Valuation

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Valuation
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Contents

• Introduction Fundamentals of Where Value Comes
  From
• Discounting and IRR Review
• Overview of Alternative Valuation Methods
• Valuation Using Multiples
• Valuation Using Discounted Free Cash Flow
• Valuation Using Projected Earnings and Equity
  Cash Flow
• Case Studies

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Valuation, Decision Making and Risk

• Every major decision a company makes is in one
  way or another derived from how much the outcome
  of the decision is worth. It is widely
  recognized that valuation is the single financial
  analytical skill that managers must master.
• Valuation analysis involves assessing
• Future cash flow levels, (cash flow is reality)
  and
• Risks in valuing those cash flows, whether it be
  the cash flow from assets, debt or equity
• Measurement value forecasting and risk
  assessment -- is a very complex and difficult
  problem.
• Intrinsic value is an estimate and not observable

Reference Chapter 4
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Market Value of Debt, Credit Spreads and Par Value

• Before thinking about valuation of a company,
  consider the value of debt
• The par value or the value on the balance sheet
  does not determine the value of debt
• Rather the value depends on the future level of
  cash flows (par value x coupon rate) and the risk
  applied to cash flows
• Credit spreads are driven by the risk and can be
  measured by the One of the few things we know is
  that there is a tradeoff between risk and return.
• Key idea is to use future cash flows and
  incremental discount rate in measuring market
  value

Reference Folder on Yield Spreads
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Measurement of Risk in Financial Models

• The fundamental issue in any valuation problem is
  how to assess the risk of future cash flow
  projections.
• Financial theory
• Financial theory dictates that the CAPM should be
  used to compute the WACC, that the un-levered
  beta should be used to estimate equity returns,
  that options pricing models should be used for
  credit spreads, debt capacity and covenants.
• Mathematical Models
• Mathematical models include beta adjustments for
  the CAPM, statistical models for credit analysis,
  Monte Carlo simulation and value at risk.
• Practical Market Information
• Practical market information can be used to gauge
  required equity returns, required credit spreads,
  required financial ratios to achieve investment
  grade rating and other issues.

• Consider Investment Alternatives A and B, where A
  has a higher project IRR than B. Assume A has a
  return of 11 and B has a return of 9.
• Project A or Project B would be selected through
  assessing the return on the projects relative to
  the weighted average cost of capital for each
  project. If the WACC for A is 10 and for B is
  9.5 then A is selected. One must computed beta
  for each investment.
• Compute the distributions in cash flow of project
  A and project B to equity holders. If the
  standard deviation is lower for project B, then
  assess the risk relative to the return.
• Compute the achieved rate of return from the
  ability to raise debt and then assess the return
  earned on equity. If the return on equity is
  greater for B then A, select project A.

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Problems with CAPM

• Ke Rf Beta x EMRP
• Difficulty in establishing Rf
• Cant find Betas
• Betas performed horribly during financial crisis
• EPRM cannot be measured and changes with
  perceptions over time

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Problems with Betas Confirmed by Financial
Crisis
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CAPM Post Financial Crisis

• The cost of equity was calculated using the
  capital asset pricing model, which is a
  theoretical financial model that estimates the
  cost of equity capital based on a companys
  beta which is a measure of a companys
  volatility relative to the overall market, a 6
  market risk premium and a relevant predicted beta
  and risk-free rate. The public market trading
  price targets published by securities research
  analysts do not necessarily reflect current
  market trading prices for Wyeths and Pfizers
  common stock and these estimates are subject to
  uncertainties, including the future financial
  performance of Wyeth and Pfizer and future
  financial market conditions.
• Academic studies 2-3
• Pre-Crisis Bankers 4-5
• Historical U.S. premium pre-crisis 6-8

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Problems with Growth

• Typical assumption that growth equals inflation
  means world economy would stop
• Time period before which reach stable growth is
  impossible to estimate
• Evidence that sell-side analysts chronically
  over-estimate short-term growth rates

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Example of Method 1 Financial Theory
Fundamental parameters are almost impossible to
measure
Differences in Beta, Rm and Terminal Growth have
an Immense Effect on the Value of the Investment
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Method 2 Stochastic Mathematics
If only we could measure these things
Case 1 15 Volatility 40 Mean Reversion 4.5
Long-run Marginal Cost
Case 2 25 Volatility 10 Mean Reversion 4.0
Long-run Marginal Cost
The probability of earning below the risk free
rate is about 5
The probability of earning below the risk free
rate is about 55
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Example of Method 3 Debt Capacity
Let Bankers Assess the Risk That is Their Job
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Comparison of Approaches Which Investment would
you Select

• Project A

• Project B

Project A has a higher rate of return relative to
its cost of capital, but Project B has a higher
equity return
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Valuation Diagram DCF from Free Cash Flow

• Valuation using discounted cash flows requires
  forecasted cash flows, application of a discount
  rate and measurement of continuing value (also
  referred to as horizon value or terminal value)

Continuing Value
Cash Flow
Cash Flow
Cash Flow
Cash Flow
Discount Rate is WACC
Enterprise Value
Net Debt
Reference Private Valuation Valuation Mistakes
Equity Value
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Equity Cash Flow, Debt Cash Flow, Free Cash Flow
andCost of Equity, Cost of Debt and WACC
Equity Cash Flow and Value of Equity Dividends
less Equity Issued
Value of Equity PV of Cash Flows at Cost of
Equity


Debt Cash Flow and Market Value of Debt Net
Interest plus Net Debt Payments
Value of Debt PV of Cash Flows at Incremental
Cost of Debt


Free Cash Flow EBITDA Op Taxes Cap Exp WC
Chg
Value of Enterprise PV of Cash Flows At WACC
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Valuation Overview

