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Establishing a Foundation

Establishing a Foundation. Course Focus. Valuation analysis What does the term “value” mean? Value to whom? Where should the focus be to determine if value is created? Any conflicts exist by focusing on value?. Management’s Objectives. What is management’s objective? Maximize sales?

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Establishing a Foundation

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  1. Establishing a Foundation

  2. Course Focus • Valuation analysis • What does the term “value” mean? • Value to whom? • Where should the focus be to determine if value is created? • Any conflicts exist by focusing on value? FIN 591: Financial Fundamentals/Valuation

  3. Management’s Objectives • What is management’s objective? • Maximize sales? • Maximize profit or EPS? • Maximize market share? • Maximize compensation? • … FIN 591: Financial Fundamentals/Valuation

  4. How is Shareholder Value Created? • Maximize firm value • Firm value = Market value debt + market value equity • Firm’s investments &financing affect its value. FIN 591: Financial Fundamentals/Valuation

  5. Competitiveness • Competition matters and strategy is important • Competition comes in two basic forms: • Perfect competition • Imperfect competition • Don’t confuse strategy and planning • Planning: Ideas to make a product or service and sell it profitability • Strategy: Plans that focus on the actions and responses of competitors. FIN 591: Financial Fundamentals/Valuation

  6. Strategic Thinking • About creating, protecting and exploiting competitive advantages • Perfect competition • No competitive advantage  focus on costs • Tactical decisions; not strategic!! • Imperfect competition • Exploit competitive advantages FIN 591: Financial Fundamentals/Valuation

  7. Porter’s 5 Forces FIN 591: Financial Fundamentals/Valuation

  8. FIN 591: Financial Fundamentals/Valuation

  9. Breakeven Analysis Total revenue Which cost structure is better? High fixed costs or high variable costs? $ Variable costs Fixed costs Qty FIN 591: Financial Fundamentals/Valuation

  10. Economies of Scale Matter FIN 591: Financial Fundamentals/Valuation

  11. Economies of Scale FIN 591: Financial Fundamentals/Valuation

  12. Experience Curve Theory Unit cost = Beginning cost x (n / no)a Unit $ a = -.51  Experience curve has slope = 70% no = beginning units; n = later units For manufacturing & distribution operations, costs should follow 70% curve. If constant costs aren’t declining 70-80% each time industry volume doubles, buyers are probably paying a premium for services which may or may not be of value to them. As output doubles, (deflated) costs decline linearly. Deflated costs Plotted in log-log scale Total Accumulated Qty Source: Perspectives on Experience (Boston Consulting Group, 1972) FIN 591: Financial Fundamentals/Valuation

  13. Competition Demystified FIN 591: Financial Fundamentals/Valuation

  14. MVA & Productivity • An earlier edition of the textbook concluded: • High labor productivity  create more value than low labor productivity • Companies that create more value, create more jobs. FIN 591: Financial Fundamentals/Valuation

  15. Why Use Multiples • P/E & price-to-sales ratios used frequently in valuation applications • Quick and convenient • Relies on a scaled average price of similar firms to estimate value • Fails to specify why prices are what they are • Agnostic about what determines price • See: • Reference book by Barker • Highlights shortcomings of PE ratio • Valuation textbook: Chapter 12. FIN 591: Financial Fundamentals/Valuation

  16. Justification for P/E? • Dividend growth model Current price = Dividend next period / (r - g) Current price = Payout ratio * current EPS * (1 + g) / (r - g) Divide both sides by “current EPS” P/E = Payout ratio * (1 + g) / (r - g) • P/E ratio depends on: • Constant payout ratio • Constant income growth • Constant discount rate • Incorporates both business risk and financial risk. FIN 591: Financial Fundamentals/Valuation

  17. Playing PE Games • Acquirer: PE = 25; NI = $1 mill.; shares = 1 mill. • Target: PE = 10; NI = $100k; shares = 100k • Exchange ratio = 1 share acquirer for 2 shares target • New EPS = ($1 mill. + $100 k) / 1.050 mill. shares = $1.05 vs. $1 before acquisition • If PE of combined firm = 25; new price = $26.25 vs. $25 • Moral: • Larger firm can offer smaller firm a significant premium and still have its EPS and stock price increase • Where’s the economic value added? FIN 591: Financial Fundamentals/Valuation

