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1. Valuation

2. Contents • Introduction – Where Value Comes From • Discounting Basics • Overview of Alternative Valuation Methods • Valuation Using Multiples • Valuation Using Projected Earnings • Case Studies

3. Valuation, Decision Making and Risk Every major decision a company makes is in one way or another derived from how much the outcome of the decision is worth. It is widely recognized that valuation is the single financial analytical skill that managers must master. • Valuation analysis involves assessing • Future cash flow levels, (cash flow is reality) and • Risks in valuing assets, debt and equity • Measurement value – forecasting and risk assessment -- is a very complex and difficult problem. • Intrinsic value is an estimate and not observable Reference: Chapter 6

4. Valuation Overview Valuation is a huge topic. Some Key issues in valuation analysis. • Cost of Capital in DCF or Discounted Earnings • Selection of Market Multiple and Adjustment • Growth Rates in Earnings and Cash Flow Projections • Terminal Value Method and Calculation • Use several vantage points • Do not assume false precision

5. Tools for Valuation • Financial Models: • Valuation model with project earnings or cash flows • Statistical Data: • Industry Comparative Data to establish Multiples and Cost of Capital • Industry, company knowledge and judgment • Knowledge about risks and economic outlook to assess risks and value drivers in the forecasts • Valuation should not be intimidating

6. Valuation Basics • A Company’s value depends on: • Return on Invested Capital • Weighted Average Cost of Capital • Ability to Grow • All of the other ratios – gross margins, effective tax rates, inventory turnover etc. are just details.

7. Analytical framework for Valuation – Combine Forecasts of Economic Performance with Cost of Capital Competitive position such as pricing power and cost structure affects ROIC In financial terms, value comes from ROIC and growth versus cost of capital P/E ratio and other valuation come from ROIC and Growth

8. Value Comes from Two Things • What you think future cash flows will be • How risky are those cash flows • We will deal with how to measure future cash flows and how to deal with quantifying the risk of those cash flows • Value comes from the ability to earn higher returns than the opportunity cost of capital • One of the few things we know is that there is a tradeoff between risk and return. Reference: Folder on Yield Spreads

9. Valuation and Cash Flow • Ultimately, value comes from cash flow in any model: • DCF – directly measure cash flow from explicit cash flow and cash flow from selling after the explicit period • Multiples – The size of a multiple ultimately depends on cash flow in formulas • FCF/(k-g) = Multiple • They still have implicit cost of capital and growth that must be understood • Replacement Cost – cash from selling assets • Growth rate in cash flow is a key issue in any of the models Investors cannot buy a house with earnings or use earnings for consumption or investment

10. Valuation Diagram • Valuation using discounted cash flows requires forecasted cash flows, application of a discount rate and measurement of continuing value (also referred to as horizon value or terminal value) Continuing Value Cash Flow Cash Flow Cash Flow Cash Flow Discount Rate is WACC Enterprise Value Net Debt Reference: Private Valuation; Valuation Mistakes Equity Value

11. Value Comes from Economic Profit and Growth Economic profit is the difference between profit and opportunity cost This implies that there are three variables – return, growth and cost of capital that are central to valuation analysis Once you have a good thing, you should grow

12. The Value Matrix - Stock Categorisation What is the economic reason for getting here and how long can the performance be maintained Throwing good money after bad Give the money to investors Try to get out of the business

13. Issues with ROIC include Will the ROIC move to WACC because of competitive pressures Evidence suggests that ROIC can be sustained for long periods Consider the underlying economic characteristics of the firm and the industry What is the expected change in ROIC When ROIC moves to sustainable level, then can move to terminal value calculation Examine the ROIC in models to determine if detailed assumptions are leading to implausible results Migration table ROIC Issues

14. Reasonable Estimates of Growth The short term Based on best estimate of likely outcome • The medium term outlook • Assessment of industry outlook and company position • ROIC fades towards the cost of capital • Growth fades towards GDP • The long run • Long run assumptions: • ROIC = Cost of capital • Real growth = 0% Much of valuation involves implicitly or explicitly making growth estimates – High P/E comes from high growth Reference: Level and persistence of growth rates

