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Equity Valuation

- Contents - overview
- 0. About valuation introduction McKinsey

Valuation Best Practice - 1. Valuation Frameworks the technology side
- 2. Analyzing historical performance
- 3. Projecting future performance
- 4. Continuining Value
- 5. WACC
- 6. Relative Valuation
- 7. Examination
- 50 written exam
- 50 valuation case

Goal of the module

- 1. Understand link between stock market valuation

and fundamentals - 2. Acquire and develop practical valuation skills

- best practice - 3. Understanding sources of corporate value
- 4. SkillsKnowledge to pass CIIA EV in final exam

CIIA EV Syllabus

- Equity Markets and Structures
- BKM Ch 2-3, SAB Ch. 2-3 mostly
- Covered in Module 1 Mats Hansson market

regulation - 2. Understanding the Industry Life Cycle
- BKM Ch 16 (17 new) 5 pages only
- 3. Analysing the Industry Sector and its

Constituent Companies - Mostly very basic macro definitions (Jan Antell

Module covers), BKM ch 16 (17 new) 19 pages only - 3.1. The Industry Sector
- 3.2. Characteristics of the Industry
- 3.3. Macro Factor
- 3.4. Forecasting For Companies in the Sector
- 3.5. Balance Sheet Factors
- 3.6. Corporate Strategy
- 3.7. Valuations

CIIA EV Syllabus cont.

- 4. Understanding the Company
- BKM Ch 16 (17 new) 17 pages
- 4.1. Historical performance
- 4.2. Segmental Information
- 4.3. Inventory, debtors and crediitors
- 4.4. Depreciation and amortization
- 4.5. Completing the forecasts
- 5. Valuation Models of Common Stock
- BKM Ch 17 (18 new), BM esp. ch 17 Leverage and

WACC (Corporate Finance too), SAB ch. 12, 16-18 - 5.1. DDM
- 5.2. FCFF
- 5.3. EVA MVA, CRROI, Abnormal earnings model
- 5.4. Measures of relative value

CGW Valuation (4th ed.)

- Much deeper, practioner oriented book
- Both for Corporate Developers and Equity/Industry

Analysts - Industry standard best seeling guide to Valuation
- Best valuation book
- Ch. 3 Fundamental Principles of Value Creation
- (Ch 4)
- Ch. 5 Frameworks for Valuation
- Ch. 6 Thinking About Return on Invested Caital

and Growth - Ch. 7 Analyzing Historical Performance
- Ch. 8 Forecasting Performance
- Ch. 9 Estimating Continuing Value
- Ch. 10 Estimating Cost of Capital
- Ch. 11. Calculating and Interpreting Results
- Ch. 12 Using Multiples for Valuation

Written exam 50

- 1-2 essay questions
- Copeland-Goedhart-Wessels Valuation Ch, 3, 5-12
- Lecture notes
- 1-2 valuation problems
- Relative valuation
- DCF
- FCF
- Cost of capital

Valuation Case 50

- Task Assess fundamental value of company X by

applying CGW Valuation Framework - Teams w/ 3-4 persons
- Deadline

Econ101 Supply and demand

- Prices / values increase when demand exceeds

supply - Prices / values fall when supply exceeds demand
- OK. But why does this happen?
- 1. Unique onetime-transaction
- severe contraints in demand and supply

forces - 2. New information has arrived that changes the

expected benefits of ownership of an asset

Benefits of owning?

- Critical decision point is current transaction

price vs expected benefits from ownership! - BUY (hold) if benefits from ownership exceed

potential purchase price good, value-increasing

investment decision - SELL (short) if prevailing price exceeds benefits

from owning the asset good, value creating

financing decision - ( Short selling stock lending essentially

take a loan indexed to value of a stock gt

profit from price drops negative interest on

loan)

Value creation

- Necessary condition for profitable growth
- 1. Scarce resources are used as efficiently as

possible - 2. Beating industry/market peers
- 3. Maintaining competitive edge
- 4. Attract more capital
- 5. Create basis for higher compensation levels

for (talented) agents gt better pay - (Side note Industrialism and Global warming

problem we havent yet been able to correctly

price all input resources fresh air, rain

forests) - True long run value creation must be based on

true pricing of all inputs.

Benefits of owning?

- OK. But what are the benefits from owning an

asset? - Cash flow rights
- Dividends (including their growth potential)
- Control rights
- Set corporate policy / active management
- Get access to corporate resources
- 3. Favorable risk premium
- If you can fund an investment cheaper than

others, certain cash flow stream will be worth

more to you than others - gt risks are being mispriced in the market

Listed vs private investments

- Market listed stock consensus expectations

revealed in market price continuously - Very few constraints on demand and supply
- Almost non-existant information monopolies
- Need to move very quickly on information
- gt Efficient market hypothesis Utility of

analysis low - (others have already done it)
- b) Private investments no visibility
- Possibly huge constraints on demand and supply

forces - Monopolies on ideas / resources
- Likely very inefficient market
- Utility of analysis potentially very high

