Equity Valuation

1
Equity Valuation

• Contents - overview
• 0. About valuation introduction McKinsey
  Valuation Best Practice
• 1. Valuation Frameworks the technology side
• 2. Analyzing historical performance
• 3. Projecting future performance
• 4. Continuining Value
• 5. WACC
• 6. Relative Valuation
• 7. Examination
• 50 written exam
• 50 valuation case

2
Goal of the module

• 1. Understand link between stock market valuation
  and fundamentals
• 2. Acquire and develop practical valuation skills
  - best practice
• 3. Understanding sources of corporate value
• 4. SkillsKnowledge to pass CIIA EV in final exam

3
CIIA EV Syllabus

• Equity Markets and Structures
• BKM Ch 2-3, SAB Ch. 2-3 mostly
• Covered in Module 1 Mats Hansson market
  regulation
• 2. Understanding the Industry Life Cycle
• BKM Ch 16 (17 new) 5 pages only
• 3. Analysing the Industry Sector and its
  Constituent Companies
• Mostly very basic macro definitions (Jan Antell
  Module covers), BKM ch 16 (17 new) 19 pages only
• 3.1. The Industry Sector
• 3.2. Characteristics of the Industry
• 3.3. Macro Factor
• 3.4. Forecasting For Companies in the Sector
• 3.5. Balance Sheet Factors
• 3.6. Corporate Strategy
• 3.7. Valuations

4
CIIA EV Syllabus cont.

• 4. Understanding the Company
• BKM Ch 16 (17 new) 17 pages
• 4.1. Historical performance
• 4.2. Segmental Information
• 4.3. Inventory, debtors and crediitors
• 4.4. Depreciation and amortization
• 4.5. Completing the forecasts
• 5. Valuation Models of Common Stock
• BKM Ch 17 (18 new), BM esp. ch 17 Leverage and
  WACC (Corporate Finance too), SAB ch. 12, 16-18
• 5.1. DDM
• 5.2. FCFF
• 5.3. EVA MVA, CRROI, Abnormal earnings model
• 5.4. Measures of relative value

5
CGW Valuation (4th ed.)

• Much deeper, practioner oriented book
• Both for Corporate Developers and Equity/Industry
  Analysts
• Industry standard best seeling guide to Valuation
• Best valuation book
• Ch. 3 Fundamental Principles of Value Creation
• (Ch 4)
• Ch. 5 Frameworks for Valuation
• Ch. 6 Thinking About Return on Invested Caital
  and Growth
• Ch. 7 Analyzing Historical Performance
• Ch. 8 Forecasting Performance
• Ch. 9 Estimating Continuing Value
• Ch. 10 Estimating Cost of Capital
• Ch. 11. Calculating and Interpreting Results
• Ch. 12 Using Multiples for Valuation

6
Written exam 50

• 1-2 essay questions
• Copeland-Goedhart-Wessels Valuation Ch, 3, 5-12
• Lecture notes
• 1-2 valuation problems
• Relative valuation
• DCF
• FCF
• Cost of capital

7
Valuation Case 50

• Task Assess fundamental value of company X by
  applying CGW Valuation Framework
• Teams w/ 3-4 persons
• Deadline

8
Econ101 Supply and demand

• Prices / values increase when demand exceeds
  supply
• Prices / values fall when supply exceeds demand
• OK. But why does this happen?
• 1. Unique onetime-transaction
• severe contraints in demand and supply
  forces
• 2. New information has arrived that changes the
  expected benefits of ownership of an asset

9
Benefits of owning?

• Critical decision point is current transaction
  price vs expected benefits from ownership!
• BUY (hold) if benefits from ownership exceed
  potential purchase price good, value-increasing
  investment decision
• SELL (short) if prevailing price exceeds benefits
  from owning the asset good, value creating
  financing decision
• ( Short selling stock lending essentially
  take a loan indexed to value of a stock gt
  profit from price drops negative interest on
  loan)

10
Value creation

• Necessary condition for profitable growth
• 1. Scarce resources are used as efficiently as
  possible
• 2. Beating industry/market peers
• 3. Maintaining competitive edge
• 4. Attract more capital
• 5. Create basis for higher compensation levels
  for (talented) agents gt better pay
• (Side note Industrialism and Global warming
  problem we havent yet been able to correctly
  price all input resources fresh air, rain
  forests)
• True long run value creation must be based on
  true pricing of all inputs.

11
Benefits of owning?

• OK. But what are the benefits from owning an
  asset?
• Cash flow rights
• Dividends (including their growth potential)
• Control rights
• Set corporate policy / active management
• Get access to corporate resources
• 3. Favorable risk premium
• If you can fund an investment cheaper than
  others, certain cash flow stream will be worth
  more to you than others
• gt risks are being mispriced in the market

12
Listed vs private investments

• Market listed stock consensus expectations
  revealed in market price continuously
• Very few constraints on demand and supply
• Almost non-existant information monopolies
• Need to move very quickly on information
• gt Efficient market hypothesis Utility of
  analysis low
• (others have already done it)
• b) Private investments no visibility
• Possibly huge constraints on demand and supply
  forces
• Monopolies on ideas / resources
• Likely very inefficient market
• Utility of analysis potentially very high

