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Valuation

- How much are those cash flows worth?

Standard Techniques

- Book Value
- Earnings Multiple
- Liquidation Value
- Discounted Cash-Flow

Graham,J.andH.Campbell,2001,TheTheoryandPracticeo

fCorporateFinanceEvidencefromtheField,JournalofF

inancialEconomics,60(2-3),187-243.

Book ValueFirm (Enterprise) Value Book Value

of Assets

- Still one of the most widely used and accepted

methods due to certification by accountants,

while also being perhaps the most flawed. - Based on historic numbers, ignores the future.
- Based on accounting numbers that are potentially

flawed and subject to manipulation - Ignores intangibles like customer loyalty.
- Ignores risk
- The price paid for an asset may have no relation

to its value in operation or if it had to be sold

or replaced (especially as time passes).

General Motors

Corporate Book Value gt

Common Stock (Equity) Book ValueEasy to Calculate

- Case 1 Only common stock outstanding
- Book value equals owners equity.
- Case 2 Common and preferred shares outstanding
- Book value equals owners equity minus book value

of the preferred.

GM ContinuedNo Preferred Stock

Common's Book Value gt

Pitney Bowes Inc (PBI)Has Preferred Stock

Subtract this gt

From this gt

Comparable CompaniesEarnings Multiples

- Most common method for valuing assets absent

market values. - Simple but with many potential pitfalls.

From V/EBIT to Market Value

- Obtain Comp(V/EBIT) by using the

value-to-earnings ratio of a comparable traded

company (or the average from a group of

comparable companies). - Use EBIT from the firm or asset you are valuing.

Advantages of V/EBIT

- Easy.
- Makes intuitive sense.
- If your comparables are really comparable then it

should work.

Problems with V/EBIT

- Earnings used to calculate V/EBIT are accounting

figures. - To the degree the earnings are subject to

manipulation so is EBIT. - Earnings are subject to short-term fluctuations.
- Looking for long run earnings.
- Might need to adjust earnings for extraordinary

items. - Be careful! Some firms have extraordinary

items every year. - V/EBIT assumes all companies will generate the

same growth.

Other Widely Used Multiples

- Price-to-Earnings
- Price-to-Sales
- Popular for firms with negative earnings.
- Market-to-Book value
- Also popular for firms with negative earnings.
- Asset Value-to-EBIT
- Asset Value-to-Revenues
- Also popular for firms with negative earnings.

Price-Earnings Ratios

- Very, very popular for equity valuation!
- One major pitfall when making comparisons across

companies DEBT! - The higher a firms D/E(quity) ratio the higher

the P/E(earnings) ratio. - Note
- In D/E the E stands for Equity.
- In P/E the E stands for Earnings.
- Standard terminology, you just have to know which

one is which.

P/E and Debt Example

- A firm has an equity value of 10, earnings of 1,

and no debt. - P/E 10.
- Assume the tax rate is TC. The firm now issues

enough debt so that it pays 1/(1-TC) in

interest. Earnings (which are calculated after

interest and tax payments) now equal 0. - New Earnings 1 1/(1-TC) TC/(1-TC) 0
- So long as the price of the stock does not go to

zero (which it will not if there is any expected

growth in the firm) the P/E will equal 8. - General rule More D ? Higher P/E.

Liquidation Value

- Useful if you are really thinking of liquidating

the firm. - Ignores any value from future operations.
- Do not use if the firm will continue as a going

concern. - Useful if you want to know if the firm is worth

more dead or alive.

Discounted Cash Flow Valuation

- Forecast free cash flows up to some terminal

date. - Estimate the cost of capital (a.k.a. discount

rate). - Estimate terminal value (a.k.a. continuing value)

which equals the value after the terminal date. - Discount to the present.
- Add value of excess cash (proxy for marketable

securities) and other non-operating assets. - Deduct debt and preferred stock to get the market

value of the common shares.

Example

- New Haven Tea company expected to produce free

cash flows of 200 next year (year 1). - Expect 10 cash flow growth per year up until

year 7. Thereafter expected growth of 2 per

year. - The discount rate is 8.

Solution

- First seven years is a growing annuity with an

initial value of 200 and a growth rate of 10.

- Terminal value is a perpetuity starting in year

8 with an initial value of 354.3x1.1 389.74 and

a growth rate of 2.

Solving for the PV

Three Main Questions

- What are the free cash flows?
- How to estimate the terminal value?
- How do you calculate the cost of capital?

Free Cash Flow I

- Arturo likes to calculate FCF via
- Operating Profit (EBIT)
- Taxes on EBIT
- Increase in deferred taxes
- Net Operating Profit Less Adjusted Taxes

(NOPLAT)

Depreciation Increase in Working Capital

Requirements Capital Expenditures Free Cash

Flow

Free Cash Flow II

- An alternative route (popular on the street) is
- EBIT
- Depreciation and Amortization
- EBITDA
- EBITDA
- Net Capital Expenditures
- Change in Working Capital
- Cash Taxes Paid
- Cash Interest Paid
- Free Cash Flow

From the Cash Flow Statement Capital

Expenditures Sale of Assets Net Capital

Expenditures

A Note On NOPLAT

- NOPLAT is supposed to represent the free cash

flow to the firm before capital investment. - My preference is to calculate NOPLAT as FCF

Cash Interest Paid Net Capital Expenditures. - Just remember if you use my version it is not

really NOPLAT. A better term would be

FCFBCINCE, but that acronym is pretty hard to

pronounce! - In the notes that follow where you see the

acronym NOPLAT feel free to substitute FCFBCINCE.

