Cash Flow Equity Valuation
Chris Argyrople, CFA
Concentric LLC
Enterprise Valuation &
Cash Flow Analysis
(Continued)
1
Reminder to Review Paine Webber
Research: Chris Dixon
• Review Paine Webber’s Free Cash Flow
Calculation
2
Greater Fool Theory of Investing
John Maynard Keynes said:
Imagine a beauty pagent, where the judges knew
that, because beauty was in the eye of the beholder,
the contest would be decided on the judge’s
perception of beauty. Someone who wanted to
predict the outcome would have to assess the
judge’s perceptions, not the contestant’s beauty. As
a result, your vote for the winner would not depend
on who you thought was prettiest. Instead, your
vote would depend on how you thought the judges
would vote. THIS IS THE GREATER FOOL
3
THEORY.
Suggestion: Don’t use
Greater Fool Justification
• Using greater fool justification does not
add value, although it may work on
occasion
• Suggestion: Analyze Cash Flows,
Business Models, & Management Teams
4
Topic Review
• What Earnings are Relevant?
– Trailing 4 Quarters
– Last Quarter times 4
– Forward 4 Quarters
– Current Calendar Year
– Current Fiscal Year (Fiscal Year <> Calendar
Year)
– 5 year Average Earnings (cyclicals)
– Peak Earnings (cyclicals)
– Five Year Forecasted Earnings
5
Valuation: Cash Flow Ratios
• TEV / EBITDA = Firm Value to OCF
• TEV / Revenue = Firm Value to Revenue
• EBITDA / Sales = Cash Flow Margins
• MV Equity/FCF = “Real” P/E,
Free Cash Flow (FCF)
Mult.
• EBITDA / Interest = Interest Coverage
• Debt / EBITDA = Leverage Indicator
6
Valuation Review
• All ratios are based on a similar concept:
• Numerator: What you are paying
• Denomin: What you get
• TEV : The Value of the Firm (Price Paid)
• EBITDA: What you get (Cash Flow
Bought)
• P : Stock Price Paid
• E : Earnings Bought
7
LBOs: Magnifies Directional Effects
Start
Sales
500
Costs
400
EBITDA
100
% Chg, CashFlow
Incr.
520
416
104
+4%
Decr.
480
384
96
- 4%
MV Debt
700
MV Equity
100
TEV
800
% Chg Stock Price
700
132
832
+32%
700
68
768
-32%
Unlevered
520
416
104
+4%
0
832
832
+4%
8
LBOs: Reasons Why
• Leverage Spurs Efficiency Gains
• People perform when they have no option
BUT to perform
• Gains from leverage are huge (to equity)
• Managers can control the firm in an LBO
• No money down strategy (where else can
you buy a company without money)
9
Cheap Stocks & Catalysts
• A stock that appears tantilizingly cheap on
a valuation basis is often very cheap for a
good reason.
• Find the reason that it is cheap.
• YOU NEED A CATALYST TO NARROW
THE GAP BETWEEN YOUR FAIR VALUE
ESTIMATE & THE CURRENT PRICE
• Without a near-term catalyst, the stock
could remain cheap indefinitely.
10
This Lecture -- More Cash
Flows
• Finer points of Free Cash Flows
• How Free Cash Flows work
• Alternate definitions of Free Cash
• My thoughts on M&M and Finance Theory
• How Multiple Changes affect a Stock
11
Free Cash Defined 2 Ways
• FCFE = NI + D&A - Capex
• FCFE = EBITDA - Interest - Taxes - Capex
• Subtract:
– Preferred Dividends
– Capitalized Interest (Usually)
– SEPARATE MAINTENANCE CAPEX FROM
EXPANSION CAPEX. THIS IS KEY.
– Add back noncash taxes shown on income
statement.
12
Free Cash Flow: Finer Points
• Should You Subtract?
– Principal Paydowns?
– Preferred Dividends?
– Proceeds of Asset Sales?
NO
YES
NO
• WHY?
– Principal payments result in value transfer to
equityholders. Not different than no payout and
adding free cashflow to balance sheet cash
– Treat Preferred Dividends as Debt
– Asset Sales not Generated from ongoing
13
operations
Include Working Capital in FCFE?