13
Valuation defined

• personal process of attempting to increase
  ones understanding of where, why and how
  benefits from ownership happen
• That process will be time-consuming, hard work.
• How motivated am I?
• Benefits vs costs extra value created thanks to
  analysis minus costs of conducting the analysis

14
Arguments against valuation

• No one can forecast
• This time is different
• Investors are not rational
• Numbers can always be tweaked to serve a
  purpose
• Life cant be reduced to some formula exercise

15
Arguments for valuation

• All of economics allocation of scarce
  resoures
• Undervalued activities gt expand! (buy)
• Overvalued activities gt shrink (sell)
• E.g. decide what to do in
• 1. Corporate restructurings
• 2. MA deals
• 3. LBOs
• 4. Capital structure optimizing
• 5. Value Based Management
• 6. IPO pricing
• 7. Capital budgeting
• 8. Corporate development
• 9. Real estate appraisals
• 10. Active money management

16
Alternative behavioral decision models

• Basis for resource allocation decisions - how can
  you do it?
• Do not invest in understanding gt 100 (gut)
  feeling based choices
• Do not invest in understanding, but watch
  closely what others are doing and follow them
  (herding) because they are likely to be onto
  something
• want and hope markets to be inefficient so there
  is always time for followers also to benefit from
  fashion waves
• Invest in understanding, build own opinion about
  value, go against the crowd if supported by
  analysis
• If possible adopt a passive investment style
  without investment in understanding enjoying
  market returns (no more no less)
• No do, if youre the CEO / corporate guy
  (corporate job)
• No do, if you run an active fund (wealth
  management job)
• No do, if you work with MAs or related deals
  (investment bank job)

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Misconceptions about valuation

• Valuation...
• Myth 1 is an objective search for true value
• Fact 1.1 All valuations are biased. The only
  questions are how much and in which direction
• Fact 1.2 The direction and magnitude of the bias
  depends on salary level and boss (motivation)
• Myth 2. provides a precise estimate of value
• Fact 2.1 There are no precise valuations (/-15
  error normal)
• Fact 2.2 The payoff to valuation is greatest
  when valuation is least precise
• Myth 3 . is better the more quantitative a
  valuation model is
• Fact 3.1 Ones understanding of a valuation
  model is inversely proportional to the number of
  inputs required for the model
• Fact 3.2 Simpler valuation models do much better
  than complex ones

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Valuation

• Purpose Profit from informed investments!
• Detect under- (over)valuation
• Buy undervalued / sell overvalued
• Eliminate market risk by finding similar
  (perfectly correlated) asset gt take opposite
  position

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Valuation goals

• Example You believe Hokia is underpriced at 25
  (fair value 25.5) and Notorola overpriced at
  13.5 (fair value 13.23). Suppose Hokia and
  Notorola betas are 1.4 against a broad market
  index. What should you do, given that, within two
  weeks,
• a) fair prices will be established for sure.
• b) actual prices are affected by market
  conditions which could go up or down by 4.
• c) mispricing still prevails unchanged.
• d) It turns out analysis was misguided and actual
  fair values were Hokia 24.55 Notorola 13.77.

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Example

• Answers
• a)
• b)
• c)
• d)

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1. Valuation means...

• ...always taking a stand on
• 1. Company future Earnings/Cash Flow potential
• profitable growth
• how profitable?
• for how long?
• 2. Required investments to sustain growth
• Working capital needs
• CapEx/Acquisition needs
• 3. The riskiness of the companys stock
• in relation to other investment alternatives

22
Valuation process (McKinsey)

• Framework for valuation technique (ch. 5)
• Strategy, Profitability, Industry development gt
  ROI Growth? (ch. 6)
• Analyzing historical performance (ch. 7)
• Forecasting future performance (ch. 8)
• Continuing value (ch. 9)
• WACC (ch. 10)
• Interpreting results (ch. 11)
• Using Multiples for Valuation (ch. 12)

23
Typical valuation process (McKinsey)

• Choice of internally consistent realistic
  valuation model
• Forecast of model inputs
• ROICs
• Invested Capital
• Investment needs
• Growth rates
• Cost of capital (discount rate)
• Usually based upon historical analysis of company
  numbers benchmarking to industry peers
• Adjusting historical inputs to strategic position
  of the company in its industry
• 4. Eye for details
• Dealing with capital structure and financial
  leverage
• Dealing with the long horizon of equity
• Etc.

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1. Valuation - summary
EnterpriseValue
Cash Flow

Cost of Capital
FCFFt
WACC
NOPLATt
NetInvestmentst
kD
kE
Target D/V
./.
ROIforec. period T
ROI post-forec. period
rf
CapExt
NWCt



CVT
Default premium
25
1. Re-cap of valuation technologies (Ch. 5)

• A. Discounted cash flow methods (as it looks
  today value)
• 1. Direct equity valuation
• 1.1. Dividend discount model (DDM)
• 1.2. Free Cash Flow to Equity model (FCFE)
• 2. Firm/enterprise valuation
• 2.1. Free Cash Flow to Firm model (FCFF)
• 2.1.1. WACC
• 2.1.2. APV
• 2.1.3. (Economic Profit and Capital Cash Flow
  models)
• B. Relative valuation
• Valuation ratios (benchmarked against industry
  peers)
• C. Option based approaches ( value of active
  management)
• Binomial, tree models
• more or less analytical formulas (Black-Scholes)
  
• D. Other valuation methods (old school)
• (Adjusted) Book value - substance value
• provides lower bound for value only

26
1.1. Generic valuation model

• Generic valuation equation Present Value
• where
• k risk-adjusted discount rate or required rate
  of return
• defined consistently with the cash flow being
  discounted!frequently assumed constant through
  time (we neglect term structure effects!)
• ECF expected cash flow of investment
• V stands for Value
• EVT terminal, horizon or continuing
  value which slices up the valuation into a
  forecast period 1-T and a horizon period T1
  to inf.

