Valuation Analysis

1
Valuation Analysis
Judson W. Russell, Ph.D., CFA University of North
Carolina-Charlotte
2
Agenda

• Equity Valuation Fundamentals Intrinsic Value
• Enterprise Valuation Fundamentals Free Cash Flow
• Equity Valuation Fundamentals Relative Value

3
Introduction

• Valuation is both art and science
• Art through reasonable, defensible
• Assumptions
• Judgment and interpretation of data
• Science through application of analytical
  formulae
• Valuation is based on future performance

4
Introduction

• Two main valuation questions
• What is a company worth by valuation metrics?
• 2) What can or will a potential buyer pay?

5
Introduction

• Three main valuation methodologies
• Intrinsic Value Approach A stocks price equals
  the net present value of its dividends.
• Relative Value Approach A stocks value is
  determined by comparing similar stock values.
• Acquisition Value Approach Calculate a companys
  stock price by determining its worth to a third
  party acquirer.
• Golden Rule Footnote your assumptions

6
Introduction

• EQUITY VALUE
• Value of shareholders interest
• After interest expense, preferred dividends and
  minority interest expense
• Multiples of net income, book value, EPS
• Other common terms
• Market Value, Market Capitalization, Offer Value
  (in an acquisition context)

7
Introduction

• ENTERPRISE VALUE
• Includes all forms of capital
• Market value of equity, debt, preferred stock,
  minority interest
• Before interest expense, preferred dividends and
  minority interest expense
• Multiples of sales, EBITDA, EBIT or any other
  applicable metric (per subscriber, per bed, etc.)
• Other common terms
• Aggregate Value, Firm Value, Total
  Capitalization, Adjusted Market Value,
  Transaction Value

8
Introduction
Equity Market Cap.

Enterprise Value
Equity Market Cap.
Net Debt
Preferred Stock
Minority Interest
9
Introduction

• COMPARABLE (or similar) in terms of

10
Equity Valuation Process

• The Graham and Dodd Approach to Security
  Selection
• Study the available facts
• Prepare an organized report
• Project earnings and related data
• Draw valuation conclusions based on established
  principles and sound logic
• Make a decision

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Valuation Process

• The top-down approach starts with an analysis of
  alternative economies and security markets.
• The initial objective is to decide how to
  allocate investment funds among countries and
  within countries to bonds, stocks, and cash.
• The second phase is the analysis of alternative
  industries. The objective at this stage is to
  determine which industries will prosper based on
  your analysis of the economy.
• The final, third, phase focuses on security
  selection. The objective is to determine which
  companies within the selected industries will
  prosper and which stocks are undervalued.

Analysis of Alternative Economies and Security
Markets
Analysis of Alternative Industries
Analysis of Individual Companies and Stocks
12
Valuation Process Example

• The top-down analysis for a U.S. homebuilder
• Economy GDP will increase 3
• Capital Markets Interest rates will remain
  low
• Industry Backlog of existing homes,
  build new starts to grow
• Homebuilding Company Homebuilder to gain
  market share based on location
• Target homebuilder sales will increase by 15
  versus the industry average of 10. Steady
  profit margins signify a 15 earnings increase.

13
Economic Cycles
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Industry Analysis

• Forecast Sales
• An insightful analysis when predicting industry
  sales is to view the industry over time and
  divide its development into stages.
• Pioneering development - A
• Rapid accelerating growth - B
• Mature growth - C
• Stabilization and market maturity - D
• Deceleration of growth and decline - E

Rate of Sales Growth
D
C
E
B
A
Time
15
Porters Five Forces
16
Valuation Approach Intrinsic Value
17
Valuation Approaches Intrinsic Value

• The value of an asset is the present value of its
  expected returns.
• The process of valuation requires estimates of
  (1) the stream of expected returns and (2) the
  required rate of return on the investment.
• The value of a preferred stock (perpetuity) is
  simply the stated annual dividend divided by the
  required rate of return on preferred stock (kp).
• A preferred stock with an 8 per year dividend
  and required return of 9 is valued as
• V 8 / 0.09 88.89

18
Valuation Approaches Intrinsic Value

• The valuation of common stock is more difficult
  than bonds or preferred stock because an investor
  is uncertain about the size of the returns, the
  time pattern of returns, and the required rate of
  return (ke).
• However, the value of common stock is still the
  present value of its future cash flows. The only
  cash flows an equity investor ever gets are
  dividends (cash or liquidating).
• A model to value common stock is the dividend
  discount model (DDM).

