Notes on Valuation Approaches

1. Notes on Valuation Approaches Summer 2009 Dr. Keith M. Howe Scholl Professor of Finance DePaul University

2. Valuation Approaches Methodologies Discounted Cash Flow Analysis Comparable Companies Analysis

3. Discounted Cash Flows (DCF) Pros • Widely accepted • Provides a generally reliable and sophisticated approach to valuation by accounting for: • Profitability • Growth • Capital investment/intensity • Capital structure • Risk and opportunity cost Cons • Generally not easy to calculate • Grounded by assumptions • Gives only an absolute valuation, which in isolation is not telling • Loaded with assumptions

4. Discounted Cash Flows (DCF) A DCF model has three parts: • Explicit forecast period • Cash flows are after-tax incremental cash flows • Continuing value or terminal period • Perpetuity • FCF, NOPLAT, NOPAT • Constant growth • Multiples • Discount rate • Discount rates can be determined a number of different ways (e.g., CAPM, Gordon growth model, APT, etc), but the expected free cash flows are discounted at the rate that reflects the risk of the cash flows.

5. How to Display a DCF- Based Model AssumptionsExample: Here we develop a base case model from Wall Street Research and CSFB projections

6. Discounted Cash Flow Valuation • ($ in millions) (1) 2004E not included in calculating NPV of cash flows. ($ in millions) 6

7. General Thoughts on Relative Valuations • Most Valuations on Wall Street Use Multiples • Multiples reflect current market perceptions • Relative Valuations require fewer explicit assumptions and are easier to use • Relative valuations often find a more receptive audience (easier to understand as there are less assumptions)

8. Price/Sales Pros • Easy to calculate • Maybe the only available multiple Cons • Ignores profitability • Does not account for margins (Fed Ex vs. UPS) or taxes (PFE vs. BMY) • Completely ignores capital structure • Debt not included in the value of the firm • Interest costs and tax shield are ignored • Ignores future growth opportunities • Ignores capital intensity and investment While simple Price/Sales has numerous pitfalls users must be aware of.

9. Price/Earnings (P/E) Pros • Most commonly used and accepted multiple with sell side research • Easy to calculate (simply need to ensure you match time periods, trailing, current, future) • Takes into account profitability Cons • Cannot use if companies do not have accounting earnings • Are GAAP earnings a good measure of cash flow? • Adjustments for normalized earnings? • Ignores Economic Profitability • A company could be buying earnings (AutoZone example, see next page) • Completely ignores capital structure • Debt not included in the value of the firm • Interest costs and tax shield are ignored • Ignores future growth opportunities • Ignores capital intensity and investment Although widely accepted, P/E has serious drawbacks.

10. Are Autozone’s Investors Only Concerned With Earnings? Through the 90’s – Autozone’s EPS grew at a 25% CAGR.

11. Enterprise Value/EBITDA (EV/EBITDA) Pros • Second most commonly used and accepted multiple on Wall Street • Easy to calculate (but need to ensure you match time periods, trailing, current, future) • Takes into account profitability • EBITDA generally a good proxy for cash • Takes into account capital structure • Includes debt in the value of the firm (should use net debt) • Includes Interest as part of cash flow Cons • Ignores Economic Profitability • Ignores capital intensity and investment The EBITDA multiple is a “cleaner” multiple, however it still misses the hurdle rate and investment required into the business.

12. Value/Book or EV/Book Important here is that Value/Book defines how much the market is paying for past investments. Pros • Used by Wall Street to gauge capital intensity and investment return • Easy to calculate • Takes into account capital structure • Includes debt in the value of the firm • Includes Interest as part of cash flow Cons • Ignores both accounting and economic profitability • Any additional problems with these metrics? (Matching/timing of values) Value/Book accounts for the investments made into a business and its future value creation potential. Profitability however is now ignored.

13. Implementing a Multiples Approach • Define the multiple • There are different definitions for the same multiple (current, trailing, forward) • It is integral to look at the entire distribution of the multiple • Understand the differences between the mean, median and standard deviation • Understand why the outlier are outliers (question relevance of the multiple and the companies inclusion in the peer group) • Understand the fundamentals of the multiple • What are the strengths and weaknesses of the multiple One more thing…..

14. Choosing a Peer Group for Relative Valuation Methods Why are you trying to determine value? Defining why you are performing a valuation has a direct effect on choosing a firm’s peers.

15. Display Example: A Valuation Perspective P/E 2004E Market/Book-Current From our analysis what can you tell me about our company?

16. Display Example: Relative Valuation- Utility Holding Companies mismatched time periods P/E – 2003(1) EV/EBITDA – 2004(2) Market/Book (1) Source: First Call (2) Source: Wall Street Research Errors to note here PE is 2003, EV/EBITDA is 2004 and Market to book is not label. Remember you MUST match time periods.

17. V/C for S&P 500 Display Example: Relative Valuation - Correct Time Periods EV / 2004E EBITDA P/E - 2004E 2003 P/E Source: I/B/E/S Estimate. Market/Book – Current Note: Value-to-Cost defined as a “real” market-to-book ratio. A Value-to-Cost ratio >1.0x implies that the market is expecting future profitable growth from the Company. Current value-to-cost ratio for the S&P 500 = 1.85x. PX’s trading multiples are consistent with the market’s expectations for future performance.