1 P.V. VISWANATH FOR A FIRST COURSE IN VALUATION 2 Different kinds of Valuation Models Free cashflow depends on reinvestment strategies, which in turn affects Operating cashflows – hence there is a joint computation problem Starting from the Zen equation, how we do we get the inputs? How to look at historical performance to generate inputs Defining competitors Different Issues with Liabilities and Asset Headings Coming up with the Stock Price Forecast 3 DCF Models Enterprise DCF Discounted Economic Profit (EVA) Adjusted Present Value (APV) Free Cashflow to Equity Advantages of Enterprise DCF Relies solely on the flow of cash in and out of the company, rather than on accounting-based earnings, which could be misleading Closely related to economic theory and competitive strategy Advantages of Discounted Economic Profit Highlights whether a company is earning its cost of capital in a given year Useful for crafting compensation strategies for firm executives APV methods work when capital structure is expected to change Free Cashflow to Equity Focuses on Value to Shareholders It doesn’t require the analyst to make assumptions regarding the value of debt. 4 Value company’s operations by discounting free cashflow from operations at the WACC. Forecast free Cashflow for as long as it is reasonable to make explicit forecasts. Past that period, assume that the growth rate will be stable and compute a terminal value. Value non-operating assets such as excess marketable securities, nonconsolidated subsidiaries, and other equity investments. Combining the value of operating and non-operating assets leads to enterprise value. Identify and value all non-equity financial claims against the company’s assets. Non-equity financial claims include fixed- and floating-rate debt, pension shortfalls, employee options and preferred stock. Subtract the value of non-equity financial claims from enterprise value to determine the value of common stock. Divide enterprise value by number of shares outstanding to determine share price. 5 The value of operations is the discounted value of forecasted future free cashflow from operations. As we have already seen, Free Cashflow from operations equals the cashflow generated by the company’s operations less reinvestment required to maintain the forecasted cashflow. Hence there are different possible firm values, with reinvestment being in each case chosen to be consistent with cashflow forecasts. Free Cashflow is the cashflow available to all investors and is independent of leverage. This is discounted using the WACC, which is an average of the returns required by the firm’s capital contributors. We then choose the reinvestment strategy that maximizes firm value. 6 In order to forecast future cashflows, we have to understand the business well; in particular, we need to know where and how value is being created. For this we need to look at key drivers of value – ROIC, NOPLAT and g, as is evident from the Zen value equation: Valuet = NOPLATt+1(1-g/ROIC)/(WACC-g) The first step is to look at the past to see if and how the company has created value, whether and how it has grown and how it compares with competitors. Excludes operating leases in Invested Capital 10/1/2008 5/1/2008 12/1/2007 7/1/2007 2/1/2007 9/1/2006 4/1/2006 11/1/2005 6/1/2005 1/1/2005 8/1/2004 3/1/2004 10/1/2003 5/1/2003 12/1/2002 7/1/2002 2/1/2002 9/1/2001 4/1/2001 11/1/2000 6/1/2000 1/1/2000 8/1/1999 3/1/1999 10/1/1998 5/1/1998 12/1/1997 7/1/1997 2/1/1997 9/1/1996 4/1/1996 11/1/1995 6/1/1995 1/1/1995 7 ROIC 0.9 0.8 0.7 0.6 0.5 0.4 ROIC 0.3 0.2 0.1 0 8 We see that ROIC, which was as high as 80% in 1995 has dropped to less than 10% in 2008! Since the cost of capital probably hasn’t fluctuated to this extent and since inflation hasn’t changed so much over time, there is probably only one conclusion: The level of competition has increased over time. (NetAdvantage) Industry publication Nation's Restaurant News reports that for the 12 months ended September 2008, the number of restaurant locations fell slightly, marking the first decline since 2000. However, segments of the industry and types of operators fared quite differently. Locations operated by independent operators declined 0.8%, while chains grew 0.8% in total. About 11% of fine dining restaurants operated by independents closed during the period. Among chains, family dining operators with 50 to 99 locations shrank by 8.9%, while those with fewer than 50 units were down 2.5%. Among all types of restaurants, only large chains with more than 100 restaurants expanded. 