Valuation
Valuation
1
March 16
Contents
• Introduction – Fundamentals of Where Value Comes From
• Discounting and IRR Review
• Overview of Alternative Valuation Methods
• Valuation Using Multiples
• Valuation Using Discounted Free Cash Flow
• Valuation Using Projected Earnings and Equity Cash Flow
• Case Studies
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Valuation, Decision Making and Risk
Every major decision a company makes is in one way or another
derived from how much the outcome of the decision is worth. It
is widely recognized that valuation is the single financial
analytical skill that managers must master.
•
Valuation analysis involves assessing
 Future cash flow levels, (cash flow is reality) and
 Risks in valuing those cash flows, whether it be the cash
flow from assets, debt or equity
•
Measurement value – forecasting and risk assessment -- is a
very complex and difficult problem.
•
Intrinsic value is an estimate and not observable
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Reference: Chapter 4
March 16
3
Market Value of Debt, Credit Spreads and Par Value
•
Before thinking about valuation of a company, consider the value of debt
 The par value or the value on the balance sheet does not determine the
value of debt
 Rather the value depends on the future level of cash flows (par value x
coupon rate) and the risk applied to cash flows
 Credit spreads are driven by the risk and can be measured by the One
of the few things we know is that there is a tradeoff between risk and
return.
•
Key idea is to use future cash flows and incremental discount rate in
measuring market value
Reference: Folder on Yield
Spreads
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Measurement of Risk in Financial Models
•
The fundamental issue in any valuation
problem is how to assess the risk of future
cash flow projections.
•
Consider Investment Alternatives A and B,
where A has a higher project IRR than B.
Assume A has a return of 11% and B has a
return of 9%.
•
Project A or Project B would be selected
through assessing the return on the projects
relative to the weighted average cost of
capital for each project. If the WACC for A is
10% and for B is 9.5% then A is selected.
One must computed beta for each
investment.
•
Compute the distributions in cash flow of
project A and project B to equity holders. If
the standard deviation is lower for project B,
then assess the risk relative to the return.
•
Compute the achieved rate of return from the
ability to raise debt and then assess the
return earned on equity. If the return on
equity is greater for B then A, select project
A.
Financial theory
 Financial theory dictates that the
CAPM should be used to compute
the WACC, that the un-levered beta
should be used to estimate equity
returns, that options pricing models
should be used for credit spreads,
debt capacity and covenants.
Mathematical Models
 Mathematical models include beta
adjustments for the CAPM, statistical
models for credit analysis, Monte
Carlo simulation and value at risk.
Practical Market Information
 Practical market information can be
used to gauge required equity
returns, required credit spreads,
required financial ratios to achieve
investment grade rating and other
issues.
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Problems with CAPM
• Ke = Rf + Beta x EMRP
• Difficulty in establishing Rf
• Can’t find Betas
• Betas performed horribly during financial crisis
• EPRM cannot be measured and changes with perceptions over
time
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Problems with Betas – Confirmed by Financial Crisis
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CAPM Post Financial Crisis
• The cost of equity was calculated using the capital asset pricing
model, which is a theoretical financial model that estimates the cost
of equity capital based on a company’s “beta” which is a measure of
a company’s volatility relative to the overall market, a 6% market
risk premium and a relevant predicted beta and risk-free rate. The
public market trading price targets published by securities research
analysts do not necessarily reflect current market trading prices for
Wyeth’s and Pfizer’s common stock and these estimates are subject
to uncertainties, including the future financial performance of Wyeth
and Pfizer and future financial market conditions.
• Academic studies – 2-3%
• Pre-Crisis Bankers – 4-5%
• Historical U.S. premium pre-crisis 6-8%
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Problems with Growth
• Typical assumption that growth equals inflation means world
economy would stop
• Time period before which reach stable growth is impossible to
estimate
• Evidence that sell-side analysts chronically over-estimate shortterm growth rates
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Example of Method 1: Financial Theory
Value Differences from Cost of Capital and Terminal Growth
Base
Low
High
Beta
1.00
1.50
0.75
Rm
5.00%
7.00%
4.00%
Growth
2.00%
0.00%
3.50%
Rf
4.50%
4.50%
4.50%
Ke
Explicit Period
Enterprise Value
Pct Difference
9.50%
7.00
57,556
15.00%
7.00
7.50%
7.00
29,615
-48.5%
102,606
78.3%
Fundamental
parameters
are almost
impossible to
measure
Differences in Beta, Rm and Terminal Growth have an
Immense Effect on the Value of the Investment
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Method 2: Stochastic Mathematics
Case 1: 15% Volatility; 40% Mean
Reversion; 4.5 Long-run Marginal Cost
The probability of earning below
the risk free rate is about 5%
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If only we could measure
these things
Case 2: 25% Volatility; 10% Mean
Reversion; 4.0 Long-run Marginal Cost
The probability of earning below
the risk free rate is about 55%
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Example of Method 3: Debt Capacity
Let Bankers Assess the Risk – That is
Their Job
Overall Project IRR
Leverage
Term
Interest Rate
Value Differences from Debt Capacity
Base
Aggressive Conservative
9.48%
9.48%
9.48%
55.00%
90.00%
31.00%
14.00
20.00
10.00
6.00%
6.00%
6.00%
Cost
Repayment Method
Equity IRR
Average DSCR
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25.6%
1.58
37,000
Level
39,000
Amortizing
36,000
Level
13.05%
2.29
25.61%
1.58
11.84%
3.15
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12
Comparison of Approaches: Which Investment would
you Select
•
•
Project A
Sources and Uses Map
Amount vs EBITDA
Senior Debt
Mezzenaine Debt
Equity
Total
Entry Multiple EV/EBITDA
Transaction Price
8,500
5,000
17,490
30,990
27.4%
16.1%
56.4%
100.0%
IRR
7.3%
10.0%
14.9%
9.80
31,360
Exit Multiple EV/EBIDA
Project IRR
WACC
Economic Return
2.66
1.56
5.47
9.68
Pct
Project B
6.00
12.16%
11.00%
1.16%
Project A has a higher rate of return relative to its cost of capital,
but Project B has a higher equity return
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Valuation Diagram – DCF from Free Cash Flow
• Valuation using discounted cash flows requires forecasted cash
flows, application of a discount rate and measurement of
continuing value (also referred to as horizon value or terminal
value)
Cash Flow
Cash Flow
Cash Flow
Cash Flow
Continuing Value
Discount Rate is WACC
Enterprise Value
Reference: Private
Valuation; Valuation
Mistakes
Net Debt
Equity Value
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Equity Cash Flow, Debt Cash Flow, Free Cash Flow and
Cost of Equity, Cost of Debt and WACC
Equity Cash Flow and Value of Equity :
Dividends less Equity Issued
+
+
Debt Cash Flow and Market Value of Debt :
Net Interest plus Net Debt Payments
Value of Debt
PV of Cash Flows at
Incremental Cost of Debt
=
=
Free Cash Flow:
EBITDA – Op Taxes – Cap Exp – WC Chg
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Value of Equity
PV of Cash Flows at
Cost of Equity
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Value of Enterprise
PV of Cash Flows
At WACC
March 16
15
Valuation Overview
Despite that fact that all we have to do is forecast cash flow and
then determine the risk associated with those cash flows,
valuation is a huge topic. Some Key issues in valuation analysis
include:
Cost of Capital in DCF or Discounted Earnings for
Measuring Risk
Selection of Market Multiple and Adjustment that implicitly
accounts for growth in cash flow and risk
Determination of Growth Rates in Earnings and Cash Flow
Projections
How to Compute Terminal Value when Cash Flow Lasts for
an Indefinite Period
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Tools for Valuation
• There is no magic answer as to whether one valuation approach
is better than others. But virtually all valuation analyses involve
the following work:
• Financial Models:
Valuation model used to project earnings or cash flows
• Statistical Data:
Industry Comparative Data to establish Multiples and Cost of
Capital
• Industry, company knowledge and judgment
Knowledge about risks and economic outlook to assess risks
and value drivers in the forecasts
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Problems with Traditional Finance and Discounted Free
Cash Flow
• The entire process is dependent on WACC and the CAPM
Rm is one of the most debated issues in finance
Beta is difficult to measure
The model doesn’t work
• Valuation is highly dependent on terminal values and growth rates
Often zero real growth is used, implying that if all companies had
zero growth, economies around the world would be stagnant
• If multiples are used, they can be very subjective
Comparable companies are not comparable at all
Arbitrary adjustments are made to the P/E and EV/EBITDA valuation
ratios
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Valuation and Cash Flow
• Ultimately, value comes from cash flow in any model:
DCF – directly measure cash flow from explicit cash flow
and cash flow from selling after the explicit period
Multiples – The size of a multiple ultimately depends on cash
flow in formulas
FCF/(k-g) = Multiple
 They still have implicit cost of capital and growth that
must be understood
Replacement Cost – cash from selling assets
• Growth rate in cash flow is a key issue in any of the models
Investors cannot buy a house with earnings or
use earnings for consumption or investment
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Reasonable Estimates of Growth – Is this Graph
Reasonable
The short term
Based on best
estimate of likely
outcome
The medium term
transition to tranquillity
The long run –
tranquillity and
equilibrium
Assessment of industry
outlook and company
position
• Long run
assumptions:
• ROIC fades towards the
cost of capital
• ROIC = Cost of
capital
• Growth fades towards
GDP
• Real growth = 0%
Much of valuation involves implicitly or explicitly
making growth estimates – High P/E comes from high
growth
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Reference: Level and
persistence of growth rates
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20
How Long will Growth Last
• Some Theoretical Issues with Growth:
The greater the current growth rate in earnings of a firm, relative to
the stable growth rate, the longer the high growth period; although
the growth rate may drop off during the period. Thus, a firm that is
growing at 40% should have a longer high-growth period than one
growing at 14%.
The larger the size of the firm, the shorter the high growth period.
Size remains one of the most potent forces that push firms towards
stable growth; the larger a firm, the less likely it is to maintain an
above-normal growth rate.
The greater the barriers to entry in a business, e.g. patents or strong
brand name, should lengthen the high growth period for a firm.
Look at the combination of the three factors A,B,C and make a
judgment. Few firms can achieve an expected growth period longer
than 10 years
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Terminal Value and Growth
• Terminal value is reached when a company has reached maturity – it grows at
the overall rate of the economy. This should be nominal growth in the
economy since all of the currency in models is in nominal terms.
• For immature companies, the reaching of equilibrium will exceed the standard
five year forecast
• Extending the forecast forces one to make assumptions for more than one year
which become very speculative
• Some suggest a fade growth period to address this issue
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Fade Period
• The fade period is the length of time it takes for the long-term
growth rate to be reached after from the growth in the last year of
the forecast.
• For example, the last year growth is 10%
• The terminal growth is 3%
• The time to get from 10% to 3% is 5 years
• You can use the formula
• Growth = Growtht-1 x [(Long term/Short term)]^(1/Fade)
• Note: This does not work with negative growth rates
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Growth When Companies are Earning More than their
Cost of Capital
• It is a lot more difficult to maintain growth when you are earning
40% return on investment than when you are earning 10% in the
terminal period
A study by Chan, Karceski,
and Lakonishok titled, “The
Level and Persistence of
Growth Rates,” published
in 2003. According to this
study, analyst “growth
forecasts are overly
optimistic and add little
predictive power.”
Competition tends to compress margins and growth
opportunities, and sub-par performance spurs corrective
actions.
With the passage of time, a firm’s performance tends to
converge to the industry norm.
Consideration should be given to whether the industry is in a
growth stage that will taper down with the passage of time or
whether its growth is likely to persist into the future.
Competition exerts downward pressure on product prices and
product innovations and changes in tastes tend to erode
competitive advantage. The typical firm will see the return
spread (ROIC-WACC) shrink over time.
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Growth Issues
• Growth issues include
Growth is difficult to sustain
Investment analysts
overestimate growth
Examine sustainable growth
formulas from dividend
payout and from
depreciation rates
IBES Growth and Actual Growth from Chan Article
25
Acutal Growth over 5 Years and I/B/E/S Median
Growth
Law of large numbers
means that it is more difficult
to maintain growth after a
company becomes large
22.4
Actual Growth in Income
I/B/E/S Growth
20
15
15.1
Optimism in the lowest growth
category is still present.
12.3
10.2
9.5
10
8.0
6.0
6.5
6.5
5
2.0
0
Lowest
Second Lowest
Median
Second Highest
Highest
Growth Rate Category
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Valuation Basics – Inclusion of Returns
• The future cash flow of a company and the risk of that company’s
cash flow can be measured by:
ROIC =
Return on Invested Capital
EBIT x (1-tax rate) (NOPLAT)
Ability to Grow
Investment
Weighted Average Cost of Capital
It is in the formula: Cash Flow (ROIC x Inv)/(k-g) which is the
basis for multiples
• All of the other ratios – gross margins, effective tax rates,
inventory turnover etc. are just details.
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Analytical framework for Valuation – Combine Forecasts
of Economic Performance with Cost of Capital
Competitive position
such as pricing power
and cost structure
affects ROIC
In financial terms, value
comes from ROIC and
growth versus cost of capital
P/E ratio
and other
valuation
come from
ROIC and
Growth
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Practical Discounting Issues in Excel
• NPV formula assumes end of period cash flow
• Growth rate is ROE x Retention rate
• If you are selling the stock at the end of the last period and doing
a long-term analysis, you must use the next period EBITDA or the
next period cash flow.
• If there is growth in a model, you should use the add one year of
growth to the last period in making the calculation
• To use mid-year of specific discounting use the IRR or XIRR or
sumproduct
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Valuation and Sustainable Growth
• Value depends on the growth in cash flow. Growth can be
estimated using alternative formulas:
 Growth in EPS = ROE x (1 – Dividend Payout Ratio)
 Growth in Investment = ROIC x (1-Reinvestment Rate)
 Growth = (1+growth in units) x (1+inflation) – 1
• When evaluating NOPLAT rather than earnings, a similar
concept can be used for sustainable growth.
 Growth = (Capital Expenditures/Depreciation – 1) x
Depreciation Rate
• Unrealistic to assume growth in units above the growth in the
economy on an ongoing basis.
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Gordon’s Model and Valuation
• Gordon’s model is
• P0 = D1/(k-g)
• Example
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Value Comes from Economic Profit and Growth
Economic profit is
the difference
between profit and
opportunity cost
Growth +
Capital Junkies
Power House
ROIC/WACC +
++ve
-
Capital Killers
Once you have a
good thing, you
should grow
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Cash Cows
Growth -
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This implies that there
are three variables –
return, growth and
cost of capital that are
central to valuation
analysis
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31
The Value Matrix - Stock Categorisation
Growth +
Power House
Perennial under achiever or future prospects

