Valuation
NYU
Valuing a Business I
Prof. Ian Giddy
New York University
What’s a Company Worth?
 Required
returns
 Types of Models
Balance
sheet models
Comparables
Corporate cash flow models
 Estimating
Growth Rates
 Applications
 Option-based models
Copyright ©2004 Ian H. Giddy
Valuation 3
IBM
Source: biz.yahoo.com
Copyright ©2004 Ian H. Giddy
Valuation 4
IBM
Source: biz.yahoo.com
Copyright ©2004 Ian H. Giddy
Valuation 5
IBM’s Financials
Source: morningstar.com
Copyright ©2004 Ian H. Giddy
Valuation 6
Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
Value of
Liabilities
 Book
 Market
Value of Equity
Copyright ©2004 Ian H. Giddy
Valuation 7
Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
 Or what?
A New York City study estimated that the 322 trees surveyed had an
average value of $3,225 per tree and a total value of $1,038,458. The
value was said to be the amount the city would have to pay to
replace the tree. (New York Times, 12 May 2003)
Copyright ©2004 Ian H. Giddy
Valuation 8
Relative Valuation

In relative valuation, the value of an asset is derived
from the pricing of 'comparable' assets, standardized
using a common variable such as earnings,
cashflows, book value or revenues. Examples include
-• Price/Earnings (P/E) ratios
 and variants (EBIT multiples, EBITDA multiples,
Cash Flow multiples)
• Price/Book (P/BV) ratios
 and variants (Tobin's Q)
• Price/Sales ratios
Copyright ©2004 Ian H. Giddy
Valuation 9
Comparables





Value Indicator
Earnings
Cash Flow
Revenues
Book
Copyright ©2004 Ian H. Giddy





Average
Comparable
Industry
Firms
Deals
Target
Company
Numbers or
Projections
Estimated
Value of
Target
Valuation 10
IBM: Comparables
Source: Reuters
Copyright ©2004 Ian H. Giddy
Valuation 11
Disney: Relative Valuation
Company
PE
King World Productions
10.4
Aztar
11.9
Viacom
12.1
All American Communications
GC Companies
20.2
Circus Circus Enterprises 20.8
Polygram NV ADR
22.6
Regal Cinemas
25.8
Walt Disney
27.9
AMC Entertainment
29.5
Premier Parks
32.9
Family Golf Centers
33.1
CINAR Films
48.4
Average
27.44
Copyright ©2004 Ian H. Giddy
Expected Growth
7.00%
12.00%
18.00%
15.8
15.00%
17.00%
13.00%
23.00%
18.00%
20.00%
28.00%
36.00%
25.00%
18.56%
PE ratio divided
by the growth rate
PEG
1.49
0.99
0.67
20.00%0.79
1.35
1.22
1.74
1.12
1.55
1.48
1.18
0.92
1.94
1.20
Valuation 13
IBM: Forward Comparables
Source: morningstar.com
Copyright ©2004 Ian H. Giddy
Valuation 14
Corporate Cash Flow
Copyright ©2004 Ian H. Giddy
Valuation 15
Discounted Cashflow Valuation:
Basis for Approach
t = n CF
t
Value = 
t
t =1 (1+ r)
where

n = Life of the asset
 CFt = Cashflow in period t
 r = Discount rate reflecting the riskiness of
the estimated cashflows
Copyright ©2004 Ian H. Giddy
Valuation 16
Start with the
Weighted Average Cost of Capital
Choice
Cost
1. Equity
- Retained earnings
- New stock issues
- Warrants
Cost of equity
- depends upon riskiness of the stock
- will be affected by level of interest rates
Cost of equity = riskless rate + beta * risk premium
2. Debt
- Bank borrowing
- Bond issues
Cost of debt
- depends upon default risk of the firm
- will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity =
Capital
Cost of capital = Weighted average of cost of equity and
cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©2004 Ian H. Giddy
Valuation 17
IBM’s Cost of Capital
IBM
Cost of Capital
Cost
Amount
Weight
Debt
10-year bond yield
Tax rate
After-tax cost
4.95%
29%
3.5%
61.9
31%
Risk-free Treasury
Beta
Market Risk Premium
From CAPM
4.50%
1.47
5.50%
12.6%
137.4
69%
9.77%
199.3
Equity
Total
Source: IBMfinancing.xls
Copyright ©2004 Ian H. Giddy
Valuation 18
Valuation: The Key Inputs

