1-Using the method of comparable, perform a valuation of Apple Inc. (AAPL). Based on your valuation, what trading strategy would you recommend? Justify your decision.
Notes:
- Use the financial database WRDS to collet firm’s accounting information and stock prices.
- Use the following comparable firms: Microsoft Corp (MSFT) and IBM Corporation (IBM)
- Calculate the following comparison: price – earnings ratio (P/E), The price – to – book ratio (P/B), and the price-to- sales ratio (P/S)
- Use data from the last five years available (e.g. 2013 – 2017)
2-Discuss the merits and limitations of using the method of comparable as valuation methods.
Introduction
Valuation technique needs to have the benefits that outrun the costs of employing it. It must also be favorably compared with other alternative techniques. Apple Inc is one of the prime companies whose stock is seen as an attractive alternative for investment. There are many factors which are relevant to be considered for valuation of a firm. Cost is one of these. Other than this, the efficiency of the valuation also is needed to be as best as possible. Even though analysts should consider the routes which are less costly, the possible effects of taking shortcuts should be analyzed as well. Multiple Analyses is one of the valuations often used by analysts. It is cheap and uses minimal information. These may include book values, sales, earnings, and cash flows. The comparable method is one of the analyses which use multiple analyses.
Data & Method:
The firm which has to be valued is analyzed as compared to its comparable companies. The firm that is being analyzed for valuation is Apple Inc. The data for comparable valuation is taken from the WRDS website. The accounting information and stock prices of Apple Inc for the average of the last five years from 2013-2017 have been extracted. The data is then used for comparable analysis in measures of Price/Earnings ratio, Price/Book Value Ratio, and Price/Sales Ratio. The comparable companies include Microsoft Inc and IBM Corporation. The data extracted includes book value, earnings, cash flow, sales, and stock prices. After the calculation of the ratios for comparable companies, the average of these multiples has been computed to get the value for Apple Inc.
Result for Five Years
The data collected has been used to compute the measures of comparable. The formulas used are.
Price per Earnings Ratio= (Market Value)/Earnings
Price per Sales Ratio= (Market Value)/Sales
Price per Book Value Ratio= (Market Value)/(Book Value)
Table 1: Apple’s Valuation (2013 to 2017) using Comparable method
| COMPANY’S NAME | AVERAGE SALES ($) | AVERAGE EARNINGS ($) | AVERAGE BOOK VALUE ($) | AVERAGE MARKET VALUE ($) | AVERAGE P/S | AVERAGE P/E | AVERAGE P/B |
| Microsoft Corp. | 86630 | 18826 | 78640 | 383299.4 | 4.4 | 20.4 | 4.9 |
| IBMCorp. | 86669 | 11864 | 16952 | 157616.1 | 1.8 | 13.3 | 9.3 |
| Apple Inc. | 206349 | 44796 | 123349 | ? | ? | ? | ? |
| AVERAGE | 4.4 + 1.8 / 2 = 3.1 | 20.4 + 13.3 / 2 = 16.9 | 4.9 + 9.3 / 2 = 7.1 | ||||
| AVERAGE MULTIPLE FOR COMPARABLES | APPLE’S NUMBER | APPLE’S VALUATION | VALUATION PER SHARE | ||||
| SALES | 3.1 | X | 206349 | = | 639682 | 140.2 | |
| EARNINGS | 16.9 | X | 44796 | = | 757052 | 165.97 | |
| BOOK VALUE | 7.1 | X | 123349 | = | 875778 | 192 | |
| TOTAL | 2272512 | ||||||
| AVERAGE | |||||||
| 2272512 / 3 | 498.17/ 3 | ||||||
| AVERAGE | 757504 | 166.07 | |||||
| APPLE’S STOCK PRICE AVERAGE | APPLE’S NUMBER OF SHARES AVERAGE | DECISION | |||||
| 190.994 | 4561.2988 | (190.994 > 166.07) The stock is expensive | |||||
Result:
Stock Price: $190.994
Number of Shares of Apple Inc: 4561.29
Decision: $190.994 >166.07
The stock was found to be expensive. The decision should be to sell the stock. The valuation as per the comparable method shows that the company is overvalued. It shows that the company is being priced for more than its real value. Studies have shown that the comparable method provides better valuation if the firms are representative of their industry (Alford, 1992, p.94). Furthermore, Liu, Nissim and Thomas (2002, p.136) also found the performance of the multiples derived from earnings to explain the stock prices surprisingly well. Therefore, the best decision would be to sell the stock at this high price as at this value it is expected to decline in future.