1/1/1995 Operating Margin = Income from Operations/Revenue 10/1/2008 5/1/2008 12/1/2007 7/1/2007 2/1/2007 9/1/2006 4/1/2006 11/1/2005 6/1/2005 1/1/2005 8/1/2004 3/1/2004 10/1/2003 5/1/2003 12/1/2002 7/1/2002 2/1/2002 9/1/2001 4/1/2001 11/1/2000 6/1/2000 1/1/2000 8/1/1999 3/1/1999 10/1/1998 5/1/1998 12/1/1997 7/1/1997 2/1/1997 9/1/1996 4/1/1996 11/1/1995 6/1/1995 9 Operating Margin 0.12 0.1 0.08 0.06 Operating Margin 0.04 0.02 0 Capital Efficiency = Revenues/Invested Capital 7/1/2008 1/1/2008 7/1/2007 1/1/2007 7/1/2006 1/1/2006 7/1/2005 1/1/2005 7/1/2004 1/1/2004 7/1/2003 1/1/2003 7/1/2002 1/1/2002 7/1/2001 1/1/2001 7/1/2000 1/1/2000 7/1/1999 1/1/1999 7/1/1998 1/1/1998 7/1/1997 1/1/1997 7/1/1996 1/1/1996 7/1/1995 1/1/1995 10 Capital Efficiency 30 25 20 15 Capital Efficiency 10 5 0 11/1/2008 6/1/2008 1/1/2008 8/1/2007 3/1/2007 10/1/2006 5/1/2006 12/1/2005 7/1/2005 2/1/2005 9/1/2004 4/1/2004 11/1/2003 6/1/2003 1/1/2003 8/1/2002 3/1/2002 10/1/2001 5/1/2001 12/1/2000 7/1/2000 2/1/2000 9/1/1999 4/1/1999 11/1/1998 6/1/1998 1/1/1998 8/1/1997 3/1/1997 10/1/1996 5/1/1996 12/1/1995 11 Revenue Growth 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 12 Operating Margin hasn’t dropped as much over time as ROIC has. What could be the reason? Invested Capital must have grown in a way not reflected in the expenses. We see that Capital Efficiency has dropped over time, and so has revenue growth. All of this probably reflects the same or related phenomena of increased capital needs coupled with decreased market share in the entertainment dollar. 13 We now need to look at competitors before we can figure out how to forecast the relevant quantities for CAKE. This is necessary because the prognosis for CAKE depends on our analysis of the competitive situation. To do this, we have to first figure out who are CAKE’s competitors. We have already discussed Dupont Analysis and seen that Dupont Analysis gives us a good idea of the operating and financial strategies of a firm. Now a firm might compete with different sorts of firms in its industry broadly defined, where each firm might use different strategies. Still, the closest competitors are those who are using similar strategies. There are many companies that are identified as competitors to CAKE in the sense of being in the same industry, viz. restaurants. Mergent lists 18 such firms that are publicly traded. 14 DineEquity Inc (DIN) Landry's Restaurants, Inc. (LNY) Ruby Tuesday, Inc. (RT) Steak n Shake Co. (The) (SNS) Bob Evans Farms, Inc. (BOBE) Texas Roadhouse Inc (TXRH) O'Charley's Inc. (CHUX) Chipotle Mexican Grill Inc (CMG) Darden Restaurants, Inc. (DRI) Carrols Corp. (CRLL) California Pizza Kitchen Inc (CPKI) Cracker Barrel Old Country Store, Inc. (CBRL) P.F. Chang's China Bistro, Inc. (PFCB) Panera Bread Co. (PNRA) Brinker International Inc. (EAT) Buffalo Wild Wings Inc (BWLD) Denny's Corp (DENN) TravelCenters of America LLC (TA) 15 Ticker DIN LNY RT SNS CAKE BOBE TXRH CHUX CMG DRI CRLL CPKI CBRL PFCB PNRA EAT BWLD DENN TA Total_Asset_Turnover EBITDA_Margin LTDebt_Equity 0.45 0.18 10.15 0.76 15.46 2.93 1.09 4.36 1.36 1.13 1.78 0.53 1.41 9.93 0.61 1.45 10.55 0.22 1.48 11.33 0.37 1.6 -5.57 0.74 1.72 13.51 0.01 1.75 12.61 1.2 1.79 9.4 35.76 1.85 7.78 0.42 1.85 8.68 8.4 1.86 9.92 0.61 1.86 13.68 1.88 6.29 1.52 1.92 14.15 ? 