Valuation

1
Valuation

2
Today

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

3
Today

• Getting started with SPs research insight.
• A powerful tool for getting financial information
  and producing reports
• Maybe too powerful if you use numbers generated
  by SP analysts, you must understand how they are
  derived!
• Available on library computers.
• You can use RIWeb to compute the financial ratios
  you need for next class.

4
Today

• Getting started with SPs research insight.
• A powerful tool for getting financial information
  and producing reports
• Maybe too powerful if you use numbers generated
  by SP analysts, you must understand how they are
  derived!
• Available on library computers.
• You can use RIWeb to compute the financial ratios
  you need for next class.

5
Today

• First of three accounting statements
• Income statement first
• Balance sheet
• Cash Flows
• Interrelationships can reveal important facts and
  trends
• Settle group and sector assignments

6
General Thoughts on Valuation

• We will be using quantitative models.
• But one size does not fit all.
• Obviously, a DDM wont work for a company that
  doesnt pay dividends.
• Estimating growth for a cyclical company is
  problematic.
• Sometimes, its 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.

7
Valuation Models

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

8
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 always sells at a discount, theres
  probably a reason.
• Valuation Versus Market
• Is it undervalued relative to the market now?
• How has that relationship evolved over time?
• Absolute Valuation

9
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?

10
DCF

• DDMs
• FCFE
• The holy grail the numerator should be the cash
  flows that can be distributed to shareholders
  while retaining enough cash to support the
  assumed growth rate
• The holy grail 2 your discount rate should
  match your numerator type

11
Basic Dividend Discount Model

• P D1
• (r-g)

12
Two Stage DDM

• P?? D1_____ ___Pn___
• (1Khg) (1Khg)n
• Where PnDPSn1
• (Kst-Gn)

13
Citigroup Gordon Growth DDM
14
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 Misspecified

15
Growth Failure Companies Maintaining 20 Growth
16
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

17
Free Cash Flow Valuation

• Simple Definition
• FCF
• Operating EarningsDepreciation
• -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?

18
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

19
Large Capitalization Stocks Key Valuation Metrics
20
Large Capitalization Stocks Performance of
Valuation Measure By Sector
21
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
  isToo Good to Be True

22
What are Comparable Assets?
23
Comparable Assets

• Similar Cash Flow, Growth and Risk
• Generally in Similar Industries
• Complicating Issues Size, Business Mix,
  Leverage, Profitability
• Understand Implicit Assumptions

24
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
• 2003 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

25
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 421
• 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

26
When to use what?

1. P/E
2. P/FCF
3. P/B
4. P/Sales
5. EV/EBITDA
6. Other measures???

27
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

28
2. Free Cash Flow Yield(instead of earnings)

• Operating EarningsDepreciation Expense- Cap
  Ex-?Working CAP
• Cash Available for Distribution to Shareholders
• Strips Back Some Accounting Artifice
• Incorporates Info from Balance Sheet

29
3. Price to Book Value

• Less Meaningful Today
• Useful in Distressed Situations
• Useful in Lower Growth Industries
• (Energy, Utilities, Financials)

30
3. Price to Book Value

• Useful in Financials Where Reserves can be
  Manipulated
• Influenced by ROE and Cost of Equity
• Significant Accounting Issues (Buybacks,
  Repurchase, Restructuring)
• Can be Useful in Mean Reverting Mature Industries
  (Energy, Utilities)

31
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 EquityMV of
  Debt-Cash)/Sales Corrects for Companies with
  Different Leverage

32
5. Enterprise Value to Ebitda

• (Market Value of EquityDebt-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

33
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!