• Despite that fact that all we have to do is
  forecast cash flow and then determine the risk
  associated with those cash flows, valuation is a
  huge topic. Some Key issues in valuation
  analysis include
• Cost of Capital in DCF or Discounted Earnings for
  Measuring Risk
• Selection of Market Multiple and Adjustment that
  implicitly accounts for growth in cash flow and
  risk
• Determination of Growth Rates in Earnings and
  Cash Flow Projections
• How to Compute Terminal Value when Cash Flow
  Lasts for an Indefinite Period

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Tools for Valuation

• There is no magic answer as to whether one
  valuation approach is better than others. But
  virtually all valuation analyses involve the
  following work
• Financial Models
• Valuation model used to project earnings or cash
  flows
• Statistical Data
• Industry Comparative Data to establish Multiples
  and Cost of Capital
• Industry, company knowledge and judgment
• Knowledge about risks and economic outlook to
  assess risks and value drivers in the forecasts

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Problems with Traditional Finance and Discounted
Free Cash Flow

• The entire process is dependent on WACC and the
  CAPM
• Rm is one of the most debated issues in finance
• Beta is difficult to measure
• The model doesnt work
• Valuation is highly dependent on terminal values
  and growth rates
• Often zero real growth is used, implying that if
  all companies had zero growth, economies around
  the world would be stagnant
• If multiples are used, they can be very
  subjective
• Comparable companies are not comparable at all
• Arbitrary adjustments are made to the P/E and
  EV/EBITDA valuation ratios

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Valuation and Cash Flow

• Ultimately, value comes from cash flow in any
  model
• DCF directly measure cash flow from explicit
  cash flow and cash flow from selling after the
  explicit period
• Multiples The size of a multiple ultimately
  depends on cash flow in formulas
• FCF/(k-g) Multiple
• They still have implicit cost of capital and
  growth that must be understood
• Replacement Cost cash from selling assets
• Growth rate in cash flow is a key issue in any of
  the models

Investors cannot buy a house with earnings or use
earnings for consumption or investment
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Reasonable Estimates of Growth Is this Graph
Reasonable
The short term Based on best estimate of likely
outcome

• The medium term transition to tranquillity
• Assessment of industry outlook and company
  position
• ROIC fades towards the cost of capital
• Growth fades towards GDP

• The long run tranquillity and equilibrium
• Long run assumptions
• ROIC Cost of capital
• Real growth 0

Much of valuation involves implicitly or
explicitly making growth estimates High P/E
comes from high growth
Reference Level and persistence of growth rates
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How Long will Growth Last

• Some Theoretical Issues with Growth
• The greater the current growth rate in earnings
  of a firm, relative to the stable growth rate,
  the longer the high growth period although the
  growth rate may drop off during the period. Thus,
  a firm that is growing at 40 should have a
  longer high-growth period than one growing at
  14.
• The larger the size of the firm, the shorter the
  high growth period. Size remains one of the most
  potent forces that push firms towards stable
  growth the larger a firm, the less likely it is
  to maintain an above-normal growth rate.
• The greater the barriers to entry in a business,
  e.g. patents or strong brand name, should
  lengthen the high growth period for a firm.
• Look at the combination of the three factors
  A,B,C and make a judgment. Few firms can achieve
  an expected growth period longer than 10 years

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Terminal Value and Growth

• Terminal value is reached when a company has
  reached maturity it grows at the overall rate
  of the economy. This should be nominal growth in
  the economy since all of the currency in models
  is in nominal terms.
• For immature companies, the reaching of
  equilibrium will exceed the standard five year
  forecast
• Extending the forecast forces one to make
  assumptions for more than one year which become
  very speculative
• Some suggest a fade growth period to address this
  issue

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Fade Period

• The fade period is the length of time it takes
  for the long-term growth rate to be reached after
  from the growth in the last year of the forecast.
• For example, the last year growth is 10
• The terminal growth is 3
• The time to get from 10 to 3 is 5 years
• You can use the formula
• Growth Growtht-1 x (Long term/Short
  term)(1/Fade)
• Note This does not work with negative growth
  rates

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Growth When Companies are Earning More than their
Cost of Capital

• It is a lot more difficult to maintain growth
  when you are earning 40 return on investment
  than when you are earning 10 in the terminal
  period
• Competition tends to compress margins and growth
  opportunities, and sub-par performance spurs
  corrective actions.
• With the passage of time, a firms performance
  tends to converge to the industry norm.
• Consideration should be given to whether the
  industry is in a growth stage that will taper
  down with the passage of time or whether its
  growth is likely to persist into the future.
• Competition exerts downward pressure on product
  prices and product innovations and changes in
  tastes tend to erode competitive advantage. The
  typical firm will see the return spread
  (ROIC-WACC) shrink over time.

A study by Chan, Karceski, and Lakonishok
titled, The Level and Persistence of Growth
Rates, published in 2003. According to this
study, analyst growth forecasts are overly
optimistic and add little predictive power.
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Growth Issues

• Growth issues include
• Growth is difficult to sustain
• Law of large numbers means that it is more
  difficult to maintain growth after a company
  becomes large
• Investment analysts overestimate growth
• Examine sustainable growth formulas from dividend
  payout and from depreciation rates

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Valuation Basics Inclusion of Returns

• The future cash flow of a company and the risk of
  that companys cash flow can be measured by
• Return on Invested Capital
• Ability to Grow
• Weighted Average Cost of Capital
• It is in the formula Cash Flow (ROIC x
  Inv)/(k-g) which is the basis for multiples
• All of the other ratios gross margins,
  effective tax rates, inventory turnover etc. are
  just details.