Valuation defined

- personal process of attempting to increase

ones understanding of where, why and how

benefits from ownership happen - That process will be time-consuming, hard work.
- How motivated am I?
- Benefits vs costs extra value created thanks to

analysis minus costs of conducting the analysis

Arguments against valuation

- No one can forecast
- This time is different
- Investors are not rational
- Numbers can always be tweaked to serve a

purpose - Life cant be reduced to some formula exercise

Arguments for valuation

- All of economics allocation of scarce

resoures - Undervalued activities gt expand! (buy)
- Overvalued activities gt shrink (sell)
- E.g. decide what to do in
- 1. Corporate restructurings
- 2. MA deals
- 3. LBOs
- 4. Capital structure optimizing
- 5. Value Based Management
- 6. IPO pricing
- 7. Capital budgeting
- 8. Corporate development
- 9. Real estate appraisals
- 10. Active money management

Alternative behavioral decision models

- Basis for resource allocation decisions - how can

you do it? - Do not invest in understanding gt 100 (gut)

feeling based choices - Do not invest in understanding, but watch

closely what others are doing and follow them

(herding) because they are likely to be onto

something - want and hope markets to be inefficient so there

is always time for followers also to benefit from

fashion waves - Invest in understanding, build own opinion about

value, go against the crowd if supported by

analysis - If possible adopt a passive investment style

without investment in understanding enjoying

market returns (no more no less) - No do, if youre the CEO / corporate guy

(corporate job) - No do, if you run an active fund (wealth

management job) - No do, if you work with MAs or related deals

(investment bank job)

Misconceptions about valuation

- Valuation...
- Myth 1 is an objective search for true value
- Fact 1.1 All valuations are biased. The only

questions are how much and in which direction - Fact 1.2 The direction and magnitude of the bias

depends on salary level and boss (motivation) - Myth 2. provides a precise estimate of value
- Fact 2.1 There are no precise valuations (/-15

error normal) - Fact 2.2 The payoff to valuation is greatest

when valuation is least precise - Myth 3 . is better the more quantitative a

valuation model is - Fact 3.1 Ones understanding of a valuation

model is inversely proportional to the number of

inputs required for the model - Fact 3.2 Simpler valuation models do much better

than complex ones

Valuation

- Purpose Profit from informed investments!
- Detect under- (over)valuation
- Buy undervalued / sell overvalued
- Eliminate market risk by finding similar

(perfectly correlated) asset gt take opposite

position

Valuation goals

- Example You believe Hokia is underpriced at 25

(fair value 25.5) and Notorola overpriced at

13.5 (fair value 13.23). Suppose Hokia and

Notorola betas are 1.4 against a broad market

index. What should you do, given that, within two

weeks, - a) fair prices will be established for sure.
- b) actual prices are affected by market

conditions which could go up or down by 4. - c) mispricing still prevails unchanged.
- d) It turns out analysis was misguided and actual

fair values were Hokia 24.55 Notorola 13.77.

Example

- Answers
- a)
- b)
- c)
- d)

1. Valuation means...

- ...always taking a stand on
- 1. Company future Earnings/Cash Flow potential
- profitable growth
- how profitable?
- for how long?
- 2. Required investments to sustain growth
- Working capital needs
- CapEx/Acquisition needs
- 3. The riskiness of the companys stock
- in relation to other investment alternatives

Valuation process (McKinsey)

- Framework for valuation technique (ch. 5)
- Strategy, Profitability, Industry development gt

ROI Growth? (ch. 6) - Analyzing historical performance (ch. 7)
- Forecasting future performance (ch. 8)
- Continuing value (ch. 9)
- WACC (ch. 10)
- Interpreting results (ch. 11)
- Using Multiples for Valuation (ch. 12)

Typical valuation process (McKinsey)

- Choice of internally consistent realistic

valuation model - Forecast of model inputs
- ROICs
- Invested Capital
- Investment needs
- Growth rates
- Cost of capital (discount rate)
- Usually based upon historical analysis of company

numbers benchmarking to industry peers - Adjusting historical inputs to strategic position

of the company in its industry - 4. Eye for details
- Dealing with capital structure and financial

leverage - Dealing with the long horizon of equity
- Etc.

1. Valuation - summary

EnterpriseValue

Cash Flow

Cost of Capital

FCFFt

WACC

NOPLATt

NetInvestmentst

kD

kE

Target D/V

./.

ROIforec. period T

ROI post-forec. period

rf

CapExt

NWCt

CVT

Default premium

1. Re-cap of valuation technologies (Ch. 5)

- A. Discounted cash flow methods (as it looks

today value) - 1. Direct equity valuation
- 1.1. Dividend discount model (DDM)
- 1.2. Free Cash Flow to Equity model (FCFE)
- 2. Firm/enterprise valuation
- 2.1. Free Cash Flow to Firm model (FCFF)
- 2.1.1. WACC
- 2.1.2. APV
- 2.1.3. (Economic Profit and Capital Cash Flow

models) - B. Relative valuation
- Valuation ratios (benchmarked against industry

peers) - C. Option based approaches ( value of active

management) - Binomial, tree models
- more or less analytical formulas (Black-Scholes)

- D. Other valuation methods (old school)
- (Adjusted) Book value - substance value
- provides lower bound for value only

1.1. Generic valuation model

- Generic valuation equation Present Value
- where
- k risk-adjusted discount rate or required rate

of return - defined consistently with the cash flow being

discounted!frequently assumed constant through

time (we neglect term structure effects!) - ECF expected cash flow of investment
- V stands for Value
- EVT terminal, horizon or continuing

value which slices up the valuation into a

forecast period 1-T and a horizon period T1

to inf.

