Approach of Firm Valuation

1
Approach of Firm Valuation

• Security Selection Criteria

2
Free Cash Flow to the Firm

• The free cash flow to the firm (FCFF) is the sum
  of the cash flow to all claim holder in the firm,
  including stockholders, bondholders, and
  preferred stockholders
• FCFF Free cash flow to equity Interest
  expense (1-Tax rate) Principal repayments
  New debt issues Preferred dividends

3
Free Cash Flow to the Firm

• FCFF EBIT(1-Tax rate) Depreciation Capital
  expenditure Change in Working capital
• Free cash flows to the firm compared with other
  measures Table 15.1 on page 384
• FCFF
• FCFE
• EBITDA
• EBIT(1-Tax rate)

4
The Cost of Capital Approach

• A firm that is growing at a rate that it can
  sustain in perpetuitya stable growth ratecan be
  valued using a stable growth model
• Illustration 15.1 on Pages 386-387
• Constant growth
• General model

5
Free Cash flow to Equity Model

• Free cash flows to equity
• The cash flows left over after meeting all
  financial obligations, including debt payments,
  and after covering capital expenditures and
  working capital needs
• Free cash flow to equity Net income (Capital
  expenditures Depreciation) (Change in working
  capital) (Preferred dividends) (New debt
  issued Debt repayment)

6
Peter Lynchs Approach

• Whats wrong with high expectation of 30 return?
• How do you design a portfolio to get 12-15
  return?
• How many stocks should you own?
• Its best to own as many stocks as there are
  situations in which (a) youve got an edge and
  (b) youve uncovered an exciting prospect that
  passes all the tests of research.

7
Peter Lynchs Approach

• Since there is no way to anticipate when pleasant
  surprise of various kinds might happen, you
  increase your odds of benefiting from one by
  owning several stocks (5-10 stocks).
• A foolish diversity
• There is no use diversifying into unknown
  companies just for the sake of diversity.

8
Watering the Weeds

• Buying and selling as it relates to portfolio
  management
• Constantly recheck stocks and stories, add and
  subtract to your investments as things change
• Stay in the market forever and rotate stocks
  depending on the fundamental situations

9
Watering the Weeds

• Rotate in and out of stocks depending on what has
  happened to the price as it relates to the story
• If you decide that a certain amount youve
  invested in the stock market will always be
  invested in the stock market, youll save
  yourself a lot of mistimed moves and general
  agony.

10
A Price Drop in a Good Stock

• If you cant convince yourself
• When Im down 25 percent, Im a buyer and
  banish forever the fatal thought When Im down
  25, Im a seller, then youll never make a
  decent profit in stocks.
• Detest stop orders When you put it in a 15
  stop order, youre admitting that youre going to
  sell the stock for less than its worth today,
  but with the volatility in todays market, a
  stock almost always hits the stop.

11
A Price Drop in a Good Stock

• The belief of Sell when its a double will
  never let you benefit from a big winner.
• Stick around to see what happens as long as the
  original story continues to make sense, or gets
  better, and youll be amazed at the results in
  several years.

12
Edward Lampert and ESL

• The Next Warren Buffett (1962 to date)
• Start ESL Fund at age 25 in 1988
• 29 annual return from 1988 to 2004
• Four Mentors James Tobin , Robert Rubin, Warren
  Buffett, and Philip Fisher

13
Lampert Investment Philosophy

• Exploit market inefficiency
• Search for companies seriously undervalued
• Focus on easily understandable companies which
  are able to generate sustainable cash over the
  long run
• Hold just a few major investments at a time and
  stay in close touch with the companies

14
Lampert Investment Philosophy

• Evaluating risk and valuing risk are really what
  it is all about
• Protect the downsize risk and preserve the
  principals
• Rather earn a bumpy 15 than a flat 12 and
  ignore the ups and downs in stock prices

15
Lampert Learning Process

• Major in Economics at Yale University and work as
  a research assistant for Professor James Tobin
• Work for Robert Rubin in the arbitrage department
  at Goldman Sachs and learn how to evaluate risk
  quickly in a situation often with incomplete
  information
• Study the concept of Philip Fishers 1958 classic
  book, Common Stock and Uncommon Profits

16
Lampert Learning Process

• Move to Fort Worth to start his ESL investment
  fund, partnering with a fund manager Richard
  Rainwater
• Analyze Buffetts investments by reverse
  engineering deals, that is, putting yourself in
  Buffetts shoes at that time when he make his
  initial investment

17
Kmart-Sears ESL Operation

• Run his 9 billion ELS fund with just 15
  employees, mostly research analysts
• Hold 14.6 of Sears and then sell Sears 28
  billion credit card business to raise capital
• Scoop up Kmarts debts as creditors fled after
  Kmart in Chapter 11 in 2002

18
Kmart-Sears ESL Operation

• Get control of 23 billion Kmart for less than 1
  billion in bankruptcy court by converting its
  debts into shares and then sell 68 Kmart stores
  to raise 847 million
• Negotiate with the four kidnappers
• Kmart-Sears merger as Sears Holding which has
  3.8 billion in tax credits carried over from
  previous losses

19
What to Buy? Fishers 15 Points

• Do the company have products or services with
  sufficient market potential to make possible a
  sizable increase in sales for al least several
  years?
• Does the management have a determination to
  continue to develop new products or processes
  that will still further total sales potential?

20
What to Buy? Fishers 15 Points

• How effective are the companys RD efforts in
  relation to its size?
• Does the company have an above-average sales
  organization?
• Does the company have a worthwhile profit margin?

21
Fishers 15 Points

• What is the company doing to maintain or improve
  profit margins?
• Does the company have outstanding labor and
  personnel relations?
• Does the company have outstanding executive
  relations?

22
Fishers 15 Points

• Does the company have depth to its management?
• How good are the companys cost analysis and
  accounting controls?
• Are there other aspects of the business which
  will give the investor important clues as to how
  outstanding the company may be in relation to its
  competition?

23
Fishers 15 Points

• In the foreseeable futures will the growth of the
  company require sufficient equity financing so
  that the larger number of shares then outstanding
  will largely cancel the existing stockholders
  benefit from this anticipated growth?

24
Fishers 15 Points

• Does the company have a short-range or long-range
  outlook in regard to profits?
• Does the management talk freely to investors
  about its affairs when things going well but
  calm up when troubles are disappointments
  occur?
• Does the company have a management of
  unquestionable integrity?

25
Case Study Companies

• 1301?? 6505??? 1473?? 4526?? 6605??
• 1723?? 1729?? 1736?? 2002??
  2105??
• 2317?? 2330??? 2347?? 2352?? 2353??
• 2357?? 2391?? 2395?? 2439?? 3008???
• 3009??? 5203?? 2881?? 2882?? 2891???

26
Case Study Companies

• 2912??? 9915?? 9917?? 9921?? 9934??
• 9939?? 9940?? 1527?? 9942?? 1726??
• 1716?? 2332?? 2412??? 1531??? 2447??
• 4103?? 4105?? 4535?? 5478??
  5903??
• 6234?? 6244?? 8099??? 8941?? 1742??
• 1560???? 8033??