ROIC EBIT x (1-tax rate) (NOPLAT) Investment
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Analytical framework for Valuation Combine
Forecasts of Economic Performance with Cost of
Capital
Competitive position such as pricing power and
cost structure affects ROIC
In financial terms, value comes from ROIC and
growth versus cost of capital
P/E ratio and other valuation come from ROIC and
Growth
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Practical Discounting Issues in Excel

• NPV formula assumes end of period cash flow
• Growth rate is ROE x Retention rate
• If you are selling the stock at the end of the
  last period and doing a long-term analysis, you
  must use the next period EBITDA or the next
  period cash flow.
• If there is growth in a model, you should use the
  add one year of growth to the last period in
  making the calculation
• To use mid-year of specific discounting use the
  IRR or XIRR or sumproduct

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Valuation and Sustainable Growth

• Value depends on the growth in cash flow. Growth
  can be estimated using alternative formulas
• Growth in EPS ROE x (1 Dividend Payout Ratio)
• Growth in Investment ROIC x (1-Reinvestment
  Rate)
• Growth (1growth in units) x (1inflation) 1
• When evaluating NOPLAT rather than earnings, a
  similar concept can be used for sustainable
  growth.
• Growth (Capital Expenditures/Depreciation 1)
  x Depreciation Rate
• Unrealistic to assume growth in units above the
  growth in the economy on an ongoing basis.

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Gordons Model and Valuation

• Gordons model is
• P0 D1/(k-g)
• Example

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Value Comes from Economic Profit and Growth
Economic profit is the difference between profit
and opportunity cost
This implies that there are three variables
return, growth and cost of capital that are
central to valuation analysis
Once you have a good thing, you should grow
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The Value Matrix - Stock Categorisation
What is the economic reason for getting here and
how long can the performance be maintained
Throwing good money after bad
Give the money to investors
Try to get out of the business
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Microsoft Value Creation and Earnings
Earnings are a good indicator of value but not
always as shown by the recent increases which
resulted from share buybacks
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Microsoft Return and Revenue Growth
Strong Returns plus growth resulted in increased
price when return fell, the price fell
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General Motors Slow Growth and Low ROE
GM had low growth and low returns and the stock
price did not increase.
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ROIC Issues

• Issues with ROIC include
• Will the ROIC move to WACC because of competitive
  pressures
• Evidence suggests that ROIC can be sustained for
  long periods
• Consider the underlying economic characteristics
  of the firm and the industry
• What is the expected change in ROIC
• When ROIC moves to sustainable level, then can
  move to terminal value calculation
• Examine the ROIC in models to determine if
  detailed assumptions are leading to implausible
  results
• Migration table

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Practical Growth Rate Issues Growth Rate
Estimation vs. ROE and Retention Rate

• What we really need to estimate are reinvestment
  rates and marginal returns on equity and capital
  in the future (the change in income over the
  change in equity).
• Those who use analysts or historical growth
  rates are implicitly assuming something about
  reinvestment rates and returns, but they are
  either unaware of these assumptions or do not
  make them explicit. This means, look at the ROE
  and the dividends to make sure that the growth is
  consistent.
• Future ROE depends on changes in economic
  variables affecting the existing investment and
  new projects with incremental returns.

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Alternative Valuation Methods
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Valuation Ranges

• Do not claim to derive a single number
  unrealistic to derive one number
• Forecasting uncertainty
• Cost of capital uncertainty
• Bigger ranges for growth companies and for
  emerging economies

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General Valuation Approaches

• Typical Valuation Approaches are Differentiated
  According to
• Relative Valuation
• Multiples, Comparative Transactions
• Absolute Valuation
• DCF, APV, Risk Neutral Valuation, Option Pricing
• We Differentiate by
• Direct Valuation
• DCF, Multiples etc.
• Indirect Valuation
• Equity IRR from LBO Multiples, Accretion/Dilution
  in EPS from integrated merger analysis, IRR and
  debt capacity in project finance

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Direct Valuation Models

• There are many valuation techniques for assets
  and investments including
• Income Approach
• Discounted Cash Flow
• Venture Capital method
• Risk Neutral Valuation
• Sales Approach
• Multiples (financial ratios) from Comparable
  Public Companies of from Transactions or from
  Theoretical Analysis
• Liquidation Value
• Cost Approach
• Replacement Cost (New) and Reproduction Cost of
  similar assets
• Other
• Break-up Value
• Options Pricing
• The different techniques should give consistent
  valuation answers

See the appraisal folder in the financial library
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Indirect Valuation from Modelling Transactions

• Instead of using DCF or multiples, back into the
  value of a company
• Leveraged buyout
• Entry and exit multiples, debt capacity and
  EBITDA Growth. See how much you can pay an
  finance and obtain an equity rate or return
  consistent general benchmarks such as 20.
• Project Finance
• Given contracts and assumptions about cash flows
  over the life of the asset and debt capacity, see
  how much investment can be made to generate and
  equity rate of return.
• Merger Integration
• Given assumptions about financing and accounting
  in a mergers, see how much you can afford to pay
  and still achieve accretion in earnings per share.

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Example of Comparing Valuation under Alternative
Methods
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Sum of the Parts Analysis

• Morgan Stanley performed a sum of the parts
  analysis, which is designed to imply a value of a
  company based on the separate valuation of the
  companys business segments. Morgan Stanley
  calculated ranges of implied equity values per
  share for Wyeth, assuming a hypothetical
  disposition of Wyeths Nutrition, Consumer and
  Animal Health divisions.
• Morgan Stanley valued Wyeths divisions using
  multiple ranges derived from comparable precedent
  transactions.
• Morgan Stanley used a 3.5x to 4.5x multiple of
  aggregate value to estimated 2008 revenue for
  Wyeths Nutrition and Consumer divisions, and
• 11.0x to 13.0x multiple of aggregate value to
  estimated 2009 EBITDA for the Animal Health
  division.
• The Pharmaceutical division was valued at a
  public market trading multiple range of 9.0x to
  11.0x estimated 2009 P/E multiple.
• Based on the multiple ranges described above, and
  including the net present value of the step-up in
  the tax basis of the assets which would result
  from such a theoretical transaction, this
  analysis implied a range for Wyeths common stock
  of approximately 33 to 40 per share. Morgan
  Stanley noted that the merger consideration had
  an implied value of 50.19 per share.

