Security Analysis

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Valuation

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Valuation Overview  Valuation  Discounted cash flow models  DDM   FCFE Relative valuation   over time across assets at a given time   relative to comparables relative to the market 2

General Thoughts on Valuation    We will be using quantitative models.

 But one size does not fit all.

   Obviously, a DDM won’t work for a company that doesn’t pay dividends.

Estimating growth for a cyclical company is problematic.

Sometimes, it’s easier to compare ratios with comparables.

 But this comparison should be both across comparables and across time.

Use more than one valuation metric  The more metrics that produce the same answer, the better.

Sensitivity analysis is vital .

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Valuation Models   Discounted Cash Flow  DDM  FCFE Relative Valuation    P/E P/B Other ratios (some predict better than others for different industries.

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Valuation Methods     Valuation Versus Own History  Is it relatively cheap now?

Valuation Versus Peer Group  Is it undervalues relative to peers now?

 How has that relationship evolved over time?

 If a company a reason.

always sells at a discount, there’s probably Valuation Versus Market   Is it undervalued relative to the market now?

How has that relationship evolved over time?

Absolute Valuation 5

What you may find     Companies that look cheap, and always have.

Firms that look good in industries that look bad.

 That is, the industry currently looks expensive but the firm is the cheapest thing in the industry.

Industries that look good with firms that are average for the industry.

How can you tell?

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DCF   DDM’s FCFE   The holy grail: growth rate the numerator should be the cash flows that can be distributed to shareholders while retaining enough cash to support the assumed The holy grail 2: your discount rate should match your numerator type 7

Basic Dividend Discount Model P= D 1 (r-g) 8

Two Stage DDM  Pо=∑ D 1 _____+ ___P n ___ (1+K hg )† (1+K hg )ⁿ Where P n =DPS n+1 (K st -G n ) 9

Citigroup: Gordon Growth DDM

Dividend R growth P=D/(R-g) Citigroup

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Dividend Discount Model

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1.6

1.6

$ 9.00% 4.00% 32.00

$ 9.00% 5.00% 40.00

$ 9.00% 6.00% 53.33

$ 9.00% 7.00% 80.00

$47.00

1.6

9.00% 8.00% $ 160.00

Dividend R growth P=D/(R-g)

$ 1.60

10.00% 5.00% $ 32.00

$ 1.60

10.00% 6.00% $ 40.00

$ 1.60

10.00% 7.00% $ 53.33

$ 1.60

10.00% 8.00% $ 80.00

$ 1.60

10.00% 9.00% $ 160.00

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DDM Challenges       Certainty and Growth Rate of Dividends Appropriate Discount Rates Length of Growth Period(s) Normal growth is what??? Small Changes in Assumptions Lead to Widely Disparate Values Outliers Most likely to be Mis-specified 11

Growth Failure: Companies Maintaining 20% Growth

% 2 1 0 5 4 3 10 9 8 7 6 5 Years 10 Years 15 Years % Companies w/20% Growth

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Growth Failure: Persistence of Excessive Growth

First Year

-15.00%

Seventh Year

-0.30% -0.20% -1.00% -0.90% -1.80% -1.70% -3.30% -9.90% -10.00% -5.00% 0.00% 0.90% 1.70% 1.00% 1.30% 1.10% 1.90% 3.70% 5.00% 8.60% 10.00% Low PE High PE 13

Discount Model Applications      Testing of Assumptions: Solve for Implied Values.

 Take P as given, pick R and solve for g.

Must have Stable Growth and Leverage Companies Cross Sectional, Time Series Analysis  DDM may produce low values for a particular industry. Prefers Low PE/High Dividend Payers over High PE Cash Retainers  The high P/E cash retainers can perhaps be better valued by FCF.

FCF is often a good Alternative to Dividends 14

Free Cash Flow Valuation   Simple Definition: FCF= Operating Earnings+Depreciation -Capital Expenditure-∆Working Capital You may be able to do better, but this is useful for forecasting.

Why Could This Be More Effective than DDM?