15. Growth issues include Growth is difficult to sustain Law of large numbers means that it is more difficult to maintain growth after a company becomes large Investment analysts overestimate growth Examine sustainable growth formulas from dividend payout and from depreciation rates Growth Issues

16. Sustaining Growth and ROIC > WACC • Mean Reversion of Long-term Growth • Competition tends to compress margins and growth opportunities, and sub-par performance spurs corrective actions. • With the passage of time, a firm’s performance tends to converge to the industry norm. • Consideration should be given to whether the industry is in a growth stage that will taper down with the passage of time or whether its growth is likely to persist into the future. • Competition exerts downward pressure on product prices and product innovations and changes in tastes tend to erode competitive advantage. The typical firm will see the return spread (ROIC-WACC) shrink over time. A study by Chan, Karceski, and Lakonishok titled, “The Level and Persistence of Growth Rates,” published in 2003. According to this study, analyst “growth forecasts are overly optimistic and add little predictive power.”

17. Alternative Valuation Methods

18. Alternative Valuation Models • There are many valuation techniques for assets and investments including: • Income Approach • Discounted Cash Flow • Venture Capital method • Risk Neutral Valuation • Sales Approach • Multiples (financial ratios) from Comparable Public Companies of from Transactions or from Theoretical Analysis • Liquidation Value • Cost Approach • Replacement Cost (New) and Reproduction Cost of similar assets • Other • Break-up Value • Options Pricing • The different techniques should give consistent valuation answers See the appraisal folder in the financial library

19. Example of Comparing Valuation under Alternative Methods

20. Risk Neutral Valuation • Theory – If one can establish value with one financial strategy, the value should be the same as the value with alternative approaches • In risk neutral valuation, an arbitrage strategy allows one to use the risk free rate in valuing hedged cash flows. • Forward markets are used to create arbitrage • Risk neutral valuation does not work with risks that cannot be hedged • Use risk free rate on hedged cash flow • Example • Valuation of Oil Production Company • Costs Known • No Future Capital Expenditures

21. Practical Implications of Risk Neutral Valuation • Use market data whenever possible, even if you will not actually hedge • Use lower discount rates when applying forward market data in models Valuation with high discount rates And Uncertain cash flows Valuation with Forward Markets and Low Discount Rates

22. Venture Capital Method • Two Cash Flows • Investment (Negative) • IPO Terminal Value (Positive) • Terminal Value = Value at IPO x Share of Company Owned • Valuation of Terminal Value • Discount Rates of 50% to 75% • Risky cash flows • Other services See the article on private valuation

23. Valuation Diagram – Venture Capital • Valuation in venture capital focuses on the value when you will get out, the discount rates and how much of the company you will own when you exit. Continuing Value Cash Flow Cash Flow Cash Flow Cash Flow • In the extreme, if you have given away half of your company away, and the cash flow is the same before and after your give away, then the amount you would pay for the share must account for how much you will give away. Discount Rates Enterprise Value Evaluate how much of the equity value that you own Net Debt Equity Value

24. Venture Capital Method • Determine a time period when the company will receive positive cash flow and earnings. • e.g. projection of earnings in year 7 is 20 million. • At the positive cash flow period, apply a multiple to determine the value of the company. • e.g. P/E ratio of 15 – terminal value is 20 x 15 • Use high discount rate to account for optimistic projections, strategic advice and high risk; • e.g. 50% discount rate – [20 x 15]/[1+50%]^7 = 17.5 million • Establish percentage of ownership you will have in the future value through dividing investment by total value • e.g. 5 million investment / 17.5 million = 28.5% • You make an investment and receive shares (your current percent). You know the investment and must establish the number of shares