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Risk Neutral Valuation

• Theory If one can establish value with one
  financial strategy, the value should be the same
  as the value with alternative approaches
• In risk neutral valuation, an arbitrage strategy
  allows one to use the risk free rate in valuing
  hedged cash flows.
• Forward markets are used to create arbitrage
• Risk neutral valuation does not work with risks
  that cannot be hedged
• Use risk free rate on hedged cash flow
• Example
• Valuation of Oil Production Company
• Costs Known
• No Future Capital Expenditures

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Practical Implications of Risk Neutral Valuation

• Use market data whenever possible, even if you
  will not actually hedge
• Use lower discount rates when applying forward
  market data in models

Valuation with high discount rates And Uncertain
cash flows
Valuation with Forward Markets and Low
Discount Rates
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Examples of Risk Neutral Valuation

• Risk neutral valuation means that one attempts to
  remove the risk from the cash flow and then
  discount the adjusted cash flow at the risk free
  rate. (This is how options pricing models were
  developed.)
• There are various examples of risk neutral
  valuation that can be applied in valuation
• If there is a construction contract that includes
  a premium say 20 to eliminate cost over-run
  and delay risk this verifies the risk rather
  than attempts to simulate the risk or use of a
  high discount rate.
• If there is a long-term contract that fixes the
  price, the project can be financed with a lower
  discount rate.
• If a project can secure political risk insurance
  to eliminate political and currency conversion
  risk, a lower discount rate can be used rather
  than attempting to measure political risk.
• Other examples

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Venture Capital Method

• Two Cash Flows
• Investment (Negative)
• IPO Terminal Value (Positive)
• Terminal Value Value at IPO x Share of Company
  Owned
• Valuation of Terminal Value
• Discount Rates of 50 to 75
• Risky cash flows
• Other services

See the article on private valuation
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Valuation Diagram Venture Capital

• Valuation in venture capital focuses on the value
  when you will get out, the discount rates and how
  much of the company you will own when you exit.

Continuing Value
Cash Flow
Cash Flow
Cash Flow
Cash Flow

• In the extreme, if you have given away half of
  your company away, and the cash flow is the same
  before and after your give away, then the amount
  you would pay for the share must account for how
  much you will give away.

Discount Rates
Enterprise Value
Evaluate how much of the equity value that you own
Net Debt
Equity Value
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Venture Capital Method

• Determine a time period when the company will
  receive positive cash flow and earnings.
• e.g. projection of earnings in year 7 is 20
  million.
• At the positive cash flow period, apply a
  multiple to determine the value of the company.
• e.g. P/E ratio of 15 terminal value is 20 x 15
• Use high discount rate to account for optimistic
  projections, strategic advice and high risk
• e.g. 50 discount rate 20 x 15/1507
  17.5 million
• Establish percentage of ownership you will have
  in the future value through dividing investment
  by total value
• e.g. 5 million investment / 17.5 million 28.5
• You make an investment and receive shares (your
  current percent). You know the investment and
  must establish the number of shares

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Venture Capital Method Continued

• In the venture capital method, there are only two
  cash flows
• The investment
• The value when the company is sold
• The value received when the company is sold
  depends on the percentage of the company that is
  owned. If there is dilution in ownership, the
  value is less.
• Therefore, an adjustment must be made for
  dilution and the percent of the company retained.
  See the Cost of Capital folder for and example
• e.g. Share value without dilution 17.5/700,000
  25 per share
• If an additional 30 of shares is floated, the
  value per share must be increased by 30 to
  maintain the value.
• Value per share 17.5/((500,000VC shares) x
  1.3)
• VC Shares (25 x 1.3)/17.5-500,000 343,373

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Replacement Cost

• First a couple of points regarding replacement
  cost theory
• In theory, one can replace the assets of a
  company without investing in the company. If you
  are valuing a company, you may think about
  creating the company yourself.
• If you replaced a company and really measured the
  replacement cost, the value of the company may be
  more than replacement cost because the company
  manages the assets better than you could.
• By replacing the assets and entering the
  business, you would receive cash flows. You can
  reconcile the replacement cost with the
  discounted cash flow approach

53
Measuring Replacement Cost

• Replacement cost includes
• Value of hard assets
• Value of patents and other intangibles
• Cost of recruiting and training management
• Analysis
• Begin with balance sheet categories, account for
  the age of the plant
• Add cost of hiring and training management
• If the company is generating more cash flow than
  that would be produced from replacement cost, the
  management may be more productive than others in
  managing costs or be able to realize higher
  prices through differentiation of products.
• The ratio of market value to replacement cost is
  a theoretical ratio that measures the value of
  management contribution

54
Replacement Value and Tobins Q

• Recall Tobins Q as
• Q Enterprise Value / Replacement Cost
• Buy assets and talent etc and should receive the
  ROIC. Earn industry average ROIC.
• If the ROIC gt industry average, then Q gt 1.
• If the ROIC lt industry average, then Q lt 1

55
Real Options in Investment Decisions

• Example of real options in many investments
• the right to abandon an asset in the research and
  development phase
• the right to abandon the plant during
  construction
• the right to delay construction of the facility
• the right not to dispatch the plant when prices
  below short-run marginal cost
• the right to retire or mothball the plant before
  the end of its physical life
• the right to extend the life of the plant instead
  of retiring it at the end of its planned life
  and
• the right to expand the asset

56
Real Options and Problems with DCF

• The DCF model has many conceptual flaws, the most
  significant of which is assuming that cash flows
  are normally distributed around the mean or base
  case level.
• For many investments, the cash flows are skewed
• When an asset is to be retired, there is more
  upside than downside because the asset will
  continue to operate when times are good, but it
  will be scrapped when times are bad.
• An investment decision often involves the
  possibility to expand in the future. When the
  expansion decision is made, it will only occur
  when the economics are good.
• During the period of constructing an asset, it is
  possible to cancel the construction expenditures
  and limit the downside if it becomes clear that
  the project will not be economic.