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1.1. Frameworks for DCF-based valuation

28
1.1. Value of a multibusiness company (all
present values, mill.)

29
1.1. Discounted cash flow models
DDM
FCFE
where EVTE Expected horizon or continuing
value of equity kE is the required rate of
return on (typically levered) equity
FCFF
where EVTF Expected horizon or continuing
value of firm WACC weighted average cost of
capital kE (E/V) kD(1-tC)(D/V)
30
1.1. Valuation and KVDs

• While correct, generic formulas are not user
  friendly given the large number of difficult
  forecasts required...
• Therefore, we frequently simplify valuations by
  specifying cash flows in terms of Key Value
  Drivers (KVD)
• Most important KVDs are
• 1. Cash flow growth (g)
• 2. Quality of investment (ROI or equivalent)
• 3. Quantitity of investment
• e.g. retention or plowback ratio
• investments into net working capital and fixed
  assets
• 4. Required rate of return
• (5. Starting level of key cash flow or invested
  capital item)

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1.1. Simplifying valuations

• Typical simplifications (apart from assuming a
  constant discount rate over time)
• 1. No cash flow growth (mature industry w/ full
  capacity utilization)
• no growthgt no investments either gt cash flow
  steady forever
• However cash replacement investments needed to
  support long-term production capability of
  assets
• 2. Constant cash flow growth (Gordon model)
• cash flow grows at g percent per period, forever
• growth must be supported by investment
• there are limits to productivity enhancements!
• given the additional assumption that ROI of new
  investment remains constant over time, the
  retention or plowback ratio b, i.e. periodic
  investments as a percentage of cash flow is a
  constant!g bROI (in DDM of FCFE use ROE
  instead!)

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1.1. Simplifying valuations

• Typical simplifications (apart from assuming a
  constant discount rate over time) (cont.)...
• 3. Industry competition wipes out economic profit
  after T periods, no profitable growth thereafter
• industry converges towards perfect competition
  (ROICWACC)
• strategic edge evaporates over time
• sensible and prudent given that for no firm can
  perpetual g gt nominal GDP -- which often happens
  in practice with 2!
• 4. Industry competition reduces economic profits
  by period T, but some profitable growth
  opportunities persist
• some companies have excelled over very long
  periods so 3. may in some cases be downward
  biased

33
1.1. QD valuation formulas

• Handy formulas include (see appendix for more
  detail)
• Formulas given for equity valuation so E cash
  earnings, use after-tax EBIT in place of E in
  firm valuations!
• (Formulas will be given in final exam.)
• 1. No growth
• 2. Constant perpetual cash flow growth

Symbols E cash earnings (DDM, FCFE) or
EBIT(1-TaxRate) k required rate of return on
equity or WACC b plowback (retention) rate of
earnings or EBIT(1-TaxRate) ROE return on
equity or after-tax return on investment
ROIROI(1-TaxRate) g growth rate of
earnings or EBIT(1-TaxRate)
1.
Note EDIV as no investments!
2.
or EP formulation
34
1.1. Re-cap of valuation theory

• Handy formulas ... cont.
• 3. Growth T periodsno growth thereafter4.
  Supernormal growth T periods normal constant
  growth thereafter

3.
or EP formulation
or approximately
4.
or EP formulation
or approximately
35
1.3. Simple valuation example NOG Corp.

• Example NOG Corp.
• 100 equity financed no growth company
• Produces a constant EBIT of 10 MEUR
• depr. assumed cash replacement investment
• 10 mill. shares outstanding
• Corporate Tax rate 26
• Past stock returns havebeen...
  gt
• Riskfree rate is currently 4
• The expected market risk premium is 6

36
1.3. NOG fair price?

• Example NOG Corp.
• What is current fair share price of NOG?
• V PV(FCF,k)?
• V PV(DIV,k)?
• gt we need cash flow forecast FCF and discount
  rate k!
• FCF EBIT minus taxes DIV (as no debt!
  repl.inv.depr.!)FCF 10(1-0.26) 7.4 MEUR
• k required rate of return on NOG unlevered
  equity?...
• Simplest model is CAPM, so we need NOG equity
  beta estimate...suppose NOG unlevered beta
  estimate is 0.81

37
1.3. Estimating NOG cost of equity

• Example NOG Corp.
• Using CAPM to define risk adjusted discount rate
  k 4 0.81 6 8.86 p.a.

38
1.3. And the fair share value is...

• Example NOG...
• Then

per share
39
1.3. If NOG had growth prospects...

• Example NOG...
• If the future expected free cash flows were,
  e.g., ...
• with no growthafter 2016...
• Then
• V 123 MEUR
• and
• P 12.3 /sh.
• (Can you spotan unrealisticassumption inthe
  valuation?)

