Introduction to Equity Valuation

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Introduction to Equity Valuation

• Chris Argyrople, CFA
• Concentric LLC
• Enterprise Valuation
• Cash Flow Analysis

2
Today in the Financial Markets(1998)

• Hollywood Entertainment had a tender offer for
  11 / share that fell through.
• Not enough investors wanted to sell at the 11
  price
• What happened ???
• The stock fell 20 to close at 8.8125 !!
• DOES THIS MAKE SENSE ?? ARBs Unwinding ??

3
Today in the Markets, 9/15/98

• Dow rose above 8,000 again, nobody knows where it
  will go next.
• Port Mgr Likes Rainforest Café (RAIN)
• Stock closed at 6 5/16
• He says 3 net cash
• 98 EPS estimate is 0.75
• Is it a screaming buy???
• Feb 1, 1999 Price 5 7/8
• STOCK ULTIMATELY FELL TO 1

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MMs Theory

• The Value of An Asset is Independent of How it is
  Financed
• Example Buy a 300,000 house. At closing, the
  seller just wants a certified check for 300,000.
  He doesnt care whether the money came out of
  your passbook account or whether you wrote a
  mortgage.
• This logic holds for all assets

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Modigliani Miller (MM)

• MM Postulated that, Capital Structure Does Not
  Matter
• Do you Agree?? Why or Why not?
• My View
• At any instant, CS DOESNT MATTER
• But, as time horizon lengthens, CS DOES Matter.
• Debate??

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P/E Ratio can be Misleading

• Company A B
• are Identical
• Identical
• Assets, CashFlow,
• Growth Rates
• P/Es
• A 15.0 , B 8.5

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Why P/E is Misleading

• Why is P/E Misleading? Comments?
• Why doesnt Interest Expense properly account for
  associated cost of the debt?
• Capitalized Interest
• Yield Curve ST Debt vs. LT Debt
• This is part of it, but
• Cost of Debt NOT Cost of Equity
• You cant compare Apples Oranges

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So, is B Cheaper than A?

• Which firms stock is cheaper, B or A?
• My answer B is cheaper (lower P/E), but A is
  probably a better equity investment.
• A is less risky, throws off more free cash flow,
  and has less constraints (less debt)
• Bs debt constrains its choices, and if something
  goes wrong, B gets hammered
• Debt can make managements either Very Aggressive
  OR Very Risk Averse

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Enterprise Value

• Total Enterprise Value (TEV) Firm Value
• TEV Debt Equity - Cash
• Use Market Values, NOT Book Values, but, it is ok
  to use Book Debt as a Proxy for Market Debt
  (usually)
• Measures the value of the entire company,
  independent of capital structure.
• This is the right way to do it. Any arguments??

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Why Subtract Cash from TEV?

• Cash is not really part of the business, it is
  portable fungible
• It can be used to pay down debt (same as
  subtracting off cash from TEV)
• It can be dividended to equityholders (same as
  subtracting cash from TEV)
• IMAGINE A SHELL COMPANY WITH ONLY CASH, WHAT IS
  THE COMPANY WORTH? This is why you subtract cash.

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More Sophisticated TEV

• TEV Debt Equity - Working Capital
• If there is extra working capital, it may make
  sense to subtract off the WC
• This technique is difficult to implement because
  companies require a certain amount of WC to
  sustain operations, so it is difficult to
  ascertain how much to subtract. Subtracting WC
  is sophistic.

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TEV Trick

• Subtract Working Capital when it is Negative
• Why? Because negative Working Capital usually
  requires additional funding, thus diluting
  current stockholders (somehow)
• Subtracting a negative is equivalent to adding
  the Working Capital to TEV
• When WC lt 0, it would be kind of erroneous to
  subtract cash (wrong way)

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Valuation Operating Cash Flow

• How do we value a company using TEV?
• Answer
• Compare Enterprise Value to Operating Cash Flow
• EBITDA Earnings Before Interest
  Taxes Depreciation Amortization
• EBITDA Operating Cash Flow
• EBITDA Operating Income NonCash
  Charges

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What is EBITDA?

