Provides a generally reliable and sophisticated approach t

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Notes on Valuation Approaches

• Summer 2009
• Dr. Keith M. Howe
• Scholl Professor of Finance
• DePaul University

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Valuation Approaches
Methodologies
Discounted Cash Flow Analysis
Comparable Companies Analysis
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Discounted Cash Flows (DCF)

• Pros
• Widely accepted
• Provides a generally reliable and sophisticated
  approach to valuation by accounting for
• Profitability
• Growth
• Capital investment/intensity
• Capital structure
• Risk and opportunity cost
• Cons
• Generally not easy to calculate
• Grounded by assumptions
• Gives only an absolute valuation, which in
  isolation is not telling
• Loaded with assumptions

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Discounted Cash Flows (DCF)

• A DCF model has three parts
• Explicit forecast period
• Cash flows are after-tax incremental cash flows
• Continuing value or terminal period
• Perpetuity
• FCF, NOPLAT, NOPAT
• Constant growth
• Multiples
• Discount rate
• Discount rates can be determined a number of
  different ways (e.g., CAPM, Gordon growth model,
  APT, etc), but the expected free cash flows are
  discounted at the rate that reflects the risk of
  the cash flows.

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How to Display a DCF- Based Model
AssumptionsExample
Here we develop a base case model from Wall
Street Research and CSFB projections
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Discounted Cash Flow Valuation
( in millions)
(1) 2004E not included in calculating NPV of
cash flows.
( in millions)
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General Thoughts on Relative Valuations

• Most Valuations on Wall Street Use Multiples
• Multiples reflect current market perceptions
• Relative Valuations require fewer explicit
  assumptions and are easier to use
• Relative valuations often find a more receptive
  audience (easier to understand as there are less
  assumptions)

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Price/Sales

• Pros
• Easy to calculate
• Maybe the only available multiple
• Cons
• Ignores profitability
• Does not account for margins (Fed Ex vs. UPS) or
  taxes (PFE vs. BMY)
• Completely ignores capital structure
• Debt not included in the value of the firm
• Interest costs and tax shield are ignored
• Ignores future growth opportunities
• Ignores capital intensity and investment

While simple Price/Sales has numerous pitfalls
users must be aware of.
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Price/Earnings (P/E)

• Pros
• Most commonly used and accepted multiple with
  sell side research
• Easy to calculate (simply need to ensure you
  match time periods, trailing, current, future)
• Takes into account profitability
• Cons
• Cannot use if companies do not have accounting
  earnings
• Are GAAP earnings a good measure of cash flow?
• Adjustments for normalized earnings?
• Ignores Economic Profitability
• A company could be buying earnings (AutoZone
  example, see next page)
• Completely ignores capital structure
• Debt not included in the value of the firm
• Interest costs and tax shield are ignored
• Ignores future growth opportunities
• Ignores capital intensity and investment

Although widely accepted, P/E has serious
drawbacks.
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Are Autozones Investors Only Concerned With
Earnings?
Through the 90s Autozones EPS grew at a 25
CAGR.
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Enterprise Value/EBITDA (EV/EBITDA)

• Pros
• Second most commonly used and accepted multiple
  on Wall Street
• Easy to calculate (but need to ensure you match
  time periods, trailing, current, future)
• Takes into account profitability
• EBITDA generally a good proxy for cash
• Takes into account capital structure
• Includes debt in the value of the firm (should
  use net debt)
• Includes Interest as part of cash flow
• Cons
• Ignores Economic Profitability
• Ignores capital intensity and investment

The EBITDA multiple is a cleaner multiple,
however it still misses the hurdle rate and
investment required into the business.
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Value/Book or EV/Book

• Important here is that Value/Book defines how
  much the market is paying
• for past investments.
• Pros
• Used by Wall Street to gauge capital intensity
  and investment return
• Easy to calculate
• Takes into account capital structure
• Includes debt in the value of the firm
• Includes Interest as part of cash flow
• Cons
• Ignores both accounting and economic
  profitability
• Any additional problems with these metrics?
  (Matching/timing of values)

Value/Book accounts for the investments made into
a business and its future value creation
potential. Profitability however is now ignored.
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Implementing a Multiples Approach

• Define the multiple
• There are different definitions for the same
  multiple (current, trailing, forward)
• It is integral to look at the entire distribution
  of the multiple
• Understand the differences between the mean,
  median and standard deviation
• Understand why the outlier are outliers (question
  relevance of the multiple and the companies
  inclusion in the peer group)
• Understand the fundamentals of the multiple
• What are the strengths and weaknesses of the
  multiple

One more thing..
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Choosing a Peer Group for Relative Valuation
Methods

• Why are you trying to determine value?

Defining why you are performing a valuation has a
direct effect on choosing a firms peers.
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Display Example A Valuation Perspective
P/E 2004E
Market/Book-Current
From our analysis what can you tell me about our
company?
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Display Example Relative Valuation- Utility
Holding Companies mismatched time periods
P/E 2003(1)
EV/EBITDA 2004(2)
Market/Book
(1) Source First Call (2) Source Wall Street
Research
Errors to note here PE is 2003, EV/EBITDA is 2004
and Market to book is not label. Remember you
MUST match time periods.
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Display Example Relative Valuation - Correct
Time Periods
P/E - 2004E
EV / 2004E EBITDA
2003 P/E
Source I/B/E/S Estimate.
Market/Book Current
Note Value-to-Cost defined as a real
market-to-book ratio. A Value-to-Cost ratio
gt1.0x implies that the market is expecting future
profitable growth from the Company. Current
value-to-cost ratio for the SP 500 1.85x.
PXs trading multiples are consistent with the
markets expectations for future performance.