1.1. Frameworks for DCF-based valuation

1.1. Value of a multibusiness company (all

present values, mill.)

1.1. Discounted cash flow models

DDM

FCFE

where EVTE Expected horizon or continuing

value of equity kE is the required rate of

return on (typically levered) equity

FCFF

where EVTF Expected horizon or continuing

value of firm WACC weighted average cost of

capital kE (E/V) kD(1-tC)(D/V)

1.1. Valuation and KVDs

- While correct, generic formulas are not user

friendly given the large number of difficult

forecasts required... - Therefore, we frequently simplify valuations by

specifying cash flows in terms of Key Value

Drivers (KVD) - Most important KVDs are
- 1. Cash flow growth (g)
- 2. Quality of investment (ROI or equivalent)
- 3. Quantitity of investment
- e.g. retention or plowback ratio
- investments into net working capital and fixed

assets - 4. Required rate of return
- (5. Starting level of key cash flow or invested

capital item)

1.1. Simplifying valuations

- Typical simplifications (apart from assuming a

constant discount rate over time) - 1. No cash flow growth (mature industry w/ full

capacity utilization) - no growthgt no investments either gt cash flow

steady forever - However cash replacement investments needed to

support long-term production capability of

assets - 2. Constant cash flow growth (Gordon model)
- cash flow grows at g percent per period, forever
- growth must be supported by investment
- there are limits to productivity enhancements!
- given the additional assumption that ROI of new

investment remains constant over time, the

retention or plowback ratio b, i.e. periodic

investments as a percentage of cash flow is a

constant!g bROI (in DDM of FCFE use ROE

instead!)

1.1. Simplifying valuations

- Typical simplifications (apart from assuming a

constant discount rate over time) (cont.)... - 3. Industry competition wipes out economic profit

after T periods, no profitable growth thereafter - industry converges towards perfect competition

(ROICWACC) - strategic edge evaporates over time
- sensible and prudent given that for no firm can

perpetual g gt nominal GDP -- which often happens

in practice with 2! - 4. Industry competition reduces economic profits

by period T, but some profitable growth

opportunities persist - some companies have excelled over very long

periods so 3. may in some cases be downward

biased

1.1. QD valuation formulas

- Handy formulas include (see appendix for more

detail) - Formulas given for equity valuation so E cash

earnings, use after-tax EBIT in place of E in

firm valuations! - (Formulas will be given in final exam.)
- 1. No growth
- 2. Constant perpetual cash flow growth

Symbols E cash earnings (DDM, FCFE) or

EBIT(1-TaxRate) k required rate of return on

equity or WACC b plowback (retention) rate of

earnings or EBIT(1-TaxRate) ROE return on

equity or after-tax return on investment

ROIROI(1-TaxRate) g growth rate of

earnings or EBIT(1-TaxRate)

1.

Note EDIV as no investments!

2.

or EP formulation

1.1. Re-cap of valuation theory

- Handy formulas ... cont.
- 3. Growth T periodsno growth thereafter4.

Supernormal growth T periods normal constant

growth thereafter

3.

or EP formulation

or approximately

4.

or EP formulation

or approximately

1.3. Simple valuation example NOG Corp.

- Example NOG Corp.
- 100 equity financed no growth company
- Produces a constant EBIT of 10 MEUR
- depr. assumed cash replacement investment
- 10 mill. shares outstanding
- Corporate Tax rate 26
- Past stock returns havebeen...

gt - Riskfree rate is currently 4
- The expected market risk premium is 6

1.3. NOG fair price?

- Example NOG Corp.
- What is current fair share price of NOG?
- V PV(FCF,k)?
- V PV(DIV,k)?
- gt we need cash flow forecast FCF and discount

rate k! - FCF EBIT minus taxes DIV (as no debt!

repl.inv.depr.!)FCF 10(1-0.26) 7.4 MEUR - k required rate of return on NOG unlevered

equity?... - Simplest model is CAPM, so we need NOG equity

beta estimate...suppose NOG unlevered beta

estimate is 0.81

1.3. Estimating NOG cost of equity

- Example NOG Corp.
- Using CAPM to define risk adjusted discount rate

k 4 0.81 6 8.86 p.a.

1.3. And the fair share value is...

- Example NOG...
- Then

per share

1.3. If NOG had growth prospects...

- Example NOG...
- If the future expected free cash flows were,

e.g., ... - with no growthafter 2016...
- Then
- V 123 MEUR
- and
- P 12.3 /sh.
- (Can you spotan unrealisticassumption inthe

valuation?)