25. Venture Capital Method Continued • In the venture capital method, there are only two cash flows • The investment • The value when the company is sold • The value received when the company is sold depends on the percentage of the company that is owned. If there is dilution in ownership, the value is less. • Therefore, an adjustment must be made for dilution and the percent of the company retained. See the Cost of Capital folder for and example • e.g. Share value without dilution = 17.5/700,000 = 25 per share • If an additional 30% of shares is floated, the value per share must be increased by 30% to maintain the value. • Value per share = 17.5/((500,000+VC shares) x 1.3) • VC Shares: (25 x 1.3)/17.5-500,000 = 343,373

26. Replacement Cost • First a couple of points regarding replacement cost theory • In theory, one can replace the assets of a company without investing in the company. If you are valuing a company, you may think about creating the company yourself. • If you replaced a company and really measured the replacement cost, the value of the company may be more than replacement cost because the company manages the assets better than you could. • By replacing the assets and entering the business, you would receive cash flows. You can reconcile the replacement cost with the discounted cash flow approach

27. Measuring Replacement Cost • Replacement cost includes: • Value of hard assets • Value of patents and other intangibles • Cost of recruiting and training management • Analysis • Begin with balance sheet categories, account for the age of the plant • Add: cost of hiring and training management • If the company is generating more cash flow than that would be produced from replacement cost, the management may be more productive than others in managing costs or be able to realize higher prices through differentiation of products. • The ratio of market value to replacement cost is a theoretical ratio that measures the value of management contribution

28. Replacement Value and Tobin’s Q • Recall Tobin’s Q as: • Q = Enterprise Value / Replacement Cost • Buy assets and talent etc and should receive the ROIC. Earn industry average ROIC. • If the ROIC > industry average, then Q > 1. • If the ROIC < industry average, then Q < 1

29. Real Options and Problems with DCF • The DCF model has many conceptual flaws, the most significant of which is assuming that cash flows are normally distributed around the mean or base case level. • For many investments, the cash flows are skewed: • When an asset is to be retired, there is more upside than downside because the asset will continue to operate when times are good, but it will be scrapped when times are bad. • An investment decision often involves the possibility to expand in the future. When the expansion decision is made, it will only occur when the economics are good. • During the period of constructing an asset, it is possible to cancel the construction expenditures and limit the downside if it becomes clear that the project will not be economic.

30. Real Options and DCF Problems - Continued • Problems with DCF because of flexibility in managing assets: • In operating an asset, the asset can be shut down when it is not economic and re-started when it becomes economic. This allows the asset to retain the upside but not incur negative cash flows. • When developing a project, there is a possibility to abandon the project that can limit the downside as more becomes known about the economics of the project. • In deciding when to construct an investment, one can delay the investment until it becomes clear that the decision is economic. This again limits the downside cash flows. • In each of these cases, management flexibility provides protection in the downside which means that DCF model produces biased results.

31. Fundamental Valuation • What was behind the bull market of 1980-1999 • EPS rose from 15 to 56 • Nominal growth of 6.9% -- about the growth in the real economy (the real GDP) • Keeping P/E constant would have large share price increase • Long-term interest rates fell – lower cost of capital increases the P/E ratio • Real Market • Value by ROIC versus growth • Select strategies that lead to economic profit • Market value from expected performance

32. Three Primary Methods Discussed in Remainder of Slides • Market Multiples • Discounted Free Cash Flow • Discounted Earnings and Dividends • Warning: No method is perfect or completely precise • Use industry expertise and judgement in assessing discount rates and multiples • Different valuation methods should yield similar results • Bangor Hydro Case

33. Discounting Basics

34. Bt = It +1 + It +2 + It +3 + ... + It +n + F (1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)n Debt (Bond) Valuation • Bt is the value of the bond at time t • Discounting in the NPV formula assumes END of period • It +n is the interest payment in period t+n • F is the principal payment (usually the debt’s face value) • r is the interest rate (yield to maturity) Case exercise to illustrate the effect of discounting (credit spread) on the value of a bond

35. Risk Free Discounting • If the world would involve discounting cash flows at the risk free rate, life would be easy and boring