57
Real Options and DCF Problems - Continued

• Problems with DCF because of flexibility in
  managing assets
• In operating an asset, the asset can be shut down
  when it is not economic and re-started when it
  becomes economic. This allows the asset to
  retain the upside but not incur negative cash
  flows.
• When developing a project, there is a possibility
  to abandon the project that can limit the
  downside as more becomes known about the
  economics of the project.
• In deciding when to construct an investment, one
  can delay the investment until it becomes clear
  that the decision is economic. This again limits
  the downside cash flows.
• In each of these cases, management flexibility
  provides protection in the downside which means
  that DCF model produces biased results.

58
Simulation Exercise

• To demonstrate how options affect valuation,
  consider a simple simulation exercise
• Enter the following inputs
• Volatility is the standard deviation of the
  percent change in a variable over time.

59
Fundamental Valuation

• What was behind the bull market of 1980-1999
• EPS rose from 15 to 56
• Nominal growth of 6.9 -- about the growth in the
  real economy (the real GDP)
• Keeping P/E constant would have large share price
  increase
• Long-term interest rates fell lower cost of
  capital increases the P/E ratio
• Real Market
• Value by ROIC versus growth
• Select strategies that lead to economic profit
• Market value from expected performance

60
Three Primary Methods Discussed in Remainder of
Slides

• Market Multiples Relative Valuation
• Discounted Free Cash Flow
• Discounted Earnings and Dividends
• Warning No method is perfect or completely
  precise
• Use industry expertise and judgment in assessing
  discount rates and multiples
• Different valuation methods should yield similar
  results
• Bangor Hydro Case

61
Discounting Basics
62
Debt (Bond) Valuation

• Bt is the value of the bond at time t
• Discounting in the NPV formula assumes END of
  period
• It n is the interest payment in period tn
• F is the principal payment (usually the debts
  face value)
• r is the interest rate (yield to maturity)

Case exercise to illustrate the effect of
discounting (credit spread) on the value of a bond
63
Risk Free Discounting

• If the world would involve discounting cash flows
  at the risk free rate, life would be easy and
  boring

64
Equity Dividend Discount Valuation and Gordons
Model

• Vt is the value of an equity security at time t
• Dt n is the dividend in period tn
• k is the equity cost of capital difficult to
  find (CAPM)
• E(?) refers to expected dividends
• If dividends had no growth the value is D/k
• If dividends have constant growth the value is
  D/(k-g)
• Terminal Value is logically a multiple of book
  value per share

65
Example of Capitalization Rates

• Proof of capitalization rates using excel and
  growing cash flows

66
Equity Valuation - Free Cash Flow Model

• FCFtn is the free cash flow in the period t n
  often defined as cash flow from operations
  less capital expenditures
• k is the weighted average or un-leveraged cost
  of capital
• E() refers to an expectation
• Alternative Terminal Value Methods

67
Setting-Up the Model to Reflect Period
Discounting with Terminal Value and Transaction
Dates

• The example shown accounts for mid-year
  discounting and terminal value at the end of the
  period. The discount rate assumes annual
  discounting using the formula
• The terminal value must use the last mid year
  value multiplied by (1g)1.5

Terminal value is after the last period cash flow
and must use mid year period x (1g)1.5
Precise discounting with mid year period
68
Valuation Using Multiples
69
Advantages and Disadvantages of Multiples

• Disadvantages
• Valuation depends on opinions of others and not
  the underlying drivers of value.
• Too simple Does not account for prospective
  changes in cash flow
• Accounting Based Depends on accounting
  adjustments in EBITDA, earnings
• Timing Problems Changing expectations affect
  multiples and using multiples from different time
  periods can cause problems.

• Advantages
• Objective does not require discount rate of
  terminal value
• Simple does not require elaborate forecast
• Flexible can use alternative multiples and make
  adjustments to the multiples
• Theoretically correct consistent with DCF
  method if there are stable cash flows and
  constant growth FCF/(k-g).

There are reasons similar companies in an
industry should have different multiples because
of ROIC and growth this must be understood
70
Equity Analysis Target Prices

• Equity Research Analyst Price Targets Analysis
• Morgan Stanley reviewed and analyzed future
  public market trading price targets for Wyeths
  common stock and Pfizers common stock prepared
  and published by equity research analysts. These
  targets reflect each analysts estimate of the
  future public market trading price of Wyeths
  common stock and Pfizers common stock. Morgan
  Stanley noted that the range of equity analyst
  price targets of Wyeths common stock was between
  approximately 33 and 48 per share. Morgan
  Stanley further calculated that using a cost of
  equity of 8.5 and a discount period of one year,
  the present value of the equity analyst price
  target range for Wyeths common stock was
  approximately 30 to 44 per share, with a mean
  target price of 40.82 and a median target price
  of 40.00. Morgan Stanley noted that the merger
  consideration had an implied value of 50.19 per
  share of Wyeths common stock based upon 17.45
  per share of Pfizer common stock, the closing
  price of Pfizers common stock on January 23,
  2009, the last trading day prior to announcement
  of the proposed merger.