A publicly traded firm potentially has an infinite life.
The value is therefore the present value of cash flows
forever.
t =  CF
t
Value = 
t
t = 1 (1+ r)

Since we cannot estimate cash flows forever, we
estimate cash flows for a “growth period” and then
estimate a terminal value, to capture the value at the
end of the period:
t = N CFt
Terminal Value
Value = 

N
t
(1
+
r)
(1
+
r)
t =1
Copyright ©2004 Ian H. Giddy
Valuation 19
Dividend Discount Models:
General Model

Dt
Vo  
t
t  1 (1  k )
 V0
= Value of Stock
 Dt = Dividend
 k = required return
Copyright ©2004 Ian H. Giddy
Valuation 20
No Growth Model
D
Vo 
k
Stocks that have earnings and dividends that
are expected to remain constant
 Preferred Stock

Copyright ©2004 Ian H. Giddy
Valuation 21
No Growth Model: Example

D
Vo 
k



Burlington Power & Light
has earnings of $5 per share
and pays out 100% dividend
The required return that
shareholders expect is 12%
The earnings are not
expected to grow but remain
steady indefinitely
What’s a BPL share worth?
E1 = D1 = $5.00
k = .12
V0 = $5.00/0.12 = $41.67
Copyright ©2004 Ian H. Giddy
Valuation 22
Constant Growth Model
Do (1  g )
Vo 
kg
g
= constant perpetual growth rate
Copyright ©2004 Ian H. Giddy
Valuation 23
Constant Growth Model: Example

Do (1  g )
Vo 
kg



Motel 6 has earnings of $5
per share. It reinvests 40%
and pays out 60%dividend
The required return that
shareholders expect is 12%
The earnings are expected
to grow at 6% per annum
What’s an M6 share worth?
E1 = $5.00 k = 12%
D1 = $3.00 g = 6%
V0 = 3.00 / (.12 - .06) = $50.00
Copyright ©2004 Ian H. Giddy
Valuation 24
Estimating Dividend Growth Rates
g  ROE  b
g
= growth rate in dividends
 ROE = Return on Equity for the firm
 b = plowback or retention percentage rate
i.e.(1- dividend payout percentage rate)
Copyright ©2004 Ian H. Giddy
Valuation 25
Or Use Analysts’ Expectations?
Source: biz.yahoo.com
Copyright ©2004 Ian H. Giddy
Valuation 26
Shifting Growth Rate Model
(1  g1)
DT (1  g 2 )
V o  Do 

t
T
( k  g 2 )(1  k )
t 1 (1  k )
T
t
 g1
= first growth rate
 g2 = second growth rate
 T = number of periods of growth at
g1
Copyright ©2004 Ian H. Giddy
Valuation 27
Shifting Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3

+ D4 / (.15 - .05) ( (1.15)3
Mindspring
pays dividends
$2 per share.
The required
return that
shareholders
expect is 15%
The dividends
are expected to
grow at 20% for
3 years and 5%
thereafter
What’s a
Mindspring
share worth?
V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
Copyright ©2004 Ian H. Giddy
Valuation 28
Stable Growth and Terminal Value




