Alternative Approaches to Value Enhancement

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Alternative Approaches to Value Enhancement

• Maximize a variable that is correlated with the
  value of the firm. There are several choices for
  such a variable. It could be
• an accounting variable, such as earnings or
  return on investment
• a marketing variable, such as market share
• a cash flow variable, such as cash flow return on
  investment (CFROI)
• a risk-adjusted cash flow variable, such as
  Economic Value Added (EVA)
• The advantages of using these variables are that
  they
• Are often simpler and easier to use than DCF
  value.
• The disadvantage is that the
• Simplicity comes at a cost these variables are
  not perfectly correlated with DCF value.

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Economic Value Added (EVA) and CFROI

• The Economic Value Added (EVA) is a measure of
  surplus value created on an investment.
• Define the return on capital (ROC) to be the
  true cash flow return on capital earned on an
  investment.
• Define the cost of capital as the weighted
  average of the costs of the different financing
  instruments used to finance the investment.
• EVA (Return on Capital - Cost of Capital)
  (Capital Invested in Project)
• The CFROI is a measure of the cash flow return
  made on capital
• CFROI (Adjusted EBIT (1-t) Depreciation
  Other Non-cash Charges) / Capital Invested

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Estimating EVA for Nestle

• Capital Invested 29500 Million Sfr
• Return on Capital 12.77
• Cost of Capital 8.85
• Economic Value Added in 1995 (.1277 - .0885)
  (29,500 Million Sfr) 1154.50 Million Sfr

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Estimating Tsingtaos EVA in 1996

• Tsingtao Brewery, a Chinese Beer manufacturer,
  has make significant capital investments in the
  last two years, and plans to increase its exports
  over time. Using 1996 numbers, Tsingtao had the
  following fundamentals
• Return on Capital 1.28
• Cost of Capital 15.51
• Capital Invested 3,015 million CC
• Economic Value Added in 1996 429 million CC

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J.P. Morgans Equity EVA 1996

• Equity Invested at the end of 1995 10,451
  Million
• Net Income Earned in 1996 1,574 Million
• Cost of Equity for 1996 7 0.94 (5.5)
  12.17
• I used the riskfree rate from the start of 1996
• Equity EVA for J.P. Morgan 1574 Million -
  (10,451 Million)(.1217) 303 Million

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Things to Note about EVA

• EVA is a measure of dollar surplus value, not the
  percentage difference in returns.
• It is closest in both theory and construct to the
  net present value of a project in capital
  budgeting, as opposed to the IRR.
• The value of a firm, in DCF terms, can be written
  in terms of the EVA of projects in place and the
  present value of the EVA of future projects.

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A Simple Illustration

• Assume that you have a firm with
• IA 100 In each year 1-5, assume that
• ROCA 15 ? I 10 (Investments are at beginning
  of each year)
• WACCA 10 ROC New Projects 15
• WACCNew Projects 10
• Assume that all of these projects will have
  infinite lives.
• After year 5, assume that
• Investments will grow at 5 a year forever
• ROC on projects will be equal to the cost of
  capital (10)

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Firm Value using EVA Approach

• Capital Invested in Assets in Place 100
• EVA from Assets in Place (.15 .10)
  (100)/.10 50
• PV of EVA from New Investments in Year 1
  (.15 - .10)(10)/.10 5
• PV of EVA from New Investments in Year 2
  (.15 - .10)(10)/.10/1.1 4.55
• PV of EVA from New Investments in Year 3
  (.15 - .10)(10)/.10/1.12 4.13
• PV of EVA from New Investments in Year 4
  (.15 - .10)(10)/.10/1.13 3.76
• PV of EVA from New Investments in Year 5
  (.15 - .10)(10)/.10/1.14 3.42
• Value of Firm 170.86

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Firm Value using DCF Valuation Estimating FCFF
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Firm Value Cost of Capital and Capital Invested
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Firm Value Present Value of FCFF
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EVA Valuation of Nestle
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DCF Valuation of Nestle
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Year-by-year EVA Changes

• Firms are often evaluated based upon
  year-to-year changes in EVA rather than the
  present value of EVA over time.
• The advantage of this comparison is that it is
  simple and does not require the making of
  forecasts about future earnings potential.
• Another advantage is that it can be broken down
  by any unit - person, division etc., as long as
  one is willing to assign capital and allocate
  earnings across these same units.
• While it is simpler than DCF valuation, using
  year-by-year EVA changes comes at a cost. In
  particular, it is entirely possible that a firm
  which focuses on increasing EVA on a year-to-year
  basis may end up being less valuable.