71
Example of Problems with Relative Valuation
Housing Prices

• During the housing bubble, appraisers would use
  the value of similar transactions to estimate the
  value of properties
• Appraisers would have a lot of tricks and make
  biased estimates by using houses with relatively
  high value and ignoring those with lower value
  (if they did not make high estimates, they would
  not be hired)
• The fundamentals of housing value from evaluating
  the income levels relative to the house price,
  the trends in housing or the demand and supply of
  housing were ignored.
• This lead to absurd valuations.

72
Valuation from Multiples

• Valuation from multiples is known as relative
  valuation because valuation is compared to other
  companies and not to fundamental cash flows.
• A measure of value is standardized by earnings or
  something else
• Financial Multiples
• P/E Ratio
• EV/EBITDA
• Price/Book
• Industry Specific
• Value/Oil Reserve
• Value/Subscriber
• Value/Square Foot
• Issues
• Where to find the multiple data and comparable
  companies
• What income or cash flow base to use
• Discounts for lack of marketability

73
Mechanics of Multiples

• Find market multiple from comparable companies
• Rarely are there truly comparable companies
• Understand economics that drive multiples (growth
  rate, cost of capital and return)
• P/E Ratio (forward versus trailing)
• Value/Share P/E x Projected EPS
• P/E trailing and forward multiples
• Market to Book
• Value/Share Market to Book Ratio x Book
  Value/Share
• EV/EBITDA
• Value/Share (EV/EBITDA x EBITDA Debt) divided
  by shares
• P/E and M/B use equity cash flow EV/EBITDA uses
  free cash flow

In the long-term P/E ratios tend to revert to a
mean of 15.0
74
More Valuation Examples Adjustments to Multiples

• Here the multiple is adjusted for risk and the
  dividends are accounted for in computing the rate
  of return

75
Relate Multiples to Growth in a Crude Way

• The multiples depend on assessment of growth as
  illustrated by the quote below

Theory of growth and multiples depends on
long-term growth more than short-term growth.
Also depends greatly on the cost of capital.
76
Real World Examples of Bad Practice
Comparison of equity value (P) to EBITDA compares
value after debt to income before interest
favors companies with less debt

• Invalid comparable companies
• Logical comparisons

Sample should have similar WACC and growth rates
and therefore be in the same industry and have
the same kind of risks. Note difference in size
and difference in company profile.
77
Examples of Valuation with Multiples from Analyst
Reports

• Note how the industry multiples are used and then
  adjusted for risk and growth. The multiple is
  adjusted for growth, risk and rate of return.

78
Use of Multiples in Valuation
The red bars from the DCF valuation are compared
to market date

• Should be able to explain difference from
• Growth
• 2. WACC
• 3. ROIC

79
Illustration of Some Multiples

• Multiples for a couple companies are shown below

Which multiple best reflects value for the
various companies note the EV/EBITDA is most
stable
80
EV/EBITDA Multiples in LBOs
81
EV/EBITDA by Size and Type
82
EV/EBITDA by Industry
83
Which Multiple to Use

• Valuation from multiples uses information from
  other companies
• It is relevant when the company is already in a
  steady state situation and there is no reason to
  expect that you can improve estimates of EBITDA
  or Earnings
• One of the challenges is to understand which
  multiple works in which situation
• Leveraged Buyout
• EV/EBITDA is used
• Changes in the common equity ratio
• Intangible assets make book value inappropriate
• Different leverage makes P/E difficult
• Banks/Insurance
• Market/Book may be best
• Not many intangible assets, so book value is
  meaningful
• Book value is the value of loans which is
  adjusted with loan loss provisions
• Cost of capital and financing is very important
  because of the cost of deposits

84
Multiples - Summary

• Useful sanity check for valuation from other
  methods
• Use multiples to avoid subjective forecasts
• Among other things, well done multiple that
  accounts for
• Accounting differences
• Inflation effects
• Cyclicality
• Use appropriate comparable samples
• Use forward P/E rather than trailing
• Comprehensive analysis of multiples is similar to
  forecast
• Use forecasts to explain why multiples are
  different for a specific company

When you compute the terminal value using CF x
(1g)/(k-g) Compute the implied EV/EBITDA from
the data Also compute the implied P/E and the
implied EV/EBITDA when computing the DCF
85
P/E Ratio, Growth and Reconciliation to Cash Flow

• P D1/(k-g)
• g ROE (1-DPO) or DPO 1 - g/ROE
• P/E D/E/(k-g)
• Substituting for D/E DPO
• P/E (1-g/r)/(k-g)
• g -- long term growth rate in earnings and cash
  flow
• r -- rate of return earned on new investment
• k -- discount rate
• (k-g) (1-g/r)/(P/E)
• k (1-g/r)/(P/E) g
• Example if r k than the formula boils down to
  1/(k)
• If the g 0, the formula is P/E 1/k

86
Price to Earnings and Other Statistics
Market crashed after very high PE in 2000
Low P/E when long-term interest rates where high
87
Understanding the P/E Ratio
1/PE 6.6

• Corporations as a whole, typically reinvests
  about 50 percent of its profits every year to
  achieve this profit growth, leaving the other
  half to pay to shareholders as dividends and
  share repurchases. This translates to a cash
  yield to shareholders of about 3 to 3.5 percent
  at the long-term average P/E ratio of 15.1 Adding
  the annual 3 to 3.5 percent increase in share
  prices to the cash yield of 3 to 3.5 percent
  results in total real shareholder returns of
  about 6 1/2 percent per year.
• Between 1980 and 1999, earnings per share for the
  SP 500 rose from 15 to 56. If the forward P/E
  ratio had remained constant, earnings growth
  alone would have boosted the index by 302 points.
  This nominal annual growth in earnings of 6.9
  percent equals 3.2 percent in real terms, close
  to the long-term average growth in real profits
  for the economy. Simultaneously, U.S. interest
  rates and inflation fell dramatically. Long term
  U.S. government bond yields peaked at nearly 15
  percent in 1981 and then fell, more or less
  steadily, to 5.7 percent in 1999. The decline in
  inflation and interest rates drove P/E ratios
  back up to more typical levels. This occurred
  because during the high-inflation years,
  companies were unable to increase returns on
  capital commensurate with the rise in cost of
  capital, leading to extremely low P/E ratios.