1.3. NOG as levered equity?

- Example NOG...
- What if NOG was levered instead with 40 MEUR

perpetual 4 debt? - We have at least three valuation model choices
- 1. Firm level APV
- 2. Firm level WACC calculation
- 3. Direct equity valuation
- Let us go back to no growth scenario, for

simplicity!

1.3. APV valuation

- Example NOG...
- Method 1. Firm level APV Add PV(financing

side effects) to unlevered firm value, deduct

debt to arrive at equity value! - PV(fin. side FX) PV(interest tax shields)

PV(tCkDD) 0.26 0.04 40 / 0.04 10.4

MEUR. - Value Unlevered firm value PV(int.tax sh.)
- Value 83.521 19.4 93.921
- ./. Debt 40 MEUR gt Value of total Equity is

93.921 - 40 53.921 MEUR.

1.3. WACC valuation

- Example NOG...
- Method 2. Firm level WACC valuation WACC kE

(E/V) kD(1-tc)(D/V) - Need target D/V, assume D/V0.4259 (40/93.921)
- Need kE, cost of levered equity assume int.rate

tax shields are risk free, then... - kE kU (kU-kD)(1- tc)D/E
- kE 0.0886(0.0886-0.04)0.74(0.4259/0.5741)

0.11528, i.e. 11.528 - Thus, WACC11.528(0.5741) 40.74(0.4259)

7.8789 - Value of enterprise/firm 7.4 / 0.078789

93.921 MEUR. - ./. Debt 40 MEUR gt Value of total Equity is

thus 93.921 ./. 40 53.921 MEUR.

1.3. FCFE valuation

- Example NOG...
- Method 3. Direct equity valuation (FCFEDDM

here) Define FCFE (EBIT-IntExpenses)(1-TaxRat

e) - ltgt FCFE (10 - 400.04)(1-0.26) 6.216 MEUR.
- Discount with cost of levered equity

kE11.528... - Value of equity 6.216 / 0.11528 53.921 MEUR.

1.3. NOG summary

- Three methods, one result.!

1.3. Key points in example

- 1. Match cost of capital with CF to be

discounted! - Equity cash flow levered cost of equity
- Debt cash flow gt cost of debt
- Firm cash flow gt WACC if levered, cost of

unlevered equity if unlevered firm or APV

valuation - 2. Valuation in nominal terms!
- 3. Leverage increases kE!
- 4. Normally growth through investments complicate

the analysis - required investment to sustain growth?
- growth horizon?
- quality of growth?
- capital structure implications of growth?
- target D/V ratio? constant / changing?

2. Relative valuation (ch. 12)

- Suppose EPS and corresponding P/E ratios of two

no-growth firms A and B in the same industry

are - We interpret same industry here as meaning cash

flows of the two firms are perfectly correlated

due to similar business logic and capital

structure. - What do the two P/E ratios 12 and 8 tell us about

the valuation of A and B...?

2. Relative valuation (Ch. 12)

- Consider investment strategy
- Buy 10000 B shares, short sell 12000 A shares

cost of strategy -100009.6 1200012 -96000

144000 48000 (receive money!) - Annual Dividends received from B 100001.2

12000 /share. - Annual Dividends owed from shorting

A-120001-12000 /share. - Annual cash flow difference from position is

zero!!! - We receive money up front against no future

liability gt arbitrage opportunity, likely to be

short-livedas arbitrageurs / speculators / hedge

funds etc. rush to exploit it.

2. Relative valuation (Ch. 12)

- gt buying pressure increases PB, and selling

pressure lowers PA, causing P/E ratios to

converge! If P/E of A and B would be equal, for

example 10, implying PA10 and PB 12, then

there would be no arbitrage opportunity...Buy

10000 B shares, short sell 12000 A shares cost

of strategy -1000012 1200010 -12000

12000 0. - Annual Dividends received from B 100001.2

12000 /share. - Annual Dividends owed from short position in A

-120001 -12000 /share. - Annual cash flow difference is zero.
- (Running it backwards, buy A short B, produces

similar outcome.)

2. Relative valuation

- Example is a Modigliani-Miller Law of One

Price justification for usage of valuation

ratios, measures of relative value ltgt - Similar things, in terms of expected return and

risk, - should cost as much.
- Conversely, if market is efficient ( limits to

arbitrage small) and P/E ratios are persistently

different, then the two firms are somehow

different - note besides differing growth prospects and

risk, low correlation between cash flows of firms

even in same industry may occur because of low

quality of reported accounting information

2. Relative valuation

- Even with limits to arbitrage (e.g. expensive

shorting or low liquidity), and some degree of

dissimilarity between the two firms, valuation

differences offer a tempting risk arbitrage

opportunity - Those who have A strive to sell it quickly when

the price is still high - B looks like a cheap buy, especially compared

to the roughly similar quality A - Demand and supply move to narrow relative

valuation gap

2. Relative valuation

- If a stock has a low multiple compared to an

industry comparison group, it could be due to - False comparison group (apples vs oranges)
- Error in multiple computation
- Temporary items distort multiple
- Differences in risk (e.g. leverage)
- Differences in growth outlook
- Other differences such as liquidity of stock,

quality of governance, - Market pricing error (buying opportunity)