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Year-to-Year EVA Changes Nestle
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When Increasing EVA on year-to-year basis may
result in lower Firm Value

• 1. If the increase in EVA on a year-to-year basis
  has been accomplished at the expense of the EVA
  of future projects. In this case, the gain from
  the EVA in the current year may be more than
  offset by the present value of the loss of EVA
  from the future periods.
• For example, in the Nestle example above assume
  that the return on capital on year 1 projects
  increases to 13.27 (from the existing 12.77),
  while the cost of capital on these projects stays
  at 8.85. If this increase in value does not
  affect the EVA on future projects, the value of
  the firm will increase.
• If, however, this increase in EVA in year 1 is
  accomplished by reducing the return on capital on
  future projects to 12.27, the firm value will
  actually decrease.

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Firm Value and EVA tradeoffs over time
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EVA and Risk

• 2. When the increase in EVA is accompanied by an
  increase in the cost of capital, either because
  of higher operational risk or changes in
  financial leverage, the firm value may decrease
  even as EVA increases.
• For instance, in the example above, assume that
  the spread stays at 3.91 on all future projects
  but the cost of capital increases to 9.85 for
  these projects (from 8.85). The value of the
  firm will drop.

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Nestles Value at a 9.95 Cost of Capital
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EVA The Risk Effect
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EVA and Changes in Market Value

• The relationship between EVA and Market Value
  Changes is more complicated than the one between
  EVA and Firm Value.
• The market value of a firm reflects not only the
  Expected EVA of Assets in Place but also the
  Expected EVA from Future Projects
• To the extent that the actual economic value
  added is smaller than the expected EVA the market
  value can decrease even though the EVA is higher.

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High EVA companies do not earn excess returns
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Increases in EVA do not create excess returns
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When focusing on year-to-year EVA changes has
least side effects

• 1. Most or all of the assets of the firm are
  already in place i.e, very little or none of the
  value of the firm is expected to come from future
  growth.
• This minimizes the risk that increases in
  current EVA come at the expense of future EVA
• 2. The leverage is stable and the cost of capital
  cannot be altered easily by the investment
  decisions made by the firm.
• This minimizes the risk that the higher EVA is
  accompanied by an increase in the cost of
  capital
• 3. The firm is in a sector where investors
  anticipate little or not surplus returns i.e.,
  firms in this sector are expected to earn their
  cost of capital.
• This minimizes the risk that the increase in
  EVA is less than what the market expected it to
  be, leading to a drop in the market price.

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Valuation Closing Thoughts

• Spring 2002
• Aswath Damodaran

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Do you have your life vests on?
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Truths about Valuation

• Truth 1 Bias is endemic in valuation and can
  enter in subtle and not so subtle ways.
• Truth 2. A valuation is never precise and is
  never quite done.
• Truth 3 Complexity comes with a cost More
  information is not always better than less
  information.

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Approaches to Valuation

• Discounted cashflow valuation, where we try
  (sometimes desperately) to estimate the intrinsic
  value of an asset by using a mix of theory,
  guesswork and prayer.
• Relative valuation, where we pick a group of
  assets, attach the name comparable to them and
  tell a story.
• Contingent claim valuation, where we take the
  valuation that we did in the DCF valuation and
  divvy it up between the potential thieves of
  value (equity) and the potential victims of this
  crime (lenders)

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Basis for all valuation approaches

• We all believe market are inefficient, and that
  we can find under and over valued assets because
  of our superior intellect, models, information or
  some combination of all three.
• Some Sobering facts
• 70-80 of portfolio managers under perform market
  indices.
• The Vanguard 500 Index fund is poised to overtake
  the Fidelity Magellan fund as the largest mutual
  fund in the United States. In the last 5 years,
  it has been the best performing large mutual fund
  in the United States.
• The more people trade, the more they seem to
  lose.
• A study of mutual fund portfolios discovered that
  they would have made a higher return, if they had
  frozen their portfolios on January 1.
• A study of individual investors by Terrence
  ODean also noted a negative correlation between
  returns earned and transactions volume (and this
  is before trading costs)

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Discounted Cash Flow Valuation

• What is it In discounted cash flow valuation,
  the value of an asset is the present value of the
  expected cash flows on the asset.
• Philosophical Basis Every asset has an intrinsic
  value that can be estimated, based upon its
  characteristics in terms of cash flows, growth
  and risk.
• Information Needed To use discounted cash flow
  valuation, you need
• to estimate the life of the asset
• to estimate the cash flows during the life of the
  asset
• to estimate the discount rate to apply to these
  cash flows to get present value
• Market Inefficiency Markets are assumed to make
  mistakes in pricing assets across time, and are
  assumed to correct themselves over time, as new
  information comes out about assets.

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The Lego Blocks of Valuation
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The Models You Used in DCF Valuation
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What you found ...
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The Most Undervalued stocks were..
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The most undervalued in May 2001 were
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The ultimate test Did undervalued stocks make
money?
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More on the winners...

• About 60 of all buy recommendations make money
  about 45 of sell recommendations beat the
  market.
• There are two or three big winners in each
  period.
• Apple Computer in December 1996
• Checkpoint Software in June 1999
• Stocks on which there is disagreement among
  different people tend to do worse than stocks on
  which there is no disagreement
• Stocks that are under valued on both a DCF and
  relative valuation basis do better than stocks
  that are under valued on only one approach.

