AAA 2008 Annual Meeting CPE Session #44

1. AAA 2008 Annual MeetingCPE Session #44 Sprint Nextel Valuing Firm Equity Mary LéaMcAnally InderKhurana Rebecca Shortridge CPE session #44 AAA Annual Meeting 2008

2. After this session you should be able to: • Implement an income method to estimate fair value of a share of publicly traded stock (Sprint Nextel) • Understand how Level 2 and Level 3 inputs affect valuation techniques and fair-value estimates • Use Sprint Nextel case materials in your classroom • Background Reading • Case and financial statements • Teaching note CPE session #44 AAA Annual Meeting 2008

3. Estimating fair value of a share ofSprint Nextel stock There exists a quoted price in an active market for an identical asset SFAS 157: Use market approach, Level 1 asset Fair value 12/31/2006: $18.79 per share CPE session #44 AAA Annual Meeting 2008

4. So, why use an income approach? • Forge conceptual links for students between observable fair value and intrinsic value derived with other valuation technique • Expose students to common income-approach model (one of many) • Segue to next session on intangible asset impairment at Sprint Nextel CPE session #44 AAA Annual Meeting 2008

5. Building blocks of theSprint Nextel case • Valuation technique: Income approach (SFAS 157.18) • General class of models: Multiperiod excess earning method (SFAS 157.18) • Specific model: Residual operating income model • Forecast future net operating profit after tax with short-term and long-term growth • Forecast future net operating assets • Weighted-average cost of capital (WACC) • Present value of lump sums and perpetuities CPE session #44 AAA Annual Meeting 2008

6. Valuation technique: Income approach (SFAS 157.18) • The income approach converts future amounts (cash flows or earnings) to a single present amount (discounted). • Examples of income approach and SFAS 157 • Shares of stock when no active market exists • Restricted securities • Intangible assets and impairments thereof • OTC option on traded equity • Etc., etc., etc. • SFAS 157 does not prioritize valuation techniques. CPE session #44 AAA Annual Meeting 2008

7. General class of models: Multiperiod excess earnings Questions to explore with your students: • What are excess earnings? • Earnings over and above “expected” earnings • How do excess earnings arise? • Managers create firm value by making operating decisions that earn more than the company’s cost of capital • Balance sheet is missing some assets. These earn a return over and above the required return on the balance sheet assets CPE session #44 AAA Annual Meeting 2008

8. General class of models: Multiperiod excess earnings Questions to explore with your students: • What would the value of a firm be with no excess earnings? • Firm value is based on future operations earnings • With no excess earnings, firm value would be equal to its net book value CPE session #44 AAA Annual Meeting 2008

9. Specific model: Residual operating income model ROPI model defines value in terms of future operating earnings (as opposed to net income) ROPI is operating income in excess of a “charge” for the cost of operating assets such as inventory, AR, property plant and equipment etc.; net of operating liabilities such as AP, accruals, pensions etc. Net operating assets (NOA) do not include debt and ancillary investments – these are financing decisions unrelated to managers’ day to day operating decisions CPE session #44 AAA Annual Meeting 2008

10. Defining Residual Operating Income Residual operating income is net operating profit after-tax in excess of expected operating profit. Calculated as: “Expected” operating profit Excludes interest expense and nonoperating revenues and expenses Start-of-year Net Operating Assets CPE session #44 AAA Annual Meeting 2008

11. Sprint Nextel: 2006 Net Operating Profit After Tax Operating income $2,484 Tax at 38% $ 944 Net Operating Profit After Tax $1,540 NOTE: The valuation model uses projected net operating profit after tax. We calculate the amount for 2006 as an example. CPE session #44 AAA Annual Meeting 2008

12. Defining Residual Operating Income Residual operating income is net operating profit after-tax in excess of expected operating profit. Calculated as: “Expected” operating profit Excludes interest expense and nonoperating revenues and expenses Start-of-year Net Operating Assets CPE session #44 AAA Annual Meeting 2008

13. Defining Net Operating Assets Traditional Balance Sheet equation: A = L + E Operating v. Nonoperating Balance Sheet equation: NOA = Net Debt + E

14. Sprint Nextel: 2006 Net Operating Assets Operating assets – all of Sprint Nextel’s assets less marketable securities Operating liabilities – all of Sprint Nextel’s liabilities except long-term debt and current portion thereof Operating assets $97,146 Less Operating liabilities $21,876 Net Operating Assets (NOA) $75,270 CPE session #44 AAA Annual Meeting 2008

15. The Residual Operating Income Valuation Model Book value of Net Operating Assets Present value of Year 2 ROPI Present value of Terminal period ROPI Book value of Net Debt Present value of Year 1 ROPI CPE session #44 AAA Annual Meeting 2008