19
Valuation Approaches Intrinsic Value

• The DDM assumes that the value of a share of
  common stock is the present value of all future
  dividends as
• V D1/(1ke)1 D2/(1ke)2 D?/(1ke)?
• Since estimating D? is impossible, other methods
  have evolved based upon a terminal stock value,
  or a constant rate of growth.

20
Valuation Approaches Intrinsic Value

• Assume an investor wants to buy a stock, hold it
  for one year, and then sell it. We must evaluate
  the dividend cash flows as well as the terminal
  value in one year. These cash flows are then
  discounted at the investors required rate of
  return.
• A company earned 2.50 a share last year and paid
  a 1 dividend (40 dividend payout). The firm
  has a consistent record regarding payout and we
  expect it to earn 2.75 per share during the
  coming year. We expect the stock to trade at 22
  at the end of the coming year. Further, the
  risk-free rate is 5, the market return is 10,
  and the stocks beta is 1.2.
• ke rf b(E(rm) rf ) 5 1.2 (10-5) 11,
• D1 E1(dividend payout) 2.75(.4) 1.10
• V D1/(1ke)1 Stock Value1/(1ke)1
• V 1.10/(1.11)1 22/(1.11)1
• V 0.99 19.82 20.81

21
Valuation Approaches Intrinsic Value

• When valuing a firm with an infinite holding
  period we assume that dividends, at some point,
  exhibit a constant rate of growth.
• Assume that a firm is in a state of constant
  growth, we can value the infinite stream of cash
  flows using the following abbreviated formula
• V D1/(ke - g)
• For instance, in our previous example lets
  assume that the holding period is infinite and
  the firms dividends are growing at 6 per year
  perpetually. The dividend in one year was 1.10
  and the required rate of return was 11.
• V 1.10/(.11- .06) 22.00

22
Valuation Approaches Intrinsic Value

• We can employ the same technique for firms that
  have varying rates of growth by assuming that the
  growth rate becomes constant, at some point.
• For instance, suppose we have a firm experiencing
  rapid growth due to its position in the product
  cycle. At some point the growth rate has to slow
  or the firm will become the market!
• We can accommodate this scenario with a
  multistage model by discounting the rapid growth
  phase dividends individually and then determining
  the terminal value using the constant growth
  methodology.
• V D1/(1ke)1 D2/(1ke)2 (Dn1/(ke-g))
  /(1ke)n

23
Valuation Approaches Intrinsic Value

• Suppose that ABC Company has a current dividend
  of 1.00 per share with growth expectations of
  20 for each of the next two years. After that
  point, the firm expects dividends to grow at 4
  each year indefinitely. Given a cost of equity
  of 11, calculate the value of the firms shares.
• V D1/(1ke)1 D2/(1ke)2 V2/(1ke)2
• where V2 D3/(ke g)
• V 1.20/(1.11)1 1.44/(1.11)2
  (1.50/(.11-.04)) /(1.11)2
• V 1.08 1.17 17.39 19.64

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Exercise One

• Suppose that ABC Company has a current dividend
  of 0.75 per share with growth expectations of
  15 for each of the next three years. After that
  point, the firm expects dividends to grow at 4
  each year indefinitely. Given a cost of equity
  of 12, calculate the value of the firms shares.

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Exercise One

• Suppose that ABC Company has a current dividend
  of 0.75 per share with growth expectations of
  15 for each of the next three years. After that
  point, the firm expects dividends to grow at 4
  each year indefinitely. Given a cost of equity
  of 12, calculate the value of the firms shares.
• D0 0.75, g1 15, g2 4, ke 12

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Valuation Approach Intrinsic Value

• DISCOUNTED CASH FLOW ANALYSIS
• Intrinsic value of the company
• Unlevered free cash flows
• Independent of capital structure
• Free cash flows generated by the assets that are
  available to all capital holders
• Present value of (1) free cash flows and (2)
  projected terminal value
• Terminal value is used to estimate value beyond
  the forecast period
• Exit Multiple Method (assumes the sale of the
  business)
• Perpetuity Growth Rate Method
• (3) Discount rate Weighted average cost of
  capital (WACC)
• WACC ka wdkd(1-t) weke

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(No Transcript)
28
Free Cash Flow Analysis

8
FCF1
FCF2
FCF3
FCF4
FCF5
FCFn
How do we account for the remaining cash flows of
the firm? Terminal Value Approach Constant
Growth Method
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Terminal Value Calculation
A. The Exit Multiple Method
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The Present Value of the Terminal Value
Discounted Cash Flow Analysis
1 2010 EBITDA (Terminal Value) 113.10
2 x Exit multiple 6.5x
3 Pretax Sales Proceeds (future value) 735.15
4 / discount factor (back 5 years at 12) 0.5674
5 Present value of terminal value 417.14
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Terminal Value as of Enterprise Value
Discounted Cash Flow Analysis

• Provides a reality check of the DCF value
• Higher the , more of the Enterprise Value is
  being realized with the assumed sale of the
  business at the end of the forecast period
• Confidence level in the 70-85 range, depending
  on the company and situation

32
Terminal Value as of Enterprise Value
Discounted Cash Flow Analysis

• How much of the Enterprise Value for the Company
  is being generated by the Terminal Value?
• What is your comfort level with this percentage?

