Valuation
How much are those cash flows
worth?
Standard Techniques
•
•
•
•
Book Value
Earnings Multiple
Liquidation Value
Discounted Cash-Flow
Graham,J.andH.Campbell,2001,“TheTheoryandPracticeofCorporateFinance:EvidencefromtheField,”Jour
nalofFinancialEconomics,60(2-3),187-243.
Book Value
Firm (Enterprise) Value = Book
Value of Assets
• Still one of the most widely used and accepted methods
due to certification by accountants, while also being
perhaps the most flawed.
• Based on historic numbers, ignores the future.
• Based on accounting numbers that are potentially flawed
and subject to manipulation
• Ignores intangibles like customer loyalty.
• Ignores risk
• The price paid for an asset may have no relation to its
value in operation or if it had to be sold or replaced
(especially as time passes).
General Motors
Balance Sheet
PERIOD ENDING
31-Dec-03
31-Dec-02
31-Dec-01
Total Current Assets
86,261,000
57,118,000
47,186,000
198,778,000
189,859,000
183,661,000
72,594,000
36,152,000
39,724,000
3,790,000
6,992,000
10,006,000
970,000
7,619,000
6,921,000
-
-
-
Other Assets
58,924,000
41,372,000
14,177,000
Deferred Long Term Asset
Charges
27,190,000
32,759,000
22,294,000
Long Term Investments
Property Plant and Equipment
Goodwill
Intangible Assets
Accumulated Amortization
Total Assets
448,507,000
371,871,000
323,969,000
Common Stock (Equity) Book
Value
Easy to Calculate
• Case 1: Only common stock outstanding
– Book value equals owner’s equity.
• Case 2: Common and preferred shares
outstanding
– Book value equals owner’s equity minus book
value of the preferred.
GM Continued
No Preferred Stock
Balance Sheet
PERIOD ENDING
31-Dec-03
31-Dec-02
31-Dec-01
Misc. Stocks Options Warrants
-
-
-
Redeemable Preferred Stock
-
-
-
Preferred Stock
-
-
-
Common Stock
937,000
1,032,000
1,020,000
13,421,000
10,198,000
9,463,000
Treasury Stock
-
-
-
Capital Surplus
15,185,000
21,583,000
21,519,000
Other Stockholder Equity
-4,275,000
-25,999,000
-12,295,000
Total Stockholder Equity
25,268,000
6,814,000
19,707,000
Stockholders' Equity
Retained Earnings
Pitney Bowes Inc (PBI)
Has Preferred Stock
Stockholders' Equity
Misc. Stocks Options Warrants
-
-
-
Redeemable Preferred Stock
-
-
-
Preferred Stock
1,334
1,456
1,627
Common Stock
323,338
323,338
323,338
Retained Earnings
4,057,654
3,848,562
3,658,481
Treasury Stock
-3,313,027
-3,198,414
-2,943,690
Capital Surplus
Other Stockholder Equity
Total Stockholder Equity
18,063
1,087,362
-
6,979
-121,615
-155,380
853,327
891,355
Comparable Companies
Earnings Multiples
• Most common method for valuing assets:
absent market values.
• Simple but with many potential pitfalls.
Market Value of Company
V / EBIT 
Earnings Before Interest and Taxes
Debt + Equity