16. Sprint Nextel: 2006 Net Nonoperating Liabilities (Debt) Nonoperating liabilities – long-term debt and current portion thereof Nonoperating assets – marketable securities Nonoperating liabilities $22,154 Less Nonoperating assets $ 15 Net Operating Assets (NOA) $22,139 CPE session #44 AAA Annual Meeting 2008

17. Forecasting ROPI for Sprint Nextel:A simplified approach Start with 2006 sales – $41,028 Assume a short-term growth rate – 20% Use this rate to forecast sales over the short term (here, 4 years). This period is called the “forecast horizon” Assume a long-term growth rate:g – 3% Use this rate to forecast sales over the rest of the firm’s life. This means that Sprint Nextel will continue to operate at this rate (an equilibrium level) forever. This period is called the “terminal period” CPE session #44 AAA Annual Meeting 2008

18. Forecasting Sales for Sprint Nextel Forecasted Sales = Prior-year sales × 1.2 CPE session #44 AAA Annual Meeting 2008

19. Forecasting Sales for Sprint Nextel × 1.2 × 1.2 × 1.2 × 1.03 20% growth in forecast period 3% growth in terminal period CPE session #44 AAA Annual Meeting 2008

20. Forecasting Net Operating Profit After Tax for Sprint Nextel Use projected Sales to determine future net operating profit after tax Assume an operating profit margin – 7.5% Use this rate to forecast operating income over the forecast horizon and for the terminal period NOTE: This is higher than the historical profit margin and the stock value is very sensitive to this margin. CPE session #44 AAA Annual Meeting 2008

21. Forecasting Net Operating Profit After Tax for Sprint Nextel Net Operating Profit After Tax = Projected Sales × 7.5% CPE session #44 AAA Annual Meeting 2008

22. Forecasting Net Operating Assets for Sprint Nextel Start with 2006 NOA Assume a growth rate for NOA – 5% Use this rate to forecast net operating assets each year NOTE: An alternate approach uses historical Total Asset Turnover ratio to forecast NOA. CPE session #44 AAA Annual Meeting 2008

23. Forecasting Net Operating Assets for Sprint Nextel Forecasted NOA = Prior-year NOA × 1.05 2006 NOA from balance sheet CPE session #44 AAA Annual Meeting 2008

24. Forecasting Expected Operating Profit for Sprint Nextel Calculate expected net operating profit after tax with a weighted average cost of capital of 8.07% CPE session #44 AAA Annual Meeting 2008

25. Forecasting Expected Operating Profit for Sprint Nextel Expected operating income = NOA start of year × 8.07% Classroom discussion ideas: What happens to WACC if company becomes riskier? How does the level of WACC affect expected income? CPE session #44 AAA Annual Meeting 2008

26. Forecasting Residual Operating Profit for Sprint Nextel Classroom discussion ideas: Why are residual earnings negative for Sprint Nextel? What does that mean conceptually? CPE session #44 AAA Annual Meeting 2008

27. Sprint Nextel: ROPI valuation Classroom discussion ideas: What happens to WACC if company becomes riskier? How does the level of WACC affect expected income?

28. Estimating stock price: ROPI model Classroom discussion ideas: 12/31/2006 stock price is $18.79. WHY is our estimate different? CPE session #44 AAA Annual Meeting 2008

29. Sprint Nextel case:Model assumptions and inputs • Discounting expected and not contractual future amounts • Assumptions are to be those that market participants would use in pricing the asset (SFAS 157.11) • Level 2 inputs required to estimate the model: • WACC: market beta, risk-free rate, credit spread CPE session #44 AAA Annual Meeting 2008

30. Sprint Nextel case:Model assumptions and inputs • Level 3 inputs required to estimate the model: • Short and long-term growth rates for sales and operating assets / liabilities • Macro-conditions • Industry factors, trends, competition, strategy • Firm specific earnings outlook - growth • Operating profit margins CPE session #44 AAA Annual Meeting 2008

31. Sprint Nextel case: Teaching Ideas • Case assumes students understand • Discounting of lump sums and perpetuities • WACC: theory and calculations • Basics of Net Operating Assets / Debt (net) • Case can be shortened by providing projected ROPI • Case can be augmented by requiring students to calculate Net Operating Assets • Excel spreadsheet projected in class, inputs changed to show sensitivity of value to input choices CPE session #44 AAA Annual Meeting 2008

32. Sprint Nextel case: Teaching Materials • Case with Sprint Nextel 2006 financial statements • Background reading on Residual Operating Income valuation model • Teaching notes • Excel spreadsheet • Powerpoints CPE session #44 AAA Annual Meeting 2008

33. Link to other applications: CPE session #44 AAA Annual Meeting 2008