Present Value of Exit Multiple 417 Enterprise
Value 589.7   Percentage 417/589.7 70.7
33
Terminal Value Calculation
B. The Perpetuity Growth Method
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Discounted Cash Flow Analysis

• Now well look at the perpetuity growth technique
  to capture the terminal value of Company.
• The terminal value captures all future cash flows
  of the firm assuming a constant growth factor.
• The operating cash flow of the firm in 2010 is
  55.5. Assuming a growth rate of 4 the
  operating cash flow in 2011 would be 57.72.
• We have a discount factor of 12 and a growth
  factor of 4 with a cash flow of 57.72.

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Perpetuity Growth Formula
Discounted Cash Flow Analysis

• Terminal Value FCFN1
• (ka - g)
• where
• FCFN1 steady-state free cash flow in period
  N1
• g nominal perpetual growth rate
• ka discount rate
• Terminal Value 55.5(1.04) 57.72 721.5
• .12-.04 0.08
• Present Value of Perpetuity Growth Terminal Value
  721.5/(1.125) 409.40

36
Exercise Two Discounted Cash Flow Analysis
A Simple Example
Criteria

• Calculate
• WACC
• Present Value of the Free Cash Flows
• Terminal Value based upon Perpetuity Growth Rate
  and Exit Multiple
• Equity Value based upon Exit Multiple Terminal
  Value

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Discounted Cash Flow Analysis
Answer Key

• Calculate
• WACC
• Weighed Average Cost of Capital Debt Ratio x
  (Kd) x (1-tax rate) Equity Ratio x (Ke)
• Kd Cost of Debt
• Ke Cost of Equity
• Cost of Equity Rf b(Rmh - Rfh)
• Rf Risk-free return
• b Beta of the security
• (Rmh - Rfh) Market risk premium
• Rmh Historical Market return
• Rfh Historical Risk-free return
• Ke 5.4 1.1(8.0) 14.2
• WACC 35 x (7.5) x (1- .4) 65 x ( 14.2)
• 1.58 9.23
• 10.81

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Analysis of Selected Publicly Traded Companies
Answer Key contd

• Calculate
• Present Value of the Free Cash Flows

Discount rate WACC 10.81
Total PV FCF 686.9

• Terminal Value based upon Perpetuity Growth Rate
• Perpetuity Growth Rate Terminal Value
  FCFn1/(k-g)
• FCFn1 Free cash flow projected one year after
  year n
• k discount rate (WACC)
• g annual nominal growth of FCF into perpetuity
• Perpetuity TV 290.0(1.033)/(10.81 - 3.3)
• 299.57/7.51
• 3989.0

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Analysis of Selected Publicly Traded Companies
Answer Key contd

• Calculate
• Terminal Value based upon Exit Multiple
• Exit Multiple Terminal Value Statisticn x
  Multiple
• Statisticn Operating statistic being used (i.e.
  exit year EDITDA figure)
• Multiple Relevant multiple from analysis of
  selected acquisitions
• Exit Multiple TV 500.0 x 8.0
• 4000.0

• Equity Value based upon Exit Multiple Terminal
  Value

40
Relative Value Analysis
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How do we use relative value?

• The hardest part of relative value is finding
  comparable firms.
• Once you have a decent list of comparables you
  need to determine which scaling variable to?
• Next, you want to compare your target firms
  multiple to the average of the comparable set.
• Finally, make sure that you account for
  differences, e.g. leverage, market position,
  patents, etc.

42
Comparing PE Ratios across a Sector
43
Relative Value

• Investors prefer to estimate the value of common
  stock using an earnings multiplier model.
• P0 D1/(ke - g)
• Divide both sides by next years projected
  earnings
• P0/E1 (D1/E1)(1/(ke - g))
• The P/E ratio (forward) is determined by
• The expected dividend payout ratio (D1/E1)
• The required rate of return on the stock (ke)
• The expected growth rate of dividends (g)

44
Relative Value

• Assume that a firm has an expected dividend
  payout of 40, a required rate of return of 11,
  and a growth rate of dividends of 6. Next
  years earnings (E1) are expected to be 2.75.
• P0/E1 (.40)(1/(.11-.06)) 8.0x
• The value of the stock today is based on the P/E1
  and estimate of E1.
• P0 P0/E1 x E1 8.0 x 2.75 22.00

