Firm valuation (2)
Class 7
Financial Management, 15.414
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7 Today
Firm valuation
x
Free cashflows
x
Profitability, financial ratios, and terminal value
Reading
x
Brealey and Myers, Chapter 12.4 – 12.6 x
Wilson Lumber Co. MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Firm valuation Two approaches
Focus on cashflows to equityholders
Equity = PV of dividends
Useful with moderate growth, constant payout ratio
Focus on cashflows generated by assets Assets = PV of free cashflows
More general, because cashflows may not be paid out
Equity = assets – debt
3
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Balance sheet
Assets
Liabilities and Equity
Current Liabilities
Current
Assets
Long-Term Debt
Fixed Assets
1. Tangible fixed
assets
2. Intangible
fixed assets
Shareholders’
Equity
Value = PV(FCFs)
Value = Debt + PV(divs) 4
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
FCF approach Asset value
PV of assets =
FCF1 FCF2
FCFH Term. value
...
2
H
1r (1 r)
(1 r)
(1 r)H
Free cashflow
Cash generated by the assets after all reinvestment FCF = EBIT (1 – W) + depreciation – 'NWC – CAPX FCF = EBIT (1 – W) – 'Net assets
FCF = Operating cashflow (before interest) – CAPX 5
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Working capital
Assets
Liabs. and equity
Current assets
cash
accounts receivable
inventory
Current liabilities
accounts payable
Long-term debt
bank loans
bonds
Long-term assets
equipment
buildings
land
intangibles
Equity
common stock
retained earnings
Net assets = Total assets – current liabilities (excl. s-t debt)
6
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Sustainable growth 16%
Cash deficits
g > g*
Plowback
70%
Growth
12%
8%
Plowback
30%
4%
Cash surpluses
g < g*
0%
1.0%
5.0%
9.0%
13.0%
17.0%
Return on equity
14
21.0%
25.0%
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Sustainable growth Forecasting
Long-run growth = sustainable growth
Faster in the short run, but not forever
Forecast must be internally consistent
Growth forecasts should be consistent with payout policy and
profitability
CitiBank financial goals, 1988 Growth: 15% ROE: 18% Payout: 30% Leverage ratio (debt / assets): 95% Are these goals feasible?
15
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Time Warner, 1989
Warner Communications ($ million)
Cashflow projections
Oper. income
Taxes
After-tax income
Depreciation
Deferred taxes
CAPX
' in NWC
Miscellaneous
Free cashflow
1989
$770
-193
577
228
-7
-336
5
-416
$52
1990
893
-246
647
245
0
-225
-80
-15
572
1991
1,145
-458
687
270
172
-180
-80
-5
863
Source: Lazard Freres (advisor to Warner)
16
1992
1,320
-528
792
271
198
-177
-80
-3
1,001
1993
1,482
-593
889
271
222
-183
-80
-3
1,117
1994
1,655
-662
993
273
248
-188
-80
-3
1,243
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Time Warner
Firm valuation
Discount rate = 11.5%
Firm value =
=
FCF1 FCF2
FCF3
FCFH Term. value
...
2
3
H
1r (1 r) (1r)
(1 r)
(1r)H
52
572
863
1,243
T.V.
...
1.115 1.115 2 1.115 3
1.115 6 1.115 6
Equity value = Firm value – Debt ($970 million) Terminal value three ways Constant growth Multiples (financial ratios of comparable firms) NPVGO
17
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Terminal value 1
Constant growth
Forecasted growth after 1994 = 5% Terminal value =
FCF1995 1,243 u 1.
05
= $20,079 million
r g
0.115 0.
05
Is the forecast internally consistent?
Projected earnings = $993; projected book equity = $5,055 Reinvestment = CAPX – Depr. + 'NWC
= 188 – 273 + 80 =
–$5 million
g* = ROE u plowback = (993 / 5,055) u (-5 / 993) = 0% 18
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Time Warner, 1989
Warner Communications ($ million)
Cashflow projections
Oper. income
Taxes
After-tax income
Depreciation
Deferred taxes
CAPX
' in NWC
Miscellaneous
Free cashflow
1989
$770
-193
577
228
-7
-336
5
-416
$52
1990
893
-246
647
245
0
-225
-80
-15
572
1991
1,145
-458
687
270
172
-180
-80
-5
863
Source: Lazard Freres (advisor to Warner)
19
1992
1,320
-528
792
271
198
-177
-80
-3
1,001
1993
1,482
-593
889
271
222
-183
-80
-3
1,117
1994
1,655
-662
993
273
248
-188
-80
-3
1,243
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Terminal value 2 Financial ratios
Multiples of comparable firms
P/E ratio Price-to-cashflow
Price-to-sales
Market-to-book equity Determinants of P/E and M/B
1 ª
price
º
P/E u«
r ¬price NPVGO »¼
Higher if NPVGO is large
M/B =
payout
(r / ROE) plowback
20
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
P/E ratios, Dec. 1998 350
300
Histogram
All U.S. stocks
250
200
150
100
50
0
0
4
9
13
18
22
27
P/E ratio 21
31
36
40
45
49
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
B/M ratios, Dec. 1998 800
700
Histogram
All U.S. stocks
600
500
400
300
200
100
0
-0.5
-0.1
0.3
0.7
1.1
1.5
B/M ratio 22
1.9
2.3
2.7
3.1
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Terminal value 2 Financial ratios
P/E ratio
Comparables P/E = 18
Earnings1994 = 993 Ÿ Terminal value = 18 u 993 = $17,874
M/B ratio Comparables M/B = 2.79
BV1994 = 5,055 Ÿ Terminal value = 2.79 u 5,055 = $14,103
23
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Terminal value 3
Zero NPVGO
How much will Warner be worth if its competitive advantage is
eliminated by 1994?
(Sustainability question in strategy) NPVGO = 0 Ÿ Value = EPS / r
Earnings1994 = 993 Terminal value = 993 / 0.115 = $8,635 24
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Time Warner Debt = $970 million
Firm value =
52
572
863
1,243
T.V.
...
1.115 6 1.115 6
1.115 1.115 2 1.115 3
Approach
Terminal
Value
Firm
Value
Equity
Value
Per
Share
Constant growth
P/E
M/B
Zero NPVGO
$20,079
17,874
14,103
8,635
$13,522
12,374
10,412
7,566
$12,552
11,404
9,442
6,596
$65.89
59.86
49.56
34.62
Actual offer = $70 / share
25
MIT SLOAN SCHOOL OF MANAGEMENT
15.414
Class 7
Time Inc. stock price, 1989 $ 190
180
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140
130
120
110
100
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