40
1.3. NOG as levered equity?

• Example NOG...
• What if NOG was levered instead with 40 MEUR
  perpetual 4 debt?
• We have at least three valuation model choices
• 1. Firm level APV
• 2. Firm level WACC calculation
• 3. Direct equity valuation
• Let us go back to no growth scenario, for
  simplicity!

41
1.3. APV valuation

• Example NOG...
• Method 1. Firm level APV Add PV(financing
  side effects) to unlevered firm value, deduct
  debt to arrive at equity value!
• PV(fin. side FX) PV(interest tax shields)
  PV(tCkDD) 0.26 0.04 40 / 0.04 10.4
  MEUR.
• Value Unlevered firm value PV(int.tax sh.)
• Value 83.521 19.4 93.921
• ./. Debt 40 MEUR gt Value of total Equity is
  93.921 - 40 53.921 MEUR.

42
1.3. WACC valuation

• Example NOG...
• Method 2. Firm level WACC valuation WACC kE
  (E/V) kD(1-tc)(D/V)
• Need target D/V, assume D/V0.4259 (40/93.921)
• Need kE, cost of levered equity assume int.rate
  tax shields are risk free, then...
• kE kU (kU-kD)(1- tc)D/E
• kE 0.0886(0.0886-0.04)0.74(0.4259/0.5741)
  0.11528, i.e. 11.528
• Thus, WACC11.528(0.5741) 40.74(0.4259)
  7.8789
• Value of enterprise/firm 7.4 / 0.078789
  93.921 MEUR.
• ./. Debt 40 MEUR gt Value of total Equity is
  thus 93.921 ./. 40 53.921 MEUR.

43
1.3. FCFE valuation

• Example NOG...
• Method 3. Direct equity valuation (FCFEDDM
  here) Define FCFE (EBIT-IntExpenses)(1-TaxRat
  e)
• ltgt FCFE (10 - 400.04)(1-0.26) 6.216 MEUR.
• Discount with cost of levered equity
  kE11.528...
• Value of equity 6.216 / 0.11528 53.921 MEUR.

44
1.3. NOG summary

• Three methods, one result.!

45
1.3. Key points in example

• 1. Match cost of capital with CF to be
  discounted!
• Equity cash flow levered cost of equity
• Debt cash flow gt cost of debt
• Firm cash flow gt WACC if levered, cost of
  unlevered equity if unlevered firm or APV
  valuation
• 2. Valuation in nominal terms!
• 3. Leverage increases kE!
• 4. Normally growth through investments complicate
  the analysis
• required investment to sustain growth?
• growth horizon?
• quality of growth?
• capital structure implications of growth?
• target D/V ratio? constant / changing?

46
2. Relative valuation (ch. 12)

• Suppose EPS and corresponding P/E ratios of two
  no-growth firms A and B in the same industry
  are
• We interpret same industry here as meaning cash
  flows of the two firms are perfectly correlated
  due to similar business logic and capital
  structure.
• What do the two P/E ratios 12 and 8 tell us about
  the valuation of A and B...?

47
2. Relative valuation (Ch. 12)

• Consider investment strategy
• Buy 10000 B shares, short sell 12000 A shares
  cost of strategy -100009.6 1200012 -96000
  144000 48000 (receive money!)
• Annual Dividends received from B 100001.2
  12000 /share.
• Annual Dividends owed from shorting
  A-120001-12000 /share.
• Annual cash flow difference from position is
  zero!!!
• We receive money up front against no future
  liability gt arbitrage opportunity, likely to be
  short-livedas arbitrageurs / speculators / hedge
  funds etc. rush to exploit it.

48
2. Relative valuation (Ch. 12)

• gt buying pressure increases PB, and selling
  pressure lowers PA, causing P/E ratios to
  converge! If P/E of A and B would be equal, for
  example 10, implying PA10 and PB 12, then
  there would be no arbitrage opportunity...Buy
  10000 B shares, short sell 12000 A shares cost
  of strategy -1000012 1200010 -12000
  12000 0.
• Annual Dividends received from B 100001.2
  12000 /share.
• Annual Dividends owed from short position in A
  -120001 -12000 /share.
• Annual cash flow difference is zero.
• (Running it backwards, buy A short B, produces
  similar outcome.)

49
2. Relative valuation

• Example is a Modigliani-Miller Law of One
  Price justification for usage of valuation
  ratios, measures of relative value ltgt
• Similar things, in terms of expected return and
  risk,
• should cost as much.
• Conversely, if market is efficient ( limits to
  arbitrage small) and P/E ratios are persistently
  different, then the two firms are somehow
  different
• note besides differing growth prospects and
  risk, low correlation between cash flows of firms
  even in same industry may occur because of low
  quality of reported accounting information

50
2. Relative valuation

• Even with limits to arbitrage (e.g. expensive
  shorting or low liquidity), and some degree of
  dissimilarity between the two firms, valuation
  differences offer a tempting risk arbitrage
  opportunity
• Those who have A strive to sell it quickly when
  the price is still high
• B looks like a cheap buy, especially compared
  to the roughly similar quality A
• Demand and supply move to narrow relative
  valuation gap

51
2. Relative valuation

• If a stock has a low multiple compared to an
  industry comparison group, it could be due to
• False comparison group (apples vs oranges)
• Error in multiple computation
• Temporary items distort multiple
• Differences in risk (e.g. leverage)
• Differences in growth outlook
• Other differences such as liquidity of stock,
  quality of governance,
• Market pricing error (buying opportunity)

52
2. Four best practices (CGW)

• Choose comparables with similar prospects for
  ROIC and Growth
• Use multiples based on forward-looking estimates
• Use enterprise value (EV) multiples based on
  EBITA to mitigate problems with capital structure
  and one-time gains and losses
• Adjust the EV multiple for nonoperating items,
  such as excess cash, operating leases, employee
  stock options, amnd pension expenses (same as w/
  ROIC and FCFF adjusting)

53
2. What is relative valuation?

