as analogue switch-off in cities continues.
* An apetite for SLR cameras and high megapixel digital model.
* Mobile subscribers will replace current entry-level models, and average
mobile handset prices will rise.





Threats
* An economic slowdown in 2013 will damage consumer confidence.
* Tough competition and more price cutting could hit margins, placing more
vendors and retailers under pressure.
*Multi-Functional devices could cannibalise demand for other popular
devices.




SWOT


2 COMPANY ANALYSIS
Dick Smith is a leading retailer of consumer electronics products in Australia and New Zealand. With 359 stores,
pro-forma revenue of $1.28bn in FY2013 and approximately 3,700 employees, Dick Smith is the largest consumer
electronics retailer in Australia and New Zealand by total number of stores and is one of the largest by total retail
sales value.
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Dick Smiths category focus is on office and mobility products and related accessories, which together
accounted for 68% of FY2013 revenue. Dick Smith also has a competitive offering in entertainment products and
accessories. Within these categories, Dick Smith stocks over 280 brands as well as its own Dick Smith private label
brand.

At the time of acquisition (November 2012), Dick Smith was experiencing weak sales growth and a decline in
profitability. Set out below is a summary of Dick Smiths pro-forma historical consolidated income statements for
FY2011-2013, the pro-forma forecast consolidated income statement for FY2014, and the statutory forecast
consolidated income statement for FY2014.

The pro forma forecast consolidated income statement differs from the statutory forecast consolidated income
statement as the pro forma forecast consolidated income statement reflects the full year effect of the operating and
capital structure that will be in place upon completion of the Offer but excludes the costs of the Offer, the
accelerated expenses of the pre-Offer management incentive scheme, one-off tax implications arising as a result of the
Offer and other non-recurring items which are not expected to occur in the future. The pro forma forecast income
statement also excludes certain restructuring costs expected to be incurred in FY2014.
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Upon taking control of the business in November 2012, the new management team began implementing a
comprehensive transformation program. The program covered all areas of the business and would seek to address
revenues, gross profits, costs and the balance sheet, as well as customer experience and internal culture. The
management team began engaging with Dick Smiths suppliers and employees, focusing on the retail basics of buy-
move-sell, with examples including:
Buy it: Developing strategic relationships with key suppliers, renegotiating supplier agreements, and
increasing supplier collaboration of on pricing and promotion

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Source: Dick Smith Holdings Prospectus
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CODB stands for the cost of doing business. Key operating metrics are located in Exhibit 4 in the Appendix.


Move it: Closing distribution centres, significant clearance of aged and obsolete stock, improved stock
management and order including starting direct-to-store, and upgraded store replenishment system.
Sell it (stores): New staff inceptive model linked to real-time KPI dashboard/
Sell it (marketing): New higher-frequency marketing program and renegotiated marketing and supplier
agreements.
Sell it (omni-channel): Migration to new digital platform.
Part of Dick Smiths strategy is to benchmark itself against local competitors such as JB Hi-Fi and Harvey Norman. In
doing so, firm management have identified three key areas for improvement, including:
1) Store productivity: A key productivity measure for productivity is Sales per Square Metre. Dick Smith is
approximately 60% behind JB Hi-Fi in this regard and approximately equivalent to Dixons in the U.S.
2) Stock Turn: Dick Smiths stock turn (~4x) is the lowest among local and global peers, with JB Hi-Fi at
6.1x and Dixons about 8.7x.
3) Omni-Channel: Dick Smith lags JB Hi-Fi in key online metrics such as unique visitors (440k v 1.15m),
Facebook likes (73,840 v 578,821) and Hitwise rankings where JB Hi-Fi is the fifth highest Australian
retailer by site visits.
See Exhibit 3 for further information about the transformation strategy.
Management says Dick Smith is "well positioned for future growth" by opening stores, building online sales and
private-label products and negotiating better deals with suppliers, but no forecasts were provided in the prospectus
beyond 2014. Some independent analysts have forecasted 8 per cent EBITDA and EPS growth in 2015 and suggest
Dick Smith will pay a 15 a share dividend. On the $2.20 issue price this represents a 6.8 per cent yield. Whether
Dick Smith can boost earnings in 2016 and 2017 will depend on if it can boost like-for-like sales, expand gross
margins, cut costs further and improve sales density, which is well below that at JB Hi-Fi. There have been
suggestions in the media that suppliers had given Dick Smith "sweetheart" deals prior to the IPO that may not be
sustainable into the near future. Contained within the provided excel spreadsheet are detail historicals and future
estimates.