  18. P/S Multiplier • Price / sales per share • Assumes operating characteristics have the same relation to sales for all firms • Problems: • Doesn’t reflect differences in efficiencies • Doesn’t reflect differences in capital investments • Doesn’t reflect differences in growth prospects • Relationship to P/E ratio • Price / earnings = Price / (ROS% * sales) • Price / sales = ROS% * (Price / earnings) • So what? FIN 591: Financial Fundamentals/Valuation

  19. A Simplified Valuation Model • Assume a firm with no growth opportunities Market value of the firm = Corporate ROIC * book value of assets Required market rate • Example: A company earns 15% rate of return on its $50 million capital. The required market rate of return is 12%. What is the firm’s value? Answer:.15 * $50 M / .12 = $62.5 M • If ROIC = 9%, value = $37.5 M. FIN 591: Financial Fundamentals/Valuation

  20. Present Value of Growth Opportunities • PVGO = Investment * Investment’s ROIC Required market rate • Example: PVGO = $1000 * .15/.12 = $1250 • If ROIC is 10%, value = _______. FIN 591: Financial Fundamentals/Valuation

  21. Growth and Value • Growth is only valuable if: • Return on invested capital (ROIC) > WACC • NPV > 0 • If ROIC = WACC • Growth neither creates nor destroys value • NPV = 0 • If ROIC < WACC • Growth destroys value • NPV < 0. FIN 591: Financial Fundamentals/Valuation

  22. A Long-Term View • True value improvement comes from management following a long-term investment strategy • LVI = (1 - dividends for next 5 years ) * 100 Current stock price • Provides estimate of investors’ confidence in management to sustain a long-term competitive advantage in its markets • Look at Exhibit 4.9 in Valuation text • Dividends have been discount, contrary to the above formula. FIN 591: Financial Fundamentals/Valuation

  23. EXHIBIT 4.9 PRESENT VALUE OF EXPECTED DIVIDENDS* FOR SELECTED S&P 500 COMPANIES Present value of dividends expected over the next 5 years Dollars Share price Dollars Dividends as percentage of stock price Percent 4.97 3.38 3.23 6.66 6.73 1.90 3.36 1.52 3.04 4.80 5.26 3.07 1.98 2.92 5.45 3.20 4.23 4.61 0.40 4.73 1.82 43.59 42.14 26.80 41.57 70.33 16.00 36.73 22.97 92.68 51.66 38.08 51.40 24.83 47.79 42.24 46.62 42.71 45.49 29.38 74.55 53.05 11.4 8.0 12.1 16.0 9.6 11.9 9.2 6.6 3.3 9.3 13.8 6.0 8.0 6.1 12.9 6.9 9.9 10.1 1.4 6.3 3.4 8.7 Abbott Laboratories Boeing Campbell Soup Dow Chemical Eli Lilly Ford Motor Co Gillette Hewlett-Packard International Business Machines Johnson & Johnson Kellogg Lockheed Martin McDonald's New York Times Occidental Petroleum PepsiCo Rohm & Haas Sears Roebuck Texas Instruments United Parcel Service Wal-Mart Stores Average FIN 591: Financial Fundamentals/Valuation * Assuming 7% growth in dividends during next 5 years. Cost of equity based on risk free rate of 4.3%, market risk premium of 5.0% and Bloomberg beta Source: Bloomberg; McKinsey analysis

  24. Is the Market Price Correct? • Are financial markets efficient? • Information is reflected in prices immediately • Firms should expect to receive fair value for securities they sell • Financial managers can’t time issues of bonds and stocks • Securities markets can’t be affected by management “cooking the books”. FIN 591: Financial Fundamentals/Valuation

  25. Efficient Markets and the Information Set All information relevant to a stock Information set of publicly available information Information set of past prices FIN 591: Financial Fundamentals/Valuation

  26. Evidence • Academic studies generally supportive of weak form and semi-strong form EMH • Evidence to the contrary exists • Fads in stock prices • Seasonalities • January effect, day-of-the-month & week effects • Others • P/E effect, moving averages • How can EMH explain October 1987 & 1997? FIN 591: Financial Fundamentals/Valuation