• In relative valuation, the value of an asset is
  compared to the values assessed by the market for
  similar or comparable assets.
• To do relative valuation then,
• we need to identify comparable assets and obtain
  market values for these assets
• convert these market values into standardized
  values, since the absolute prices cannot be
  compared. This process of standardizing creates
  price multiples.
• compare the standardized value or multiple for
  the asset being analyzed to the standardized
  values for comparable asset, controlling for any
  differences between the firms that might affect
  the multiple, to judge whether the asset is under
  or over valued

54
2. Standardizing Value

• Prices can be standardized using a common
  variable such as earnings, cashflows, book value
  or revenues.
• Earnings Multiples
• Price/Earnings Ratio (PE) and variants (PEG and
  Relative PE)
• Value/EBIT
• Value/EBITDA
• Value/Cash Flow
• Book Value Multiples
• Price/Book Value(of Equity) (PBV)
• Value/ Book Value of Assets
• Value/Replacement Cost (Tobins Q)
• Revenues
• Price/Sales per Share (PS)
• Value/Sales
• Industry Specific Variable (Price/kwh, Price per
  ton of steel ....)

55
2.1. Price Earnings Ratio Definition

• PE Market Price per Share / Earnings per Share
• There are a number of variants on the basic PE
  ratio in use.
• They are based upon how the price and the
  earnings are defined.
• Price is usually the current price
• is sometimes the average price for the year
• EPS earnings per share in most recent financial
  year
• earnings per share in trailing 12 months
  (Trailing PE)
• forecasted earnings per share next year
  (Forward PE)
• forecasted earnings per share in future year

56
2.1. PE from fundamentals

• For perpetual growth model (Gordon) divide thru
  w/ E1 to get theoretical forward PE
• For 2-stage model T period growth no
  growth...then

57
2.1. PE with 2-stage model

• You need double digit g, ROE and T together with
  below 10 k to generate PE ratios above 20!
• If required rate of return of equity would be
  13 (high beta stock),
• PEs have a very hard time exceeding 15!

58
2.2. PEG ratio

• PE ratio divided by estimated earnings growth
  rate 100
• PEG1 is neutral valuation
• In actual fact, risk and payout (1-plowback)
  continue to affect PEG-ratio
• Division by g does not neutralize the effect of
  growth due to non-linearities

59
2.3. Relative PE

• Ratio of firm PE to overall market P/E
• should use same earnings base in calculation
• Normalization by market enables better
  comparisons of valuations over time
• - Not (as) dependent on market interest rate
  level
• Increases when firm growth rate above market
  growth rate
• Decreases when firms riskiness w.r.t. market
  increases (high beta stocks)

60
2.4. Value/Earnings and Value/Cashflow Ratios

• While price earnings ratios look at the market
  value of equity relative to earnings to equity
  investors
• Value/earnings ratios look at the market value of
  the firm relative to operating earnings. Value to
  cash flow ratios modify the earnings number to
  make it a cash flow number.
• The form of value to cash flow ratios that has
  the closest parallels in DCF valuation is the
  value to Free Cash Flow to the Firm, which is
  defined as
• Value/FCFF (Market Value of Equity Market
  Value of Debt)
• EBIT (1-tc) - (Cap Ex - Deprecn) - Chg in WC

61
2.5. Enterprise value / FCFF

• Multiple is increasing in FCF
  (EBIT) growth and decreasing in cost of capital
  WACC!

62
2.6. Alternatives to FCFF - EBIT and EBITDA

• Many find FCFF too messy to use in multiples
  (partly because capital expenditures and working
  capital have to be estimated). They use modified
  versions of the multiple with the following
  alternative denominator
• after-tax operating income or EBIT(1-tC)
• pre-tax operating income or EBIT
• net operating income (NOI), a slightly modified
  version of operating income, where any
  non-operating expenses and income is removed from
  the EBIT
• EBITDA, which is earnings before interest, taxes,
  depreciation and amortization.

63
2.6. Pros of Value/EBITDA

• 1. EBIT gt 0 even when earnings negative.
• 2. Some long-term high growth firms may have
  misleading (too low) current earnings due to
  heavy investment needs
• 3. Comparing firms with differing leverage is OK.
• (EBIT level, WACC might differ though)

64
2.7. Price-Book Value Ratio Definition

• The price/book value ratio is the ratio of the
  market value of equity to the book value of
  equity, i.e., the measure of shareholders equity
  in the balance sheet.
• Price/Book Value Market Value of Equity
  Book Value of Equity

2-stage growth no growth
/ BV0
Note E1 BV0ROE
ltgt
ltgt
65
2.7. P/B to ROE

• Like PEG, ROE could be normalized against
  differing ROE levels by division to give a Value
  Ratio
• Value Ratio (P/B) / ROE

66
2.8. Price Sales Ratio Definition

• The price/sales ratio is the ratio of the market
  value of equity to the sales.
• Price/ Sales Market Value of Equity
• Total RevenuesCould also
  normalize it against profit margins
• Normalized Price/Sales (Price/Sales) / Profit
  Margin

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2.9. Choosing the right multiple

• EV/EBIT and EV/EBITDA and P/B have the best
  accuracy
• P/S and P/E worse
• Always use foreward earnings / EBIT etc.

