1. Valuation

2. Valuing a Business I NYU Prof. Ian Giddy New York University

3. What’s a Company Worth? • Required returns • Types of Models • Balance sheet models • Comparables • Corporate cash flow models • Estimating Growth Rates • Applications • Option-based models

4. IBM Source: biz.yahoo.com

5. IBM Source: biz.yahoo.com

6. IBM’s Financials Source: morningstar.com

7. Equity Valuation: From the Balance Sheet Value of Assets • Book • Liquidation • Replacement Value of Liabilities • Book • Market Value of Equity

8. Equity Valuation: From the Balance Sheet Value of Assets • Book • Liquidation • Replacement • Or what? A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)

9. Relative Valuation • In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include -- • Price/Earnings (P/E) ratios • and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios • and variants (Tobin's Q) • Price/Sales ratios

10. Comparables • Value Indicator • Earnings • Cash Flow • Revenues • Book • Average • Comparable • Industry • Firms • Deals Target Company Numbers or Projections Estimated Value of Target

11. IBM: Comparables Source: Reuters

12. PE ratio divided by the growth rate Disney: Relative Valuation Company PE Expected Growth PEG King World Productions 10.4 7.00% 1.49 Aztar 11.9 12.00% 0.99 Viacom 12.1 18.00% 0.67 All American Communications 15.8 20.00% 0.79 GC Companies 20.2 15.00% 1.35 Circus Circus Enterprises 20.8 17.00% 1.22 Polygram NV ADR 22.6 13.00% 1.74 Regal Cinemas 25.8 23.00% 1.12 Walt Disney 27.9 18.00% 1.55 AMC Entertainment 29.5 20.00% 1.48 Premier Parks 32.9 28.00% 1.18 Family Golf Centers 33.1 36.00% 0.92 CINAR Films 48.4 25.00% 1.94 Average 27.44 18.56% 1.20

13. IBM: Forward Comparables Source: morningstar.com

14. Corporate Cash Flow

15. Discounted Cashflow Valuation: Basis for Approach • where • n = Life of the asset • CFt = Cashflow in period t • r = Discount rate reflecting the riskiness of the estimated cashflows

16. Start with theWeighted Average Cost of Capital Choice Cost 1. Equity Cost of equity - Retained earnings - depends upon riskiness of the stock - New stock issues - will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. Debt Cost of debt - Bank borrowing - depends upon default risk of the firm - Bond issues - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]

17. IBM’s Cost of Capital

18. Valuation: The Key Inputs • A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. • Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

19. Dividend Discount Models:General Model • V0 = Value of Stock • Dt = Dividend • k = required return

20. No Growth Model • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock

21. No Growth Model: Example • Burlington Power & Light has earnings of $5 per share and pays out 100% dividend • The required return that shareholders expect is 12% • The earnings are not expected to grow but remain steady indefinitely • What’s a BPL share worth? E1 = D1 = $5.00 k = .12 V0 = $5.00/0.12 = $41.67

22. Constant Growth Model • g = constant perpetual growth rate

23. Constant Growth Model: Example • Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend • The required return that shareholders expect is 12% • The earnings are expected to grow at 6% per annum • What’s an M6 share worth? E1 = $5.00 k = 12% D1 = $3.00 g = 6% V0 = 3.00 / (.12 - .06) = $50.00

24. Estimating Dividend Growth Rates • g = growth rate in dividends • ROE = Return on Equity for the firm • b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)

25. Or Use Analysts’ Expectations? Source: biz.yahoo.com

26. Shifting Growth Rate Model • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1

27. Shifting Growth Rate Model: Example • Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% • The dividends are expected to grow at 20% for 3 years and 5% thereafter • What’s a Mindspring share worth? D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

28. Stable Growth and Terminal Value • When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate • This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. • While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. • When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.

29. Choosing a Growth Pattern: Examples Company Valuation in Growth Period Stable Growth PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth rate in the world economy DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term US growth rate Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth rate in the European economy

30. The Building Blocks of Valuation

31. Estimating Future Cash Flows • Dividends? • Free cash flows to equity? • Free cash flows to firm?

32. Better Than Dividends:Free Cash Flows Revenue - Expenses - Depreciation = EBIT Adjust for tax: EBIT(1-T) + Depreciation - Capex - Ch working capital = Free Cash Flows to Firm

33. Deriving IBM’s Free Cash Flows IBMvaluation.xls

34. Two Applications

35. Equity Valuation in Practice • Estimating discount rate • Estimating cash flows • Estimating growth • Application with constant growth: Optika • Application with shifting growth: Fong

36. Valuing a Firm with DCF: The Short Version Historical financial results Projected sales and operating profits Adjust for noncash items Free cash flows to the firm (FCFF) Calculate weighted average cost of capital (WACC) Discount to present using constant growth model FCFF(1+g)/(WACC-g) Estimate stable growth rate (g) Present value of free cash flows - Market value of debt Value of shareholders equity

37. Optika: Facts • The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m. • Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%. • The market value of equity is €1.3b. • Is this firm fairly valued in the market? What assumptions might be changed?

38. Optika optika.xls

39. Optika WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) CAPM: 7%+1(5.50%) Equity Value: Firm Value - Debt Value = 2681-250 = 2431 Debt cost (7%+1.5%)(1-.35) optika.xls

40. Valuing a Firm with DCF: The Extended Version Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC) Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity

41. Valuation Example: Shifting Growth

42. Valuation Example: Shifting Growth fong.xls

43. Case Study: IBM IBMvaluation.xls

44. Summary:The Building Blocks of Valuation

45. Alternatives

46. What’s a Company Worth?Alternative Models • The options approach • Option to expand • Option to abandon • Creation of key resources that another company would pay for • Patents or trademarks • Teams of employees • Customers • Examples?

47. What’s a Company Worth?The Options Approach Value of the Firm or project Present Value of Expected Cash Flows if Option Excercised

48. The Value of a Corporate Option • Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. • The value of these rights increases with the volatility of the underlying business. • The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits.

49. Extreme Situations: Equity is Like an Option Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights

50. Marvel in Trouble, 1996 Banks • Secured and senior • Get fully repaid under plan Icahn et al. Choices: • Accept Perelman’s plan • Sell the debt at $.14-$.17 • Reject plan and propose own Perelman • Controls Marvel equity • NPV is negative • Option value may be positive