2.05 11.28 7.09 0.06 0.26 16 If we sort the competitors according to each of the three ratios and consider the firms that are closest to the Cheesecake Factory (two firms with higher ratios and two firms with lower ratios), we note the following: Total Asset Turnover RT 1.09 SNS EBITDA Margin LT Debt/Equity SNS 0.53 PFCB 0.61 CRLL 9.4 1.13 PFCB 9.92 CAKE 1.41 CAKE 9.93 CAKE 0.61 BOBE 1.45 BOBE 10.55 CHUX 0.74 TXRH 1.48 DENN 11.28 DRI 1.2 17 SNS (Steak n Shake) and BOBE (Bob Evans Farms) are represented on two of the three lists. Of the three ratios, though, the first two represent strategic decisions that are more related to the firms’ operations. On that basis, it may make sense to add PFCB (PF Chang’s China Bistro) as well since it has a EBITDA Margin close to CAKE’s. SNS, while it has a total asset turnover ratio not too far from that of CAKE, has an EBITDA Margin not at all close to that of CAKE. What this points out is that we should get more information on what these competitors do and in which sub-category of the industry they belong. We note that firms such as DineEquity are in a completely different line of business (moderately priced, family restaurants) or CBRL (specialty retail outlets including restaurants) or CRLL (which has low-priced restaurants), whereas firms such as CAKE, BOBE and SNS are all upscale restaurants that are looking to provide a quality brand dining experience with a twist. Although we could proceed further with this, let us pick SNS, BOBE, PFCB as CAKE’s competitors. 18 To compute ROIC and FCF, we cannot use the company’s financial statements directly because these statements mix operating performance, nonoperating performance and capital structure. Hence we need to reorganize the accountant’s financial statements into new statements that separate these three components. We will use the company’s financial statements to compute ROIC and Invested Capital, which will require computing Net Operating Assets and Net Operating Liabilities. We start with operating working capital. 19 This is defined essentially as Current Assets less Current Liabilities Includes all current assets necessary for the operation of the business including working cash balances, trade accounts receivable, inventory and prepaid expenses. Excluded are excess cash and marketable securities (cash greater than required for running the business) Non-interest-bearing operating current liabilities include liabilities related to the ongoing operations of a business. Examples are liabilities related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue) and the government (income taxes payable). 20 R&D outlays is traditionally expensed. However, R&D is an asset in the sense that it generates future cashflows. Hence, historical information on R&D outlays should be used to capitalize and compute the R&D asset. This will also have implications for NOPAT since not all R&D outlays should be considered expenditures chargeable to current income. CAKE does not have any R&D so this is not as much of an issue for this company. We will now consider issues regarding firm operating liabilities. 21 If a company runs a defined-benefit plan for its employees, it must fund the plan each year. If it funds the plan faster than its pension expenses dictate, it can recognize a portion of the excess assets on the balance sheet. However, this is properly considered a non-operating asset and not part of invested capital. However, this is part of what a stockholder owns and must be computed separately. On the other hand, if a plan is underfunded, it must recognize a portion of this underfunding as a liability. This is not an operating liability and must be reckoned with separately. Again, CAKE has no pension obligations. 22 The best way to take employee options into account is to actually estimate their value and subtract from the enterprise value. Alternatively, we can make assumptions regarding the number of options that are likely to be exercised and compute a sort of “present value” number of those options. Adding this number to the number of shares outstanding, we get the number of shares outstanding on a diluted basis. This is then used to divide total stockholder wealth and obtain estimated share price. 