3 THE IPO PROCESS
IPO listing is the action of taking a privately-owned organisation and transitioning it to a publicly-owned entity whose
shares can be traded on a stock exchange. There are a variety of reasons for going public, including that it provides
greater access to capital and diversification in the shareholding base. It also allows existing shareholders to more easily
realise the value of their holding (or investment) as was the intention of Anchorage Capital Partners in Dick Smith in
2014. Though most private firms will typically list on their local exchange (i.e. an Australian company will list on the
ASX), the internationalisation of capital markets now means that firms have a choice and in some cases can choose to
list in more than one location. Though exchanges that compete for these listings are able to offer sweeteners to lure
private firms, the process from inquiry to listing is fairly homogenous. This guide provides a fairly simple overview of
what is required for a company to list on the Australian Securities Exchange (See Exhibit 5 and 6).
Most listings in Australia require firms to satisfy a number of important conditions that typically relate to the amount
of assets under control of the firm or its profitability. Under the profitability test, firms must be a going concern,
have their financial statements audited, and exhibit three years of profit amongst other strict criteria. The asset test,


the criteria most private firms attempt to satisfy, requires firms to have net tangible assets at the time of admission of
at least $2million (after deducted the cost of fund raising), or a market capitalisation post-IPO of at least $10million.
Under the asset criteria, the firm is also required to ensure enough funds are allocated to working capital and that
there is a minimum cash balance. The ASX also requires a relatively modest division of shareholding. That is the
company requires at least 500 shareholders who each hold shares with a value of at least $AU2000.
After a firm has satisfied the pre-requisites, the equity issuance process will begin with the appointment of some key
advisers. In September 2013, Anchorage appointed Goldman Sachs and Macquarie to explore sale (exit) options,
including an IPO. Other potential participants during this process include accountants, lawyers, and any advisers
required to provide expert reports in connection with the IPO (for example, in a mining IPO a geologists report may
be required). These participants are involved with the preparation of the prospectus and participate in the due
diligence process for the IPO. Additionally, they are involved in pricing the offering
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, marketing the offering to
investors and being available to the company for any further advice, where necessary, throughout the IPO process.
One of the more important facets of listing surrounds the due diligence process. Due diligence is the process of
providing reasonable grounds that there is nothing in the registration statement (prospectus) that is misleading or
untrue. Due diligence procedures include things such as reviewing company documents and contracts, visiting
company offices and facilities (to ensure the authenticity of stated assets), soliciting true and fair opinions from
auditors, and interviewing company and industry personnel. This diligence process is run at the same time as the
prospectus is being drafted. In Australia, the Corporations Act (Section 710) requires that a prospectus must contain
all the information that investors and their professional advisers would reasonably require to make an informed
assessment about: 1) the rights and liabilities attaching to the shares offered; 2) the assets and liabilities, financial
position and performance, profits and losses and prospects of the share issuer. The due diligence process is guided by
a due diligence committee comprised of representatives of the company and other parties potentially liable under the
prospectus. The process is undertaken to help ensure that the information contained in the prospectus meets legal
requirements and to ensure that any parties with potential liability will be able to rely on due diligence defences in
law.
Following the preparation of the prospectus, the lead managers (and the underwriting syndicate) will begin marketing
the IPO to certain institutional investors by undertaking IPO roadshows. These roadshows are a series of meeting
between the company, investment bankers, and institutional investors to gauge the general interest in the offer. The
Corporations Act, however, imposes strict restrictions on advertising an IPO before the prospectus is lodged with
ASIC to protect investors not privy to these private negotiations
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. By the time registration of the prospectus is ready
to become effective, the underwriter and the offering firms management must have negotiated the final offering
price and the underwriting discount. The negotiated price depends on perceived investor demand and current market
conditions (e.g. price multiples of comparable companies and previous offering experience of industry peers). Once
the underwriter and the management agree on the offering price and discount, the underwriting agreement is signed,
and the final registration is filed with ASIC.
After the disclosure is lodged with ASIC, the marketing campaign to retail investors can begin. The original
prospectus lodgement date for Dick Smith Holdings occurred on Thursday 14
th
November 2013. The lodgement
date is normally subject to an exposure period of 7 days a period that allows potential investors to digest the
contents of the prospectus, but prohibits the firm from processing any applications received. After a formal listing
application is lodged with the ASX, the offer to retail investors starts and is typically open for a period of 3-4 weeks.
Dick Smith Holdings retail offer closed on Monday 2
nd
December 2013.