Stretched balance sheet

High industry growth

Restructuring

“Franchise” value

May look expensive

Pricing power

Clear Investment strategy

How sustainable?
Throwing good money after
bad
What is the economic
reason for getting
here and how long
can the performance
be maintained
ROIC/WACC +
++ve
Capital Killers
Cash Cows

Look cheap but for good reason

Low industry growth

Cyclical or permanent

Cash generative and rich

Industry or company specific factors

Risk/opportunity of diversification

Low rating with strong yield support
Try to get out of the
business
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Growth -
Give the money
to investors
March 16
32
Microsoft Value Creation and Earnings
Microsoft From: 03-January-90 to: 15-December-99
Stock Price and Dividends
IRR 33.4%
Microsoft From: 24-August-90 Stock Price and Dividends
IRR 10.7%
45.00
25.00
Adjusted Close
Stock Price
Stock Price and Dividends
24-Aug-90
40.00
Adjusted Close
Stock Price
Stock Price and Dividends
3-Jan-90
21-Sep-06
15-Dec-99
20.00
35.00
30.00
15.00
25.00
EPS Index
Stock Index
EPS Index
Stock Index
20.00
10.00
15.00
10.00
5.00
5.00
Earnings are a good indicator of
value; but not always as shown by
the recent increases which resulted
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9/3/1999
5/3/1999
1/3/1999
9/3/1998
5/3/1998
1/3/1998
9/3/1997
5/3/1997
1/3/1997
9/3/1996
5/3/1996
1/3/1996
9/3/1995
5/3/1995
1/3/1995
9/3/1994
5/3/1994
1/3/1994
9/3/1993
5/3/1993
1/3/1993
9/3/1992
5/3/1992
1/3/1992
9/3/1991
5/3/1991
1/3/1991
9/3/1990
5/3/1990
1/3/1990
8/24/2006
2/24/2006
8/24/2005
2/24/2005
8/24/2004
2/24/2004
8/24/2003
2/24/2003
8/24/2002
2/24/2002
8/24/2001
2/24/2001
8/24/2000
2/24/2000
8/24/1999
2/24/1999
8/24/1998
2/24/1998
8/24/1997
2/24/1997
8/24/1996
2/24/1996
8/24/1995
2/24/1995
8/24/1994
2/24/1994
8/24/1993
2/24/1993
8/24/1992
2/24/1992
8/24/1991
2/24/1991
8/24/1990
-
Microsoft Return and Revenue Growth
Microsoft From: 03-January-90 to: 15-December-99
Stock Price and Dividends
IRR 33.4%
Microsoft From: 29-August-90 Stock Price and Dividends
IRR 9.5%
35.00
0.40
Adjusted Close
Stock Price
Stock Price and Dividends
29-Aug-90
20.00
3-Jan-90
18.00
0.35
30.00
Adjusted Close
Stock Price
Stock Price and Dividends
0.40
0.35
16.00
0.30
0.30
25.00
14.00
0.25
Stock Index
Revenue
10.00 Index
ROE
Index
ROE
Index
0.20
0.20
ROE
0.25
12.00
20.00
15.00
0.15
8.00
0.15
6.00
10.00
0.10
0.10
4.00
5.00
0.05
-
1
170 339 508 677 846 1015 1184 1353 1522 1691 1860 2029 2198 2367 2536 2705 2874 3043 3212 3381 3550 3719 3888
0.05
2.00
-
1
106 211 316 421 526 631 736 841 946 1051 1156 1261 1366 1471 1576 1681 1786 1891 1996 2101 2206 2311 2416
Strong Returns plus growth resulted in
increased price; when return fell, the price
fell
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Stock Index
Revenue Index
ROE
General Motors – Slow Growth and Low ROE
GM From: 11-January-93 to: 08-September-06
Stock Price and Dividends
IRR 0.0%
GM From: 11-January-93 to: 08-September-06
Stock Price and Dividends
IRR 0.0%
3.00
5.00
11-Jan-93
Adjusted Close
Stock Price
Stock Price and Dividends
8-Sep-06
0.40
Adjusted Close
Stock Price
Stock Price and Dividends
11-Jan-93
4.00
0.30
2.50
3.00
0.20
2.00
2.00
ROE
EPS Index
Stock Index
Index
0.10
1.00
1.50
-
(2.00)
7/11/2006
1/11/2006
7/11/2005
1/11/2005
7/11/2004
1/11/2004
7/11/2003
1/11/2003
7/11/2002
1/11/2002
7/11/2001
1/11/2001
7/11/2000
1/11/2000
7/11/1999
1/11/1999
7/11/1998
1/11/1998
7/11/1997
1/11/1997
7/11/1996
1/11/1996
7/11/1995
1/11/1995
7/11/1994
1/11/1994
7/11/1993
(1.00)
1/11/1993
-
1.00
(0.10)
0.50
(0.20)
(3.00)
7/11/2006
1/11/2006
7/11/2005
1/11/2005
7/11/2004
1/11/2004
7/11/2003
1/11/2003
7/11/2002
1/11/2002
7/11/2001
1/11/2001
7/11/2000
1/11/2000
7/11/1999
1/11/1999
7/11/1998
1/11/1998
7/11/1997
1/11/1997
7/11/1996
1/11/1996
7/11/1995
1/11/1995
7/11/1994
1/11/1994
7/11/1993
(0.30)
1/11/1993
(4.00)
GM had low growth
and low returns and
the stock price did
not increase.
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35
Stock Index
Revenue Index
ROE
ROIC Issues
• Issues with ROIC include
Will the ROIC move to WACC because of competitive pressures
 Evidence suggests that ROIC can be sustained for long periods
 Consider the underlying economic characteristics of the firm and the industry
What is the expected change in ROIC
 When ROIC moves to sustainable level, then can move to terminal value
calculation
Examine the ROIC in models to determine if detailed assumptions are
leading to implausible results
Migration table
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Practical Growth Rate Issues: Growth Rate Estimation
vs. ROE and Retention Rate
• What we really need to estimate are reinvestment rates and
marginal returns on equity and capital in the future (the change in
income over the change in equity).
• Those who use analyst’s or historical growth rates are implicitly
assuming something about reinvestment rates and returns, but
they are either unaware of these assumptions or do not make
them explicit. This means, look at the ROE and the dividends to
make sure that the growth is consistent.
• Future ROE depends on changes in economic variables affecting
the existing investment and new projects with incremental returns.
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Alternative Valuation Methods
Valuation
38
March 16
Valuation Ranges
• Do not claim to derive a single number – unrealistic to derive one
number
Forecasting uncertainty
Cost of capital uncertainty
Bigger ranges for growth companies and for emerging
economies
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General Valuation Approaches
• Typical Valuation Approaches are Differentiated According to:
Relative Valuation
 Multiples, Comparative Transactions
Absolute Valuation
 DCF, APV, Risk Neutral Valuation, Option Pricing
• We Differentiate by
Direct Valuation
 DCF, Multiples etc.
Indirect Valuation
 Equity IRR from LBO Multiples, Accretion/Dilution in EPS from
integrated merger analysis, IRR and debt capacity in project finance
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Direct Valuation Models
•
There are many valuation techniques for assets and investments including:



Income Approach

Discounted Cash Flow

Venture Capital method

Risk Neutral Valuation
Sales Approach

Multiples (financial ratios) from Comparable Public Companies of from Transactions or from
Theoretical Analysis