23 As mentioned before, Operating lease payments need to be capitalized. Operating leases represent a set of obligations to make payments in the future and must be included in the firm’s liabilities. However, these payments also represent access to future services and hence futures cashflows. Therefore there is also a corresponding asset. Capitalization of operating leases will, thus, increase Invested Capital. 24 This includes common stock, as well as additional paid-in capital plus retained earnings. Accumulated other Comprehensive Income is also to be included. This consists of currency adjustments and aggregate unrealized gains and losses from liquid assets whose value has changed but have not been sold yet. Treasury stock should be deducted from total equity. 25 Deferred Taxes are noncash expenses that represent future costs. For example, straight-line depreciation is used to determine taxes reported in financial statements, while accelerated depreciation can be used to compute actual taxes owed. Hence the financial statements will show “taxes owed” or deferred taxes. This will be offset in the future when more depreciation will be recognized in the financial statements and actual taxes paid will be greater than the taxes payable according to reported income. Hence this “delay” in taxes is temporary. The best way to deal with this is to use actual taxes paid as discussed below. Deferred taxes could also derive from non-operating items such as pensions. In such cases, they should be aggregated with the corresponding non-operating item. 26 NOPLAT or Net Operating Profit Less Adjusted Taxes measures the dollar return on the firm’s operations. This differs from Net Income in that NI is affected by the firm’s financing, while NOPLAT is solely the result of the firm’s operating side. NOPLAT can then be evaluated relative to the Invested Capital (IC) to see if the firm’s operations are profitable or not, separate from its capital structure. Furthermore, ROIC = NOPLAT/IC is more likely to be stable and can be analyzed profitably. FCF is NOPLAT adjusted for noncash operating expenses and incremental investments in capital; as such, it can be lumpy and vary widely from year to year. Consequently, it is not as stable as NOPLAT and its year-to-year variations cannot be treated as “deviations.” 27 We start out with Earnings before interest, taxes and amortization of goodwill, which is essentially revenue less operating expenses (e.g. COGS, selling costs, general and administrative costs, depreciation). We exclude interest income, gains and losses from the firm’s non-operating assets. Operating Leases are operating liabilities. Hence expenses associated with these liabilities should be included, but not other payments that are not operations related. Operating lease payments included both financing payments and “rent” for the leased asset. A firm’s financial statements include both of these as expenses – obviously, the financing payments have to be excluded from NOPLAT. R&D is an asset. R&D expenses that are attributable to the current year should be included, but that part of R&D that is actually an investment should be excluded. 28 Firms that are highly leveraged will pay lower taxes because of the tax deductibility of interest. In computing NOPLAT, this effect of debt on taxes must be eliminated. To compute operating taxes, we take reported taxes, subtract tax payments on interest income and add back the tax shield on interest expense, as well as on the operating lease interest expense. The tax effects of each non-operating item can be computed by multiplying each line item dollar amount by the company’s marginal tax rate (the amount of tax saved if taxable income fell by a dollar). This marginal tax rate is essentially the sum of the statutory tax rate on federal and state income, and