Investment Banking Internship Class

1
Investment Banking Internship Class

• Valuation II
• Intrinsic Value

2
Objectives

• A. Review the importance of intrinsic value
• B. Understand how to calculate intrinsic value,
  using the 8 key methods

3
Review the Importance of Intrinsic Value

• What is intrinsic value?
• The present value of a firms cash flows
  discounted by the firms required rate of return
• In an efficient market, what should the
  relationship be between a firms intrinsic value
  and market value?
• In a truly efficient market, the intrinsic value
  should equal its market value
• What happens if it doesnt?
• There are opportunities for profit

4
Intrinsic Value (continued)

• How do you determine Intrinsic Value?
• It is a value assigned by the analyst
• It is based on specific theories and assumptions
• Analysts use specific models for estimation
• Lots of models exist, but remember, they are
  proxies for reality not reality

5
Intrinsic Value (continued)

• What happens if the intrinsic value is greater
  than the market price (and your intrinsic value
  is correct)?
• Intrinsic Value gt Market Price
• Buy
• Intrinsic Value lt Market Price
• Sell or Short Sell
• Intrinsic Value Market Price
• Hold or Fairly Priced or Fully Valued

6
Questions

• Do you understand the importance of intrinsic
  value?

7
Understand how to calculate Intrinsic Value

• For the purposes of your company report, we will
  cover the following topics1.  Discount
  Rate2.  Discount Dividend Models3.  Internal
  Rate of Return (IRR)4.  Present Value of Free
  Cash Flows to Equity 5. Value of Operations
  plus Cash
• 6.  Present Value of Operating Free Cash Flows
• 7. Price to Book Value
• 8. Relative Valuation Models
•      

8
1.  Discount Rate

• What is the discount rate?
• It is the rate of return required by investors to
  compensate them for the risk of the firm
• What is the theory behind the discount rate?
• The CAPM Model
• This is one method broadly used by practitioners
  to determine a companys required rate of return.
  This is the rate that is used to determine the
  companys cost of equity.
• What is the formula?
• K rf beta (risk premium)

9
Discount Rate (continued)

• What are the discount rate components?
• The nominal risk-free interest rate
• The risk premium (rM - rf )
• If the market is efficient, over time, the return
  earned by investors should compensate them for
  the risk of the investment.
• How is it used?
• It is used to discount all future cash flows to
  determine the present value of future dividends
  and terminal values.
• We use it to determine what the appropriate
  discount rate is for our company

10
Discount Rate (continued)

• Where do you get the risk free rate?
• Generally, the risk-free rate is considered the
  rate on a 3 month or 1 year US Treasury bill that
  you expect to receive over the life of the
  investment
• Where do you get the beta?
• The easiest method is to get it from Bloomberg.
  You type your company ticker equity and BETA.
  Then make sure the index is the SP 500 or SPX
  (everyone should calculate their beta versus SPX)

11
Discount Rate (continued)

• What about the time frame?
• You get to pick the time frame. If you think the
  next 3 years are more consistent with the past,
  choose a longer time period. If it is more
  consistent with the most recent period, choose a
  shorter time period. The minimum period is 60
  observations, whether monthly (preferred) or
  weekly.
• What is the adjusted beta?
• Beta is volatile depending on the time period.
  Companies such as Bloomberg calculate an adjusted
  beta, which is 2/3 the calculated beta and 1/3
  the market beta of 1. It tends to lower the beta
  and hence reduce the discount rate, which is more
  consistent with actual results

12
Challenges with the Discount Rate (DR)

• What are your assumptions for the Discount Rate?
• 1. What is the time period for calculating beta?
• Is beta stable over all time periods?
• Do you use the adjusted or calculated beta?
• 2. What is your forecast for the market risk
  premium?
• Small changes can have a big impact on your DR
• Is the market risk premium stable over time?
• 3. What is your risk-free rate?
• Is it stable over time?
• 4. Is the Discount Rate useful?
• Or should you just set a high hurdle rate, say
  15, to make sure you compensate for these other
  concerns?