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The three mechanisms used for pricing and allocating IPOs can be categorised as: 1) auctions; 2) fixed-priced offers; 3) book building. With auctions, the
market-clearing price is determined after bids are submitted. With fixed-priced offer, the price is set prior to the allocation.
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Publicity of the listing pre-lodgement is restricted to roadshow presentations, market research, independent reports, tombstone statement, or pathfinder
prospectuses.


4 CASE STUDY TASKS/QUESTIONS
Comparable companies play an important role in the valuation of IPO firms. The challenge in valuing a company
based on comparables is partly laid in identifying a similar set of companies (or indices) and finding appropriate
metrics to justify that particular valuation. Given the information that you have provided, prepare a report to cover
the following questions/issues.
1. Which companies provide the best comparison to DSH in your analysis? Discuss the strengths and
weaknesses behind your decision.
2. Identify which ratios (multiples) are appropriate for your relative valuation. Discuss this matter in detail,
outlining the strength of the ratios you have chosen.
3. Determine the value of the firm using the comparables approach.
4. Discuss the strengths and weaknesses of your valuation. How could it be improved? ((Provide both
qualitative and quantitative solutions)).
5. Using a more holistic valuation approach, does DSH represent fair value for its long term investors?



















5 APPENDIX
Exhibit 1: Key Dates in DSH IPO

Exhibit 2: Key Offer Statistics

Exhibit 3: Key elements of the transformation strategy





Exhibit 4: Key Operating Metrics









Exhibit 5: Contents of an IPO Prospectus











Exhibit 6: IPO Timeline




6 APPENDIX 2: RELATIVE VALUATION (SHORT NOTES)
Relative valuation analysis is the most commonly used technique for which we try and deduce value. From real estate
practitioners, to market analysts, sporting pundits, and grocery shoppers, its almost second nature to infer value
from a set of comparable items. For example, if United beat Chelsea (let's say 2-1) and Chelsea beat Tottenham, then
in mathematic terms (transitive relation) United must be better than Tottenham (and of course Chelseanot too far
from the truth). If three different tuna brands sell between $1 and $1.20, then if we are looking at a fourth brand that
is of similar quality and quantity then we would not expect to pay anything outside of this range. At one stage or
another in our lives we have all used relative valuation to guide our investment/purchasing decisions.

The Easy Part
Relative valuation allows us to form an assessment about the value of an asset from a market of similar or comparable
assets. In lectures, I typically spend no more than 5 minutes discussing the steps involved in relative valuation analysis
because to do otherwise would be to insult your intelligence. The same applies in this forum. To perform relative
firm/asset valuation, the following steps are typically followed:

1. Identify comparable firms and obtain market values for those firms.
2. Convert these market values into standardised values. (i.e. instead of comparing price, compare Price / Earnings;
instead of comparing EV, compare EV / EBITDA)
3. Compare these standardised values against a series of comparable firms.
4. Evaluate using personal judgement whether the firm is over/under-valued.

The guiding principle in this type of analysis is arbitrage. What some like to term, the law of one price, suggests
that two assets that have similar underlying characteristics should trade at a similar price. In fixed-income securities
and currency trading this is a common type of strategy and for the former, because contracts have a limited life,
convergence is ultimately a certainty. We must remember though, in equities, two assets can be similar in many
respects and trade at substantially different premiums - remember the old coinage: the market can remain irrational
longer than you can stay solvent! In light of this information, relative valuation seems a curious choice in investment
decision analysis. Then again, many people still favour technical analysis, but this argument to be had on another day.

What's the difference between Intrinsic Valuation and Relative Valuation?
You will remember when I examined intrinsic valuation analysis that one of the biggest difficulties I spoke of was
setting assumptions for the forecast horizon and terminal period. When most people first come across relative
valuation, they believe for some reason that they are free from these assumptions in the same way politicians are free
to skirt around the truth. A common phrase used by analysts goes something like this - "this is a fair valuation at
6*EBIT". I've never really known what this means (and i will discuss how flaky this comment is later), but because
this is what the market is currently pricing the asset at, your position is what is typically referred to as defensible
(this word is part of every investment bankers lexicon). We are all clever enough here to know, however, that just
because our stock is trading at a particular price, that it doesn't necessarily represent fair value, or even a meaningful
trading opportunity.

My point here is a very simple one. Relative valuation is based on assumptions about growth, risk and return on
capital in the same way intrinsic valuation is. The difference is that they are explicitly made in an intrinsic valuation


analysis, whereas with relative analysis they form part of the ratio that you select for your analysis. If you want to
undertake relative valuation analysis properly, then there are two things you need to do:

1. Forget about rules of thumb (EV/EBITDA < 6 = cheap, P/E < 12 = cheap, P/Book < 1 = cheap).
2. Examine the drivers of the ratio in question and compare these drivers to other comparable assets.