Liquidation Value
Cost Approach


•
Replacement Cost (New) and Reproduction Cost of similar assets
Other

Break-up Value

Options Pricing
The different techniques should give consistent valuation answers
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See the appraisal
folder in the
financial library
March 16
41
Indirect Valuation from Modelling Transactions
• Instead of using DCF or multiples, back into the value of a company:
Leveraged buyout
 Entry and exit multiples, debt capacity and EBITDA Growth. See how
much you can pay an finance and obtain an equity rate or return
consistent general benchmarks such as 20%.
Project Finance
 Given contracts and assumptions about cash flows over the life of the
asset and debt capacity, see how much investment can be made to
generate and equity rate of return.
Merger Integration
 Given assumptions about financing and accounting in a mergers, see
how much you can afford to pay and still achieve accretion in earnings
per share.
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Example of Comparing Valuation under Alternative
Methods
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Sum of the Parts Analysis
• Morgan Stanley performed a sum of the parts analysis, which is designed to imply a value
of a company based on the separate valuation of the company’s business segments.
Morgan Stanley calculated ranges of implied equity values per share for Wyeth, assuming a
hypothetical disposition of Wyeth’s Nutrition, Consumer and Animal Health divisions.
• Morgan Stanley valued Wyeth’s divisions using multiple ranges derived from comparable
precedent transactions.
• Morgan Stanley used a 3.5x to 4.5x multiple of aggregate value to estimated 2008 revenue
for Wyeth’s Nutrition and Consumer divisions, and
• 11.0x to 13.0x multiple of aggregate value to estimated 2009 EBITDA for the Animal Health
division.
• The Pharmaceutical division was valued at a public market trading multiple range of 9.0x to
11.0x estimated 2009 P/E multiple.
• Based on the multiple ranges described above, and including the net present value of the
step-up in the tax basis of the assets which would result from such a theoretical transaction,
this analysis implied a range for Wyeth’s common stock of approximately $33 to $40 per
share. Morgan Stanley noted that the merger consideration had an implied value of $50.19
per share.
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Risk Neutral Valuation
• Theory – If one can establish value with one financial strategy, the value
should be the same as the value with alternative approaches
• In risk neutral valuation, an arbitrage strategy allows one to use the risk
free rate in valuing hedged cash flows.
• Forward markets are used to create arbitrage
• Risk neutral valuation does not work with risks that cannot be hedged
• Use risk free rate on hedged cash flow
• Example
Valuation of Oil Production Company
Costs Known
No Future Capital Expenditures
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Practical Implications of Risk Neutral Valuation
• Use market data whenever possible, even if you will not actually
hedge
• Use lower discount rates when applying forward market data in
models
Valuation with high
discount rates
And
Uncertain cash
flows
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Valuation with
Forward
Markets and
Low Discount
Rates
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Examples of Risk Neutral Valuation
• Risk neutral valuation means that one attempts to remove the risk from
the cash flow and then discount the adjusted cash flow at the risk free
rate. (This is how options pricing models were developed.)
• There are various examples of risk neutral valuation that can be applied in
valuation:
If there is a construction contract that includes a premium – say 20%
to eliminate cost over-run and delay risk; this verifies the risk rather
than attempts to simulate the risk or use of a high discount rate.
If there is a long-term contract that fixes the price, the project can be
financed with a lower discount rate.
If a project can secure political risk insurance to eliminate political
and currency conversion risk, a lower discount rate can be used
rather than attempting to measure political risk.
Other examples …
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Venture Capital Method
• Two Cash Flows
Investment (Negative)
IPO Terminal Value (Positive)
Terminal Value = Value at IPO x Share of Company Owned
• Valuation of Terminal Value
Discount Rates of 50% to 75%
See the article on private
valuation
Risky cash flows
Other services
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Valuation Diagram – Venture Capital
• Valuation in venture capital focuses on the value when you will
get out, the discount rates and how much of the company you will
own when you exit.
Cash Flow
Cash Flow
Cash Flow
Discount Rates
Enterprise Value
Net Debt
Evaluate how much of the
equity value that you own
Equity Value
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Cash Flow
Continuing Value
•In the extreme, if you
have given away half
of your company
away, and the cash
flow is the same
before and after your
give away, then the
amount you would
pay for the share
must account for how
much you will give
March away.
16
49
Venture Capital Method
• Determine a time period when the company will receive positive cash flow and
earnings.
e.g. projection of earnings in year 7 is 20 million.
• At the positive cash flow period, apply a multiple to determine the value of the
company.
e.g. P/E ratio of 15 – terminal value is 20 x 15
• Use high discount rate to account for optimistic projections, strategic advice and high
risk;
e.g. 50% discount rate – [20 x 15]/[1+50%]^7 = 17.5 million
• Establish percentage of ownership you will have in the future value through dividing
investment by total value
e.g. 5 million investment / 17.5 million = 28.5%
• You make an investment and receive shares (your current percent). You know the
investment and must establish the number of shares
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Venture Capital Method Continued
• In the venture capital method, there are only two cash flows
The investment
The value when the company is sold
• The value received when the company is sold depends on the percentage
of the company that is owned. If there is dilution in ownership, the value
is less.
• Therefore, an adjustment must be made for dilution and the percent of the
company retained. See the Cost of Capital folder for and example
e.g. Share value without dilution = 17.5/700,000 = 25 per share
If an additional 30% of shares is floated, the value per share must
be increased by 30% to maintain the value.
Value per share = 17.5/((500,000+VC shares) x 1.3)
VC Shares: (25 x 1.3)/17.5-500,000 = 343,373
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Replacement Cost
• First a couple of points regarding replacement cost theory
In theory, one can replace the assets of a company without
investing in the company. If you are valuing a company, you
may think about creating the company yourself.
If you replaced a company and really measured the
replacement cost, the value of the company may be more
than replacement cost because the company manages the
assets better than you could.
By replacing the assets and entering the business, you
would receive cash flows. You can reconcile the
replacement cost with the discounted cash flow approach
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Measuring Replacement Cost
• Replacement cost includes:
Value of hard assets
Value of patents and other intangibles
Cost of recruiting and training management
• Analysis
Begin with balance sheet categories, account for the age of the plant
Add: cost of hiring and training management
• If the company is generating more cash flow than that would be produced
from replacement cost, the management may be more productive than
others in managing costs or be able to realize higher prices through
differentiation of products.
• The ratio of market value to replacement cost is a theoretical ratio that
measures the value of management contribution
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Replacement Value and Tobin’s Q
• Recall Tobin’s Q as:
Q = Enterprise Value / Replacement Cost
• Buy assets and talent etc and should receive the ROIC. Earn
industry average ROIC.
If the ROIC > industry average, then Q > 1.
If the ROIC < industry average, then Q < 1
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Real Options in Investment Decisions
• Example of real options in many investments
the right to abandon an asset in the research and development
phase;
the right to abandon the plant during construction;
the right to delay construction of the facility;
the right not to dispatch the plant when prices below short-run
marginal cost;
the right to retire or mothball the plant before the end of its physical
life;
the right to extend the life of the plant instead of retiring it at the end
of its planned life; and
the right to expand the asset
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Real Options and Problems with DCF
• The DCF model has many conceptual flaws, the most significant
of which is assuming that cash flows are normally distributed
around the mean or base case level.
• For many investments, the cash flows are skewed:
When an asset is to be retired, there is more upside than
downside because the asset will continue to operate when
times are good, but it will be scrapped when times are bad.
An investment decision often involves the possibility to
expand in the future. When the expansion decision is made,
it will only occur when the economics are good.
During the period of constructing an asset, it is possible to
cancel the construction expenditures and limit the downside if
it becomes clear that the project will not be economic.
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Real Options and DCF Problems - Continued
• Problems with DCF because of flexibility in managing assets:
In operating an asset, the asset can be shut down when it is not
economic and re-started when it becomes economic. This allows the
asset to retain the upside but not incur negative cash flows.
When developing a project, there is a possibility to abandon the
project that can limit the downside as more becomes known about
the economics of the project.
In deciding when to construct an investment, one can delay the
investment until it becomes clear that the decision is economic. This
again limits the downside cash flows.
• In each of these cases, management flexibility provides protection in the
downside which means that DCF model produces biased results.
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Simulation Exercise
• To demonstrate how options affect valuation, consider a simple
simulation exercise
• Enter the following inputs
• Volatility is the standard deviation of the percent change in a
variable over time.
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Fundamental Valuation
• What was behind the bull market of 1980-1999
EPS rose from 15 to 56
Nominal growth of 6.9% -- about the growth in the real economy (the
real GDP)
Keeping P/E constant would have large share price increase
Long-term interest rates fell – lower cost of capital increases the P/E
ratio
• Real Market
Value by ROIC versus growth
Select strategies that lead to economic profit
Market value from expected performance
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Three Primary Methods Discussed in Remainder of
Slides
• Market Multiples – Relative Valuation
• Discounted Free Cash Flow
• Discounted Earnings and Dividends
• Warning: No method is perfect or completely precise
• Use industry expertise and judgment in assessing discount rates
and multiples
• Different valuation methods should yield similar results
• Bangor Hydro Case
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Discounting Basics
Valuation
61
March 16
Debt (Bond) Valuation
Bt = It +1 + It +2 + It +3 + ... + It +n + F
(1+r)1 (1+r)2 (1+r)3
(1+r)n (1+r)n
• Bt is the value of the bond at time t
• Discounting in the NPV formula assumes END of period
Case exercise to illustrate the
effect of discounting (credit
spread) on the value of a
bond
• It +n is the interest payment in period t+n
• F is the principal payment (usually the debt’s face value)
• r is the interest rate (yield to maturity)
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Risk Free Discounting
• If the world would involve discounting cash flows at the risk free rate,
life would be easy and boring
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Equity – Dividend Discount Valuation and Gordon’s
Model
Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ... + E(Dt +n) + ...
(1+k)1
(1+k)2
(1+k)3
(1+k)n
• Vt is the value of an equity security at time t
• Dt +n is the dividend in period t+n
• k is the equity cost of capital – difficult to find (CAPM)
• E() refers to expected dividends
• If dividends had no growth the value is D/k
• If dividends have constant growth the value is D/(k-g)
• Terminal Value is logically a multiple of book value per share
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Example of Capitalization Rates
• Proof of capitalization rates using excel and growing cash flows
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Equity Valuation - Free Cash Flow Model
Vt = E(FCFt +1)
(1+k)1
+
E(FCFt +2) + E(FCFt +3) + ...
(1+k)2
(1+k)3
+
E(FCFt +n)
(1+k)n
+
• FCFt+n is the free cash flow in the period t + n [often
defined as cash flow from operations less capital
expenditures]
• k is the weighted average or un-leveraged cost of capital
• E(•) refers to an expectation
• Alternative Terminal Value Methods
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...
Setting-Up the Model to Reflect Period Discounting with
Terminal Value and Transaction Dates
• The example shown accounts for mid-year discounting and
terminal value at the end of the period. The discount rate
assumes annual discounting using the formula:
• The terminal value must use the last mid year value multiplied by
(1+g)^1.5
Terminal value
is after the last
period cash
flow and must
use mid year
period x
(1+g)^1.5
Precise discounting
with mid year period
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Valuation Using Multiples
Valuation
68
March 16
Advantages and Disadvantages of Multiples
• Disadvantages
• Advantages
Objective – does not require
discount rate of terminal value
Simple – does not require
elaborate forecast
Flexible – can use alternative
multiples and make adjustments
to the multiples
Theoretically correct – consistent
with DCF method if there are
stable cash flows and constant
growth – FCF/(k-g).
There are reasons similar companies in an
industry should have different multiples because of
ROIC and growth – this must be understood
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Valuation depends on opinions of
others and not the underlying drivers
of value.
Too simple: Does not account for
prospective changes in cash flow
Accounting Based: Depends on
accounting adjustments in EBITDA,
earnings
Timing Problems: Changing
expectations affect multiples and
using multiples from different time
periods can cause problems.
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Equity Analysis – Target Prices
• Equity Research Analyst Price Targets Analysis
• Morgan Stanley reviewed and analyzed future public market trading price targets for
Wyeth’s common stock and Pfizer’s common stock prepared and published by equity
research analysts. These targets reflect each analyst’s estimate of the future public
market trading price of Wyeth’s common stock and Pfizer’s common stock. Morgan
Stanley noted that the range of equity analyst price targets of Wyeth’s common stock
was between approximately $33 and $48 per share. Morgan Stanley further
calculated that using a cost of equity of 8.5% and a discount period of one
year, the present value of the equity analyst price target range for Wyeth’s
common stock was approximately $30 to $44 per share, with a mean target price
of $40.82 and a median target price of $40.00. Morgan Stanley noted that the merger
consideration had an implied value of $50.19 per share of Wyeth’s common stock
based upon $17.45 per share of Pfizer common stock, the closing price of Pfizer’s
common stock on January 23, 2009, the last trading day prior to announcement of
the proposed merger.
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Example of Problems with Relative Valuation – Housing
Prices
• During the housing bubble, appraisers would use the value of
similar transactions to estimate the value of properties
Appraisers would have a lot of tricks and make biased
estimates by using houses with relatively high value and
ignoring those with lower value (if they did not make high
estimates, they would not be hired)
The fundamentals of housing value from evaluating the
income levels relative to the house price, the trends in
housing or the demand and supply of housing were ignored.
This lead to absurd valuations.
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Valuation from Multiples
• Valuation from multiples is known as relative valuation because valuation is compared to
other companies and not to fundamental cash flows.
• A measure of value is standardized by earnings or something else
Financial Multiples
 P/E Ratio
 EV/EBITDA
 Price/Book
Industry Specific
 Value/Oil Reserve
 Value/Subscriber
 Value/Square Foot
Issues
 Where to find the multiple data and comparable companies
 What income or cash flow base to use
 Discounts for lack of marketability
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Mechanics of Multiples
•
Find market multiple from comparable companies
 Rarely are there truly comparable companies
 Understand economics that drive multiples (growth rate, cost of
capital and return)
•
P/E Ratio (forward versus trailing)
In the long-term P/E ratios tend to revert to
a mean of 15.0
 Value/Share = P/E x Projected EPS
 P/E trailing and forward multiples
•
Market to Book
 Value/Share = Market to Book Ratio x Book Value/Share
•
EV/EBITDA
 Value/Share = (EV/EBITDA x EBITDA – Debt) divided by shares
•
P/E and M/B use equity cash flow; EV/EBITDA uses free cash flow
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More Valuation Examples – Adjustments to Multiples
• Here the multiple is adjusted for risk and the dividends are
accounted for in computing the rate of return
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Relate Multiples to Growth in a Crude Way
• The multiples depend on assessment of growth as illustrated by
the quote below
Theory of growth and multiples – depends on long-term
growth more than short-term growth. Also depends
greatly on the cost of capital.
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Real World Examples of Bad Practice
Comparison of equity value (P)
to EBITDA compares value after
debt to income before interest –
favors companies with less debt
• Invalid comparable companies
• Logical comparisons
Sample should have similar WACC and growth
rates and therefore be in the same industry and
have the same kind of risks. Note difference in size
and difference in company profile.
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Examples of Valuation with Multiples from Analyst
Reports
• Note how the industry multiples are used and then adjusted for
risk and growth. The multiple is adjusted for growth, risk and rate
of return.
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Use of Multiples in Valuation
The red bars from
the DCF valuation
are compared to
market date
Should be able to
explain difference
from:
1.Growth
2. WACC
3. ROIC
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Illustration of Some Multiples
• Multiples for a couple companies
are shown below
Which multiple best reflects value for the various
companies – note the EV/EBITDA is most stable
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EV/EBITDA Multiples in LBO’s
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EV/EBITDA by Size and Type
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EV/EBITDA by Industry
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Which Multiple to Use
• Valuation from multiples uses information from other companies
• It is relevant when the company is already in a steady state situation and there is no
reason to expect that you can improve estimates of EBITDA or Earnings
• One of the challenges is to understand which multiple works in which situation:
Leveraged Buyout
 EV/EBITDA is used
 Changes in the common equity ratio
 Intangible assets make book value inappropriate
 Different leverage makes P/E difficult
Banks/Insurance
 Market/Book may be best
 Not many intangible assets, so book value is meaningful
 Book value is the value of loans which is adjusted with loan loss provisions
 Cost of capital and financing is very important because of the cost of
deposits
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Multiples - Summary
• Useful sanity check for valuation from other methods
• Use multiples to avoid subjective forecasts
• Among other things, well done multiple that accounts for
When you compute the terminal
value using
CF x (1+g)/(k-g)
Compute the implied
Accounting differences
EV/EBITDA from the data
Inflation effects
Also compute the implied P/E
and the implied EV/EBITDA
when computing the DCF
Cyclicality
• Use appropriate comparable samples
• Use forward P/E rather than trailing
• Comprehensive analysis of multiples is similar to forecast
• Use forecasts to explain why multiples are different for a specific company
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P/E Ratio, Growth and Reconciliation to Cash Flow
•
P = D1/(k-g)
•
g = ROE * (1-DPO) or DPO = 1 - g/ROE
•
P/E = D/E/(k-g)
•
Substituting for D/E = DPO
•
P/E = (1-g/r)/(k-g)
 g -- long term growth rate in earnings and cash flow
 r -- rate of return earned on new investment
 k -- discount rate
•
(k-g) = (1-g/r)/(P/E)
•
k = (1-g/r)/(P/E) + g
•
Example: if r = k than the formula boils down to 1/(k)
•
If the g = 0, the formula is P/E = 1/k
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Price to Earnings and Other Statistics
Market crashed after
very high PE in 2000
1985
1990
1995
2000
2006
11.5
15.2
16.5
28.6
16.0
S&P 500
3.9%
3.7%
2.3%
1.2%
1.76%
Prime Rate
9.9%
10.0%
8.8%
9.2%
8.3%
10-Year Treasury
10.6%
8.6%
6.6%
6.0%
4.7%
N/A
7.5%
5.4%
5.9%
5.3%
P/E Ratios
S&P 500
Dividend Yields
LIBOR
Low P/E when longterm interest rates
where high
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1/PE = 6.6%
Understanding the P/E Ratio
• Corporations as a whole, typically reinvests about 50 percent of its profits
every year to achieve this profit growth, leaving the other half to pay to
shareholders as dividends and share repurchases. This translates to a
cash yield to shareholders of about 3 to 3.5 percent at the long-term
average P/E ratio of 15.1 Adding the annual 3 to 3.5 percent increase in
share prices to the cash yield of 3 to 3.5 percent results in total real
shareholder returns of about 6 1/2 percent per year.
• Between 1980 and 1999, earnings per share for the S&P 500 rose from
$15 to $56. If the forward P/E ratio had remained constant, earnings
growth alone would have boosted the index by 302 points. This nominal
annual growth in earnings of 6.9 percent equals 3.2 percent in real terms,
close to the long-term average growth in real profits for the economy.
Simultaneously, U.S. interest rates and inflation fell dramatically. Long
term U.S. government bond yields peaked at nearly 15 percent in 1981
and then fell, more or less steadily, to 5.7 percent in 1999. The decline in
inflation and interest rates drove P/E ratios back up to more typical levels.
This occurred because during the high-inflation years, companies were
unable to increase returns on capital commensurate with the rise in cost
of capital, leading to extremely low P/E ratios.
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Example of Valuation with Multiples – Comparison of
Different Transactions
Note how multiples cover the
cycle in a commodity
business
Demonstrates that the
multiple in the merger is
consistent with other
transactions
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Example of Computation of Multiples from Comparative
Data
• JPMorgan also calculated an implied range of terminal values for Exelon
at the end of 2009 by applying a range of multiples of 8.0x to 9.0x to
Exelon's 2009 EBITDA assumption.
Note that the
median is
presented before
the mean
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Comparison with all Acquisitions Since 2001
All US Banking Acquisitions with a total deal value over $200m
SOV-Waypoint Deals in 2004
# of Deals
Price/Book
Price/Tangible Book
Price/LTM Earnings
Price/Deposits
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1
Median
Mean
Median
Mean
Median
Mean
Median
Mean
238.5
251.8
22.0
32.1
Deals since 2003 Deals since 2002
Deals since 2001
7
16
20
28
238.5
256.1
238.7
238.7
241.0
249.6
240.8
244.6
304.7
299.2
290.4
299.2
319.3
309.6
301.4
307.3
20.7
20.4
20.3
20.3
20.9
20.3
19.9
20.2
29.9
30.4
30.1
30.2
31.4
32.8
32.1
31.4
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90
Adjustments to Multiples
• Process
Find multiples from similar public companies
Adjust multiples for
 Liquidity
 Size
 Control premium
 Developing country discount
Apply adjusted multiples to book value, earnings, and EBITDA
• There is often more money in dispute in determining the discounts and
premiums in a business valuation than in arriving at the pre-discount
valuation itself. Discounts and premiums affect not only the value of the
company, but also play a crucial role in determining the risk involved,
control issues, marketability, contingent liability, and a host of other
factors.
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Adjustments to Multiples – Marketability and Liquidity
Discount
•
If the entity were closely held with no (or little) active market for the
shares or interest in the company, then a non-marketability discount
would be subtracted from the value.
•
Non-marketabiliy Discounts – ranges from 10% to 30%
•
…represents the reduction in value from a marketable interest level
of value to compensate an investor for illiquidity of the security, all
else equal.
•
The size of the discount varies base on:
 relative liquidity (such as the size of the shareholder base);
 the dividend yield, expected growth in value and holding period;
 and firm specific issues such as imminent or pending initial public
offering (IPO) of stock to be freely traded on a public market.
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92
Studies of Liquidity Discount
• Private and public transactions
Attempt to compute EV/EBITDA in public and private transactions
Adjust so that the transactions are comparable
Compute the ratio in pubic and private transactions
Discount of 20 to 28 percent for US firms
Discount of 44 to 54 percent for non-US firms
• Other studies
Value in IPO versus value of private trades before IPO
High liquidity in 40-50% range, but selection bias
Theory involves control by public board
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Adjustments to Multiples – Controlling Interest Premium
•
Controlling interest value
…the value of the enterprise as a whole assuming that the
stock is freely traded in a public market and includes a
control premium.
 Control premium
…reflects the risks and rewards of a majority or
controlling interest.
 A controlling interest is assumed to have control power over
the minority interests.
•
Minority interest value
…represents the value of a minority interest “as if freely
tradable” in a public market.
 Minority interest discount
…represents the reduction in value from an absence of
control of the enterprise.
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Private Companies Sell At A Small Discount
Median P/E Multiples: Public vs. Private Deals
30
25
25
25
24
23
21
Multiples