13
2. Dividend Discount Models (DDMs)

• What are Dividend Discount Models?
• Models which take into account discounting
  expected future cash flows to gain a reference
  for the value of a company
• How do they work?
• DDMs determine the firms value by taking the
  present value of all future cash flows
  (dividends) and the eventual sale of equity or
  terminal value

14
Dividend Discount Models (continued)

• How do you determine the final sale price of the
  stock?
• Remember the PE is the price divided by EPS.
  Therefore, the future value of the stock is the
  estimated PE in the future times the estimated
  EPS
• You calculate the 2011 EPS. Multiply the 2011
  EPS estimate by your estimated 2011 PE ratio to
  get the price of the stock
• So instead of guessing the future price, do you
  guess the future PE? Any hints?
• A good starting point is calculating your
  harmonic mean PE for your last 5 years (positive
  PEs only). The formula is
• (5/(1/PE1)(1/PE2)(1/PE3)(1/PE4) (1/PE5))

15
Dividend Discount Models (continued)

• What next?
• Find the present value of the future cash flows
  (dividends) for the next five years and the
  forecast sale price by discounting them by the
  discount rate calculated above.
• This will give you an intrinsic value at your
  estimated discount rate.
• Divide the present value by the current market
  price and you will get the percentage of
  overvaluation or (under-valuation)
• From this valuation point, you can determine
  whether the stock is attractive (buy) or not
  (hold or sell)

16
Dividend Discount Models (continued)

• What are we assuming?
• We are assuming that the stocks dividend growth
  rate will be at a constant rate over time.
  Although this may be unrealistic for fast-growing
  or cyclical firms, DDMs may be appropriate for
  some mature, slower-growing firms. Two and
  three-growth stage models can be used to modify
  this model as alternative assumptions
• What factors will impact the dividend growth
  rate?
• The dividend growth rate will be influenced by
  the age of the industry life cycle, structural
  changes, and economic trends

17
Challenges with DDMs

• What are your assumptions for DDMs?
• 1. Dividends grow at a constant rate
• This is rarely the case
• 2. The constant growth rate will continue for an
  infinite period
• This is also rarely the case
• 3. The required rate of return (k) is greater
  than the infinite growth rate (g). If g gt k, the
  model become meaningless because the denominator
  becomes negative
• If you have this problem, you will need to reduce
  g downward. Document this clearly in your
  reports.

18
3.  Internal Rate of Return

• What is the internal rate of return?
• It is the discount rate that equates the present
  value of cash outflows for an investment with the
  present value of its cash inflows.
• Theoretically, you compare your firms cost of
  capital to the IRR
• Accept (reject) any investment proposal with an
  IRR greater (less) than your cost of capital
• What are my cash flows?
• Your dividends and your eventual sale of the
  shares

19
Challenges with the IRR

• What are your assumptions for the IRR?
• 1. Do dividends grow at a constant rate?
• This is rarely the case
• 2. What is your terminal value?
• How sure are you of that terminal value?
• Your choice of method for calculating your
  terminal value will have a big impact on this
  calculation

20
4. Free Cash Flow to the Firm (FCFF)

• What is the difference between cash flow and free
  cash flow?
• Free cash flow recognizes that some investing and
  financing activities are critical to the ongoing
  success of the firm over and above net income and
  depreciation. Free cash flow takes these
  additional costs into account
• What is Free Cash Flows to the Firm (FCFF)?
• Cash flow available to the companys suppliers of
  capital after all direct operating costs (CGS,
  SGA, etc.), necessary investments in working
  capital, and investments in fixed capital.

21
Free Cash Flow to the Firm (continued)

• How do we calculate FCFF?
• FCFF is equal to EBIT (1-tax rate)
  depreciation (non cash charges) capital
  expenditures change in net working capital
  terminal value
• This is the cash flow generated by a companys
  operations and available to all who have provided
  capital to the firm both equity and debt.

22
Free Cash Flow to the Firm (continued)

• What is the appropriate discount rate?
• Because we are dealing with the cash flow
  available for all capital suppliers, we use the
  WACC, which combines the companys cost of equity
  and debt.
• Where do we find the cost of equity?
• The cost of equity was determined with the
  calculation of the discount rate k.
• Where do you find the cost of debt?
• The cost of debt is the interest rate at which
  the company borrows money from the financial
  markets. As a proxy, you can use the imbedded
  cost of debt you calculated for your latest year
  (generally adding a 1-2.0 premium)

23
Free Cash Flow to the Firm (continued)

• How do you calculate the weight for debt?
• Weight of Debt LTD/Enterprise Value
• What is enterprise value?
• The enterprise value is the total market value of
  an enterprise plus the value of its debt. It is
  a step beyond market capitalization. It starts
  with market capitalization, and then adds in
  preferred equity, minority interest, and the
  market value of the firms debt, then subtracts
  out the value of cash and cash equivalents. It
  is a better statistic than market value alone