2. Four best practices (CGW)

- Choose comparables with similar prospects for

ROIC and Growth - Use multiples based on forward-looking estimates
- Use enterprise value (EV) multiples based on

EBITA to mitigate problems with capital structure

and one-time gains and losses - Adjust the EV multiple for nonoperating items,

such as excess cash, operating leases, employee

stock options, amnd pension expenses (same as w/

ROIC and FCFF adjusting)

2. What is relative valuation?

- In relative valuation, the value of an asset is

compared to the values assessed by the market for

similar or comparable assets. - To do relative valuation then,
- we need to identify comparable assets and obtain

market values for these assets - convert these market values into standardized

values, since the absolute prices cannot be

compared. This process of standardizing creates

price multiples. - compare the standardized value or multiple for

the asset being analyzed to the standardized

values for comparable asset, controlling for any

differences between the firms that might affect

the multiple, to judge whether the asset is under

or over valued

2. Standardizing Value

- Prices can be standardized using a common

variable such as earnings, cashflows, book value

or revenues. - Earnings Multiples
- Price/Earnings Ratio (PE) and variants (PEG and

Relative PE) - Value/EBIT
- Value/EBITDA
- Value/Cash Flow
- Book Value Multiples
- Price/Book Value(of Equity) (PBV)
- Value/ Book Value of Assets
- Value/Replacement Cost (Tobins Q)
- Revenues
- Price/Sales per Share (PS)
- Value/Sales
- Industry Specific Variable (Price/kwh, Price per

ton of steel ....)

2.1. Price Earnings Ratio Definition

- PE Market Price per Share / Earnings per Share
- There are a number of variants on the basic PE

ratio in use. - They are based upon how the price and the

earnings are defined. - Price is usually the current price
- is sometimes the average price for the year
- EPS earnings per share in most recent financial

year - earnings per share in trailing 12 months

(Trailing PE) - forecasted earnings per share next year

(Forward PE) - forecasted earnings per share in future year

2.1. PE from fundamentals

- For perpetual growth model (Gordon) divide thru

w/ E1 to get theoretical forward PE - For 2-stage model T period growth no

growth...then

2.1. PE with 2-stage model

- You need double digit g, ROE and T together with

below 10 k to generate PE ratios above 20! - If required rate of return of equity would be

13 (high beta stock), - PEs have a very hard time exceeding 15!

2.2. PEG ratio

- PE ratio divided by estimated earnings growth

rate 100 - PEG1 is neutral valuation
- In actual fact, risk and payout (1-plowback)

continue to affect PEG-ratio - Division by g does not neutralize the effect of

growth due to non-linearities

2.3. Relative PE

- Ratio of firm PE to overall market P/E
- should use same earnings base in calculation
- Normalization by market enables better

comparisons of valuations over time - - Not (as) dependent on market interest rate

level - Increases when firm growth rate above market

growth rate - Decreases when firms riskiness w.r.t. market

increases (high beta stocks)

2.4. Value/Earnings and Value/Cashflow Ratios

- While price earnings ratios look at the market

value of equity relative to earnings to equity

investors - Value/earnings ratios look at the market value of

the firm relative to operating earnings. Value to

cash flow ratios modify the earnings number to

make it a cash flow number. - The form of value to cash flow ratios that has

the closest parallels in DCF valuation is the

value to Free Cash Flow to the Firm, which is

defined as - Value/FCFF (Market Value of Equity Market

Value of Debt) - EBIT (1-tc) - (Cap Ex - Deprecn) - Chg in WC

2.5. Enterprise value / FCFF

- Multiple is increasing in FCF

(EBIT) growth and decreasing in cost of capital

WACC!

2.6. Alternatives to FCFF - EBIT and EBITDA

- Many find FCFF too messy to use in multiples

(partly because capital expenditures and working

capital have to be estimated). They use modified

versions of the multiple with the following

alternative denominator - after-tax operating income or EBIT(1-tC)
- pre-tax operating income or EBIT
- net operating income (NOI), a slightly modified

version of operating income, where any

non-operating expenses and income is removed from

the EBIT - EBITDA, which is earnings before interest, taxes,

depreciation and amortization.

2.6. Pros of Value/EBITDA

- 1. EBIT gt 0 even when earnings negative.
- 2. Some long-term high growth firms may have

misleading (too low) current earnings due to

heavy investment needs - 3. Comparing firms with differing leverage is OK.
- (EBIT level, WACC might differ though)

2.7. Price-Book Value Ratio Definition

- The price/book value ratio is the ratio of the

market value of equity to the book value of

equity, i.e., the measure of shareholders equity

in the balance sheet. - Price/Book Value Market Value of Equity

Book Value of Equity

2-stage growth no growth

/ BV0

Note E1 BV0ROE

ltgt

ltgt

2.7. P/B to ROE

- Like PEG, ROE could be normalized against

differing ROE levels by division to give a Value

Ratio - Value Ratio (P/B) / ROE

2.8. Price Sales Ratio Definition

- The price/sales ratio is the ratio of the market

value of equity to the sales. - Price/ Sales Market Value of Equity
- Total RevenuesCould also

normalize it against profit margins - Normalized Price/Sales (Price/Sales) / Profit

Margin

2.9. Choosing the right multiple

- EV/EBIT and EV/EBITDA and P/B have the best

accuracy - P/S and P/E worse
- Always use foreward earnings / EBIT etc.