When a firm’s cash flows grow at a “constant” rate forever, the
present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
This “constant” growth rate is called a stable growth rate and
cannot be higher than the growth rate of the economy in which
the firm operates.
While companies can maintain high growth rates for extended
periods, they will all approach “stable growth” at some point in
time.
When they do approach stable growth, the valuation formula
above can be used to estimate the “terminal value” of all cash
flows beyond.
Copyright ©2004 Ian H. Giddy
Valuation 29
Choosing a Growth Pattern: Examples
Company
PWC
Valuation in
Nominal U.S. $
Firm
DirecTV
Nominal US$
Equity: FCFE
Allianz
Nominal Euro
Equity: Dividends
Copyright ©2004 Ian H. Giddy
Growth Period Stable Growth
10 years
6%(long term
(3-stage)
nominal growth rate
in the world economy
5 years
4%: based upon
(2-stage)
expected long term
US growth rate
0 years
3%: set equal to
nominal growth rate
in the European
economy
Valuation 30
The Building Blocks of Valuation
Choose a
Cash Flow
Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Cashflows to Firm
Net Income
EBIT (1- tax rate)
- (1- ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n)
- Change in Work. Capital
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF)
[ = Debt Ratio]
& A Discount Rate
Cost of Equity
Cost of Capital
WACC = ke ( E/ (D+E))
 Basis: The riskier the investment, the greater is the cost of equity.
 Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
& a growth pattern
Stable Growth
Two-Stage Growth
g
g
Three-Stage Growth
g
|
t
Copyright ©2004 Ian H. Giddy
High Growth
|
Stable
High Growth
Transition
Stable
Valuation 31
Estimating Future Cash Flows
Dividends?
 Free cash
flows to
equity?
 Free cash
flows to firm?

Copyright ©2004 Ian H. Giddy
Valuation 32
Better Than Dividends:
Free Cash Flows
Revenue
- Expenses
- Depreciation
= EBIT
Adjust for tax: EBIT(1-T)
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
81.20
(67.99)
(4.95)
8.26
5.90
4.95
(4.31)
(0.90)
5.64
+ Depreciation
- Capex
- Ch working capital
= Free Cash Flows to Firm
Copyright ©2004 Ian H. Giddy
Valuation 33
Deriving IBM’s Free Cash Flows
Data
Sales, ttm
Operating costs
Depreciation
EBIT
Tax
Cap Ex
Change in WC
Interest expense
4Q02ttm
$ 81.20
$ 67.99
$ 4.95
$ 8.26
$ 2.36
$ 4.31
$ 0.90
$ 0.15
Free Cash Flows
84%
29%
$b
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
Copyright ©2004 Ian H. Giddy
billion
billion
billion
billion
billion
billion
billion
billion
81.20
(67.99)
(4.95)
8.26
5.90
4.95
(4.31)
(0.90)
5.64
Interest
$
0.15
FCFE
$
5.49
IBMvaluation.xls
Valuation 34
Two Applications
Copyright ©2004 Ian H. Giddy
Valuation 35
Equity Valuation in Practice
 Estimating
discount rate
 Estimating cash flows
 Estimating growth
 Application with constant growth: Optika
 Application with shifting growth: Fong
Copyright ©2004 Ian H. Giddy
Valuation 37
Valuing a Firm with DCF:
The Short Version
Historical
financial
results
Projected sales
and operating
profits
Adjust for
noncash
items
Free cash flows to the firm
(FCFF)
Discount to present using
constant growth model
FCFF(1+g)/(WACC-g)
Present
value of free
cash flows
Copyright ©2004 Ian H. Giddy
- Market
value of
debt
Calculate weighted
average cost of
capital (WACC)
Estimate stable
growth rate (g)
Value of
shareholders
equity
Valuation 38
Optika: Facts
The firm has revenues of €3.125b, growing at
5% per annum. Costs are estimated at 89%,
and working capital at 10%, of sales. The
depreciation expense next year is calculated
to be €74m.
 Optika’s marginal tax rate is 35%, and the
interest on its €250m of debt is 8.5%.
 The market value of equity is €1.3b.
 Is this firm fairly valued in the market? What
assumptions might be changed?