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The Most Overvalued stocks are...
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The Most Over Valued Firms in May 2001 were...
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Relative Valuation

• What is it? The value of any asset can be
  estimated by looking at how the market prices
  similar or comparable assets.
• Philosophical Basis The intrinsic value of an
  asset is impossible (or close to impossible) to
  estimate. The value of an asset is whatever the
  market is willing to pay for it (based upon its
  characteristics)
• Information Needed To do a relative valuation,
  you need
• an identical asset, or a group of comparable or
  similar assets
• a standardized measure of value (in equity, this
  is obtained by dividing the price by a common
  variable, such as earnings or book value)
• and if the assets are not perfectly comparable,
  variables to control for the differences
• Market Inefficiency Pricing errors made across
  similar or comparable assets are easier to spot,
  easier to exploit and are much more quickly
  corrected.

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Standardizing Value

• Prices can be standardized using a common
  variable such as earnings, cashflows, book value
  or revenues.
• Earnings Multiples
• Book Value Multiples
• Revenues
• Industry Specific Variable (Price/kwh, Price per
  ton of steel ....)

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The Four Steps to Understanding Multiples

• Anna Kournikova knows PE. Or does she?
• In use, the same multiple can be defined in
  different ways by different users. When comparing
  and using multiples, estimated by someone else,
  it is critical that we understand how the
  multiples have been estimated
• 8 times EBITDA is not always cheap
• Too many people who use a multiple have no idea
  what its cross sectional distribution is. If you
  do not know what the cross sectional distribution
  of a multiple is, it is difficult to look at a
  number and pass judgment on whether it is too
  high or low.
• You cannot get away without making assumptions
• It is critical that we understand the
  fundamentals that drive each multiple, and the
  nature of the relationship between the multiple
  and each variable.
• There are no perfect comparables
• Defining the comparable universe and controlling
  for differences is far more difficult in practice
  than it is in theory.

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Estimating a Multiple

• Use comparable firms, compute the average
  multiple and adjust subjectively for differences
• Use comparable firms, run a regression of
  multiple against fundamentals and estimate
  predicted multiple for firm
• Use market, run a regression of multiple against
  fundamentals and estimate a predicted multiple
  for firm

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The Multiples you used were ...
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Valuation Results DCF vs Relative Valuation
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Valuation Results December 1999 ...
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Valuations May 2000
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Valuations December 2000
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DCF vs Relative Valuations
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Most undervalued on a Relative Basis
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The Most under valued firms in May 2001 were
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Most Over Valued Firms are..
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Most overvalued firms in May 2001 were..
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Contingent Claim (Option) Valuation

• Options have several features
• They derive their value from an underlying asset,
  which has value
• The payoff on a call (put) option occurs only if
  the value of the underlying asset is greater
  (lesser) than an exercise price that is specified
  at the time the option is created. If this
  contingency does not occur, the option is
  worthless.
• They have a fixed life
• Any security that shares these features can be
  valued as an option.

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Indirect Examples of Options

• Equity in a deeply troubled firm - a firm with
  negative earnings and high leverage - can be
  viewed as an option to liquidate that is held by
  the stockholders of the firm. Viewed as such, it
  is a call option on the assets of the firm.
• The reserves owned by natural resource firms can
  be viewed as call options on the underlying
  resource, since the firm can decide whether and
  how much of the resource to extract from the
  reserve,
• The patent owned by a firm or an exclusive
  license issued to a firm can be viewed as an
  option on the underlying product (project). The
  firm owns this option for the duration of the
  patent.

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Results of Option Valuations

• Number of firms valued using option models 23
• Median increase in value from the option model
  87
• What types of firms do you think had the biggest
  increase in value?

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Your recommendations were to ..
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Value Enhancement

• For an action to create value, it has to
• Increase cash flows from assets in place
• Increase the expected growth rate
• Increase the length of the growth period
• Reduce the cost of capital
• The value enhancement measures that have been
  widely promoted as new and different are neither.
  
• EVA and CFROI have their roots in traditional
  discounted cash flow models
• Measures (like EVA and CFROI) do not create
  value managers do.

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ChoicesChoicesChoices
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Picking your approach

• Asset characteristics
• Marketability
• Cash flow generating capacity
• Uniqueness
• Your characteristics
• Time horizon
• Reasons for doing the valuation
• Beliefs about markets

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What approach would work for you?

• As an investor, given your investment philosophy,
  time horizon and beliefs about markets (that you
  will be investing in), which of the the
  approaches to valuation would you choose?
• Discounted Cash Flow Valuation
• Relative Valuation
• Neither. I believe that markets are efficient.

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Some Not Very Profound Advice

• Its all in the fundamentals.
• Focus on the big picture dont let the details
  trip you up.
• Keep your perspective it is only a valuation.
• If you have to choose between valuation skills
  and luck.

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Or maybe you can fly.