2.9. Choosing Between the Multiples

- Many multiples exist...which one to use?
- In addition, relative valuation can be relative

to a sector (or comparable firms) or to the

entire market - Since there can be only one final estimate of

value, there are three choices at this stage - Take a simple average of all multiple implied

values? - Take a weighted average of all multiple implied

values? - Choose best multiple and imply value from it?

2.9. Picking one Multiple

- Usually best method (and easiest)compared to

averaging business... - The multiple that is used can be chosen in one

of three ways - Cynics Pick the multiple that serves your

purpose! - Use the multiple that actually has been shown to

be related to actual market values. How do we

know? Research team needed. - Use the multiple that seems to make the most

sense for that sector, given how value is

measured and created.

2.9. Guidelines

- Some common sense guidelines for multiple

choice - Sector Multiple Used Rationale
- Cyclical Manufacturing PE, Relative PE Often with

normalized earnings - High Tech, High Growth PEG Big differences in

growth across firms - High Growth/No Earnings PS, VS Assume future

margins will be good - Heavy Infrastructure VEBITDA Firms in sector have

losses in early years and reported earnings

can vary - depending on depreciation method
- REITa P/CF Generally no cap ex investments
- from equity earnings
- Financial Services PBV Book value often marked to

market - Retailing PS If leverage is similar across firms
- VS If leverage is different

3. Valuation framework (Ch. 6-)

- Copeland-Koller-Murrin Valuation...
- Best practice
- Widely accepted, sound principles
- Steps are
- 1. Analyze historical performance
- 2. Estimate cost of capital
- 3. Forecast performance
- 4. Estimate continuing value
- 5. Evaluate scenarios

3. Step 1. Analyzing Historical Performance

- Assess historical KVDs and FCF
- - Strive to pick an entire historical economic

cycle - - beware of cyclically low/high recent cash

flow! - - normalization often advisable

3. Step 1. Analyzing Historical Performance

- Integrate Income and Balance sheets to cash flows

and further to key ratios - Reorganize accounting statements for valuation

purpose - Invested capital
- NOPLAT (roughly after-tax EBIT)
- historical ROIC
- breakdown in tree ROIC Operating margin

Capital Turnover - historical Economic Profit
- historical FCFF
- historical growth
- historical investment rates (into NWC and CapEx)
- credit health liquidity position
- other stuff
- goodwill, operating leases, reserves
- Benchmark to peers or market
- caution to differing international accounting

conventions

3. Realistic ROI and growth levels

- Example Stockmann ROI

3. Realistic ROI and growth levels

- Example Stockmann Sales Growth

4. WACC or APV?

- WACC-method works best when...
- 1. Target long-term capital structure can be

assumed constant - 2. Capital structure is simple, few embedded

liability options - APV-method works best when...
- 1. Target D/V is not constant through time
- 2. Complicated option-features present
- e.g. significant executive options (warrants)
- significant mezzanine financing convertible debt

etc. - Valuation steps with APV
- 1. Compute 100 equity financed (i.e. unlevered)

enterprise value - 2. Add PV of financial side fx like subsidized

financing, debt capacity - 3. Add excess marketable securities
- 4. Subtract senior claim values senior bonds,

junior bonds, mezzanine, executive warrants...to

get value of equity

4.1. Estimating cost of capital

- Cost of capital reflects, among other things at

least... - investors willingness to entrust their money

with the (managers of) the firm for a reasonable

price given the expected outlook on company cash

flow - Cost of capital increasing in factors reducing

willingness (mistrust) - High risk
- Illquidity (foreign listed? size/turnover?)
- Bad/unclear corporate governance
- Wierd ownership structure (only domestic owners,

single majority owner?)

4.1. Estimating cost of capital - Risk

- (Given no pricing error) If cash flow growth

prospects do not explain (e.g.) a high valuation,

it must be due to (most) investors being really

eager to hold the stock low cost of capital - they perceive it as low risk OR
- they truly trust the CG OR
- it is really big liquid (blue chip) OR
- it is a large global company listed on many

stock exchanges - (wide globally diversified ownership base)

4.1. Estimating cost of capital - Risk

- The major component traditionally assumed to

impact cost of capital - Debt financing Use of bond ratings to gauge risk

class and credit spread - Equity financing Level of systematic risk of

industry (unlevered equity beta) financial

leverage effect

4.1. Estimating WACC

- 1. Use market value weights for all types of

capital - 2. Specify cost of capital items after-tax to

match after tax free cash flow. - 3. Use nominal cost of capital (1real

rate)(1Einfl.) - to match nominal cash flow modelling
- 4. Utilize market prices at date of valuation, if

possible - Debt deducted should equal debt in WACC
- Check for gross discrepancies between assumed

target D/V ratio in WACC and that implied by

your valuation!