  27. EXHIBIT 4.8 MARKET REACTION TO PHARMACEUTICAL PRODUCT ANNOUNCEMENTS Abnormal returns percent, 1998-2003 Announcement return -1/+1 day Announcement return -3/+3 days Lilly-Zovant AstraZeneca-Nexium Development successes (e.g., approvals) Lilly-Evista Wyeth-Enbrel Wyeth-Protonix Abbott-Humira Pfizer-Zeldox NovoNordisk-Ragaglitazar Schering-Angeliq Development setbacks (e.g., withdrawals) NovoNordisk-Levormeloxifene BMS-Vanlev2 AstraZeneca-Iressa BMS-Vanlev 1 FIN 591: Financial Fundamentals/Valuation Source: Datastream; Factiva; McKinsey analysis

  28. 110 108 106 104 102 100 98 96 94 92 90 EXHIBIT 4.10 NO CLEAR IMPACT OF U.S. GAAP RECONCILIATIONS Average cumulative abnormal return (CAR) index -1/+1 CAR t-Stat (0.5%) (1.54) Positive earnings • impact (n = 16) Negative earnings impact (n = 34) CAR t-Stat 1.7% 14.63 Day relative to announcement Source: SEC filings; Datastream; Bloomberg; McKinsey analysis FIN 591: Financial Fundamentals/Valuation

  29. EXHIBIT 4.11 NO CONSISTENT MARKET REACTION TO SFAS-142 GOODWILL ANNOUNCEMENT Abnormal return on announcement datePercent Goodwill amortization as percent of year end equity market value, 2001 Source: Datastream; McKinsey analysis FIN 591: Financial Fundamentals/Valuation

  30. EXHIBIT 4.12 MARKET REACTION AT ANNOUNCEMENT OF GOODWILL IMPAIRMENT Cumulative abnormal return (CAR) index, n = 54 Average -1/+1 CAR t-Stat 0.1% 0.3 Time Warner Day relative to announcement FIN 591: Financial Fundamentals/Valuation Source: SEC filings; Datastream; Bloomberg; McKinsey analysis

  31. EXHIBIT 4.13 VOLUNTARY OPTION EXPENSING HAS NO IMPACT ON SHARE PRICE Abnormal return on announcement date (percent) Summary statistics n = 120 R2 = 0.4% Slope = 0.01 t-Stat = 0.7 P-value = 47.1% Impact of option expense on pre-tax income(percent) * Defined as the absolute value of option expense divided by the pre-tax earnings before option expense Source: SEC Filings; Datastream; Bloomberg; McKinsey analysis FIN 591: Financial Fundamentals/Valuation

  32. EXHIBIT 4.14 EFFECT OF INVENTORY ACCOUNTING CHANGE ON SHARE VALUE Cumulative abnormal return, months from date of accounting change Percent 110 firms switching to LIFO 22 firms switching from LIFO Source: S. Sunder, “Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,” Empirical Research in Accounting: Selected Studies, 1973 FIN 591: Financial Fundamentals/Valuation

  33. EXHIBIT 4.15 MARKET VALUE OF 3COM COMPARED TO THE VALUE OF PALMONE OWNERSHIP BY 3COM 5% carve-out Future separation announced Full spin-off $ Billion Source: Datastream FIN 591: Financial Fundamentals/Valuation

  34. EXHIBIT 4.16 SHARE PRICE DISPARITY OF DUAL-LISTED COMPANIES Relative difference in valuationPercent Royal Dutch Petroleum NV relative to Shell T&T PLC Unilever NV relative to Unilever PLC Source: Datastream FIN 591: Financial Fundamentals/Valuation

  35. Can Fundamental AnalystsBeat the Market? • Based on belief that stock market values reflect economic values • Fundamentalists also believe that there is publicly available info that allows them to form better estimates of value than contained in market prices • Price = Dividend1 / ( 1 + r) + Dividend2 / (1 + r )2 + … • Why isn’t the info reflected in the price? FIN 591: Financial Fundamentals/Valuation

  36. The End FIN 591: Financial Fundamentals/Valuation

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