20
20
18
16
17
18
17
15
15
21
19
20
19
16
24
21
17
17
13
10
5
0
1996
1997
1998
1999
2000
2001
Public
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Source: Mergerstat (U.S. Only)
Disclaimer: Data is continually updated and is subject to change
2002
2003
2004
2005
2006
Private
March 16
96
Liquidity Determines Valuation Premium
Median Transaction Multiples by Deal Size
14
12.8
12
Multiples
10.9
10.0
10 9.6
11.4
8.8
11.6
11.1
8.3
8
11.1
10.3
9.3
9.2
8.2
7.7
11.8
11.3
9.3
6.9
8.4
7.0
9.4
8.6
8.8
7.8
9.9
9.4
11.8 11.4
11.3
9.9
9.1
8.5
6
4
2
0
1996
1997
1998
1999
Under $250 Million
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2000
2001
$250 to $500 Million
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Source: Mergerstat (U.S. Only)
Disclaimer: Data is continually updated and is subject to change
2002
2003
2004
2005
2006
Over $500 Million
March 16
97
P/E Analysis – Use of P/E Ratio in Valuation
• J.P. Morgan performed an analysis comparing Exxon's price to earnings
multiples with Mobil's price to earnings multiples for the past five years.
• The source for these price to earnings multiples was the one and two year
prospective price to earnings multiple estimates by I/B/E/S International
Inc. and First Call, organizations which compile brokers' earnings
estimates on public companies. Such analysis indicated that Mobil has
been trading in the recent past at an 8% to 15% discount to Exxon.
• J.P. Morgan's analysis indicated that if Mobil were to be valued at
price to earnings multiples comparable to those of Exxon, there
would be an enhancement of value to its shareholders of
approximately $11 billion.
• Finally, this analysis suggested that the combined company might enjoy
an overall increase in its price to earnings multiple due to the potential for
improved capital productivity and the expected strategic benefits of the
merger. According to J.P. Morgan's analysis, a price to earnings multiple
increase of 1 for Exxon Mobil would result in an enhancement of value to
shareholders of approximately $10 billion.
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P/E Ratio, Growth and Reconciliation to Cash Flow
•
P/E = (1-g/r)/(k-g)
 g -- long term growth rate in earnings and cash flow
 r -- rate of return earned on new investment
 k -- discount rate
•
(k-g) = (1-g/r)/(P/E)
•
k = (1-g/r)/(P/E) + g
•
Example: if r = k than the formula boils down to 1/(k)
•
If the g = 0, the formula is P/E = 1/k
•
P = E/(k-g) x (1-g/r)
 If, for some reason, g = r, then the Gordon model could be applied
to compute k.
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Company Profile in website
• http://finance.yahoo.com/
• http://googlefinance.com/
• http://marketwatch.com/
• http://bloomberg.com/
• http://pages.stern.nyu.edu/~adam
odar/
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0
Price Earnings Ratio
• The price earnings ratio is obviously very important in stock
evaluation. Therefore, I describe some background related to the
ratio and some theory with regards to the P/E ratio. Subjects
related to the P/E ratio include:
Dividend growth Model
Theory of price earnings ratio and growth
P/E ratio and the EV/EBITDA ratio
The PE ratio depends more on accounting
The PE is affected by leverage
The EV/EBITDA ignores depreciation and capital expenditure
Case exercise on P/E and EV/EBITDA
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1
P/E Ratio versus EV/EBITDA
• Use the EV/EBITDA when the funding does not make much difference in
valuation
Many companies in an industry with different levels of gearing and
companies do not attempt to maximize leverage
Very high levels of gearing and wildly fluctuating earnings
When the earnings are affected by accounting policy and account
adjustments
• Use the P/E ratio when cost of funding clearly affects valuation and/or
when the level of gearing is stable and similar for different companies
Debt capacity can provide essential information on valuation
EBITDA does not account for taxes, capital expenditures to replace
existing assets, depreciation and other accounting factors that can
affect value.
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2
P/E Ratio
• If you use the P/E ratio for valuation, the ratio implies that only
this year or last years earnings matter
• Cash matters to investors in the end, not earnings (different
lifetime of earnings)
• When earnings reflect cash flow, P/E is reasonable for valuation
• High P/E causes treadmill and does not necessary imply that
companies are performing well
• Earnings can be managed and manipulated
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3
Use of P/E Ratio Formula to Compute the Required
Return on Equity Capital
• It will become apparent later that one cannot get away from estimating the
cost of equity capital and the CAPM technique is inadequate from a theoretical
and a practical standpoint.
• The following example illustrates how the formula can be used in practice:
k = (1-g/r)/(P/E) + g
•
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4
P/E Notes
• High ROE does not mean high PE – Hence the existence of high
ROE stocks with low PEs
• Growth and value are not always positively correlated
• Growth from improvement will always be value enhancing
whereas growth from reinvestment depends upon the return
against the benchmark return
• Reinvestment should also include “ Cash hoarding”
• PB is better at differentiating ROE differences than PE
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5
Relationship Between Multiples
• The P/E, EV/EBITDA and Cash Flow Multiples should be
consistent and you should understand why one multiple gives you
a different answer than another multiple.
• Each of the multiples is affected by
The discount rate – the risk of the cash flow
The ability of the company to earn more than its cost of
capital
The growth rate in cash flow or earnings
• Differences in the ratios are a function of
Leverage, Depreciation Rates, Taxes, Capital Expenditures
relative to cash flow
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6
Relationship Between Multiples
• Enterprise Value = NOPLAT x (1-g/ROIC)/(WACC – g)
• NOPLAT = Investment x ROIC
• NOPLAT = EBIT x (1-t)
• EBITDA = EBIT + Depreciation
EV/EBITDA
• EBT = EBIT – Interest
• NI = EBT x (1-t)
NI/Market Cap
• Market Cap = EV – Debt
MB = Market Cap/Equity
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7
Relationship Between Multiples - Illustration
• Assume
Value = NOPLAT x (1-g/ROIC)/(WACC –g)
This is the EVA Formula
• Assume
No Taxes
No Leverage
No Depreciation
No Growth Rate
ROIC = 10%
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8
Comparative Multiples
• With the simple assumptions, each of the multiples is the same as shown
below
Exercise: Data table with alternative
parameters to investigate P/E and
EV/EBITA
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9
Comparative Multiples
• Once taxes, leverage and
depreciation are added, the
multiples diverge as shown on
the table below:
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0
Valuation From Discounted Free Cash Flow
Valuation
111
March 16
Advantages and Disadvantages of DCF
• Disadvantages
• Advantages
 Theoretically Valid – value comes from
free cash flow and assessing risk of
the free cash flow.
 Operating and Financial Values –
explicitly separates value from
operating the company with value of
financial obligations and value from
cash
 Sensitivity – forces an understanding
of key drivers of the business and
allows sensitivity and scenario analysis
 Assumptions: Requires WACC
assumptions and residual value
assumptions. There are major problems
with WACC estimation and the long-term
growth assumption.
 Forecasting Problems: Complex forecasting
models can easily be manipulated
 Growth: The residual value depends on a
number of assumptions which can easily
distort value
 Real Options: Discussed above
 Fundamental – not biased by optimism
or pessimism in the market
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2
Problems with DCF –
Range in Values
• Note the range in values in
the analyst report
• The range is less when a
terminal value is used, but
the range is still very high
• The high range exists even
though there is a tight range
in discount rates
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3
Discounted Cash Flow – Morgan Stanley Example
•
Morgan Stanley performed a discounted cash flow analysis, which is designed to imply a value of a
company by calculating the present value of estimated future cash flows of the company.
•
Morgan Stanley calculated ranges of implied equity values per share for Wyeth, based on
discounted cash flow analyses utilizing Wall Street analyst estimates compiled by Thomson First
Call and Wyeth management projections for the calendar years 2009 through 2013. In arriving at
the estimated equity values per share of Wyeth’s common stock, Morgan Stanley calculated a
terminal value by applying a range of perpetual free cash flow growth rates ranging from (0.5)% to
0.5%.
•
Such rate range was derived, based on Morgan Stanley’s judgment, after considering a number of
factors, including growth of the overall economy, projected earnings expectations for comparable
pharmaceutical companies and Wyeth’s upcoming patent expiration profile.
•
Morgan Stanley observed that this range implied P/E multiples for Wyeth that were consistent with
the P/E multiples of the comparable companies studied by Morgan Stanley and identified above
under “— Comparable Companies Analysis.” The unlevered free cash flows and the terminal value
were then discounted to present values using a range of weighted average cost of capital from
7.0% to 9.0%.
•
Morgan Stanley selected this range using the capital asset pricing model. The weighted average
cost of capital is a measure of the average expected return on all of a given company’s equity
securities and debt based on their proportions in such company’s capital structure.
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4
Discounted Cash Flow – General Discussion
• Executives and investors alike can draw reassurance from an important
trend that has gained momentum even through years of the market's
twists and turns. More and more investors, analysts, and investment
bankers are turning to fundamental financial analysis and sophisticated
discounted cash flow (DCF) models as the touchstone of corporate
valuation.
• Recent accounting scandals and inappropriate calculation of revenues
and capital expenses give DCF new importance. With heightened
concerns over the quality of earnings and reliability of standard valuation
metrics like P/E ratios, more investors are turning to free cash flow, which
offers a more transparent metric for gauging performance than earnings.
It is harder to fool the cash register. Developing a DCF model demands a
lot more work than simply dividing the share price by earnings or sales.
But in return for the effort, investors get a good picture of the key drivers
of share value: expected growth in operating earnings, capital efficiency,
balance sheet capital structure, cost of equity and debt, and expected
duration of growth. An added bonus is that DCF is less likely to be
manipulated by aggressive accounting practices.
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5
Discounted Flow
• Use the discounted cash flow when you know something more
about the company that can be obtained with a forecast
• Any cash flow forecast involves:
Value =
Cash flow during explicit forecast period +
Present of cash flow after explicit forecast period
• The second item generally involves some kind of growth
projection.
• Value of Equity = Value of Enterprise – Value of Net Debt
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6
Step by Step Valuation with Free Cash Flow
• Step by Step valuation using free cash flow:
Step 1: Compute projected free cash flow over the explicit forecast
period and discount the free cash flow at the WACC
Step 2: Make adjustments to free cash flow in the last forecast year
Step 3: Add terminal value to cash flow to establish enterprise value
Step 4: Make other balance sheet adjustments for balance sheet
liabilities and assets that are not in cash flow but affect value
Step 5: Subtract current value of debt net of surplus cash to
establish the total equity value.
Step 6: Divided the equity value by the current outstanding shares to
establish value per share
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7
DCF Discussion
• DCF models are powerful, but they do have shortcomings. DCF is merely
a mechanical valuation tool, which makes it subject to the axiom "garbage
in, garbage out". Small changes in inputs can result in large changes in
the value of a company. Investors must constantly second-guess
valuations; the inputs that produce these valuations are always changing
and susceptible to error.
• DCF analysis shows that changes in long-term growth rates have the
greatest impact on share valuation. Interest rate changes also make a big
difference. Example: Sun Microsystems, which recently traded on the
market at $3.25, is valued at almost $5.50, which makes its price of $3.25
a steal. The model assumes a long-term growth rate of 13.0%. If we cut
the growth rate assumption by 25%, Sun's share valuation falls to $3.20.
If we raise the growth rate variable by 25%, the shares go up to $7.50.
Similarly, raising interest rates by one percentage point pushes the share
value to $3.55; a one percent fall in interest rates boosts the value to
about $7.70.
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8
Discounted Cash Flow
• Why would you make a cash flow forecast of more than one year
If the company is stable and you know the stable level of
earnings and cash flow, then a cash flow forecast does not
add anything to the valuation analysis
If you do not know what the future earnings will be, then a
cash flow forecast is helpful as long as you have information
to make the forecast
If you know earnings and cash flow will fluctuate and then