• EBITDA is the Cash Flow thrown off by the
  underlying business
• Because it is before Financing Charges, Taxes,
  and Accounting Choices it is more difficult for
  management to game.
• Obviously, EBITDA is still subject to Revenue
  Recognition and Inventory Accounting issues

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Why EBITDA is Better

• EBITDA is not Subject to acceleration of
  Depreciation or Amortization
• EBITDA is not affected by Capitalized Interest
• EBITDA is not altered by Capital Structure
• EBITDA is not subject to Tax tricks
• It is a cash flow measure, and businesses are
  propelled by cash

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Valuation TEV EBITDA

• Use TEV / EBITDA as one of your primary metrics.
• Low TEV / EBITDA ratios are good
• TEV / EBITDA measures the value of entire
  business vs. the operating cash flow
• Better Apples to Apples Comparison than P/E,
  P/Book, and Price/Revenue ratios

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Key Valuation Points

• Ratios like P/E are of little value by
  themselves. They must be compared to similar
  firms to identify Relative Value
• Growth Rate drives Valuations, if this is not the
  case, then you have a mis-pricing
• Estimating Growth Rates is very difficult, Very
  Difficult if not Impossible.
• So, what do you do?

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Valuation Cash Flow Ratios

• TEV / EBITDA Firm Value to OCF
• TEV / Revenue Firm Value to Revenue
• EBITDA / Sales Cash Flow Margins
• MV Equity/FCFE Real P/E, Free Cash Flow
  (FCFE) Mult.
• EBITDA / Interest Interest Coverage
• Debt / EBITDA Leverage Indicator

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Asset Valuation

• Asset Value PV(cash flows)
• Cash flows are independent of financing, BUT
• Financing can dominate the Enterprise Value of a
  company
• What does this Mean???

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FREE CASH FLOW

• Above all FREE CASH FLOW IS KING
• (if you could predict growth, then growth would
  be King)
• Free Cash Flow to Equity FCFE
• FCFE NI Depreciation Amort - Capex
• NI Net Income
• Capex Capital Expenditures

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How Free Cash Works

• Balance Sheet
• Year 1 Year 2
• Cash 10 10
• Other Assets 400 400
• Total Assets 410 410
• Debt 65 35 Debt
• Other Liab Eq. 345 375 O.E.
• Free Cash Flow 30

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Back to Company A B
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Free Cash Improves the B/Sheet

• In the Example, Free Cash of 30 can be used to
• PAY DOWN DEBT A GOOD THING
• INCREASE CASH A GOOD THING
• DIVIDEND PAYMENT A GOOD THING
• ACQUISITIONS A GOOD THING
• SHARE BUYBACK A GOOD THING
• UPGRADE PPE A GOOD THING
• NEW PROJECTS A GOOD THING

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If Free Cash was -30

• After dipping into cash of 10, THE COMPANY WOULD
  HAVE TO COME UP WITH THE OTHER 20 !!! HOW?
• BORROW MORE A BAD THING
• ISSUE EQUITY A BAD THING
• GO BANKRUPT A BAD THING
• SQUEEZE WORKING CAP. A BAD THING
• SELL ASSETS A BAD THING
• CUT DOWN CAPITAL EXP. A BAD THING

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Argyrople Intro. Rule of Thumb

• Buy Stocks Positive Free Cash Flow
• Short Stocks Negative Free Cash Flow
• You wouldnt believe how many people dont
  understand this.
• This is a simple rule that will keep you out of
  some trouble.

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Assuming No Valuation Change (TEV)

• With No Valuation Change, Free Cash Flow is what
  determines the change in stock price. This is a
  simple concept, but most students dont
  understand it.
• Company A B are Identical from the OCF line up,
  but due to capital structure, As stock rises
  Bs stock falls.
• I DONT BELIEVE MM EXPLAINS THIS PROBLEM

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MM was Right Wrong

• In our No-Growth example, Capital Structure does
  not affect the value of the assets (partially
  because the positive free cash flow firm builds
  cash does not add to assets)
• Enterprise Value stays constant BUT
• Stock of Positive FCF firm Rises
• Stock of Negative FCF firm Falls

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Thus, Modified MM

• At any point in time, Capital Structure does not
  matter -- Value of the Assets is Independent of
  Financing
• Over time, Capital Structure does matter for
  stockholders AND it is important to the total
  enterprise value of the firm too (because
  eventually the stock of firm B will be wiped out)
  -- Cash Flow thrown off by Assets is altered by
  Financing