88
Example of Valuation with Multiples Comparison
of Different Transactions
Note how multiples cover the cycle in a commodity
business
Demonstrates that the multiple in the merger is
consistent with other transactions
89
Example of Computation of Multiples from
Comparative Data

• JPMorgan also calculated an implied range of
  terminal values for Exelon at the end of 2009 by
  applying a range of multiples of 8.0x to 9.0x to
  Exelon's 2009 EBITDA assumption.

Note that the median is presented before the mean
90
Comparison with all Acquisitions Since 2001
91
Adjustments to Multiples

• Process
• Find multiples from similar public companies
• Adjust multiples for
• Liquidity
• Size
• Control premium
• Developing country discount
• Apply adjusted multiples to book value, earnings,
  and EBITDA
• There is often more money in dispute in
  determining the discounts and premiums in a
  business valuation than in arriving at the
  pre-discount valuation itself. Discounts and
  premiums affect not only the value of the
  company, but also play a crucial role in
  determining the risk involved, control issues,
  marketability, contingent liability, and a host
  of other factors.

92
Adjustments to Multiples Marketability and
Liquidity Discount

• If the entity were closely held with no (or
  little) active market for the shares or interest
  in the company, then a non-marketability discount
  would be subtracted from the value.
• Non-marketabiliy Discounts ranges from 10 to
  30
• represents the reduction in value from a
  marketable interest level of value to compensate
  an investor for illiquidity of the security, all
  else equal.
• The size of the discount varies base on
• relative liquidity (such as the size of the
  shareholder base)
• the dividend yield, expected growth in value and
  holding period
• and firm specific issues such as imminent or
  pending initial public offering (IPO) of stock to
  be freely traded on a public market.

93
Studies of Liquidity Discount

• Private and public transactions
• Attempt to compute EV/EBITDA in public and
  private transactions
• Adjust so that the transactions are comparable
• Compute the ratio in pubic and private
  transactions
• Discount of 20 to 28 percent for US firms
• Discount of 44 to 54 percent for non-US firms
• Other studies
• Value in IPO versus value of private trades
  before IPO
• High liquidity in 40-50 range, but selection
  bias
• Theory involves control by public board

94
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95
Adjustments to Multiples Controlling Interest
Premium

• Controlling interest value the value of the
  enterprise as a whole assuming that the stock is
  freely traded in a public market and includes a
  control premium.
• Control premium reflects the risks and rewards
  of a majority or controlling interest.
• A controlling interest is assumed to have control
  power over the minority interests.
• Minority interest value represents the value of
  a minority interest as if freely tradable in a
  public market.
• Minority interest discount represents the
  reduction in value from an absence of control of
  the enterprise.

96
Private Companies Sell At A Small Discount
Median P/E Multiples Public vs. Private Deals
Multiples
Source Mergerstat (U.S. Only) Disclaimer Data
is continually updated and is subject to change
97
Liquidity Determines Valuation Premium
Median Transaction Multiples by Deal Size
Multiples
Source Mergerstat (U.S. Only) Disclaimer Data
is continually updated and is subject to change
98
P/E Analysis Use of P/E Ratio in Valuation

• J.P. Morgan performed an analysis comparing
  Exxon's price to earnings multiples with Mobil's
  price to earnings multiples for the past five
  years.
• The source for these price to earnings multiples
  was the one and two year prospective price to
  earnings multiple estimates by I/B/E/S
  International Inc. and First Call, organizations
  which compile brokers' earnings estimates on
  public companies. Such analysis indicated that
  Mobil has been trading in the recent past at an
  8 to 15 discount to Exxon.
• J.P. Morgan's analysis indicated that if Mobil
  were to be valued at price to earnings multiples
  comparable to those of Exxon, there would be an
  enhancement of value to its shareholders of
  approximately 11 billion.
• Finally, this analysis suggested that the
  combined company might enjoy an overall increase
  in its price to earnings multiple due to the
  potential for improved capital productivity and
  the expected strategic benefits of the merger.
  According to J.P. Morgan's analysis, a price to
  earnings multiple increase of 1 for Exxon Mobil
  would result in an enhancement of value to
  shareholders of approximately 10 billion.

99
P/E Ratio, Growth and Reconciliation to Cash Flow

• P/E (1-g/r)/(k-g)
• g -- long term growth rate in earnings and cash
  flow
• r -- rate of return earned on new investment
• k -- discount rate
• (k-g) (1-g/r)/(P/E)
• k (1-g/r)/(P/E) g
• Example if r k than the formula boils down to
  1/(k)
• If the g 0, the formula is P/E 1/k
• P E/(k-g) x (1-g/r)
• If, for some reason, g r, then the Gordon model
  could be applied to compute k.