Merits of Comparable Method
This valuation method is one of the methods which are used most extensively. The reason for it, it is very easy to use and is relatively very cheap as well. As this method uses the accounting information which has been published in the financial reports of the company, no efforts on the collection of data are needed which makes it super easy and cheap. The use of this valuation is justified in many situations as well. In the case when a firm is thinly traded or is a private company, with no relatable trading prices, these measures can be used to get an idea of the value of its equity from the comparable in case the stocks are efficiently priced as well. Furthermore, the study conducted in 2005 showed that discounted cash flows are better ways of valuation. However, the forecasts of the cash flows can be assessed by using the comparable multiples given that the executives using these are critical consumers of the published multiples and have the ability to identify any unexpected differences (Koller et al., 2005, p.9). According to Case and Wachter (2005, p.204) the investors who are looking to float the IPOs also use these measures to get an idea of the price at which the stock should be valued by the market.
Limitations of Comparable Method
There are many relevant limitations of comparable methods. One of these is that the valuation done by using multiple based methods is based on market valuation. If a market is not valuing an entire sector correctly, then it may end up as the wrong valuation for the relative company as well. It was seen in the 1990’s Internet bubble in which the entire sector of technology was highly valued (Kluaymai-Ngarm, 2016, p.41). Another example of such wrong valuation is that a new company which is valued in the context of the market would show a high valuation which would be incorrect. A study by and Kim and Ritter (1999, p.423) showed that the use of comparable firms’ multiples is recommended for the valuation of the IPOs. However, the multiples of Price/Earnings, Price/Sales and Market/Book ratios for comparable firms produce modest ability of predicting value.
Secondly, the method of multiple comparable methods using denominators can be inconsistent across companies. Like the Price per Earnings ratio uses earnings which are affected by the capital structure of the company. Thus, two companies with similar operations but different debt sourcing would have different earnings and consequently different measures of P/E ratios (Penman, 2001, p.110).
Thirdly, the different measures give different results which often tend to create misunderstandings. Also with negative denominators, the measures do not tend to be accurate and meaningful. It also found that the comparables tend to encourage the formation of bubbles (Kedar-Levy, 2004, p.7). The high comparables are provided as justification for the high price of offering the IPO. This can cause the development of pyramid schemes (Case & Wachter, 2005, p.197).
Conclusion
The valuation done by the comparable method for Apple Inc stock in the context of IBM and Microsoft Inc for the last five years has shown that the stock was overvalued for the last five years. Therefore, the best decision would be to sell Apple stock. However, it should not be ignored that there is a certain limitation of this valuation technique. For instance, it is assumed that if a stock is overvalued, its price will decline over time trying to reach its “real” value. It gives the reason for selling such stock. However, we can see that even though the stock price of Apple declined in 2014 as compared to 2014, it still appreciated slowly over time reaching from $100 in 2014 to $154 in 2017. Hence, if it was still undervalued, it should not have been appreciated. Thus, this method has its limitations.
References:
Alford, A.W., 1992. The Effect of the Set of Comparable Firms on the Accuracy of the Price-Earnings Valuation Method. Journal of Accounting Research, 30(1), pp.94-108.
Case, B. & Wachter, S., 2005. Residential real estate price indices as financial soundness indicators: methodological issues. BIS paper, (21), pp.197-211.
Kedar-Levy, H., 2004. Learning the CAPM through Bubbles. In Society, E., ed. Econometric Society 2004 Far Eastern Meetings. No. 775., 2004. Econometric Society.
Kim, M. & Ritter, J.R., 1999. Valuing IPOs. Journal of Financial Economics, 53(3), pp.409-437.
Kluaymai-Ngarm, J., 2016. An empirical investigation of bubble and contagion effects in the Thai stock market. [Online] Available at: https://dspace.lboro.ac.uk/dspace-jspui/bitstream/2134/23127/1/Thesis-2016-KluaymaiNgarm.pdf [Accessed 13 June 2018].
Koller, T., Goedhart, M. & Wessels, D., 2005. The Right Role for Multiples in Valuation. McKinsey on Finance, 15(1), pp.7-11.
Liu, J., Nissim, D. & Thomas, J., 2002. Equity Valuation Using Multiples. Journal of Accounting Research, 40(1), pp.135-172.
Penman, S.H., 2001. Fundamental Analysis:Lessons from the Recent Stock Market Bubble. Security Analysts Journal, pp.106-115.
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