Copyright ©2004 Ian H. Giddy
Valuation 39
Optika
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
Treasury bond rate
Debt Spread
Market risk premium
Revenues next year
-COGS
-Depreciation
=EBIT
EBIT(1-Tax)
+Depreciation
-Capital Expenditures
-Change in WC
-Free Cash Flow to Firm
Cost of Equity (from CAPM)
Cost of Debt (after tax)
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1
7%
1.50%
5.50%
T+1
3281
2920
74
287
187
74
-74
-16
171
12.50%
5.53%
11.38%
2681
optika.xls
Equity Value
Copyright ©2004 Ian H. Giddy
2431
Valuation 40
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
WACC:
Treasury bond rate
Debt Spread
ReE/(D+E)+RdD/(D+E)
Market risk premium
Optika
Revenues next year
Value:
-COGS
-Depreciation
FCFF/(WACC-growth
rate)
=EBIT
EBIT(1-Tax)
+Depreciation
-Capital Expenditures
Equity Value:
-Change in WC
Firm Value - Debt Value
-Free Cash Flow to Firm
Cost of Equity (from CAPM)
= 2681-250 = 2431 Cost of Debt (after tax)
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1
7%
1.50%
5.50%
T+1
3281
2920
74
287
187
74
-74
-16
171
12.50%
5.53%
11.38%
CAPM:
7%+1(5.50%)
Debt cost
(7%+1.5%)(1-.35)
2681
optika.xls
Equity Value
Copyright ©2004 Ian H. Giddy
2431
Valuation 41
Valuing a Firm with DCF:
The Extended Version
Historical
financial
results
Adjust for
nonrecurring
aspects
Gauge
future
growth
Projected sales
and operating
profits
Adjust for
noncash
items
Projected free cash flows
to the firm (FCFF)
Year 1
FCFF
Year 2
FCFF
Year 3
FCFF
Year 4
FCFF
Discount to present using weighted
average cost of capital (WACC)
Present
value of free
cash flows
Copyright ©2004 Ian H. Giddy
+ cash,
securities &
excess assets
- Market
value of
debt
…
Terminal year FCFF
Stable growth model
or P/E comparable
Value of
shareholders
equity
Valuation 42
Valuation Example: Shifting Growth
Fong Industries (Pte) Ltd Singapore
Profit & Loss (S$'000)
FYE 30 Jun
Turnover
1994
1995
1996
1997
1998
1999
9,651
57,888
125,010
120,323
136,003
134,813
Directors' Fees & Rem
Amortisation
Depreciation
Interest Expense
Bad Debts W/O
Fixed Assets W/O
FX loss
107
0
639
227
249
269
1,041
445
368
279
1,277
615
820
280
3,812
1,002
964
39
4,494
697
85
961
35
4,673
1,078
100
543
282
Profit b/f Tax
933
1,250
3,774
6,897
4
1,990
838
Assoc Co
(74)
933
Tax
Profit a/f Tax
Effective Tax Rate
1,990
3
930
1,990
0.32%
0.00%
EBITDA
ISC
Copyright ©2004 Ian H. Giddy
3,745
792.51%
841.57%
108.17%
(14)
1,176
3,811
6,883
96
292
929
178
742
884
2,882
6,705
24.83%
24.38%
2.59%
(768)
(7)
(156)
7,292
1,799
37
838
11.46%
EOI
27
3,009
489.27%
-19.65%
6,270
625.75%
108.37%
9,597
890.26%
####
12,113
1737.88%
Valuation 43
Valuation Example: Shifting Growth
Fong Industries
Growth1
Growth2
Tax
Revenue
Expenses
EBIT
WC
b (unlevered)
b (levered)
Kd
MVe
MVd
Combined
Rm
Rf
Ke
WACC
25%
5%
25%
134,813
91.01%
7,580
10%
1.06
1.09
5.50%
218,993
7,379
226,372
12.00%
4.00%
for 3 years
thereafter
effective
(S$'000); T0
of Revenue
(S$'000)
of Revenue
(S$'000)
(S$'000)
(S$'000)
PERMkt
32.66
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
Firm Value
Equity Value
PERcomputed
147,773
140,394
20.94
T1
168,516
153,375
4,533
10,608
7,956
4,533
4,533
3,370
4,586
T2
210,645
191,719
4,533
14,394
10,795
4,533
4,533
4,213
6,582
4,586
6,582
T3
263,307
239,648
4,533
19,125
14,344
4,533
4,533
5,266
9,078
187,655
196,733
T4
276,472
251,631
4,533
20,308
15,231
4,533
4,533
1,317
13,915
$0.65
12.69%
12.41%