The Ratios
There are literally hundreds of ratios that can be used to compute market values for an asset. To list a few:

1.Earnings ratios (P/E ratio, PEG ratio, EV/EBITDA, EV/EBIT);
2.Book ratios (P/Book, EV/Invested Capital);
3.Revenue ratios (EV/Sales, P/Sales);
4.Industry ratios (EV/Price of Ounce of Gold, P/No. of Customers)

Every year this list will grow, and every year particular ratios will move in and out of favour which begs the question,
which multiple or group of multiples is relevant for our analysis? A good question that we can only really answer after
we have discussed the strengths and limitations of multiple analysis in more detail.

A Platform for Success (or at least an avenue to avoid failure)!
Every multiple/relative valuation analysis that is conducted should check off on the following things:

1. That the multiple is properly defined. Ratios should mean something and be consistently defined.
Remember that this analysis is about calculating value. Therefore, if you are deciding on whether to use the ratio
Price / No. of Users, then your first question is will no. of users translate into value for this company. Just because I
have 10,000 users visit my site doesn't mean that it is going to (or will be able to) generate value for me. Being
properly defined also means that the numerator and denominator of the ratio are defined in a consistent fashion.
Therefore if we are dealing with equity cash flows in the numerator, then the denominator needs to represent a
similar claim.

2. The multiple is appropriately described. Finding a comparable firm should be more involved than simply
looking up the GICS industry code and picking a range of firms in the same industry. Ultimately selecting a
comparable firm is a trade-off between similar companies and having enough data points to be able to find an
"average".

3. The multiple is appropriately analysed. As I mentioned earlier in this post, ratios are driven by particular
factors. It is imperative that we have some understanding of these factors if we are going to make buy/sell decisions.

There are two basic groups of problems with relative valuation analysis. The first group of problems can be
summarised as economic problems and they include the fact that relative valuation subscribes to arbitrage
principles and that it implicitly makes assumptions about risk and return. Although these problems are widely
acknowledged the second class of problems are not. These are the statistical problems and the issue with not
understanding these problems is that the conclusions you infer from the data can often be misleading.



When the subject of relative valuation analysis is broached, one of the first questions that is usually put forward is
what ratio will give the most 'correct' estimate of value. Even the most novice investor has heard of at least half a
dozen financial valuation ratios, and sophisticated investors will throw around hundreds at a time. The answer is not a
simple one and depends on what the analysis is being used for and what data you have access to. Usually, your analysis
will triangulate between several different ratios in order to overcome some of the idiosyncratic issues of one
measure.

I have spoken in previous posts about incentives - and the incentives to sell a stock to a client will normally deliver
you a set of ratios that may not be useful if you were on the other side. Ratios are not always complementary - they
can sometimes even tell you a completely different story. This is why the definition step is so important - if we know
what goes into the ratio, then we can ensure that we are asking the right question the next time someone proffers us
an investment based on some good looking ratios. The second point about data availability is a less important one, but
necessary nonetheless. If a firm is not yet mature, burning through cash but generating good growth, then you may
not be able to compute some of the better known ratios that are applied to mature firms. Is P/E for example, the best
measure of a firm that is yet to generate positive earnings? Sure you can forecast earnings ahead and then apply a
forward looking P/E to future EPS but is the forecast error worth the effort?

Just like in intrinsic valuation analysis, multiples can be used to calculate enterprise value or the market value of
equity. If you are a trader, chances are your focus is on the market value of equity, and if you are interested in
purchasing the business, then your interest may be geared to the former. The definition step of relative
valuation analysis is about ensuring that your multiple is defined in such a way what that the output reflects either
equity or enterprise value.

What's in a definition?
If we take the most popular ratio we know, Price / Earnings, it is clear that this is a measure of the firm's outstanding
equity. Price, as we all know, is a function of the market value of equity, derived from the expected cash flows to
equity holders. In the denominator - earnings (Net Income / Shares Outstanding or EPS) are measured after interest
payments (to debtholders) and taxes. It is therefore, an accounting proxy of the cash flow available to equity holders.
At a very basic level, the price / earnings is consistently defined.

If I chose P / EBITDA in my valuation analysis, is this measure consistently defined? The numerator, unchanged,
reflects the market value of equity. In this ratio, however, EBITDA includes interest payments to be distributed to
debtholders. If we have two identical firms, in all respects other than the second firm has a substantially higher
proportion of debt, then what your analysis will show is that the second firm is comparatively undervalued! Why?
Think about how increasing your proportion of debt affects EBITDA. Relative to price, a more geared firm will
generate a comparatively undervalued (but incorrect) signal.