.
Earnings Before Interest and Taxes
From V/EBIT to Market Value
 V 
Market Value of Asset = Comp 
  EBIT.
 EBIT 
• Obtain Comp(V/EBIT) by using the valueto-earnings ratio of a “comparable” traded
company (or the average from a group of
comparable companies).
• Use EBIT from the firm or asset you are
valuing.
Advantages of V/EBIT
• Easy.
• Makes intuitive sense.
• If your comparables are really comparable
then it should work.
Problems with V/EBIT
• Earnings used to calculate V/EBIT are
accounting figures.
– To the degree the earnings are subject to
manipulation so is EBIT.
• Earnings are subject to short-term fluctuations.
– Looking for “long run” earnings.
– Might need to adjust earnings for extraordinary items.
• Be careful! Some firms have “extraordinary” items every
year.
• V/EBIT assumes all companies will generate the
same growth.
Other Widely Used Multiples
• Price-to-Earnings
• Price-to-Sales
– Popular for firms with negative earnings.
• Market-to-Book value
– Also popular for firms with negative earnings.
• Asset Value-to-EBIT
• Asset Value-to-Revenues
– Also popular for firms with negative earnings.
Price-Earnings Ratios
• Very, very popular for equity valuation!
• One major pitfall when making
comparisons across companies – DEBT!
– The higher a firm’s D/E(quity) ratio the higher
the P/E(earnings) ratio.
– Note:
• In D/E the “E” stands for Equity.
• In P/E the “E” stands for Earnings.
• Standard terminology, you just have to know which
one is which.
P/E and Debt Example
• A firm has an equity value of 10, earnings of $1,
and no debt.
– P/E = 10.
• Assume the tax rate is TC. The firm now issues
enough debt so that it pays $1/(1-TC) in interest.
Earnings (which are calculated after interest and
tax payments) now equal 0.
– New Earnings = 1 – 1/(1-TC) + TC/(1-TC) = 0
• So long as the price of the stock does not go to
zero (which it will not if there is any expected
growth in the firm) the P/E will equal ∞.
• General rule: More D → Higher P/E.
Liquidation Value
• Useful if you are really thinking of
liquidating the firm.
– Ignores any value from future operations.
– Do not use if the firm will continue as a going
concern.
– Useful if you want to know if the firm is worth
more dead or alive.
Discounted Cash Flow Valuation
1.
2.
3.
4.
5.
6.
Forecast free cash flows up to some terminal date.
Estimate the cost of capital (a.k.a. discount rate).
Estimate terminal value (a.k.a. continuing value) which
equals the value after the terminal date.
Discount to the present.
Add value of excess cash (proxy for marketable
securities) and other non-operating assets.
Deduct debt and preferred stock to get the market
value of the common shares.
Example
• New Haven Tea company expected to
produce free cash flows of 200 next year
(year 1).
• Expect 10% cash flow growth per year up
until year 7. Thereafter expected growth
of 2% per year.
• The discount rate is 8%.
Solution
• First seven years is a growing annuity with
an initial value of 200 and a growth rate of
10%.
Year
1
2
3
FCF
200
200x1.1 242
= 220
4
5
6
7
266.2 292.8 322.1 354.3
• Terminal value is a perpetuity starting in
year 8 with an initial value of 354.3x1.1 =
389.74 and a growth rate of 2%.
Solving for the PV
7
PV  
t 1
200 1.1
t 1
t
1.08

Terminal value

1.08 .08  .02 
Value of the free cash flows
up to the terminal date
200 1.1
7
7
7