45
Relative Value

• The best known measure of relative value for
  common stock is the P/E ratio or the earnings
  multiplier.
• Analysts have also turned their attention to
  other measures of relative value
• Price/book value (P/BV) market value of the
  company divided by its book value. This metric
  is used a great deal with financial stocks since
  many of their assets are carried at values very
  close to market value. This metric can be used
  for firms with negative earnings or cash flows.
  Several studies have indicated that P/BV is a
  good indicator of future performance.
• Price/cash flow (P/CF) market value of the
  company divided by its cash flow.
• Price/sales (P/S) market value of the company
  divided by its sales.

46
Expected Growth Rate

• When a firm retains earnings and acquires assets,
  if it earns some positive rate of return on these
  additional assets, the total earnings of the firm
  will increase.
• The rate of earnings growth depends on the
  proportion of earnings retained and the rate of
  return it earns on the new assets acquired.
• Specifically, the growth rate (g) of equity
  earnings without external financing is equal to
  the percentage of net earnings retained
  (retention rate, b) times the rate of return on
  equity capital (ROE).
• g (retention rate)(return on equity)
• g (b)(ROE)
• This growth rate is called the internal or
  sustainable growth rate.
• The firm can increase its rate of growth by 1)
  retaining a larger portion of its earnings for
  reinvestment in the firm or 2) increasing its ROE
  (recall, ROE profit margin x total asset
  turnover x financial leverage).

47
Exercise 3 Analysis of Selected Publicly Traded
Companies
A Simple Example

• Criteria
• Company XYZ closing stock price is 18.00/share
• XYZ has 1,000 shares outstanding, and 100
  exercisable options outstanding with an average
  exercise price of 4.50
• XYZ has total debt of 8,000 and cash of 350

XYZ Income Statement Items Stated
Sales 12,000
Cost of Goods Sold 8,000
Gross Profit 4,000
Sales, General, and Administrative (a) 2,000
Depreciation 1,000
Operating Income 1,000
Interest Expense 710
Pre-Tax Income 290
Taxes 116
Net Income 174
(a) Includes a one-time legal settlement of 1,000 (600 after-tax) (a) Includes a one-time legal settlement of 1,000 (600 after-tax)

• Calculate
• XYZ Enterprise and Equity Value
• Multiples of Sales, EBITDA, EBIT and Net Income

48
Analysis of Selected Publicly Traded Companies
Answer Key

• Calculate
• XYZ Enterprise and Equity Value
• Equity Value (Price per share x number of
  shares outstanding) Value of options/warrants
  Value of in the money convertible debt
• Value of options (18/share current market
  price - 4.50 average exercise price) x 100
  options outstanding 1350
• (18/share x 1000 shares outstanding) 1350
  value of options 19,350
• Enterprise Value Equity value debt
  preferred stock minority interest -
  cashequivalents
• 19,350 8,000 debt - 350 cash 27,000
• Multiples of Sales, EBITDA, EBIT and Net Income

49
Exercise 4 Analysis of Selected Acquisitions
A Simple Example

• Criteria
• Company A has agreed to buy Company B for
  20.00/share in stock
• Company A and Company Bs stock prices on the day
  before announcement were 35.00 and 16.00
  respectively
• Company B has 15,000 shares outstanding, 2,000
  exercisable options outstanding with an average
  exercise price of 7.50, 150,000 in net debt to
  be assumed by Company A and minority interests of
  25,000 to be acquired for cash

• Calculate
• Implied Exchange Ratio
• Premium Paid
• Enterprise and Equity Values of transaction
• Multiples of Revenues, EBITDA and Net Income

50
Analysis of Selected Acquisitions
Answer Key

• Calculate
• Implied Exchange Ratio
• Each share of Company B stock is exchanged for
  0.5714 shares of Company A stock (20/share
  purchase price divided by 35/share Company A
  stock)
• Premium Paid
• 25 premium (4/share paid above Company Bs
  closing stock price of 16)
• Enterprise and Equity Values of transaction
• Equity Value (Amount paid for each share x
  number of shares outstanding) Value of
  options/warrants Value of in the money
  convertible debt
• Value of options (20/share paid by acquirer -
  7.50 average exercise price) x 2,000 options
  outstanding 25,000
• (20/share x 15,000 shares outstanding) 25,000
  value of options 325k
• Enterprise Value Equity purchase price debt
  preferred stock minority interest -
  cashequivalents
• 325k 150k debt 25,000 minority interest
  500k
• Multiples of Revenues, EBITDA and Net Income