There are other similarly critical aspects of the definition test that we need to think about. We know that EPS (when
looking at P/E) is not always defined in the same way. We have forward and backward looking EPS, normal and
diluted EPS, and EPS before and after abnormals. If we are comparing P/E's across different countries, then we also
need to think about the fact that different accounting standards will not always produce the same result. There is a lot
to think about here, which is why one should never rely on P/E's provided by data providers. These are what I like to
call indicative P/E's - your analysis needs to get knee deep and ensure that if you chose diluted EPS after
abnormals, that the comparative firms in your sample are treated in the same way.

The Analysis
I mentioned in the last post that the interpretation of the output is often misunderstood even by the people who
perform this valuation analysis day in and out. This failure is largely the result of our neglect for basic statistical
lessons. For example, statistics 101 says that if we have a distribution of values that is skewed in any one
direction, then standard mean variance properties cannot be used to describe the 'average' result. If I have the value 4,
5, 6, 5, 100, then is the average closer to 24 or 5. It obviously depends on what these values represent, but most
people in this situation would select 5. In multiple analysis, we often deal with two sorts of problems of inference.

Firstly, if you take a ratio like P/E, you know that the lowest value possible is 0 (because price can't be less than 0)
and the highest value is infinity. Naturally, your values are going to be skewed, especially if your sample mixes
growth and mature stocks. Therefore, we need to consider other more reliable outcomes - the median / mode.
While these are not perfect they are better than focusing on the average. An alternative is that if your analysis is not
normally distributed, then to make it so. This means that you will have to identify the outliers in your sample and
drop them from your analysis (some people use log-distributions to overcome this problem but I don't really see the
point). If a firm has $0.01 worth of earnings and its stock price is 100, then is this ratio really informative. If you have
good reason to drop these stocks from your sample, and the distribution becomes normal as a result, then going back
to the average is fine.

The Drivers
Every multiple contains a driver (or drivers). These drivers can be related to growth, risk, productivity, the firm's
capital structure, capital intensity etc... There are normally many drivers at work that will affect whether a firm
appears cheap or expensive and unless you can relate the former to these drivers then making any inferences will
produce erroneous results. Implicit in every valuation analysis are certain assumptions. Unlike DCF or intrinsic
valuation methodologies these assumptions are not explicit, rather they are determined by the market and the sample
of firms in your analysis. We can therefore learn plenty by stepping up our analysis and deconstructing these
multiples to learn what makes a firm cheap or expensive.

Going back to the P/E multiple - we should know that P / E = Price / EPS. We can restate this equation using the
DDM model because we know that Price = DPS(1) / r - g. If we take this equation and divide both sides by EPS then
we end up with the following equation



P/E = Payout Ratio*(1+g) / r-g.

Why did we do this?
Let's look at the result. The last stated equation says that P/E is driven by the payout ratio, growth, and the discount
rate. The payout ratio is a function of a firm's cash flows. If theory is to be believed then there should be a positive
relationship between growth, the payout ratio and the P/E and a negative relationship between risk and the P/E ratio
(you'll have to take my word for the moment that it is but Ill see if i can produce some pictures in the near term to
prove my point). What this tells us is that any conclusion about whether a firm is cheap or expensive needs to go hand
in hand with an assessment of the firm's risk, payout, and growth ratio.

We need however, to be careful that we don't focus on the drivers individually but consider them as a whole. Why?
Generally, a high growth firm will require higher re-investment needs, so you are unlikely to see the growth and
payout ratio (in this case) moving in the same direction. If that is the case how do we interpret our P/E result? There
is no simple formula to solve this problem. We need to apply judgement to the problem and assess the firm within
the context of its operating environment. The same kind of analysis can be applied to any number of ratios from
EV/EBITDA to the PEG ratio. We should always have an idea what makes our ratios look cheap or expensive.

Sector or Market Multiples
The final issue that I'd like to elaborate on is whether one should choose sector or market multiples. You may not
think so, but you know the answer to this question already. If you think that markets make mistakes on individual
firms but that the valuations on the sector are on average correct then you will use sector averages. If you think
that sectors are mispriced, but on average that the market is priced correctly then you will use market-wide multiples.
We know that not all sectors move together. Take the Australian agriculture sector of late - which is surging on the
back of growing worldwide demand. Stocks like GrainCorp and Rural Co have increased over 25% YTD. In any
relative valuation, you should triangulate between sector and market multiples but don't sit on the fence in terms of
the weightings you assign. Weigh up the issues, the benefits, and costs and run with it!

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