reach a stable amount, then discounted cash flow will be
better than multiple analysis
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9
DCF Valuation – Length of Forecast
• Short-run
Forecast all financial statement items
Gross-margin, selling expenses, Etc.
• Further out
Individual line items more difficult
Focus on key drivers
Operating margin, tax rate, capital efficiency
• Continuing Value
When ROIC and growth stabalise
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0
Growth Rate and Discount Rate
• A stable growth rate is a growth rate that can be sustained
forever. Since no firm, in the long term, can grow faster than the
economy which it operates it - a stable growth rate cannot be
greater than the growth rate of the economy.
• It is important that the growth rate be defined in the same
currency as the cash flows and that be in the same term (real or
nominal) as the cash flows.
• Most models use inflation as a growth rate with no new real
growth. If this were true, all existing firms would decline as a
proportion to the GDP.
• In theory, this stable growth rate cannot be greater than the
discount rate because the risk-free rate that is embedded in the
discount rate will also build on these same factors - real growth in
the economy and the expected inflation rate.
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1
DCF Example to Compute Equity Value from Free Cash Flow –
Net Debt is Bank and Minority Interest minus Cash and Listed
Investments
$
Explicit forecasts
Terminal valuation
Appraised Enterprise Value (AEV)
8,924.43
17,811.59
26,736.02
Plus:
Listed investments
Plus:
Other investments
Plus:
Cash
Total Appraised Value
3,416.00
4,356.00
20,316.00
54,824.02
Less:
Bank & other debt
Less:
Minorities
Equity value
24,282.00
78.00
30,464.02
Treatment of other
investments depend
on definition of free
cash flow. Here,
income from other
investments must not
be in free cash flow
Note how investments are added
and debt is deducted in arriving
at equity value
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2
Example of DCF
• Lehman Brothers and Evercore calculated per share equity
values by:
first determining a range of enterprise values of BellSouth by
adding the present values of the after-tax unlevered free cash
flows and
terminal values for each EBITDA terminal multiple and discount
rate scenario
then subtracting from the enterprise values the net debt
(which is total debt minus cash) and
dividing those amounts by the number of fully diluted shares
of BellSouth.
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3
Discounted Cash Flow Example
•
JPMorgan conducted a discounted cash flow analysis to determine a range of
estimated equity values per diluted share for Exelon common stock.
• JPMorgan calculated the present value of the Exelon cash flow streams from 2005
through 2009, assuming it continued to operate as a stand-alone entity, based on
financial projections for 2005 through 2007 and extensions of those projections from
2008 through 2009 in each case provided by Exelon's management.
• JPMorgan also calculated an implied range of terminal values for Exelon at the end
of 2009 by applying a range of multiples of 8.0x to 9.0x to Exelon's 2009 EBITDA
assumption.
• The cash flow streams and the range of terminal values were then discounted to
present values using a range of discount rates from 5.25% to 5.75%, which was
based on Exelon's estimated weighted average cost of capital, to determine a
discounted cash flow value range.
• The value of Exelon's common stock was derived from the discounted cash flow
value range by subtracting Exelon's debt and adding Exelon's cash and cash
equivalents outstanding as of December 31, 2004.
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4
Example of Discounted Cash Flow Analysis
• For the Exelon discounted cash flow analysis, Lehman Brothers
calculated terminal values by applying a range of terminal multiples to
assumed 2009 EBITDA of 7.72x to 8.72x. This range was based on the
firm value to 2004 estimated EBITDA multiple range derived in the
comparable companies analysis. The cash flow streams and terminal
values were discounted to present values using a range of discount rates
of 5.43% to 6.43%. From this analysis, Lehman Brothers calculated a
range of implied equity values per share of Exelon common stock.
• PSE&G: For PSEG's regulated utility subsidiary, Morgan Stanley
calculated a range of terminal values at the end of the projection period by
applying a multiple to PSE&G's projected 2009 earnings and then adding
back the projected debt and preferred stock amounts in 2009. The price to
earnings multiple range used was 14.0x to 15.0x and the weighted
average cost of capital was 5.5% to 6.0%.
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5
DCF Model Issues and Problems
• The basic structure of a DCF model is simple; more complex
issues include:
How to precisely discount including mid-year cash flows,
terminal values, and transaction periods
How to make terminal growth consistent with multiples and
inflation in the WACC
How to account for deferred taxes, net operating loss,
unfunded pension plans, derivatives, stock option plans,
minority interest, asset retirement obligations and other
liabilities
How to account for high cost debt that has been issued by
the company being valued
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6
Example of Bad DCF
• In valuing a bank in Tanzania:
The WACC used included country premium that produced a
WACC of 22%
The assets of the bank are not loans, but are government
securities
The terminal growth rate was 2%
To make the valuation consistent with multiples in Kenya
and Nigeria, liquidity and other discounts that reduced the PE
multiple from about 20 to about 8.
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7
Common Errors in Discounted Cash Flow Model
• Discounted cash flow models have assumptions about net capital
expenditures and growth that are strongly linked. When capital
expenditures change, then the growth rate should change. There
are two types of errors that show up in these valuations.
First, high growth firms with high net capital expenditures are
assumed to keep reinvesting at current rates, even as growth
drops off. Not surprisingly, these firms are not valued very
highly in these models.
Second, the net capital expenditures are reduced to zero in
stable growth, even as the firm is assumed to grow at some
rate forever. Here, the valuations tend to be too high.
Avoid errors and make the assumptions about reinvestment
a function of the growth and the return on capital. As growth
changes, the reinvestment rate must change.
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8
Three Issues that Can Add Complexity
• Deferred Taxes
• Employee Stock Options and Diluted Shares
• Minority Interest
• Derivatives Valued on Balance Sheet
• Asset Retirement Obligations
• High Interest Rate Debt
• Over-funded or Under-Funded Defined Pension Obligations
• The key is to understand how these items affect the value in
theory and be able to work through examples
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9
Deferred Tax
• There are two ways to consider deferred tax:
Option 1:
Ignore deferred tax in the calculation of free cash flow and
either add or subtract deferred tax assets or liabilities
Option 2:
Model deferred tax as part of free cash flows and explicitly
model the net operating loss
Option 1 has problems
Models future liability even though the future capital
expenditures create new cash flows
Does not consider the timing of NOL
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0
Deferred Tax
• Simulation (see Deferred Tax Example.xls) on CD, shows
If stable growth in capital expenditures, growth in deferred
tax is the same as growth in overall capital expenditures
Should subtract deferred tax changes from cash flow and
not make other adjustments to value
If use EBITDA – EBIT x Tax without considering deferred
tax, will understate value by the PV of deferred tax
Deferred tax as a percent of capital stays constant and does
not vary much for different growth rates
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1
Adjustments to DCF for Employee Stock Options
• If options issued to employees are deducted when computing net income:
Adjust EBITDA so it is the same with and without the option
The option means more cash or less debt is on the balance sheet
• Consider two companies that are identical except that one pays
employees with stock options
The enterprise value of the two companies should be the same
One company has more cash which becomes a reduction in net
debt
The second company in the future will have to dilute the existing
equity ownership
The future dilution should be a reduction in the equity value of the
company
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2
Option Example
• We apply the intrinsic value method of accounting for employee
stock-based compensation and expense it ratably over the
vesting period. We recognize compensation cost for awards on
the grant-date fair value of those awards.
Exercise
Prices
$
$
$
$
$
$
$
$
$
$
$
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4.5
6.6
6.65
7.5
7.6
7.8
9.7
11.6
12.5
17
18.1
Number
Outstanding
116,300
7,000
1,000
28,500
4,000
200
360,000
173,300
556,740
1,088,760
6,000
2,341,800
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Weighted
Average
Remaining
Life (Years)
2.1
9.9
9.9
1.4
9.5
9.7
8.2
8.3
8.2
8.2
1.3
7.8
Number
Exercisable
116,300
—
—
28,500
—
—
54,000
25,995
81,000
160,005
6,000
471,800
March 16
13
3
Minority Interest
• Minority interest should be deducted in computing the value of common
equity
• The issue is whether the minority interest should be subtracted at market
value or at book value
• If the minority interest is significant, the market value should be used
rather than the book value.
• Example:
Minority interest is 49% of the value of the company
The market value of the company is three times the book value
The minority interest should also be three times the book value
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4
Derivatives on the Balance Sheet
• The treatment of derivatives on the balance sheet depends on the manner
in which the derivatives are treated in the cash flow.
• Derivatives measure the costs or benefits signing contracts that lock in
prices, interest rates or other costs.
• If the derivatives are related to operating flows, the treatment depends on
how the contracts are treated in the cash flows.
If the contracts are included in the cash flows, the value of the
derivatives is in the free cash flow and no adjustment should be
made.
If the contracts are not included in cash flows, the value should be
added or subtracted from the enterprise value
• If the derivatives are related to locking in interest rates, the value of the
derivatives is analogous to valuing debt at market value and it should be
include in the DCF
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5
High Interest Rate Debt
• Without adjustments high interest rate debt from being a low rated
company would:
Increase the WACC
Result in high value of debt to be subtracted if the valuation is for a
M&A transaction where the new owner will have a lower cost of debt
• Theory
If the cost of debt is higher because of a higher probability of default,
the equity holders are receiving this value because they own a call
option. If two companies have the same cash flow and one has
more leverage, the enterprise value should not be reduced. Thus, in
theory, the cost of equity should be lower. The APV where all-equity
cost of capital is computed solves this problem.
• Practice
Do not use the high cost of debt in the WACC and do not adjust the
cost of equity
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6
High Coupon Debt
• If the WACC does not have the cost of the high coupon debt (and
it should not) then the market value of debt should be subtracted
and not the book value
• If two companies have the same free cash flow and one has
higher leverage then the other, then the value of the enterprise
and the value of the debt and equity together should be the same.
• If the value of debt is reduced for the risk premium, then the value
of the equity should be increased to compensate.
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7
Assets and Liabilities that Escape DCF Valuation
• Any asset or liability that has no cash flow consequences
• Carefully Analyze the Balance Sheet::
Assets  Add to Enterprise Value
 Un-utilized Land
 Un-utilized Equipment
 Legal Claims
Liabilities  Subtract From Enterprise Value
 Environmental
 Contract Provisions
 Unrecorded unfunded Liabilities
 Net Pension Liabilities not Funded
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Unfunded Pension Liabilities
• Defined benefit versus defined contribution
No issue with defined contribution since contribution covers future
obligations and there is no future obligation that is not covered
Defined benefit plan can lead to requirements to fund that are not
included in investment reserves
Difference between investment reserves and pension requirements
is unfunded liability or asset
If the liability
is included in
operating
expenses,
then no
adjustment
may be
necessary
Unfunded liability is like debt – it will have to be replaced by getting
cash through issuing debt or equity
 If a company runs a defined-benefit pension plan for its employees, it
must fund the plan each year. If the company funds its plan faster then
expenses dictate, the company can recognise a portion of the excess
assets on the balance sheet.
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9
Under-Funded or Over-Funded Pension Obligations Example
• Balanced
Accrue expense as deposit into fund and accumulate
pension fund sufficient to pay all obligations
Deposits to pension fund equal the accrued expense
Pension liability for future payments equals pension fund
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0