Working Capital I(Investment Needed to Operate

the Company)

- Arturo likes to use
- Operating Cash
- Accounts Receivable
- Inventories
- Accounts Payable
- Net Accruals
- Working Capital Reserves

Working Capital II

- For changes in working capital Catherine Nolan (a

bond analyst and my wife) likes to use - Changes in Accounts Receivable
- Changes in Inventories
- Changes in Accounts Payable
- Changes Working Capital Reserves

Why the Difference?

- Catherine Nolans argument.
- Operating cash is what you want to back out, so

including it is basically double counting. - In fact it is often double counting. If a firm

spends money on administrative costs and pays

with a check, the SGA account goes up and the

cash account goes down. - Net Accruals can include a number of non-cash

items and can be easily manipulated. You are

better of ignoring them. - Working capital is the difference between what

you owe people (accounts payable) and what you

are hoping to get paid for (accounts receivable

and inventories).

Forecasting Free Cash Flows

- Forecast Sales
- Project size of the target market.
- Project market share.
- Examine historical relationships between sales

and other components of free cash flow. - Be careful here! Are you sure the firm will

continue along its current trajectory?

Forecasting Free Cash Flows(continued)

- Check reasonableness of forecasts.
- What do the forecasts assume about the ability of

the company to generate abnormal (economic)

profits? - Gross domestic product grows at a real rate of

3.41 in a typical year (1929-2003). That means

in the long run no firm can grow faster than

this. - Are your long run estimates consistent with this?
- What do your estimates say about the firms long

run relative market share? - What do your estimates say about the long run

size of the industry relative to the rest of the

economy or related industries? For example, if

you assume BookUsHotels.com will eventually

produce X in sales you must also assume that the

hotel industry will as well.

Forecasting Free Cash Flows(continued)

- Discount Rates
- Be consistent in dealing with free cash flows and

discount rates. - Discount rates should reflect market and not firm

specific risk. - Common mistake is to increase the discount rate

in response to firm specific risk. - Example A pharmaceutical firm has a 25 chance

of making a breakthrough. This does not

influence the discount rate. It does influence

the expected future cash flows. In this case PV

.25(PV w/ breakthrough) .75(0).

Reasonable Forecasts Some Guidelines

- What are the assumptions about the companys

ability to create economic profits? - Key drivers for economic growth are the Return on

Investment Capital (ROIC) and the growth rate (g).

Calculating ROIC and g

Invested Capital Long Term Assets Working

Capital Requirements

where

The accuracy of your valuation will depend upon

the degree to which you accurately forecast ROIC

and g.

Valuation and Growth a Few Examples

- All of the following firms are perpetual growth

firms. - They use a constant investment rate (a.k.a.

plowback) rule. - They have a constant ROIC (a.k.a. return on

equity).

Example 1 Base Line No Growth Firm

Example 2 Value Creating Firm

Example 3 Growing But No Value Added Firm

ROIC vs. Discount RateWhat it Implies

- ROIC gt Discount Rate
- Normal. Firm earns an above average return on

some investments. Should stop investing when the

marginal investment has a return equal to the

discount rate. - ROIC Discount Rate
- Likely the firm is over investing! Its

investments with returns below the interest rate

are offsetting those above. Other possibility,

all investments by the firm earn exactly the rate

of interest. Yea, sure. - ROIC lt Discount Rate
- Value destruction. Buy out management and stop

the firm before it invests again!

Example 4 No Growth, Value Destroying Firm

Example 5 Growing, Value Destroying Firm

Ways of Estimating Earnings Growth

- Look at the past.
- The historical growth in earnings per share is a

typical starting point. - Look at what others are projecting.
- Other analysts may be using information you do

not have. It is often useful to know what their

estimates are. - Look at fundamentals.
- How much are they investing?
- What is the return on their investment?

Estimating the Firms Terminal (Continuing) Value

- Free cash flows (FCF) grow at a constant rate

after the forecast horizon. - Used far more often than any other method.
- Just remember, in the long run NO firm can grow

faster than GDP!

r discount rate, g growth rate, T end of

the forecast horizon

Terminal Value EstimationConstant Growth

Continued

- Be careful when you use this formula, as your

CAPEX in the FCF calculation should match the

growth rate you choose. - This is once again related to the ratio

Sales/Fixed Assets. - One can show that the previous formula can be

written in the following way

ROIC long-term return on newly invested

capital. This formula may be easier to use than

the previous formula since you do not have to

estimate CAPEX. Instead it is estimated for you

from g and ROIC.

Estimating TVsConvergence Approach

- Assumes that competitive forces will ensure that

after the forecast horizon, returns on the firms

new investments will equal the discount rate (r). - ROIC r and so,

Estimating TVAccounting Values

- Terminal value Book Value of Invested Capital
- Backward looking.
- Easy to use.

(No Transcript)

Calculating Terminal Asset Value from Projected

Book Value

- PBI grew at about 5 in 2002 and 2 in 2003.
- Average growth rate of 3.5 is not unreasonable.
- In 2003 total assets (book value) equaled

8,891,388. - Suppose want TV as of 2010 (seven years later)

8,891,388x1.0357 11,312,329.

Economic Value Added (EVA)

- EVA Invested Capital x (ROIC r)
- What is this?
- A popular buzz word!
- The value the firm created via its investments.

Remember, firms should invest so long as the

marginal return on equity (ROIC) exceeds the

interest rate. This means a typical firm should

have a positive EVA.

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