• Should working capital be included in the
Free Cash Flow calculation?
Answer:
• YES, especially if growth requires extra
investment in working capital.
• NO, if growth is independent of an
investment in working capital.
Suggestion:
• Normalize (smooth out) Working Capital
14
The Maintenance Capex
Problem
• Some students have trouble determining
maintenance capex.
• Ask the company (IR department)
• Or, to be conservative, use all PP&E
expenditures. This is the most
conservative way (for the stock buyer).
• In general, I include all PP&E (Capex)
unless I know about specific expansion
projects.
15
Value = PV(Terminal Bal. Sheet)
• Two approaches to valuation
– 1) DCF Method
– 2) Asset Value Method
• Think, for a moment, that a stock is worth
the Present Value of the Terminal Balance
Sheet. Why?
• Think of personal finance.
• Your personal net worth is your personal
balance sheet.
16
Value = PV(Terminal Bal. Sheet)
• So, your Net Worth = Assets - Liabilities
• Companies are the same, but you must
use Economic Balance Sheets, not
Accounting Balance Sheets.
• Economic Bal. Sheet = f(future cash flows)
• But, at Terminal time t:
• Valuet= Assetst - Liabilitiest
• FREE CASH FLOW DOMINATES
Terminal Valuet -- LT, Cash Flow doesn’t 17
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???
18
One Point Multiple Change
Sales
Costs
EBITDA
500
400
100
Start
MV Debt
600
MV Equity
200
TEV
800
% Chg Stock Price
MUST KNOW THIS
Effect of One Multiple
Point Change
Upward
Down
600
600
300
100
900
700
50%
-50%
19
Adjusting TEV for Off B/S Items
• Enterprise Value should be adjusted for off
Balance Sheet Items
• TEV = Debt + Equity - Cash + Off B/S Liab
- Hidden Assets (off B/S assets)
• The Most Common off B/S Liability is
Rentals. Remember the lease vs. buy
decision? Leasing is functionally
equivalent to taking on debt. Thus,
analysts should capitalize rent expense.
20
Off B/S Example
• TEV = 550
• Rent Expense is as follows
– year 1 : 20
year 2: 20
year 3: 20
– year 4 : 22
year 5: 22
– bond rate of 9%
– PV(rent) = 20 / 1.09 + 20 / 1.092 + 20 / 1.093
+ 22 / 1.094 + 22 / 1.095
– IT IS YOUR CALL WHETHER YOU DISCOUNT A
TERMINAL VALUE HERE
21
Standard vs. Adjusted TEV
Adjusted TEV
Debt
+ MV Equity
- Cash or Working Capital
+ Capitalized Rentals
- Hidden Assets
= Adjusted TEV
Compare Adjusted TEV to EBITDAR (pre- rentals)22
Capitalizing Rent Expense
• Determine the Correct amount of years to
discount (no hard & fast rule here)
• Discount annual rent expense at the
company’s LT Borrowing rates
• Add the PV of the Rent expense to TEV
• I Call this Adjusted TEV
• Thus, you will have 2 calculations,
– 1) STANDARD TEV
– 2) ADJUSTED TEV
23
Cash Flow Capitalization Table
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
5
4.33
4.21
4.10
3.99
3.89
3.79
3.70
3.60
3.52
3.43
3.35
3.27
3.20
3.13
3.06
2.99
10
7.72
7.36
7.02
6.71
6.42
6.14
5.89
5.65
5.43
5.22
5.02
4.83
4.66
4.49
4.34
4.19
15
10.38
9.71
9.11
8.56
8.06
7.61
7.19
6.81
6.46
6.14
5.85
5.58
5.32
5.09
4.88
4.68
20
12.46
11.47
10.59
9.82
9.13
8.51
7.96
7.47
7.02
6.62
6.26
5.93
5.63
5.35
5.10
4.87
25
14.09
12.78
11.65
10.67
9.82
9.08
8.42
7.84
7.33
6.87
6.46
6.10
5.77
5.47
5.20
4.95
30
15.37
13.76
12.41
11.26
10.27
9.43
8.69
8.06
7.50
7.00
6.57
6.18
5.83
5.52
5.23
4.98
24
EBITDAR Example
Sales
Costs
EBITDAR
Rentals
EBITDA
750
(500)
250
(50)
200
TEV = 2000
TEV / EBITDA = 2000 / 200 = 10 X
Adj TEV = 2000 + 6.71 * 50 = 2335.5
Adj TEV / EBITDAR = 2335.5 / 250 = 9.34 X25
EBITDAR Changes:
• EBITDAR Will alter your debt ratios.