Over-Funded Pension Obligations - Example
• Establish a fund before obligations arise
No need to make cash deposits into fund
Pension liability for future payments still is operating expense
in EBITDA but not requiring cash deposits
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1
Under-Funded Pension Obligations - Example
• Revise example to include current obligations
Fund has not been established for obligations
Need to use cash to pay for obligations; this cash not a part of
EBITDA
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2
Terminal Value
Valuation
143
March 16
Terminal Value in Corporate Model
Year after explicit
period to establish
stable cash flows
Gordon’s
CFt x (1+g)/
(WACC-g)
Explicit Forecast
Period
History
Terminal Value
PV of Cash
Year t
Step 2: PV from Year t to
current year
Valuation
Date
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Make sure Cash Flow in
period t reflects realistic
ROIC, Working Capital
that reflects long-term
growth and realistic
capital expenditures
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Infinity
Step 1: PV to year t –
End of period t, so
Gordon’s method
must use t+1 cash
flows
March 16
EV/EBITDA
that Reflects
Long-term
Growth Rate
and ROIC
Market to
Book Ratio
that
Reflects
Long-term
ROE
14
4
Estimating Continuing Value
• Continuing value is important aspect of valuation
• In actual valuations compiled by McKinsey, the terminal value is –
56% to 125% of valuation
• High terminal values are reasonable if cash flow in early years is
offset by outflows for capital spending that should generate higher
cash flows in later years
The terminal value should reflect cash flow and earnings that is at
the middle of the business cycle, or in the case of commodities,
where prices reflect long-run marginal production cost, or in the
case of high growth companies, when the market is saturated
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5
Continuing Value to Add to Free Cash Flow
• Terminal or continuing value is analogous to dividends and capital gains.
Free cash flow is dividends, residual value is capital gain.
• A few methods of computing residual value include:
Perpetuity
First, high growth firms with high net capital
expenditures are assumed to keep
reinvesting at current rates, even as growth
drops off. Not surprisingly, these firms are
not valued very highly in these models.
EBITDA Multiple
P/E Ratio
Market to Book Ratio
Replacement Cost
Second, the net capital expenditures are
reduced to zero in stable growth, even as
the firm is assumed to grow at some rate
forever. Here, the valuations tend to be too
high.
NOPLAT
• Present value of residual amount to add to present value of cash flow to
establish enterprise value
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6
Capital Expenditures and Depreciation in Terminal
Period
• Cash Flow can not be maintained if a company does not make
investments that support the cash flow – the cash flow may be the
result of earlier investments.
• Some simply set the capital expenditures equal to depreciation.
This is not correct if a company grows and experiences
inflation.
The long-term stable relationship depends on the growth
rate, and the depreciation rate.
With a higher growth rate and a longer depreciation life, the
stable rate of Capital Expenditures/Depreciaiton increases.
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7
Alternatives to Classic Terminal Value Computations in
Period “t+1”
FCF Component
EBITDA
Working Capital
Capital Expenditures
Taxes
Classic DCF
Problems
Improved Approach
Growing the Final Year Ignores the Implicit
Return on Investment in the EBITDA and the Compute the Theoretical EV/EBITDA Driven by
Grow Final Year Cash Flow at Low
Relationship Between Cap Exp Growth and
ROIC, Capital Expenditures/Depreciation, Tax
Growth Rate
EBITDA Growth
Rate and Depreciation Rate
If Revenue and Expense Growth Rates are
Changing, the Growth Rate in Working Capital
will not be Correct by Simply Applying the
Model and Additional Period After the Last
Terminal Growth to the Final Year Working
Explicit Year, Where the Revenues and
Grow at Final Year
Capital
Expenses Grow at the Terminal Growth
Either Use the Final Year Capital
Expenditures or Set Capital
Expenditures Equal to
Depreciation
Apply EBIT x Tax and Ignore
Deferred Taxes
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There is a Theoretical Relationship between
Compute the Equilibrium Capital Expenditures
Capital Expenditures and Depreciation that
to Depreciation by Making a Simple Model that
Depends on Growth and Depreciation Rates;
Extends for Many Periods. This Model is a
this Growth Rate Does Not Equal 100% Unless
Function of the Plant Life and the Growth in
there is No Growth
Capital Expenditures
Compute Equilibrium Deferred Taxes as
Function of Tax and Book Depreciation Rates
and Income Tax Rate using a Similar Method
Deferred Taxes Reach and Equilibirum Level
as Above, with a Long-term Model that
that Should be Consistent with Cap Exp Growth
Reaches Equilibrium
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8
Some Terminal Value Issues
• Should you grow from a company that is already earning a high
ROIC (is the ROIC sustainable)
• Should the capital expenditures in the last year be equal to the
depreciation expense (if not, what should be the ratio of capital
expenditures to depreciation).
• Should deferred taxes be included in the terminal year (how
should the deferred taxes correspond to the depreciation
assumptions)
• If multiples are used rather than a perpetuity formula, should the
multiples be adjusted for prospective growth or returns
• How long should a fade period be in achieving the long-term
growth
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9
Formulas for Continuing Value
• A common method for computing cash flow is using the final cash flow in the
corporate model and assuming the company is sold at the end of the
Perpetuity Value at beginning of final year = FCF/WACC
Perpetuity Adjusted for Growth = FCF(1+g)/(WACC - g)
Perpetuity using investment returns =
 NOPLAT x (1-g/ROIC)/(WACC - g)
• Once the Perpetuity Value is established for in the last year, it must be discounted to
the current value:
Current Perpetuity Value = PV(Perpetuity Value that occurs at beginning of
final year)
• NPV in excel assumes flows occur at the end of the year. Adjustments can be made
to assume that flows occur in the middle of the year.
In this case, the discounting of the residual is different from discounting of the
individual cash flows
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0
Sustainable Growth and Plowback Rate
• In the P/E ratio, the sustainable growth of earnings per share is:
g = ROE x (1 – dividend payout ratio)
This depends on assumptions with respect to constant
payout and constant ROE. It also assumes that either there
are no new share issues, or if new share issues occur, the
market to book ratio is one.
• Growth in free cash flow:
g = Dep Rate x [(Cap Exp/Dep) – 1]
Capital expenditures can be greater than depreciation
because historic depreciation is low from historic accounting
or because company has opportunities for growth.
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1
Example with Terminal Growth
• Goldman Sachs also performed an illustrative discounted cash flow analysis to
determine indications of implied terminal value multiples for FPL Group based upon
projected 2008 EBITDA as provided by Constellation’s management.
• In performing the illustrative discounted cash flow analysis, Goldman Sachs applied
discount rates ranging from 5.25% to 7.25% to the projected cash flows of FPL
Group for calendar years 2006 through 2008.
• Goldman Sachs also applied perpetuity growth rates ranging from 2.50% to
3.50%.
• Goldman Sachs derived illustrative implied equity values for Constellation’s implied
40% share of the combined company ranging from $6,822 million to $25,326 million
and illustrative implied equity values ranging from $37.76 to $140.16 per share of the
common stock of the combined company. Applying the mid-point discount rate of
6.75% and the mid-point perpetuity growth rate of 3.25%, Goldman Sachs derived an
illustrative implied equity value for Constellation’s implied 40% share of the
combined company of $12,139 million and an illustrative implied equity value of
$67.18 per share of the common stock of the combined company.
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2
Example of Terminal Value in Telecommunications
•
“Terminal value” refers to the value of all future cash flows from an asset
at a particular point in time.
• Lehman Brothers and Evercore estimated a range of terminal values in
2015 based on AT&T management estimates, in 2010 based on
consensus research estimates, and in 2008 based on BellSouth
management estimates calculated based on selected free cash flow
perpetuity growth rates of 1.0% to 2.0% for AT&T management
estimates and 1.5% to 2.5% for BellSouth management estimates
and consensus research estimates.
• For BellSouth’s Wireline segment, Citigroup and Goldman Sachs
calculated a range of estimated terminal values by multiplying the
BellSouth Wireline segment’s calendar year 2008 EBITDA by selected
multiples ranging from 4.75x to 5.25x.
• For BellSouth’s 40% interest in Cingular, BellSouth’s Wireless business
segment, Citigroup and Goldman Sachs calculated a range of estimated
terminal values by multiplying Cingular’s calendar year 2008 estimated
EBITDA by selected multiples ranging from 5.75x to 6.25x.
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3
Reasons for Multiplying by (1+g) in Perpetuity Method
• Assume
Company is sold on last day in the cash flow period
Valuation is determined from cash flow in the year after the residual period
This cash flow is final year x (1+g)
• Discounting
Since the value is brought back to final period, the discount factor should be the
final year period
Without growth, the value is the cash flow (cf x 1+g)) divided by the discount growth
The discounting should also reflect the growth rate
• Formula
1. Cash Flow for Valuation – CF x (1+g)
2. Value at Last Day of Forecast – CF x (1+g)/(WACC –g)
3. PV of the Value -- discount rate must be at last day of forecast, not mid year
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4
Problems with Use of Multiples and Growth Rates in DCF
• Multiples can cause problems
Sustainable growth once stable period has been reached is
probably less than the growth used in the explicit forecast
period. This means that the multiple should be less as well.
The multiples for evaluating a merger transaction may
include synergies and other current market items. The use of
similar multiples in terminal value is highly inappropriate.
• Constant growth rates can also cause problems
Using FCF x (1+g)/(k-g) requires the assumption that growth
is constant forever, and that the cost of capital will not
change over time.
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5
Continuing Cash Flow from NOPLAT and ROIC
• Using a multiple of NOPLAT has a couple of advantages
It is not distorted by large of small capital expenditures
Continuing value directly relates to assumptions about ROIC
For companies with low leverage, the NOPLAT multiplier is similar to the P/E
ratio
• Formulas for Computing Continuing Value with NOPLAT
Free Cash = NOPLAT – Capital Expenditure + Depreciation
Free Cash = ROIC x Investment – Capital Expenditure + Depreciation
The equation becomes:
Free Cash = (1-Real Growth/Real ROIC) x NOPLAT
 In this formulation
 G = ROIC x Plowback Rate
 Similar to ROE x Retention Rate
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6
Drivers in Terminal Value
• Rather than using growth from final year, use value drivers:
Return on Invested Capital
WACC
Capital Expenditures to Depreciation
 Natural growth from inflation
 Real growth
• Formula for Sustainable Growth
Cap Exp/Investment – Depreciation/Investment
Cap Exp/Depreciation x Depreciation – Depreciation
• Implied EV/EBITDA can be established
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7
Depreciation and Capital Expenditures in Terminal Cash
Flow
• Some assume that capital expenditures equal depreciation in the
final period
This would make sense if:
No past inflation
No past growth
To replace assets will have to pay current costs rather than
historic costs that were affected by inflation.
If the company has grown, the stable cash flows will reflect
current state of the company.
• Address with simple simulations to derive equilibrium level of
capital expenditures relative to depreciation
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8
Detailed Discounting Issues
• In excel, the NPV formula assumes that cash flows occur at the
end of the year.
• It is more reasonable to assume that cash flows occur in the
middle of the year.
• You can use discount factors that use mid-year discounting
• If the last year cash flow occurs at the middle of the year and it is
assumed that the company is sold at the end of the last year, then
you should use (1+g)^1.5 rather than (1+g) in discounting
• If you use XNPV it is equivalent to computing a daily discount rate
with the formula (1+r)^(1/365)-1 and then using the number of
days in the discounting process
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9
Valuation from Projected EPS and Dividend per
Share
Valuation
160
March 16
Valuation from Projected Earnings and Dividends
•
Earnings Valuation
 PV of EPS over forecast horizon discounted at the equity discount
rate
 Add the present value of the perpetuity EPS value reflecting the
growth rate
•
Dividend Valuation
 PV of Dividend per share over the forecast horizon
 Add present value of book value per share rather than perpetuity of
earnings because book value grows when dividends are not paid
 Can multiply the book value per share by market to book multiple
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1
Price Earnings and Gordon Model
Gordon Dividend Discount Model.
P =
D1/(K – G)