t 1
.
200 1.1
t 1
t
1.08
389.74

.
7
1.08  .06
.
Three Main Questions
• What are the free cash flows?
• How to estimate the terminal value?
• How do you calculate the cost of capital?
Free Cash Flow I
Arturo likes to calculate FCF via:
Operating Profit (=EBIT)
- Taxes on EBIT
+ Increase in deferred taxes
= Net Operating Profit Less Adjusted Taxes (=NOPLAT)
+
+
+
Depreciation
Increase in Working Capital Requirements
Capital Expenditures
=
Free Cash Flow
Free Cash Flow II
An alternative route (popular on the street) is:
EBIT
+ Depreciation and Amortization
= EBITDA
EBITDA
+ Net Capital Expenditures
+ Change in Working Capital
- Cash Taxes Paid
- Cash Interest Paid
= Free Cash Flow
From the Cash Flow Statement:
Capital Expenditures + Sale of
Assets = Net Capital
Expenditures
A Note On NOPLAT
• NOPLAT is supposed to represent the free cash
flow to the firm before capital investment.
• My preference is to calculate “NOPLAT” as FCF
+ Cash Interest Paid + Net Capital Expenditures.
• Just remember if you use my version it is not
really “NOPLAT.” A better term would be
FCFBCINCE, but that acronym is pretty hard to
pronounce!
• In the notes that follow where you see the
acronym NOPLAT feel free to substitute
FCFBCINCE.
Working Capital I
(Investment Needed to Operate the Company)
Arturo likes to use:
Operating Cash
+ Accounts Receivable
+ Inventories
- Accounts Payable
- Net Accruals
= Working Capital Reserves
Working Capital II
For changes in working capital Catherine Nolan (a
bond analyst and my wife) likes to use:
Changes in Accounts Receivable
+ Changes in Inventories
+ Changes in Accounts Payable
= Changes Working Capital Reserves
Why the Difference?
• Catherine Nolan’s argument.
– Operating cash is what you want to back out, so
including it is basically double counting.
• In fact it is often double counting. If a firm spends money on
administrative costs and pays with a check, the SG&A
account goes up and the cash account goes down.
– Net Accruals can include a number of non-cash items
and can be easily manipulated. You are better of
ignoring them.
– Working capital is the difference between what you
owe people (accounts payable) and what you are
hoping to get paid for (accounts receivable and
inventories).
Forecasting Free Cash Flows
1. Forecast Sales
A. Project size of the target market.
B. Project market share.
2. Examine historical relationships between
sales and other components of free cash
flow.
A. Be careful here! Are you sure the firm will
continue along its current trajectory?
Forecasting Free Cash Flows
(continued)
3. Check reasonableness of forecasts.
A. What do the forecasts assume about the ability of
the company to generate “abnormal” (economic)
profits?
B. Gross domestic product grows at a real rate of
3.41% in a typical year (1929-2003). That means in
the long run no firm can grow faster than this.
i.
ii.
Are your long run estimates consistent with this?
What do your estimates say about the firm’s long run
relative market share?
iii. What do your estimates say about the long run size of the
industry relative to the rest of the economy or related
industries? For example, if you assume
BookUsHotels.com will eventually produce $X in sales you
must also assume that the hotel industry will as well.
Forecasting Free Cash Flows
(continued)
4.
Discount Rates
A. Be consistent in dealing with free cash flows and
discount rates.
B. Discount rates should reflect market and not firm
specific risk.
i.
ii.
Common mistake is to increase the discount rate in
response to firm specific risk.
Example: A pharmaceutical firm has a 25% chance of
making a breakthrough. This does not influence the
discount rate. It does influence the expected future cash
flows. In this case PV = .25(PV w/ breakthrough) + .75(0).
Reasonable Forecasts Some
Guidelines
• What are the assumptions about the
company’s ability to create economic
profits?
• Key drivers for economic growth are the
Return on Investment Capital (ROIC) and
the growth rate (g).
Calculating ROIC and g
NOPLAT
ROIC 
.
Invested Capital
Invested Capital = Long Term Assets + Working Capital
Requirements
g  ROIC Investment Rate
where:
Net Investment
Investment Rate 
.
NOPLAT
The accuracy of your valuation will depend upon the degree to
which you accurately forecast ROIC and g.
Valuation and Growth a Few
Examples
• All of the following firms are perpetual
growth firms.
• They use a constant investment rate
(a.k.a. “plowback”) rule.
• They have a constant ROIC (a.k.a. “return
on equity”).
Example 1 – Base Line No Growth Firm
Investment Rate
ROIC
0.00%
20.00%
Growth Rate
Discount Rate
0.00%
10.00%
Year
NOPLAT
Net Investment
Free Cash Flow
PV(Free Cash Flow) =
0
1
2
3
4
5
100
100
100
100
100
100
0
0
0
0
0
0
100
100
100
100
100
100
100 + 100/.1 = 1100
Example 2 – Value Creating Firm
Investment Rate
25.00%
ROIC
25.00%
Growth Rate
Discount Rate
Year
NOPLAT
6.25%
10.00%
0
100
1
2
3
106.25 112.89
119.95
4
5
127.44 135.41
Net Investment
25
26.56
28.22
29.99
31.86
Free Cash Flow
75
79.69
84.67
89.96
95.58 101.56
PV(Free Cash Flow) =
75 + 79.69/(.1-.0625) = 2200
33.85
Example 3 –Growing But No Value
Added Firm
Investment Rate
25.00%
ROIC
10.00%
Growth Rate
Discount Rate
2.50%
10.00%
Year
0
1
2
3
4
5
100
102.5
105.06
107.69
110.38
113.14
Net Investment
25
25.63
26.27
26.92
27.6
28.29
Free Cash Flow
75
76.88
78.8
80.77
82.79
84.86
NOPLAT
PV(Free Cash Flow) =
75 + 76.88/(.1-.025) = 1100
ROIC vs. Discount Rate
What it Implies
• ROIC > Discount Rate
– Normal. Firm earns an above average return on
some investments. Should stop investing when the
marginal investment has a return equal to the
discount rate.
• ROIC = Discount Rate
– Likely the firm is over investing! Its investments with
returns below the interest rate are offsetting those
above. Other possibility, all investments by the firm
earn exactly the rate of interest. Yea, sure.
• ROIC < Discount Rate
– Value destruction. Buy out management and stop the
firm before it invests again!
Example 4 – No Growth, Value
Destroying Firm
Investment Rate
25.00%
ROIC
0.00%
Growth Rate
0.00%
Discount Rate
10.00%
Year
0
1
2
3
4
5
100
100
100
100
100
100
Net Investment
25
25
25
25
25
25
Free Cash Flow
75
75
75
75
75
75
NOPLAT
PV(Free Cash Flow) =
75+75/.1 = 825
Example 5 – Growing, Value
Destroying Firm
Investment Rate
25.00%
ROIC
5.00%
Growth Rate
1.25%
Discount Rate
Year
NOPLAT
10.00%
0
100
1
2
3
101.25 102.52
103.80
4
5
105.09 106.41
Net Investment
25
25.31
25.63
25.95
26.27
26.60
Free Cash Flow
75
75.94
76.89
77.85
78.82
79.81
PV(Free Cash Flow) =
75+75.94/(.1-.0125) = 942.86
Ways of Estimating Earnings
Growth
• Look at the past.
– The historical growth in earnings per share is a typical
starting point.
• Look at what others are projecting.
– Other analysts may be using information you do not
have. It is often useful to know what their estimates
are.
• Look at fundamentals.
– How much are they investing?
– What is the return on their investment?
Estimating the Firm’s Terminal
(Continuing) Value
• Free cash flows (FCF) grow at a constant
rate after the forecast horizon.
– Used far more often than any other method.
– Just remember, in the long run NO firm can
grow faster than GDP!
FCFT 1
TV 
rg
r = discount rate, g = growth rate, T = end of the
forecast horizon
Terminal Value Estimation
Constant Growth – Continued
• Be careful when you use this formula, as your CAPEX in
the FCF calculation should match the growth rate you
choose.
– This is once again related to the ratio Sales/Fixed Assets.
– One can show that the previous formula can be written in the
following way:
g 

