Module I:
Investment Banking and
Valuation
September 4, 2002
J. K. Dietrich - FBE 432 – Fall, 2002
Objectives
 Understand
how investment bankers value
firms
– Liquidation or adjusted-asset value
– Public comparables (multiples approach)
– Discounted-cash-flow methods
» WACC (entity) approach
» Flow to equity (fundamental analysis) methods
» Adjusted present value
 Compare
and contrast these methods and
understand advantages and limitations of
each
J. K. Dietrich - FBE 432 – Fall, 2002
Liquidation or Adjusted-Assets
 Value
of equity in firm is simply:
Equity = Assets – Liabilities
 A crude estimate of value is the book value
of equity and is used as a reference (times
book)
 Adjust assets for market value rather than
accounting values
 An adjusted estimate of equity value is:
Equity = Adjusted Assets - Liabilities
J. K. Dietrich - FBE 432 – Fall, 2002
Comparables using Public Firms
 Using
comparables of publicly traded firms
is very widely used by analysts (both buy
and sell side)
 Often called multiples approach
 Uses a combination of accounting and
market numbers to value companies. Most
common multiples are:
– Price/earnings
– Asset/sales
– Market/book
J. K. Dietrich - FBE 432 – Fall, 2002
Example of Comparables Method
 Greens
Health Inc., a privately owned
Supermarket chain has expected earnings of $20
million per year on sales of $205 million with total
assets of $80 million.
 In a proposed IPO, Greens will issue 10 million
shares so forecast EPS is $2 per share; the firm is
all equity.
 Using data on suitable comparables, compute a
valuation matrix
J. K. Dietrich - FBE 432 – Fall, 2002
Valuation Matrix: P/E Ratios
Comparables
PE Ratio
Implied Stock Price
Vons
18
36
Safeway
19
38
18.5
37
Average
Source: Compustat (Wharton) Raios for 1995
Using an average stock price of $37, firm value is
estimated to be $25  10m = $370 million
J. K. Dietrich - FBE 432 – Fall, 2002
Valuation: Price/Sales Ratios
Comparables
P/S Ratio
Implied Firm Value
Vons
.24
49.2
Safeway
.38
77.9
1.3
63.6
Average
Firm value is estimated to be $63.6 million
J. K. Dietrich - FBE 432 – Fall, 2002
Valuation: Market/Book Ratios
Comparables
M/B Ratio Implied Firm Value
Vons
2.0
160.0
Safeway
6.9
552.0
1.3
356.0
Average
Firm value is estimated to be $356.0 million
J. K. Dietrich - FBE 432 – Fall, 2002
Compare Results
 Range
of values is $63 to $360 million
 Wide differences in Vons and Safeways ratios
 What are differences in firms and how do they
affect comparability of valuations?
– Vons has debt-to-asset ratio of .66
– Safeway’s debt-to-asset ratio is .82
– Both firms are highly leveraged
 P-E
and P/B valuations are closer than P/S
approach
J. K. Dietrich - FBE 432 – Fall, 2002
Pitfalls in Comparables: I
 Remember
when using P/E ratios that the
estimated value is the value of equity, not
firm value.
 Example:
– Suppose Greens carried $114 million of debt.
With equity of $250 million and debt of $114,
firm value is now V = E + D = $364 million.
– How does this affect value using P/S ratios?
J. K. Dietrich - FBE 432 – Fall, 2002
Pitfalls in Comparables: II
 Are
the comparables really comparable?
Firms differ in many significant dimensions
including
– Growth rates
– Cash flows
– Risk (most obviously capital structure; note that
Greens equity value was unchanged by the fact
that it carried debt. Is this realistic?
J. K. Dietrich - FBE 432 – Fall, 2002
Pitfalls in Comparables: III
Suppose the unobserved true relation between stock price
and earnings is
Price = $9.00 + 12EPS
For Vons, say EPS =$1.50, so Price = $27 and P/E =18
For Greens, we have value = $9.00 +12 x 2 = $33
The multiples approach misprices by $4.00 or twelve
percent of firm value -- other relations could be off
more.
J. K. Dietrich - FBE 432 – Fall, 2002
Assessment
 Advantages
– Quick, easy to understand, and widely used
 Disadvantages
– Based on accounting concepts
– Ignores growth opportunities and future cash
flows
– Fails to account for differences in capital
structure
J. K. Dietrich - FBE 432 – Fall, 2002
DCF Approaches
 All
DCF approaches discount cash flows by the
appropriate discount rates
 Ingredients
– Cash flow forecasts for future periods (the past is
irrelevant)
– An associated discount rate which measures the return
on investments of comparable risk
 Three
main approaches
– WACC, APV, Flow to Equity
J. K. Dietrich - FBE 432 – Fall, 2002
DCF Approaches
 Simplest
approach is to assume first-year cash
flow and perpetual growth and discount rates
Cash Flow
PV 
rg
 More
convincing approach is to use explicit cash
flow projections over a forecast period and
discount continuing value using simplest approach
for cash flows after forecast period
J. K. Dietrich - FBE 432 – Fall, 2002
Computing the Discount Rate
 The
discount rate applied to these cash
flows represents the opportunity cost of
capital
 It can also be thought of as the expected or
required return for an investment that is
equally risky
J. K. Dietrich - FBE 432 – Fall, 2002
Equity Discount Rates
 Unlevered
Cost of Equity (rA)
– What the cost of capital would be if the firm
had no leverage.
– Depends on asset risk, but not not capital
structure
– Equals weighted-average cost of capital
(WACC)
 Levered
Cost of Equity (re)
– Cost of equity capital at a given leverage.
Clearly depends on asset risk and also on
leverage.
J. K. Dietrich - FBE 432 – Fall, 2002
Discount Rates
 We
obtain discount rates for equity using a model
of risk such as the CAPM
 CAPM states that the expected or required return
on an asset the sum of two components
– The risk free rate
– A risk premium
risk premium is b times the market risk
premium, historically about 8%
 The
J. K. Dietrich - FBE 432 – Fall, 2002
CAPM
The Capital Asset Pricing Model states that
the expected return on an asset is
r  rf  b (rm  rf )
Beta measures the sensitivity of the stock’s return to
the return on the market portfolio. Note that beta
depends on the firm’s leverage.
J. K. Dietrich - FBE 432 – Fall, 2002
Next Week – September 9 and 11
 Be
prepared to discuss Eskimo Pie case
 Review textbook discussion of capital
structure and the issues of capital structure
and corporate valuation
 Read Continental Carriers Inc. case to
familiarize yourself with the issues and data
available
J. K. Dietrich - FBE 432 – Fall, 2002