68
2.9. Choosing Between the Multiples

• Many multiples exist...which one to use?
• In addition, relative valuation can be relative
  to a sector (or comparable firms) or to the
  entire market
• Since there can be only one final estimate of
  value, there are three choices at this stage
• Take a simple average of all multiple implied
  values?
• Take a weighted average of all multiple implied
  values?
• Choose best multiple and imply value from it?

69
2.9. Picking one Multiple

• Usually best method (and easiest)compared to
  averaging business...
• The multiple that is used can be chosen in one
  of three ways
• Cynics Pick the multiple that serves your
  purpose!
• Use the multiple that actually has been shown to
  be related to actual market values. How do we
  know? Research team needed.
• Use the multiple that seems to make the most
  sense for that sector, given how value is
  measured and created.

70
2.9. Guidelines

• Some common sense guidelines for multiple
  choice
• Sector Multiple Used Rationale
• Cyclical Manufacturing PE, Relative PE Often with
  normalized earnings
• High Tech, High Growth PEG Big differences in
  growth across firms
• High Growth/No Earnings PS, VS Assume future
  margins will be good
• Heavy Infrastructure VEBITDA Firms in sector have
  losses in early years and reported earnings
  can vary
• depending on depreciation method
• REITa P/CF Generally no cap ex investments
• from equity earnings
• Financial Services PBV Book value often marked to
  market
• Retailing PS If leverage is similar across firms
• VS If leverage is different

71
3. Valuation framework (Ch. 6-)

• Copeland-Koller-Murrin Valuation...
• Best practice
• Widely accepted, sound principles
• Steps are
• 1. Analyze historical performance
• 2. Estimate cost of capital
• 3. Forecast performance
• 4. Estimate continuing value
• 5. Evaluate scenarios

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3. Step 1. Analyzing Historical Performance

• Assess historical KVDs and FCF
• - Strive to pick an entire historical economic
  cycle
• - beware of cyclically low/high recent cash
  flow!
• - normalization often advisable

73
3. Step 1. Analyzing Historical Performance

• Integrate Income and Balance sheets to cash flows
  and further to key ratios
• Reorganize accounting statements for valuation
  purpose
• Invested capital
• NOPLAT (roughly after-tax EBIT)
• historical ROIC
• breakdown in tree ROIC Operating margin
  Capital Turnover
• historical Economic Profit
• historical FCFF
• historical growth
• historical investment rates (into NWC and CapEx)
• credit health liquidity position
• other stuff
• goodwill, operating leases, reserves
• Benchmark to peers or market
• caution to differing international accounting
  conventions

74
3. Realistic ROI and growth levels

• Example Stockmann ROI

75
3. Realistic ROI and growth levels

• Example Stockmann Sales Growth

76
4. WACC or APV?

• WACC-method works best when...
• 1. Target long-term capital structure can be
  assumed constant
• 2. Capital structure is simple, few embedded
  liability options
• APV-method works best when...
• 1. Target D/V is not constant through time
• 2. Complicated option-features present
• e.g. significant executive options (warrants)
• significant mezzanine financing convertible debt
  etc.
• Valuation steps with APV
• 1. Compute 100 equity financed (i.e. unlevered)
  enterprise value
• 2. Add PV of financial side fx like subsidized
  financing, debt capacity
• 3. Add excess marketable securities
• 4. Subtract senior claim values senior bonds,
  junior bonds, mezzanine, executive warrants...to
  get value of equity

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4.1. Estimating cost of capital

• Cost of capital reflects, among other things at
  least...
• investors willingness to entrust their money
  with the (managers of) the firm for a reasonable
  price given the expected outlook on company cash
  flow
• Cost of capital increasing in factors reducing
  willingness (mistrust)
• High risk
• Illquidity (foreign listed? size/turnover?)
• Bad/unclear corporate governance
• Wierd ownership structure (only domestic owners,
  single majority owner?)

78
4.1. Estimating cost of capital - Risk

• (Given no pricing error) If cash flow growth
  prospects do not explain (e.g.) a high valuation,
  it must be due to (most) investors being really
  eager to hold the stock low cost of capital
• they perceive it as low risk OR
• they truly trust the CG OR
• it is really big liquid (blue chip) OR
• it is a large global company listed on many
  stock exchanges
• (wide globally diversified ownership base)

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4.1. Estimating cost of capital - Risk

• The major component traditionally assumed to
  impact cost of capital
• Debt financing Use of bond ratings to gauge risk
  class and credit spread
• Equity financing Level of systematic risk of
  industry (unlevered equity beta) financial
  leverage effect

80
4.1. Estimating WACC

• 1. Use market value weights for all types of
  capital
• 2. Specify cost of capital items after-tax to
  match after tax free cash flow.
• 3. Use nominal cost of capital (1real
  rate)(1Einfl.)
• to match nominal cash flow modelling
• 4. Utilize market prices at date of valuation, if
  possible
• Debt deducted should equal debt in WACC
• Check for gross discrepancies between assumed
  target D/V ratio in WACC and that implied by
  your valuation!