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Relative Valuation    Measure Comparable Assets with a Common Measure Evaluate Price vs. Fundamental Factors (P/E, P/FCF, P/S, P/Bk, EV/EBITDA) Look at Time Series Data 16

Relative Valuation     Commonly Used against Company Historical Range, Peers, or Market Easy to Access, Easy to Misuse Yields Different Answers Than DCF If it Looks Too Good to be True it Probably is…Too Good to Be True 17

What are Comparable Assets?

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Comparable Assets  Similar Cash Flow, Growth and Risk  Generally in Similar Industries  Complicating Issues: Size, Business Mix, Leverage, Profitability  Understand Implicit Assumptions 19

Comparable Assets 2004?         GE ($33.75) 2004 estimate $1.57

LTG estimate 9.4% PTax Margin 15.12% Mkt Cap $356bn ROE 21% Debt/Tot Cap 43.6% 2004 PE 21.4x

        C ($47.00) 2004 estimate $4.01

LTG estimate 11.36% PTax Margin 27.8% Mkt Cap $243bn ROE 19.52% Debt/Tot Cap 23.3% 2004 PE 11.7x

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Comparable Assets 9/03          GE ($31.79) 2003 estimate $1.56

LTG estimate 11.3% Op Margin 14.14% Mkt Cap $318bn ROE 23.8% Debt/Equity 214% 2003 PE 23x Price 9/13/04 $33.75

         UTX ($79.48) 2003 estimate $4.64

LTG estimate 11.6% Op Margin 12.26% Mkt Cap $37.2bn

ROE 26.6% Debt/Equity 51% 2003 PE 18x Price 9/13/04 $94.64

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When to use what?

1.

2.

3.

4.

5.

6.

P/E P/FCF P/B P/Sales EV/EBITDA Other measures???

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1. PE Ratio Sensitive to Volatility, Growth, Profitability  P/E = 1/r + PVGO/E  Affected by Accounting Issues   Multiple Definitions (Operating Eps, Historic, Forward, Pro-forma, Fully Diluted vs Basic) Affected by leverage 23

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2. Free Cash Flow Yield (instead of earnings)      Operating Earnings+Depreciation Expense Cap Ex-∆Working CAP Cash Available for Distribution to Shareholders Strips Back Some Accounting Artifice Incorporates Info from Balance Sheet Note that we are still stuck with perpetual growth assumption 26

3. Price to Book Value   Useful in Distressed Situations Useful in Lower Growth Industries (Energy, Utilities, Financials) 27

3. Price to Book Value Liquidation Value Going Concern Value 28

3. Price to Book Value Liquidation Value Going Concern Value 29

3. Price to Book Value     Useful in Financials Where Reserves can be Manipulated Influenced by ROE and Cost of Equity Significant Accounting Issues (Buybacks, Restructuring) Can be Useful in Mean Reverting Mature Industries (Energy, Utilities) 30

4. Price to Sales     Tougher to Manipulate Revenues Tend to be Positive!

Useful in Absence of Profitability (Highly Cyclical Situations) Enterprise Value to Sales (MV of Equity+MV of Debt-Cash)/Sales Corrects for Companies with Different Leverage 31

5. Enterprise Value to Ebitda  (Market Value of Equity+Debt Cash)/(Earnings Before Interest, Taxes, Depreciation, and Amortization)     Used in the Absence of Profits Used Where EBITDA is Free Cash Corrects For Varying Leverage But Ignores Depreciation as Real Expense 32

6. Alternative Measures?

     PE to Growth Ratio Market Value per Subscriber Market Value per Home Passed Market Value per Member Market value per Pet HOLD ON TO YOUR WALLET!

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Why Are Comparables/Relative Value So Important?

   Arbitrage Relies on “close substitutes” Be careful of stocks “obviously” cheaper than comparables 34

Why Use Multiples Analysis?

     Used prevalently in practice   Research reports full of multiples Rules of thumb based on multiples Quick – can evaluate large #s of stocks Understandable/sellable/defensible Current market data DCF relies on multiples in the end  Terminal value 35

Problem with Multiples Analysis  Quick can be too quick – and dirty 36

Issues When Using Multiples      Definitions  What are “earnings”?

Consistency  Equity versus Firm (enterprise) Uniform   Over time Cross-section (across firms) Scaling  Common sizing is useful Range/Distribution   Mean versus median outliers 37

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