• Firms with no debt still can have huge
rental / lease commitments.
• EBITDAR may alter the TEV ratio, but
usually not significantly.
26
What are “Hidden Assets” ??
Hidden Assets Include:
1. Shares in other Firms Owned
2. Real Estate or other non-EBITDA
producing assets that could be sold off
piecemeal
27
Windfall of Ignorance
• The Bull Markets have Rewarded Ignorant
Managers and Young Unsophisticated
Investors. With Markets rising 20% to
30% per year, anything that prevented you
from purchasing a stock was painful.
• Including Warrants in the TEV
Capitalization usually makes justifying
purchase a bit more difficult.
• The Next 15 years WILL NOT reward fools
28
Most Analysts Ignore Warrants
• Most Wall Street Analysts Ignore the
Dilutive Effect of Options and Warrants in
the TEV Calculation
• Why? Simple. They are Incentivized to
Recommend Stocks, thus they
Conveniently Ignore the Dilutive Effect of
Warrants. This Ignorance makes TEV
based ratios more attractive, and it makes
the stocks appear cheaper than they are.
29
More TEV Bells & Whistles
• Management Options and Warrants
Outstanding Prove to be a Small Hassle
• One Method: Add All Potentially Dilutive
Securities to Shares Outstanding &
Subtract the Resulting Cash Inflow from
TEV
• Example: Debt = 10 , Cash = 2, Shares =
20, Stock = $11, Warrants = 1 struck at $4
• TEV = 10 + (20 + 1) * 11 - 2 - 1 * 4 = 235
30
Method 2: Delta Weight Options
• Delta Weight all Option and Warrant
Traunches, then Adjust TEV
Example: Stock Price = $10
500,000 Warrants struck at $4
500,000 Warrants struck at $10
1,300,000 Warrants struck at $15
Deltas
Cash Inflow =
1 * 0.5 * $4 + 0.5 * 0.5 * 10 + 1.3 * 0.3 * 15
31
Model Formatting Tips
Chris Argyrople
Delta Partners
32
Model Formatting Tips
• Full Years on Right, Quarters on Left
• Decimals ($ millions) make it easier to
read (can keep more digits hidden)
• Underline Totals
• Full Years only : Partial Years no good
• Add Standard Ratios like DuPont Ratios
(look in textbook for ratios)
• Break out #’s by business line if possible
• Look for rationality in your ratios !!
33
Model Formatting Tips
• Graphs and Charts help !!
• Year-over-year growth is Key
• EBITDA Margin = EBITDA / Revenue
(THIS IS A KEY METRIC OF MARKET
POWER)
• Quarterly TEV / EBITDA (or any other ratio
is usually meaningless)
• Financial Statements on 1 page each
(need headers)
• KEY: Want to be able to see trends !!!
34
Comments on HW #1
• Presentation & Clarity are key
• Add: Gross Margin%, SG&A%,
Depreciation%, EBITDA%, EBIT%, PBT%,
PAT%
• Calc. y-o-y change in EBITDA, Sales, NI etc.
• Have an easy to read Valuation Box
• 1) Prepare an EPS forecast. 2) State fcst.
assumptions, 3) compare EPS to consensus
(on AOL, or call me), 4) measure growth, 5)
state what you think the stock is worth and
why.
35
Helpful Hints on Forecasting
• Call Investor Relations (IR) (I can give you the
phone numbers)
• Graph the stock and handwrite what drove major
price moves. This will help you understand what
drives this particular stock.
• Try to break out revenues & cost by product line
or division (sometimes this is impossible)
• Net out finance subsidiaries
• Use annual TEV / EBITDA & Revenue -- NEVER
QUARTERLY
36
Helpful Forecasting Hints
• Partial years are not too useful (2 or 3 quarters)
• Round off decimals and state units (ie $millions
etc.)