can be found in the firm’s 10-K statements. The firm’s reported taxes can be different from the actual taxes paid because firms are allowed to compute depreciation, provisions for liabilities etc. differently for reporting and for tax computation purposes. Hence we need to subtract from reported taxes, the change in deferred tax liabilities to get the correct amount of cash taxes paid. For NOPLAT computation, however, using the statutory tax rate should resolve this issue as well. 29 Equals investment in PP&E less the book value of any PP&E sold. Net Capex is estimated by taking the change in net property, plant and equipment and adding in depreciation; we can also use the number provided in the Statement of Cash Flows. Capex should not be computed by taking the change in gross PP&E because this quantity will drop when companies retire assets (which has no cash implications). Hence change in gross PP&E often understates the actual amount of capital expenditures. -20,000,000 -40,000,000 -60,000,000 -80,000,000 -100,000,000 11/1/2008 6/1/2008 1/1/2008 8/1/2007 3/1/2007 10/1/2006 5/1/2006 12/1/2005 7/1/2005 2/1/2005 9/1/2004 4/1/2004 11/1/2003 6/1/2003 1/1/2003 8/1/2002 3/1/2002 10/1/2001 5/1/2001 12/1/2000 7/1/2000 2/1/2000 9/1/1999 4/1/1999 11/1/1998 6/1/1998 1/1/1998 8/1/1997 3/1/1997 10/1/1996 5/1/1996 12/1/1995 30 FCF 60,000,000 40,000,000 20,000,000 0 FCF 11/1/2008 6/1/2008 1/1/2008 8/1/2007 3/1/2007 10/1/2006 5/1/2006 12/1/2005 7/1/2005 2/1/2005 9/1/2004 4/1/2004 11/1/2003 6/1/2003 1/1/2003 8/1/2002 3/1/2002 10/1/2001 5/1/2001 12/1/2000 7/1/2000 2/1/2000 9/1/1999 4/1/1999 11/1/1998 6/1/1998 1/1/1998 8/1/1997 3/1/1997 10/1/1996 5/1/1996 12/1/1995 31 Net Capex 160,000,000 140,000,000 120,000,000 100,000,000 80,000,000 60,000,000 Net Capex 40,000,000 20,000,000 0 11/1/2008 6/1/2008 1/1/2008 8/1/2007 3/1/2007 10/1/2006 5/1/2006 12/1/2005 7/1/2005 2/1/2005 9/1/2004 4/1/2004 11/1/2003 6/1/2003 1/1/2003 8/1/2002 3/1/2002 10/1/2001 5/1/2001 12/1/2000 7/1/2000 2/1/2000 9/1/1999 4/1/1999 11/1/1998 6/1/1998 1/1/1998 8/1/1997 3/1/1997 10/1/1996 5/1/1996 12/1/1995 32 Net Capex/Sales 0.14 0.12 0.1 0.08 0.06 Net Capex/Sales 0.04 0.02 0 -0.05 12/1/2008 8/1/2008 4/1/2008 12/1/2007 8/1/2007 4/1/2007 12/1/2006 8/1/2006 4/1/2006 12/1/2005 8/1/2005 4/1/2005 12/1/2004 8/1/2004 4/1/2004 12/1/2003 8/1/2003 4/1/2003 12/1/2002 8/1/2002 4/1/2002 12/1/2001 8/1/2001 4/1/2001 12/1/2000 8/1/2000 4/1/2000 12/1/1999 8/1/1999 4/1/1999 12/1/1998 8/1/1998 4/1/1998 12/1/1997 8/1/1997 4/1/1997 12/1/1996 8/1/1996 4/1/1996 12/1/1995 33 Working Capital/Revenues 0.3 0.25 0.2 0.15 0.1 0.05 0 1/1/1995 5/1/1995 9/1/1995 1/1/1996 5/1/1996 9/1/1996 1/1/1997 5/1/1997 9/1/1997 1/1/1998 5/1/1998 9/1/1998 1/1/1999 5/1/1999 9/1/1999 1/1/2000 5/1/2000 9/1/2000 1/1/2001 5/1/2001 9/1/2001 1/1/2002 5/1/2002 9/1/2002 1/1/2003 5/1/2003 9/1/2003 1/1/2004 5/1/2004 9/1/2004 1/1/2005 5/1/2005 9/1/2005 1/1/2006 5/1/2006 9/1/2006 1/1/2007 5/1/2007 9/1/2007 1/1/2008 5/1/2008 9/1/2008 34 Other Operating Liabilities/Revenues 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 1/1/1995 5/1/1995 9/1/1995 1/1/1996 5/1/1996 9/1/1996 1/1/1997 5/1/1997 9/1/1997 1/1/1998 5/1/1998 9/1/1998 1/1/1999 5/1/1999 9/1/1999 1/1/2000 5/1/2000 9/1/2000 1/1/2001 5/1/2001 9/1/2001 1/1/2002 5/1/2002 9/1/2002 1/1/2003 5/1/2003 9/1/2003 1/1/2004 5/1/2004 9/1/2004 1/1/2005 5/1/2005 9/1/2005 1/1/2006 5/1/2006 9/1/2006 1/1/2007 5/1/2007 9/1/2007 1/1/2008 5/1/2008 9/1/2008 35 Other Assets/Revenues 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 36 Valuet = NOPLATt+1(1-g/ROIC)/(WACC-g) Forecast long-term ROIC, growth rate and WACC. Forecast FCF components period-by-period for the forecastable future (5 years?) Compute NOPLAT for the five years. Compute IC for the five years. Use growth rate estimate to get NOPLAT for the sixth year and derive terminal value. Get present value of firm. Deduct value of debt and other liabilities to get equity value. Divide by number of shares outstanding to get stock price.