81
4.1. Step 2. Estimating the Cost of Capital

• The WACC can be defined in many ways, two most
  common definitions include (assumes simple DE
  only capital structure!)
• where tc is the corporate tax rate
• kU unlevered cost of equity
• kD cost of debt
• kE cost of (levered) equity

assumes debt cash flows are equally risky as debt
and therefore discounted with kD! Can always
be used!
or
assumes debt cash flows are risky and therefore
discounted with kU!
82
4.1. Step 2. Estimating the Cost of Capital

• Current practice tends to measure risk in equity
  through the beta, i.e. assume the CAPM holds.
• Then beta is the risk measure supposed to
  reflect, systematic risk, liquidity, CG,
  ownership structure
• Beware!
• ? Even ignoring 2.-4, a better APM than CAPM is
  the Fama-French 3 Factor Model
• high (low) beta stocks as well as small value
  (large growth) stocks have higher (lower) than
  average systematic risk and hence cost of equity
• On top of equity risk financial leverage must be
  taken into account...

83
4.1. FF 3FM

84
4.1. Step 2. Estimating the Cost of Capital

• Relationship between levered and unlevered cost
  of equity are as follows (zero growth case,
  approximation to other cases)
• where tc is the corporate tax rate
• kU unlevered cost of equity
• kD cost of debt
• kE cost of (levered) equity

or
assumes debt cash flows are equally risky as debt
and therefore discounted with kD!
assumes debt cash flows are risky and therefore
discounted with ku!
85
4.1. Step 2. Estimating the Cost of Capital

• Relationship between levered and unlevered equity
  betas are as follows (zero growth case,
  approximation to other cases)
• where tc is the corporate tax rate
• bU unlevered equity beta
• bD debt beta
• bE levered equity beta

or
assumes debt cash flows are equally risky as debt
and therefore discounted with kD!
assumes debt cash flows are risky and therefore
discounted with ku!
86
4.1. Target D/V?

• 1. Use market value weights for all types of
  capital
• Market D/E ratio (Book D/E ratio)
  (Book/Market ratio) !
• Only if B/M 1 then market and book gearing
  coincide
• Usually assumed constant through time, although
  not mandatory
• Think in terms of the long-term target capital
  structure
• 1. Smoothing over recent transitory capital
  structure changes
• 2. Get around circularity problem
• 3. Benchmark to industry, why deviation?
• The debt you subtract to get equity should
  normally be the debt used in the capital
  structure WACC

87
4.2. Cost of debt

• Straight investment grade debt
• Find company bond rating
• Use current yield from rating class as a proxy
  for expected cost of debt
• Below investment grade
• Significant default rates bias (promised) yields
  upward compared to expected yields!
• Need expected default rates and value in default
  to compte expected yields...
• May need to use BBB-rated debt yields as proxy
• Own rating model
• e.g. interest coverage ratio based

88
4.3. Cost of hybrids or mezzanine

• e.g. convertible bonds, capital loans etc.
• Split up value into
• (1) bond part and (2) warrant part (or
  equivalent option)
• Estimate costs as cost of debt and equity for the
  parts separately.

89
4.4. Cost of equity

• 1. CAPM expected cost ( return)
• rf risk free rate
• Market Risk Premium Erm - rf
• Beta of security / capital type i, bi
• 2. Implied IRR from valuation model
• e.g. solve for kE from P DIV1/(kE - g) given P
  and DIV1 and g forecasts!

90
4.4. Cost of equity

• 1. CAPM
• rf should be defined with
• no default risk
• no re-investment risk (term structure effects0)
• no inflation risk
• in practice, 5 or 10 year government bond yield
  typically used
• match with duration of firm cash flow
• not universally accepted, some advocate short
  maturity TBills
• choose rf consistently with MRP!
• New in U.S TIPS (Treasury-Inflation-Protected-
  Securities) replacing Tbills as a riskfree rate!
• Coming in Europe?

91
4.4. Cost of equity

• 1. CAPM
• Expected Market Risk Premium
• These days around 2-4 for developed markets
• Think Europe or World as the market
• Use consistent rf definition with above!
• Historical average likely too high
• Good luck
• Inconsistency with theories
• Survivorship bias
• Dimson-Marsh-Staunton European data

92
4.4. Cost of equity

• 1. CAPM
• Beta?
• unlevered vs levered equity betas
• preferably, use industry average unlevered equity
  betas
• historical OLS regression
• need to unlever to first get industry betas!
• use monthly data/longer estimation period to
  combat illquidity distortions

93
4.4.Historical market premium varies a lot

Forecasts made 5 (10) years ahead using D/P
regression
94
4.4. Implied market return

• 1. Pick a 2-stage model for T year horizon
• 2. Obtain market index dividend forecasts up to
  T
• 3. Estimate long-term nominal growth rate of
  market (nominal long-term GDP growth usually).
• 4. Back out rm that equates PV(dividendsHV) with
  current market index level.