• Football important numbers
2.0
• Add verbal comments (example: Duracell)
• Use Excel / Lotus fit to page commands for
formatting
• Avoid submitting work with n/a or div#0 etc
37
Helpful Forecasting Hints
• Add Annual numbers going as far back as
possible. Quarterly numbers are good, but
annual numbers are imperative.
• Ratios are key: Debt Ratios, DuPont
Ratios, Inventory Ratios etc.
• Start collecting fundamental data:
– Market Share
– Insider holdings
– Units & Price
(market size)
38
Historical Presentation
• Have a table that has TEV/EBITDA and
P/E going back historically (board
example)
• Have a line for every possible margin
• Graph the stock price and handwrite in
explanation for significant moves. This will
help you understand what drives this
company’s valuation (USA Waste
example)
• At top, have a nice summary table
39
showing: price, shares, debt, ebitda, ni, fcf,
Idea Generation
• There are many viable methods of
generating stock selection ideas.
• My Method: follow a few stocks, get to
know them well, trade < 13 times per year.
Just do your best ideas.
• Suggestion: screen for ideas.
• Why? Harness the power of the computer.
Generate lots of candidates that meet
selected criteria.
40
My Thoughts on Screening
• If you can’t follow an industry, and you
don’t get good “tips”, then screen for
candidates.
• My rule:
30% twelve-month E(r) for stocks in your
industry(s) or core competency.
50% twelve-month E(r) for stocks outside
area of expertise.
HIGHER HURDLE OFFSETS LESS
KNOWLEDGE
41
Split Adjust Historical Shares
•
•
•
•
Intel:
4q96 1q97
Shares
823 1639
NI
1910 1983
EPS
2.32 1.21 (4q96 is
WRONG)
• Should be = 1910 / (823 * 2) = $1.16
42
Why the EBITDA Framework?
• Why not just use Cash Flow from Operations
(CFO) instead of EBITDA and Cash Flow before
Financing instead of Free Cash Flow?
• EBITDA normalizes for capital structure
differences, allowing for apples to apples. To
normalize CFO, could add back interest, taxes,
and non-operating items to CFO.
• Cash Flow pre-Financing is a good proxy for
Free Cash Flow (maint. capex only). Deduct
Pref Dividends and non-recurring charges.
43
Helpful Crosschecks: Barrons
Example
Barrons, September 15, 1997 article
AOL has long claimed 9 million customers.
Revenue / customer / month = $19.95
Every quarter has 3 months
Last quarterly Revenue = $385.6 million
$385.6 / ( 3 * 19.95 ) = 6.44 million
customers
So, WHY THE DISCREPANCY???
44
America Online Example,
(contd.)
AOL is trading a subsidiary valued at $425
million for a Compuserve’s 2.6 million
customers & $175 million cash. Netting
out the cash, AOL is getting 2.6 million
subs for $250 million. The
price/subscriber works out to $96.15.
So, at $80 per AOL share, AOL is trading at
$1204.84 per customer -- a big
discrepancy versus the $96.15 that they 45
paid !!!
AOL Conclusion
1) AOL potentially lying about 9 million subs
2) AOL got a good deal on Compuserve
OR
3) AOL overvalued (worth only Compuserve)
So, it can go either way.
a) Smart Management, Accretive Deal
b) Lying Management, Overvalued Stock
46
Measure the Fundamentals
• Media & Telecommunications firms:
Market Value / Subscriber
• Airlines: Cost / Available Seat Mile
• Retailers: Average Sales / Square Foot
versus Market Value / Square
Foot
or Market Value / Store etc.
• Hotels: Market Value / Room
• Autos: Cost and Market Value / Unit
There are many metrics that can be used
47
Valuation -- Relative Value
Relative Value Matrix Helps Stockpicking
IBM GATE
DELL
TEV / EBITDA
7
11
15
P/E
16
27
35
P/Book
1.9
4.0
3.5
P/Sales
1.1
4.4
5.1
Yield
2.3% 0.0
0.0
Growth Estimate
12% 16%
21%
48