NOPLATT 1 1 

ROIC

,
TVT 
r g
ROIC = long-term return on newly invested capital.
This formula may be easier to use than the previous
formula since you do not have to estimate CAPEX.
Instead it is estimated for you from g and ROIC.
Estimating TV’s
Convergence Approach
• Assumes that competitive forces will
ensure that after the forecast horizon,
returns on the firm’s new investments will
equal the discount rate (r).
– ROIC = r and so,
NOPLATT 1
TVT 
r
Estimating TV
Accounting Values
• Terminal value = Book Value of Invested
Capital
– Backward looking.
– Easy to use.
Pitney Bowes Inc (PBI)
Balance Sheet
Assets
Total Current Assets
2,513,175
2,552,625 2,556,608
Long Term Investments
3,189,283
3,246,083 3,236,258
Property Plant and Equipment
1,070,232
1,046,935
1,008,270
Goodwill
956,284
827,241
635,873
Intangible Assets
203,606
-
-
-
-
-
Accumulated Amortization
Other Assets
Deferred Long Term Asset Charges
Total Assets
958,808
1,059,430
881,462
-
-
-
8,891,388
8,732,314
8,318,471
Calculating Terminal Asset Value
from Projected Book Value
• PBI grew at about 5% in 2002 and 2% in
2003.
– Average growth rate of 3.5% is not
unreasonable.
– In 2003 total assets (book value) equaled
8,891,388.
– Suppose want TV as of 2010 (seven years
later) = 8,891,388x1.0357 = 11,312,329.
Economic Value Added
(EVA)
EVA = Invested Capital x (ROIC – r)
• What is this?
1. A popular buzz word!
2. The value the firm created via its
investments. Remember, firms should
invest so long as the marginal return on
equity (ROIC) exceeds the interest rate.
This means a typical firm should have a
positive EVA.