95
4.5. Alternative approaches

• 1. Fama-French 3F model already mentioned as
  being the one
• (at least) academics mostly believe in
• although we know it doesnt explain well
  momentum, small growth stocks etc.-
  implementation issues estimate three premia and
  three betas instead of 11...
• 2. Use of past (long-term!) realized average
  stock return (of peers)?
• Tend to be very noisy and highly dependent on
  sample period

96
5. Step 3. Forecasting Performance

• 1. Length and detail of forecasts
• 2. Analyze industry
• business logic
• threats from new entry/new technology?
• sustainability of margins, ROIC, growth
• 3. Link between strategy and future KPIs
• Strategy gt KPI forecasts gt Inc. and BS
  forecasts gt FCFF forecasts
• 4. Evaluate alternative scenarios
• 5. Overall consistency
• growth ltgt ROIC ltgt Investments vs strategic
  view

97
5.1. Forecasting cash flows

• We should forecast expected cash flows or
  alternatively do scenario-based valuations
• Scenario prob. CF
• Optimistic 40 10
• Realistic 40 8
• Pessimistic 20 -4
• ECF 6.4
• Frequent error is to provide upward biased
  budget, or hoped for forecasts instead of
  expectation
• e.g., do the forecasts acknowledge there is some
  probability for a zero CF?

98
5.1. Forecasting FCF

• 1. Forecast KVDs
• 2. Build pro forma income statements and balance
  sheets from KVDs
• check reasonability of numbers, benchmarking,
  financing feasible?
• 3. Derive FCF from step 2.

99
5.1. Free Cash Flow To Equity - FCFE

• EBIT
• ./. Interest Expense
• EBT
• ./. taxes
• Net Income
• Depreciation
• CF from operations
• ./. Working capital increase (operative,
  non-int.bearing)
• ./. Gross capital expenditures
• ./. Debt amoritizations
• New debt issues
• FCFE

100
5.1. Free Cash Flow To Firm - FCFF

• EBITA (EBIT before Interest, Taxes and
  Goodwill Amortization)
• ./. taxes ( may have to be adjusted for
  financial items)
• NOPLAT
• Depreciation (all depreciation but goodwill
  type amortization)
• Gross CF
• ./. Working capital increase (non-interest
  bearing or operative)
• ./. Gross capital expenditures (net investment
  depreciation)
• FCFF before goodwill
• ./. Investments into goodwill (DGoodwill
  goodwill amort.)
• FCFF after goodwill

101
6. Step 4. Estimating Continuing Value

• 1. Pick simplified long-term growth model
• Industry analysis - the long run
  outlook?
• 2. Estimating long run continuing value model
  parameters
• ROIC, NOPLAT growth rate, investment rate?

or
102
6. Step 4. Estimating Continuing Value

• 1. Forecast at least 7 years (over a whole
  business cycle).
• 2. ROIC is marginal ROIC, for many companies
  ROIC WACC .
• 3. NOPLAT(T1) should be normalized.
• 4. FCF - remember to subtract investments
  required to sustain long-term growth
• 5. Growth rate - normally long term cons.
  (volume, or real) growth of industrys product
  inflation
• Long-term nominal GDP growth is about /-6

103
6. Step 4. Estimating Continuing Value

• 6. Long term growth should never exceed nominal
  GDP (nominal RF level) growth
• 7. Constant growth could be assumed zero or
  negative indicating we model a peak at T and then
  diminishing size for company in relation to
  industry/market
• 8. Frequently riskiness of firm changes as it
  enters a constant growth phase from high growth
  gt lower beta?

104
7. Step 5. Interpret the results

• 1. Calculate PV(FCFF) PV(continuing value)
• 2. Subtract debt, hybrid securities, PV(leases) ,
  minority interest, executive options
• in-the-money executive options can alternatively
  be treated as fully diluted equity gt increase
  number of shares instead of subtracting value of
  exec. options.
• 3. Add cash/excess marketable securities
• 4. Add PV(non-operative) cash flow or assets
• 5. Weight each scenario with steps 1.-4 with
  scenario probabilities to sum up.

105
7. Some closing remarks...

• Develop a habit of drawing time lines graphs
  (10-30 years ahead) of your projected ROIs
  (compare to WACC), gs
• Normalize and average out lumpy investments/NWC
  needs
• Positive NWC temporary, prudent to assume zero.
• Look out for starting level CF, HV assumptions
  many valuation errors can be traced back to
  these
• Stick to gROIb consistency
• Dont overdo cost of capital estimations (unless
  you are selling them for a good price )
• No way these will ever be 100 accurate, so dont
  worry about third decimal of your beta
• Ask is this a stock investors like? If yes, is
  it just the growth outlook, or is it something
  else? If they dont like a stock, why?
• Check ownership structure, low cost of capital
  firms have dispersed, global ownership, good
  track record of liquidity and good CG
• Very high valuation must go together with low
  cost of capital if you cant see it, suspect
  ovevaluation
• If overvaluation would actually be present who
  would/could move to exploit it? Why dont they?

106
7. Valuation - summary
EnterpriseValue
Cash Flow

Cost of Capital
FCFFt
WACC
NOPLATt
NetInvestmentst
kD
kE
Target D/V
./.
ROIforec. period T
ROI post-forec. period
rf
CapExt
NWCt



CVT
Default premium