100
Company Profile in website

• http//finance.yahoo.com/
• http//googlefinance.com/
• http//marketwatch.com/
• http//bloomberg.com/
• http//pages.stern.nyu.edu/adamodar/

101
Price Earnings Ratio

• The price earnings ratio is obviously very
  important in stock evaluation. Therefore, I
  describe some background related to the ratio and
  some theory with regards to the P/E ratio.
  Subjects related to the P/E ratio include
• Dividend growth Model
• Theory of price earnings ratio and growth
• P/E ratio and the EV/EBITDA ratio
• The PE ratio depends more on accounting
• The PE is affected by leverage
• The EV/EBITDA ignores depreciation and capital
  expenditure
• Case exercise on P/E and EV/EBITDA

102
P/E Ratio versus EV/EBITDA

• Use the EV/EBITDA when the funding does not make
  much difference in valuation
• Many companies in an industry with different
  levels of gearing and companies do not attempt to
  maximize leverage
• Very high levels of gearing and wildly
  fluctuating earnings
• When the earnings are affected by accounting
  policy and account adjustments
• Use the P/E ratio when cost of funding clearly
  affects valuation and/or when the level of
  gearing is stable and similar for different
  companies
• Debt capacity can provide essential information
  on valuation
• EBITDA does not account for taxes, capital
  expenditures to replace existing assets,
  depreciation and other accounting factors that
  can affect value.

103
P/E Ratio

• If you use the P/E ratio for valuation, the ratio
  implies that only this year or last years
  earnings matter
• Cash matters to investors in the end, not
  earnings (different lifetime of earnings)
• When earnings reflect cash flow, P/E is
  reasonable for valuation
• High P/E causes treadmill and does not necessary
  imply that companies are performing well
• Earnings can be managed and manipulated

104
Use of P/E Ratio Formula to Compute the Required
Return on Equity Capital

• It will become apparent later that one cannot get
  away from estimating the cost of equity capital
  and the CAPM technique is inadequate from a
  theoretical and a practical standpoint.
• The following example illustrates how the formula
  can be used in practice
• k (1-g/r)/(P/E) g

105
P/E Notes

• High ROE does not mean high PE Hence the
  existence of high ROE stocks with low PEs
• Growth and value are not always positively
  correlated
• Growth from improvement will always be value
  enhancing whereas growth from reinvestment
  depends upon the return against the benchmark
  return
• Reinvestment should also include Cash hoarding
• PB is better at differentiating ROE differences
  than PE

106
Relationship Between Multiples

• The P/E, EV/EBITDA and Cash Flow Multiples should
  be consistent and you should understand why one
  multiple gives you a different answer than
  another multiple.
• Each of the multiples is affected by
• The discount rate the risk of the cash flow
• The ability of the company to earn more than its
  cost of capital
• The growth rate in cash flow or earnings
• Differences in the ratios are a function of
• Leverage, Depreciation Rates, Taxes, Capital
  Expenditures relative to cash flow

107
Relationship Between Multiples

• Enterprise Value NOPLAT x (1-g/ROIC)/(WACC g)
  
• NOPLAT Investment x ROIC
• NOPLAT EBIT x (1-t)
• EBITDA EBIT Depreciation
• EV/EBITDA
• EBT EBIT Interest
• NI EBT x (1-t)
• NI/Market Cap
• Market Cap EV Debt
• MB Market Cap/Equity

108
Relationship Between Multiples - Illustration

• Assume
• Value NOPLAT x (1-g/ROIC)/(WACC g)
• This is the EVA Formula
• Assume
• No Taxes
• No Leverage
• No Depreciation
• No Growth Rate
• ROIC 10

109
Comparative Multiples

• With the simple assumptions, each of the
  multiples is the same as shown below

Exercise Data table with alternative parameters
to investigate P/E and EV/EBITA
110
Comparative Multiples

• Once taxes, leverage and depreciation are added,
  the multiples diverge as shown on the table
  below

111
Valuation From Discounted Free Cash Flow
112
Advantages and Disadvantages of DCF

• Disadvantages
• Assumptions Requires WACC assumptions and
  residual value assumptions. There are major
  problems with WACC estimation and the long-term
  growth assumption.
• Forecasting Problems Complex forecasting models
  can easily be manipulated
• Growth The residual value depends on a number
  of assumptions which can easily distort value
• Real Options Discussed above

• Advantages
• Theoretically Valid value comes from free cash
  flow and assessing risk of the free cash flow.
• Operating and Financial Values explicitly
  separates value from operating the company with
  value of financial obligations and value from
  cash
• Sensitivity forces an understanding of key
  drivers of the business and allows sensitivity
  and scenario analysis
• Fundamental not biased by optimism or pessimism
  in the market

113
Problems with DCF Range in Values

• Note the range in values in the analyst report
• The range is less when a terminal value is used,
  but the range is still very high
• The high range exists even though there is a
  tight range in discount rates

114
Discounted Cash Flow Morgan Stanley Example

• Morgan Stanley performed a discounted cash flow
  analysis, which is designed to imply a value of a
  company by calculating the present value of
  estimated future cash flows of the company.
• Morgan Stanley calculated ranges of implied
  equity values per share for Wyeth, based on
  discounted cash flow analyses utilizing Wall
  Street analyst estimates compiled by Thomson
  First Call and Wyeth management projections for
  the calendar years 2009 through 2013. In arriving
  at the estimated equity values per share of
  Wyeths common stock, Morgan Stanley calculated a
  terminal value by applying a range of perpetual
  free cash flow growth rates ranging from (0.5)
  to 0.5.
• Such rate range was derived, based on Morgan
  Stanleys judgment, after considering a number of
  factors, including growth of the overall economy,
  projected earnings expectations for comparable
  pharmaceutical companies and Wyeths upcoming
  patent expiration profile.
• Morgan Stanley observed that this range implied
  P/E multiples for Wyeth that were consistent with
  the P/E multiples of the comparable companies
  studied by Morgan Stanley and identified above
  under  Comparable Companies Analysis. The
  unlevered free cash flows and the terminal value
  were then discounted to present