4.1. Step 2. Estimating the Cost of Capital

- The WACC can be defined in many ways, two most

common definitions include (assumes simple DE

only capital structure!) - where tc is the corporate tax rate
- kU unlevered cost of equity
- kD cost of debt
- kE cost of (levered) equity

assumes debt cash flows are equally risky as debt

and therefore discounted with kD! Can always

be used!

or

assumes debt cash flows are risky and therefore

discounted with kU!

4.1. Step 2. Estimating the Cost of Capital

- Current practice tends to measure risk in equity

through the beta, i.e. assume the CAPM holds. - Then beta is the risk measure supposed to

reflect, systematic risk, liquidity, CG,

ownership structure - Beware!
- ? Even ignoring 2.-4, a better APM than CAPM is

the Fama-French 3 Factor Model - high (low) beta stocks as well as small value

(large growth) stocks have higher (lower) than

average systematic risk and hence cost of equity - On top of equity risk financial leverage must be

taken into account...

4.1. FF 3FM

4.1. Step 2. Estimating the Cost of Capital

- Relationship between levered and unlevered cost

of equity are as follows (zero growth case,

approximation to other cases) - where tc is the corporate tax rate
- kU unlevered cost of equity
- kD cost of debt
- kE cost of (levered) equity

or

assumes debt cash flows are equally risky as debt

and therefore discounted with kD!

assumes debt cash flows are risky and therefore

discounted with ku!

4.1. Step 2. Estimating the Cost of Capital

- Relationship between levered and unlevered equity

betas are as follows (zero growth case,

approximation to other cases) - where tc is the corporate tax rate
- bU unlevered equity beta
- bD debt beta
- bE levered equity beta

or

assumes debt cash flows are equally risky as debt

and therefore discounted with kD!

assumes debt cash flows are risky and therefore

discounted with ku!

4.1. Target D/V?

- 1. Use market value weights for all types of

capital - Market D/E ratio (Book D/E ratio)

(Book/Market ratio) ! - Only if B/M 1 then market and book gearing

coincide - Usually assumed constant through time, although

not mandatory - Think in terms of the long-term target capital

structure - 1. Smoothing over recent transitory capital

structure changes - 2. Get around circularity problem
- 3. Benchmark to industry, why deviation?
- The debt you subtract to get equity should

normally be the debt used in the capital

structure WACC

4.2. Cost of debt

- Straight investment grade debt
- Find company bond rating
- Use current yield from rating class as a proxy

for expected cost of debt - Below investment grade
- Significant default rates bias (promised) yields

upward compared to expected yields! - Need expected default rates and value in default

to compte expected yields... - May need to use BBB-rated debt yields as proxy
- Own rating model
- e.g. interest coverage ratio based

4.3. Cost of hybrids or mezzanine

- e.g. convertible bonds, capital loans etc.
- Split up value into
- (1) bond part and (2) warrant part (or

equivalent option) - Estimate costs as cost of debt and equity for the

parts separately.

4.4. Cost of equity

- 1. CAPM expected cost ( return)
- rf risk free rate
- Market Risk Premium Erm - rf
- Beta of security / capital type i, bi
- 2. Implied IRR from valuation model
- e.g. solve for kE from P DIV1/(kE - g) given P

and DIV1 and g forecasts!

4.4. Cost of equity

- 1. CAPM
- rf should be defined with
- no default risk
- no re-investment risk (term structure effects0)
- no inflation risk
- in practice, 5 or 10 year government bond yield

typically used - match with duration of firm cash flow
- not universally accepted, some advocate short

maturity TBills - choose rf consistently with MRP!
- New in U.S TIPS (Treasury-Inflation-Protected-

Securities) replacing Tbills as a riskfree rate! - Coming in Europe?

4.4. Cost of equity

- 1. CAPM
- Expected Market Risk Premium
- These days around 2-4 for developed markets
- Think Europe or World as the market
- Use consistent rf definition with above!
- Historical average likely too high
- Good luck
- Inconsistency with theories
- Survivorship bias
- Dimson-Marsh-Staunton European data

4.4. Cost of equity

- 1. CAPM
- Beta?
- unlevered vs levered equity betas
- preferably, use industry average unlevered equity

betas - historical OLS regression
- need to unlever to first get industry betas!
- use monthly data/longer estimation period to

combat illquidity distortions

4.4.Historical market premium varies a lot

Forecasts made 5 (10) years ahead using D/P

regression

4.4. Implied market return

- 1. Pick a 2-stage model for T year horizon
- 2. Obtain market index dividend forecasts up to

T - 3. Estimate long-term nominal growth rate of

market (nominal long-term GDP growth usually). - 4. Back out rm that equates PV(dividendsHV) with

current market index level.