P = the "correct" share price

D = dividend payment for the next period (recall from discounting exercise that the next
period must be used)

K = Required rate of return (based largely on market interest rates a adjusted for equity
risk)

G = anticipate rate of dividend growth
The model can be used to compute the cost of capital where:
R = D/P + G
Problem: D is not EPS and G is affected by payout ratio
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2
Use of Relationship between Multiples and Financial
Ratios in Residual Value
• The financial model projects the return on equity and the
relationship between ROE and the Market to book ratio can be
used to make projections of multiples
Market to Book Ratio versus Return on Equity
4.00
Exelon
3.50
y = 13.102x + 0.2595
R2 = 0.786
3.00
Market to Book
2.50
2.00
Return on equity associated
with a market to book ratio of
1.0
1.50
1.00
0.50
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
ROE
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3
Reference: Selected Valuation Issues
Valuation
164
March 16
Valuation Issues
• 1. How do you choose between firm and equity valuation
(DCF valuation versus Earnings Growth)
• Done right, firm and equity valuation should yield the same values
for the equity with consistent assumptions. Choosing between
firm (DCF) and equity valuation (PE x EPS forecasts) boils down
to the pragmatic issue of ease.
• For banks, firm valuation does not work because small
differences in WACC can have dramatic effects on valuation while
and if the market value of debt differs from the book value, firm
value can cause distortions.
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5
Firm versus Equity Valuation
• From the perspective of convenience, it is often easier to estimate
equity than the DCF, especially when leverage is changing
significantly over time (for example, in project finance and in
leveraged buyouts where equity IRR is used).
• Equity value measures a real cash flow to owners, rather than an
abstraction (free cash flows to the firm exist only on paper).
• Free cash flow is affected to a large extent by capital
expenditures which can cause problems.
• Equity cash fllow brings to light potential cash shortfalls (and the
likelihood of bankruptcy) much more directly
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6
Measurement of Expected Growth Rate
• While there are many who use historical (past) growth as a
measure of expected growth, or choose to trust analysts
(with their projections), try using fundamentals.
• Think about the two factors that determine growth - the firm's
reinvestment policy and its rate of return.
For expected growth in earnings = Retention Ratio * ROE,
where Retention Ratio is 1 – Dividend Payout
For expected growth in EBIT = Reinvestment Rate * ROC,
where reinvestment rate is Cap Exp/Depreciation
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7
Estimation of Terminal Value
• Terminal value refers to the value of the firm (or equity) at the
end of the high growth period. Estimate terminal value, with
DCF, by assuming a stable growth rate that the firm can
sustain forever. If we make this assumption, the terminal
value becomes:
• Terminal Value in year n = Cash Flow in year n+1 / (r - g)
• This approach requires the assumption that growth is
constant forever, and that the cost of capital will not change
over time.
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8
Exit multiple in DCF valuation
• In some discounted cash flow valuations, the terminal value
is estimated using a multiple, usually of earnings. In an
equity valuation model, the exit multiple may be the PE ratio.
In firm valuation models, the exit multiple is often of EBIT or
EBITDA.
• Analysts who use these multiples argue that it saves them
from the dangers of having to assume a stable growth rate
and that it ties in much more closely with their objective of
selling the firm or equity to someone else at the end of the
estimation period.
• Problems arise if the PE assumes a higher growth than is
sustainable after the holding period.
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9
Exit multiples and DCF valuation
• On the contrary, exit multiples may introduce relative
valuation into discounted cash flow valuation, and that you
create a hybrid, which is neither DCF nor relative valuation.
These exit multiples use the biggest single assumption made
in these valuation models.
• It seems foolish to assume that current multiples will remain
constant as the industry matures and changes and that
investors will continue to pay high multiples, even if the
fundamentals do not justify them. If there is stable growth,
the P/E multiple in the terminal value should be lower.
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17
0
Valuation of Firms that are Losing Money
• There are a number of reasons why a firm might have
negative earnings, and the response will vary depending
upon the reason:
- If the earnings of a cyclical firm are depressed due to a
recession, the best response is to normalize earnings by
taking the average earnings over a entire business cycle.
- Normalized Net Income = Average ROE * Current Book
Value of Equity
- Normalized after-tax Operating Income = Average ROC *
Current Book Value of Assets
- Once earnings are normalized, the growth rate used
should be consistent with the normalized earnings, and
should reflect the real growth potential of the firm rather
than the cyclical effects.
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1
Valuation of a firm that is Losing Money
• - If the earnings of a firm are depressed due to a one-time
charge, the best response is to estimate the earnings without
the one-time charge and value the firm based upon these
earnings.
- If the earnings of a firm are depressed due to poor quality
management, the average return on equity or capital for the
industry can be used to estimate normalized earnings for the
firm. The implicit assumption is that the firm will recover
back to industry averages, once management has been
removed.
- Normalized Net Income = Industry-average ROE * Current Book
Value of Equity
- Normalized after-tax Operating Income = Industry-average ROC
* Current Book Value of Assets
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2
Valuation of a firm that is losing money
• - If the negative earnings over time have caused the book
value to decline significantly over time, use the average
operating or profit margins for the industry in conjunction
with revenues to arrive at normalized earnings. Thus, a firm
with negative operating income today could be assumed to
converge on the normalized earnings five years from now. - If
the earnings of a firm are depressed or negative because it
operates in a sector which is in its early stages of its life
cycle, the discounted cash flow valuation will be driven by
the perception of what the operating margins and returns on
equity (capital) will be when the sector matures.
• - If the equity earnings are depressed due to high leverage,
the best solution is to value the firm rather than just the
equity, factoring in the reduction in leverage over time.
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3
Valuation of a private firms
• The valuation of a private firm is more difficult than stock in
a publicly traded firm. In particular,
A. The information available on private firms will be
sketchier than the information available on publicly
traded firms.
B. Past financial statements, even when available, might
not reflect the true earnings potential of the firm. Many
private businesses understate earnings to reduce their
tax liabilities, and the expenses at many private
businesses often reflect the blurring of lines between
private and business expenses.
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4
Valuation of a private firm
• C. The owners of many private businesses are taxed on the
salary they make and the dividends they take out of the
business; often do not try to distinguish between the two.
The limited availability of information does make the
estimation of cash flows impossible; past financial
statements might need to be restated to make them reflect
the true earnings of the firm. Once the cash flows are
estimated, the choice of a discount rate might be affected by
the identity of the potential buyer of the business. If the
potential buyer of the business is a publicly traded firm, the
valuation should be done using the discount rates based
upon market risk
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5
EPS Measures – Establishing a reliable starting point
• Reported EPS – EPS reported by the company using generally
accepted accounting principles. Therefore includes earnings from
recurring and non-recurring items
• Recurring EPS – Reported EPS adjusted to exclude nonrecurring items
• Fully diluted EPS – EPS adjusted to reflect dilution to existing
shareholders as a result of future increases in equity shares
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6
EPS adjustments
Item
Profits and losses on operations discontinued during the period
Profits or losses on disposals of investments acquired for resale but not
held in the ordinary course of business
Extraordinary items
Gains or losses on the disposal of fixed assets
Gains or losses on the disposal of subsidiaries/associates or business units
Goodwill amortisation
Provisions for reorganisation or restructuring
For recurring
net profit
IN
‘economic
IN
OUT
IN
OUT
OUT
IN
Note: adjustments only made to the extent disclosure allows and materiality equires
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7
Issue of shares during the year - Rights issue
Net profit for the year
Theoretical ex rights price:
20,000
Shares in issue 1 January Rights issue on 30 September Last cum div price before the stock goes ex rights
150,000
One for three
6
Existing shares
New shares
Equivalent to:
Bonus fraction of the rights issue:
Time weighted number of shares in issue
1/1 – 30/9
Rights issue
1/10 – 31/12
EPS
150,000
50,000
200,000
20,000 / 185,000
Rights issue price
2
3
1
4
@ 6.00
@ 2.00
@ 5.00
Cum rights price
Theoretical ex rights price
Bonus fraction
6
5
06-May
x6/5
x 9/12
135,000
x 3/12
50,000
18
2
20
0.1081
Historic periods’ number of shares grossed up by the bonus fraction (6/5)
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8
Share buy back
• Redeem Ltd made earnings of $ 33 million dollars for the year
ended March 2004. The number of shares issued at the start of
the year was 200 million. In September 2003 Redeem Ltd bought
back 20 million shares at market price.
Date
Shares
Weighted Average
Start of year
200 million x 6/12
100 million
After Buy Back
180 million x 6/12
90 million
Weighted Average
190 million
EPS = $33 million/ 190 million = 17. 3 CENTS
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9
Dilution – Factors and treatment
• Contingently issuable shares - Include shares in the calculation of
basic EPS if the contingency has been met.
• Options or warrants in existence over as yet un-issued shares –
Assume exercise of outstanding dilutive options and warrants
• Loan stock or preference shares convertible into equity shares in
the future – Assume that instruments are converted therefore
saving interest but increasing the number of shares in issue
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Diluted Shares
• If you have agreed to give away shares to someone, then your
claim to the cash flow of the company is reduced.
• In the extreme, if you have given away half of your company
away, and the cash flow is the same before and after your give
away, then the amount you would pay for the share must account
for how much you will give away.
• In this extreme example, you should reduce the value by ½.
• This can be accomplished by using diluted shares rather than
basic shares.
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1
Option dilution
• Calculation of the number of shares in the dilution calculation is
illustrated below:
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2
Multiple share classes
Equivalence factor approach
Net Profit
Class A
Class B
$300,000
Primary
Secondary
Par value
No.
Total par value
Price
$5.00
$0.50
800,000
4,000,000
$4,000,000
$2,000,000
$6,000,000
$10
$1.2
Secondary to primary equivalence factor
Equivalent number of primary shares
Class A EPS
Class A PE
0.1
25.00c
40.00x
1,200,000
(300,000 / 1,2000,000)
(10.00 / 0.25)
Class B EPS
Class B PE
2.5
48.00x
Class A EPS x equivalence factor
(10.00 / 0.25)
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3
Multiple Listings
• Fungible shares listed on different exchanges – EPS calculated
on the basis of total shares - Value equity based on shares held
by the investor group to whom your research is directed
State owned
“H” Shares
“A” Shares
Total
300
156.7
30
486.7
Price - local
HKD 1.50
RMB 5
Price - RMB
1.58
5
Equity Value – RMB million
769
2433
Number ( million)
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4
Employee Stock options – Latest developments
• IFRS 2 – Requires companies to measure the fair value of share-based
payments at the grant date and expense over the vesting period
• FAS 123 – The above treatment is optional
• A company grants 100 options to 200 employees. The estimated fair value is
$ 50 per option. The options are contingent on the employees working at the
Company in 3 years time. The company estimates that 25% of the employees
Will leave over the 3 year period. No employees leave in year 1 and 2 but
10% leave In year 3.
Year
Calculation
Cumulative expense
Expense
1
100 x (200 x 75%) x $50 x 1/3
$ 250,000
$ 250,000
2
100 x (200 x 75%) x $50 x 2/3 less $ 250,000
$ 500,000
$ 250,000
3
100 x 180 x $50 x 3/3 less $500,000
$ 900,000
$ 400,000
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5
Issues in the application of PEs
• Accounting Policy differences – Particularly significant for cross border
comparisons where companies may follow local, international or US
GAAP
• Loss making companies – No earnings therefore no PE
• Cyclical companies – PEs volatile through the cycle and therefore difficult
to benchmark
• Finding a suitable benchmark – Difficult to find companies that are perfect
matches in all determinants of a PE
• Growth – As discussed value and growth are not always the same
• Capital market conditions – The cost of equity will vary depending on
underlying interest rate environment that is likely to be different in different
countries
• Financing – The greater the gearing of a company the greater the cost of
equity and therefore, all other things being equal, the lower the value and
the lower the PE
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6
Valuation of Subsidiary Companies in Different
Countries
• How would things differ if we are valuing companies from different
countries, different sectors etc.
• The basic rule is:
Cash flows should be nominal
Cash flows should be stated in the currency where the subsidiary is
located
 If there are multiple currencies, use the future expected spot exchange
rates to translate cash flows
Cash flows should be discounted at cost of capital that reflects the
interest rates where the country is located
 This means that the risk free rate in the country where the subsidiary is
located should be used.
Once the value is established, translate the amount to the home
country at the spot exchange rate
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7
Valuation of Subsidiary Companies in Different
Countries
• How would things differ if we are valuing companies from
different countries, different sectors etc.
Example:
Subsidiary is located in Malaysia
Parent Company is in Hong Kong
Subsidiary company sells in Malaysia and Thailand
Subsidiary company produces in Malaysia and Thailand
Exchange Rates and Interest Rates
Spot Exchange Rates
 HK Dollars to Ringet
 Baht to Ringet
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8
Valuation of Subsidiary Companies in Different
Countries
• How would things differ if we are valuing companies from different
countries, different sectors etc.
• Cash flows should be stated in the currency where the subsidiary is
located (Malaysian Ringgit)
Compute prices and costs in Baht and Ringgit and then translate the
revenues and costs in Baht to Ringgit
To convert the Baht to Ringgit, use the expected future spot
Ringet/Baht exchange rates
Since, as a practical matter, forward exchange rates are not
available beyond 18 months, compute future spot rates from interest
rate parity
Interest rate parity means that if you invest in risk free securities of
different currencies, the spot exchange rate must reflect the future
values.
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9
Valuation of Subsidiary Companies in Different
Countries
• How would things differ if we are valuing companies from
different countries, different sectors etc.
• Example of future expected spot exchange rates:
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0
Example of Foreign Valuation
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1
Free Cash Flow
We often talk about free cash flow, sometimes, it is challenging
to assess what is "free“ cash flow or not, may wish to
elaborate on that rather than just defining free cash flow in a
text book term.
The basic point is to keep things consistent. If you define FCF as
EBITDA without other income, then the valuation does not include
other investments.
On the other hand if FCF is defined using Cash B/4 Financing that
includes other income, the other investments are included in the
valuation
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2
In-the-money Options and Convertibles
•
Can the trainer also cover dealing with in-the money
options and convertibles?
•
Convertibles can trade as straight debt if it is unlikely that the
convertibles will be converted to common shares, or if the
conversion option is in the money, it is clear that the convertibles
will be switched into common shares. In this case, the
ownership share of current shareholders is diluted.
•
If you buy the current shares, you are not really getting the
whole company because you will have to give a share of the
cash flow to the convertible bondholders.
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3
In the Money Convertibles
• Can the trainer also cover dealing with in-the money options
and convertibles?
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4
Terminal Value
Terminal value, and the use of a stable growth rate. How do you
determine that, what is the rule of thumb and how do you
determine which year onwards should be terminal year (i.e. how
long should your forecasted period be).
On how to calculate a WACC, rather than just providing the formula
of WACC, it would be useful to give instructions on where to find
the market premium data, betas and what is the best method vs
the most practical method.
Should we include country risk, exchange rate risks etc and
how to get them.
Also there is no mentioning of cash revolver and how to calculate it.
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5
LBO Valuation
•
How can LBO’s be valued by making an assumption on
target IRRs for the venture cap / private equity investor.
•
Recall the very first simple case that was developed in the class.
In this case the equity IRR was driven by the level of leverage
and the structure of the debt.
•
Valuation is realistically driven by the equity IRR criteria of
developers and not free cash flow or WACC
•
The risk metric boils down to the debt capacity of the LBO and
the value of the investment depends on the debt structure.
•
In this case, risk is driven by bankers outside of the company
rather than the management or advisors to the company.
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6
Example of Multiples to Check Valuation
Used multiples to
demonstrate that
the valuation is not
plausible
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7
Signals that you should sell
1.
Does the CEO have other board seats?
2.
Has the company made takeovers of more than $250 million in the last 3 years?
3.
Did the auditor grow up with the company?
4.
Do finance writers call the CEO:
- ‘Whiz-kid’
- Dynamo
- Takeover King
- Breath of fresh air in the ‘old’ boardroom
5.
Does the company sponsor the highest level of performing arts in the country?
6.
Does the Chairman speak at more than 4 seminars a year?
7.
Did the share price rocket because of some new technological breakthrough?
8.
Has the company recently moved into a luxurious head office?
9.
Is the company installing a state-of-the-art computer system?
10.
Is the company diversifying into media, resources, high-tech?
11.
Has the chief executive been praised by finance writers for innovative financings?
12.
Has the chief executive been involved with a previous corporate collapse?
13.
Does the Chairman have a private sauna in his office?
Source: Pierpont (Trevor Sykes) Australian Financial Review, 24 May 2002
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8
Finance Professor
•
A finance professor received a call from a large financial institution in New York, asking him to
interview for a position on their scientific advisory committee. He agreed to go up and interview,
knowing that such a position would be prestigious and with the extra income we would be able to
purchase more consumer durables. As all of you know, interviews are a long and painful process.
The interviews lasted two days and at the end of the last day the professor was interviewing with
the chief executive who would ultimately be making the hiring decision. At the very end of the
interview, the executive asked him, “what is 7 times 3?” The finance professor confidently
responded, “22.”
•
When he got home from New York his family, for once, was eagerly awaiting his return… with lists
of consumer durables in their hands. “How did it go?” they asked. “Good,” he said, “except in the
last interview they asked me 7x3 and I said 22.” “Ohh! Dad!!!” they cried, “it’s 21!” They threw out
their lists of consumer durables, knowing he would never get the job.
•
Much to his surprise he got a call 2 weeks later saying he’d gotten the position and the firm was
having a reception in his honor. At the reception he found the executive and went up to him. “Do
you remember our interview?” the professor asked. “Yes,” said the executive. “And do you
remember when you asked me 7x3 and I said 22.” “Yes,” replied the executive, “I wrote down your
answer.” “Well the correct answer is 21,” said the professor, “why did I get the job?” “Well,” said
the executive, “of all the finance professors we interviewed… you were the closest.”
•
The moral of the story is, if I can do this, you can do this: pricing bonds and non-American options
using monte carlo simulation to replicate the results achieved explicitly using decision trees.
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9
Finance Professors
• A medical doctor, an engineer, and a finance professor are at a
cocktail party.
The medical doctor pompously asserts that the medical
profession is the oldest profession. He cites a passage from
the Bible, in Genesis where god creates man and woman.
“Surely,” he says, “this was the first medical act.”
The engineer jumps in and says, “I remember a passage
prior to that, which says, out of the chaos and confusion, God
created the earth. Surely, this was the first act of engineering
and predates the first medical act.”
“Aha!” says the finance professor, “who created the
confusion?!”
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0
Resources and Contacts
• My contacts
Ed Bodmer
Phone: +001-630-886-2754
E-mail: edbodmer@aol.com
• Other Sources
http://pages.stern.nyu.edu/~adamodar/
www.sec.us.gov -- financial documents
www.finance.yahoo.com; www.googlefinance.com;
www.valueline.com -- stock prices and financial ratios
www.standardandpoors.com; www.moodys.com – credit rating and
other information
www.bondsonline.com – credit spreads
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