24
Free Cash Flow to the Firm (continued)

• How about the weight for equity?
• Weight of Equity (1- Weight of Debt)
• The sum of these two should equal 100
• What is the formula for the WACC?
• WACC (Wd Kd) (1-T) (We Ke)

25
Free Cash Flow to the Firm (continued)

• Once you have your operating free cash flows,
  then what?
• 1. You assume a constant growth rate g for your
  final cash flow, and discount that cash flow at
  WACC-g
• 2. Sum your discounted cash flows and discount
  them at your WACC to get your present value of
  the firms operating Free Cash Flow
• 3. Subtract out your long-term debt to get the
  value of your equity
• 4. Divide your firm value of equity by the
  number of shares outstanding at your last
  forecast year
• 5. Compare your intrinsic value (per share) to
  your current market price (per share)

26
Challenges with FCFF

• What are your assumptions for the FCFF
• 1. Do cash flows grow at a constant rate?
• This is rarely the case
• 2. At some point in time, you assume a growth
  rate in perpetuity
• How sure are you of that growth rate?
• Will it really grow forever (as we assume)
• 3. Do we remember that all these forecasts are
  really just thatforecasts
• Lots of things can change
• 4. Is the WACC the correct rate to discount cash
  flows?

27
5. Value of Operations Plus Cash

• What is Value of Operations plus Cash?
• Consulting history has shown that attractive
  firms are valued in a range of 6-9 times EBITDA
  multiples plus working capital less debt
  (EBITDAWCD). If you can find firms valued at
  greater than 7.5x EBITDAWCD, it may be attractive
  
• Start with your EBITDA earnings, and multiply
  those by 6 and 9 times
• Divide those by diluted shares outstanding to get
  EBITDA per share

28
Value of Operations Plus Cash (continued)

• Calculate Working Capital less long-term debt
  (Current Assets less Current Liabilities less
  long-term debt
• Divide those by diluted shares outstanding
• Add working capital less debt per share to the
  EBITDA multiples per share
• Take the average of the 6x and 9x multiples
• Divide the EBITDAWCD price by the current share
  price to determine the percent under (over)
  valued

29
Challenges with EBITDAWCD

• What are your assumptions for the EBITDAWCD?
• 1. EBITDA is the only source of value
• This is rarely the case. However, it is useful
  for valuing the operations of the firm
• 2. The multiple of 7.5x is the correct valuation
  multiple
• How sure are you of that multiple?
• 3. The multiple of 7.5x is the correct valuation
  multiple for all companies
• Perhaps different industries should use
  different valuation multiples

30
6. Free Cash Flows to Equity (FCFE)

• What is free cash flow to equity?
• It is the cash flow available to the companys
  common equity holders after all payments to debt
  holders, and after allowing for all operating
  expenditures to maintain the firms asset base
• What is our goal?
• To determine a value for the firm based on the
  free cash flow available to equity shareholders
  after payments to all other capital suppliers and
  after providing for continued growth of the firm

31
Free Cash Flows to Equity (continued)

• How is it calculated?
• Net Income depreciation capital expenditures
  needed to achieve revenue forecast change in
  net working capital principal debt repayments
  new debt terminal value
• Remember that net working capital is current
  assets less cash minus current liabilities less
  notes payable and current portion of long-term
  debt.

32
Free Cash Flows to Equity (continued)

• Once you have your free cash flows, then what?
• 1. You discount your cash flows at your discount
  rate k
• 2. You assume a constant growth rate g for your
  final cash flow, and discount that cash flow at
  k-g
• 3. Sum your discounted cash flows to get your
  present value of the firms equity
• 4. Divide the firm value by the number of shares
  outstanding at your last forecast year
• 5. Compare your intrinsic value (per share) to
  your current market price (per share)

33
Challenges with FCFE

• What are your assumptions for the FCFE
• 1. Do cash flows grow at a constant rate?
• This is rarely the case
• 2. At some point in time, you assume a growth
  rate in perpetuity
• How sure are you of that growth rate?
• Will it really grow forever (as we assume)
• 3. Do we remember that all these forecasts are
  really just thatforecasts?
• Lots of things can change
• 4. Is the Discount Rate for Equity the correct
  rate to discount cash flows?