4.5. Alternative approaches

- 1. Fama-French 3F model already mentioned as

being the one - (at least) academics mostly believe in
- although we know it doesnt explain well

momentum, small growth stocks etc.-

implementation issues estimate three premia and

three betas instead of 11... - 2. Use of past (long-term!) realized average

stock return (of peers)? - Tend to be very noisy and highly dependent on

sample period

5. Step 3. Forecasting Performance

- 1. Length and detail of forecasts
- 2. Analyze industry
- business logic
- threats from new entry/new technology?
- sustainability of margins, ROIC, growth
- 3. Link between strategy and future KPIs
- Strategy gt KPI forecasts gt Inc. and BS

forecasts gt FCFF forecasts - 4. Evaluate alternative scenarios
- 5. Overall consistency
- growth ltgt ROIC ltgt Investments vs strategic

view

5.1. Forecasting cash flows

- We should forecast expected cash flows or

alternatively do scenario-based valuations - Scenario prob. CF
- Optimistic 40 10
- Realistic 40 8
- Pessimistic 20 -4
- ECF 6.4
- Frequent error is to provide upward biased

budget, or hoped for forecasts instead of

expectation - e.g., do the forecasts acknowledge there is some

probability for a zero CF?

5.1. Forecasting FCF

- 1. Forecast KVDs
- 2. Build pro forma income statements and balance

sheets from KVDs - check reasonability of numbers, benchmarking,

financing feasible? - 3. Derive FCF from step 2.

5.1. Free Cash Flow To Equity - FCFE

- EBIT
- ./. Interest Expense
- EBT
- ./. taxes
- Net Income
- Depreciation
- CF from operations
- ./. Working capital increase (operative,

non-int.bearing) - ./. Gross capital expenditures
- ./. Debt amoritizations
- New debt issues
- FCFE

5.1. Free Cash Flow To Firm - FCFF

- EBITA (EBIT before Interest, Taxes and

Goodwill Amortization) - ./. taxes ( may have to be adjusted for

financial items) - NOPLAT
- Depreciation (all depreciation but goodwill

type amortization) - Gross CF
- ./. Working capital increase (non-interest

bearing or operative) - ./. Gross capital expenditures (net investment

depreciation) - FCFF before goodwill
- ./. Investments into goodwill (DGoodwill

goodwill amort.) - FCFF after goodwill

6. Step 4. Estimating Continuing Value

- 1. Pick simplified long-term growth model
- Industry analysis - the long run

outlook? - 2. Estimating long run continuing value model

parameters - ROIC, NOPLAT growth rate, investment rate?

or

6. Step 4. Estimating Continuing Value

- 1. Forecast at least 7 years (over a whole

business cycle). - 2. ROIC is marginal ROIC, for many companies

ROIC WACC . - 3. NOPLAT(T1) should be normalized.
- 4. FCF - remember to subtract investments

required to sustain long-term growth - 5. Growth rate - normally long term cons.

(volume, or real) growth of industrys product

inflation - Long-term nominal GDP growth is about /-6

6. Step 4. Estimating Continuing Value

- 6. Long term growth should never exceed nominal

GDP (nominal RF level) growth - 7. Constant growth could be assumed zero or

negative indicating we model a peak at T and then

diminishing size for company in relation to

industry/market - 8. Frequently riskiness of firm changes as it

enters a constant growth phase from high growth

gt lower beta?

7. Step 5. Interpret the results

- 1. Calculate PV(FCFF) PV(continuing value)
- 2. Subtract debt, hybrid securities, PV(leases) ,

minority interest, executive options - in-the-money executive options can alternatively

be treated as fully diluted equity gt increase

number of shares instead of subtracting value of

exec. options. - 3. Add cash/excess marketable securities
- 4. Add PV(non-operative) cash flow or assets
- 5. Weight each scenario with steps 1.-4 with

scenario probabilities to sum up.

7. Some closing remarks...

- Develop a habit of drawing time lines graphs

(10-30 years ahead) of your projected ROIs

(compare to WACC), gs - Normalize and average out lumpy investments/NWC

needs - Positive NWC temporary, prudent to assume zero.
- Look out for starting level CF, HV assumptions

many valuation errors can be traced back to

these - Stick to gROIb consistency
- Dont overdo cost of capital estimations (unless

you are selling them for a good price ) - No way these will ever be 100 accurate, so dont

worry about third decimal of your beta - Ask is this a stock investors like? If yes, is

it just the growth outlook, or is it something

else? If they dont like a stock, why? - Check ownership structure, low cost of capital

firms have dispersed, global ownership, good

track record of liquidity and good CG - Very high valuation must go together with low

cost of capital if you cant see it, suspect

ovevaluation - If overvaluation would actually be present who

would/could move to exploit it? Why dont they?

7. Valuation - summary

EnterpriseValue

Cash Flow

Cost of Capital

FCFFt

WACC

NOPLATt

NetInvestmentst

kD

kE

Target D/V

./.

ROIforec. period T

ROI post-forec. period

rf

CapExt

NWCt

CVT

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