fong.xls
Copyright ©2004 Ian H. Giddy
Valuation 44
Case Study: IBM
Constant growth model valuation:
FCFF
5.64
WACC
9.77%
Growth rate
5.70%
Firm Value
less debt
Equity value
146.51 billion
-61.86 billion
84.65 billion
divided by
1.69 gives
$ 50.09 per share
2-stage growth model valuation
Stage 1
10%
Stage 2
5.70%
End of year
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
Total
PV
Total PV
less debt
Equity value
2002
81.20
-67.99
-4.95
8.26
5.90
4.95
-4.31
-0.90
5.64
2003
89.32
-74.79
-5.45
9.09
6.49
5.45
-4.74
-0.99
6.20
2004
98.25
-82.27
-5.99
9.99
7.14
5.99
-5.22
-1.09
6.82
2005
108.08
-90.49
-6.59
10.99
7.85
6.59
-5.74
-1.20
7.51
2006
118.88
-99.54
-7.25
12.09
8.64
7.25
-6.31
-1.32
8.26
6.20
5.65
6.82
5.66
7.51
5.68
8.26
5.69
176.00
-61.86 billion
114.13 billion
divided by
1.69 gives
2007
130.77
-109.50
-7.97
13.30
9.50
7.97
-6.94
-1.45
9.08
235.25
244.34
153.32
2008
138.23
-115.74
-6.94
15.55
11.10
6.94
-6.94
-1.53
9.57
$ 67.53 per share
IBMvaluation.xls
Copyright ©2004 Ian H. Giddy
Valuation 46
Summary:
The Building Blocks of Valuation
Choose a
Cash Flow
Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Cashflows to Firm
Net Income
EBIT (1- tax rate)
- (1- ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n)
- Change in Work. Capital
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF)
[ = Debt Ratio]
& A Discount Rate
Cost of Equity
Cost of Capital
WACC = ke ( E/ (D+E))
 Basis: The riskier the investment, the greater is the cost of equity.
 Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
& a growth pattern
Stable Growth
Two-Stage Growth
g
g
Three-Stage Growth
g
|
t
Copyright ©2004 Ian H. Giddy
High Growth
|
Stable
High Growth
Transition
Stable
Valuation 47
Copyright ©2004 Ian H. Giddy
Alternatives
Valuation 48
What’s a Company Worth?
Alternative Models
 The
options approach
Option
to expand
Option to abandon
 Creation
of key resources that another
company would pay for
Patents
or trademarks
Teams of employees
Customers
 Examples?
Copyright ©2004 Ian H. Giddy
Valuation 50
What’s a Company Worth?
The Options Approach
Value of the Firm or project
Present Value of Expected
Cash Flows if Option Excercised
Copyright ©2004 Ian H. Giddy
Valuation 51
The Value of a Corporate Option
 Having
the exclusive rights to a product
or project is valuable, even if the
product or project is not viable today.
 The value of these rights increases with
the volatility of the underlying business.
 The cost of acquiring these rights (by
buying them or spending money on
development - R&D, for instance) has to
be weighed off against these benefits.
Copyright ©2004 Ian H. Giddy
Valuation 52
Extreme Situations:
Equity is Like an Option
Assets
Liabilities
Debt
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights
Copyright ©2004 Ian H. Giddy
Valuation 53
Marvel in Trouble, 1996

Banks
Icahn et al.

Choices:
Accept Perelman’s plan
Sell the debt at $.14-$.17
Reject plan and propose own

Perelman


Copyright ©2004 Ian H. Giddy
Secured and senior
Get fully repaid under plan
Controls Marvel equity
NPV is negative
Option value may be positive
Valuation 54
Next…
Valuation
Acquisition
Copyright ©2004 Ian H. Giddy
LBOs
Restructuring
Valuation 55
Copyright ©2004 Ian H. Giddy
Valuation 56
Copyright ©2004 Ian H. Giddy
Valuation 57
Valuation
Acquisition
LBOs
Restructuring
More to come…
Copyright ©2004 Ian H. Giddy
Valuation 59