34
7. Price to Book Value Method

• The Price to Book method assumes a methodology
  for calculating terminal value
• Since we have an estimate of our future book
  value, we can estimate, based on historical
  information, a terminal value for a Price to Book
  multiple at the end of our forecast period
• Then, you multiply your Price to Book multiple
  times your forecast book value per share to give
  your future price
• Add back in forecast dividends
• Discount the dividends and terminal value based
  on Price to Book by your cost of equity to get
  your intrinsic value

35
Challenges with the Price Book Method

• What are your assumptions for your Price to Book
  forecast?
• 1. How sure are you of your P/BV forecast?
• Is it volatile?
• 2. Do we remember that all these forecasts are
  really just thatforecasts?
• Lots of things can change
• 3. The required rate of return (k) is greater
  than the infinite growth rate (g). If g gt k, the
  model become meaningless because the denominator
  becomes negative
• If you have this problem, you will need to reduce
  g downward. Document this clearly in your
  reports.

36
8. Relative Valuation Methods

• What are relative valuation methods?
• Methods which provide information about how the
  market is currently valuing stocks at several
  levels, the market, industry, and comparative
  stocks in the industry. These are often called
  comps or comparables of similar companies or
  industries
• What is relative fair value?
• It is the value of the company relative to other
  stocks, or stocks in the same market or industry
• Which relative valuation methods are used most
  often?
• Generally, the most used in the industry is Price
  Earnings. However, Price to Sales, Price to
  Book, Dividend Yield, and Price to Cash Flow are
  also used

37
Relative Valuation Methods (continued)

• How do you use relative valuation methods?
• You compare your companys valuation ratio to the
  market, industry, its history, or other companies
• If you notice a change in relative valuation,
  i.e. it is cheaper (expensive) than it has been
  historically, it may signal it may be a buy
  (sell) assuming no other major changes in the
  company and industry
• In the Apple case, we used PE relative to the
  market. Can we use price earnings relative to
  the industry?
• Yes, although it is harder to find good forecast
  data on the industry, as most industry indices do
  not have forecasts.

38
Relative Valuation Methods (continued)

• How do I determine my buy and sell range?
• This is one of the most difficult challenges of
  being an analyst. Here is where the art comes
  in!
• Look to company history.
• If the company has traditionally traded in a
  tight range, the likelihood is that it will
  continue
• If your company is volatile, it will be more
  difficult and you will need to make the best
  decision you can
• Use wisdom and judgment
• Determine whether you think its a buy, sell or
  hold, then set your relative value consistent
  with that view

39
Relative Valuation Methods (continued)

• How do you calculate relative valuation, say, for
  example, relative PE?
• 1. Calculate your PE for your company
  historically and for your forecast period
• 2. Calculate your PE for the market/industry
  historically and for the forecast period
• 3. Calculate the relative PE (i.e. the company
  PE / market PE) for all periods
• 4. Look at the trend for the relative PE

40
Relative Valuation Methods (continued)

• 5. Based on that trend, determine what you
  consider to be a fair relative PE range, i.e. at
  what relative PE would you buy the stock, and at
  what relative PE would you sell the stock
• 6. Calculate your buy and sell ranges using the
  formula relative PE range market PE firm
  EPS Future Price

41
Challenges with Relative Valuation

• When is it most appropriate to use RVM?
• When you have a good set of comparables, i.e.
  industries/companies in terms of size and risk
• When the aggregate market is not at a valuation
  extreme, i.e. it is neither over or undervalued
• When are they inappropriate?
• When you have poor comparables or the current
  market level is at extremes.
• If you compare the value of a company to the very
  overvalued market, you might believe it is cheap.
  However, you may be wrong as company may be
  fully valued and the benchmark, the market, is
  overvalued.

42
Challenges with Intrinsic Value Methods

• What are the difficulties with these PV
  calculations?
• These cash-flow techniques are very dependent on
  two significant inputs
• 1. The growth rate of cash flows g, and
• 2. The estimate of the discount rate k (or WACC)
• A small change in either input will have a
  significant impact on the estimated value
• In addition, it is possible to derive intrinsic
  values which are substantially above or below
  current prices depending on how you adjust your
  estimated inputs to the prevailing environment.
  Be careful!

43
Summary Intrinsic Value Calculations

• The next step is to summarize your intrinsic
  calculations thus far.
• Take and average of the values calculated from
  the Dividend Discount Model, Free Cash Flows From
  Equity and Operating Cash Flow, Book Value, and
  EBITDA and compare the forecasts with the
  current market price.
• This will let you know if the companys stock is
  over- or undervalued on a percentage basis
• If you have any models in which the intrinsic
  values are negative, try to understand the
  problem (it may be because your g gt k). Not all
  models may be valid over all time periods

44
Review of Objectives

• A. Do you understand the importance of intrinsic
  value?
• B. Do you understand how to calculate intrinsic
  value, using the eight key methods discussed?