36. Vt = E(Dt +1)+ E(Dt +2) + E(Dt +3) + ... + E(Dt +n)+ ... (1+k)1 (1+k)2 (1+k)3 (1+k)n Equity – Dividend Discount Valuation and Gordon’s Model • Vt is the value of an equity security at time t • Dt +n is the dividend in period t+n • k is the equity cost of capital – difficult to find (CAPM) • E() refers to expected dividends • If dividends had no growth the value is D/k • If dividends have constant growth the value is D/(k-g) • Terminal Value is logically a multiple of book value per share

37. Example of Capitalization Rates • Proof of capitalization rates using excel and growing cash flows

38. Vt = E(FCFt +1) + E(FCFt +2) + E(FCFt +3) + ... + E(FCFt +n) + ... (1+k)1 (1+k)2 (1+k)3 (1+k)n Equity Valuation - Free Cash Flow Model • FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] • k is the weighted average or un-leveraged cost of capital • E(•) refers to an expectation • Alternative Terminal Value Methods

39. Practical Discounting Issues in Excel • NPV formula assumes end of period cash flow • Growth rate is ROE x Retention rate • If you are selling the stock at the end of the last period and doing a long-term analysis, you must use the next period EBITDA or the next period cash flow. • If there is growth in a model, you should use the add one year of growth to the last period in making the calculation • To use mid-year of specific discounting use the IRR or XIRR or sumproduct

40. Valuation and Sustainable Growth • Value depends on the growth in cash flow. Growth can be estimated using alternative formulas: • Growth in EPS = ROE x (1 – Dividend Payout Ratio) • Growth in Investment = ROIC x (1-Reinvestment Rate) • Growth = (1+growth in units) x (1+inflation) – 1 • When evaluating NOPLAT rather than earnings, a similar concept can be used for sustainable growth. • Growth = (Capital Expenditures/Depreciation – 1) x Depreciation Rate • Unrealistic to assume growth in units above the growth in the economy on an ongoing basis.

41. Valuation Using Multiples

42. Advantages Objective – does not require discount rate of terminal value Simple – does not require elaborate forecast Flexible – can use alternative multiples and make adjustments to the multiples Theoretically correct – consistent with DCF method if there are stable cash flows and constant growth. Disadvantages Implicit Assumptions: Multiples come from growth, discount rates and returns. Valuation depends on these assumptions. Too simple: Does not account for prospective changes in cash flow Accounting Based: Depends on accounting adjustments in EBITDA, earnings Timing Problems: Changing expectations affect multiples and using multiples from different time periods can cause problems. Advantages and Disadvantages of Multiples There are reasons similar companies in an industry should have different multiples because of ROIC and growth – this must be understood

43. Multiples - Summary • Useful sanity check for valuation from other methods • Use multiples to avoid subjective forecasts • Among other things, well done multiple that accounts for • Accounting differences • Inflation effects • Cyclicality • Use appropriate comparable samples • Use forward P/E rather than trailing • Comprehensive analysis of multiples is similar to forecast • Use forecasts to explain why multiples are different for a specific company

44. Mechanics of Multiples • Find market multiple from comparable companies • Rarely are there truly comparable companies • Understand economics that drive multiples (growth rate, cost of capital and return) • P/E Ratio (forward versus trailing) • Value/Share = P/E x Projected EPS • P/E trailing and forward multiples • Market to Book • Value/Share = Market to Book Ratio x Book Value/Share • EV/EBITDA • Value/Share = (EV/EBITDA x EBITDA – Debt) divided by shares • P/E and M/B use equity cash flow; EV/EBITDA uses free cash flow In the long-term P/E ratios tend to revert to a mean of 15.0

45. Valuation from Multiples • Financial Multiples • P/E Ratio • EV/EBITDA • Price/Book • Industry Specific • Value/Oil Reserve • Value/Subscriber • Value/Square Foot • Issues • Where to find the multiple data – public companies • What income or cash flow base to use • 15-20% Discount for lack of marketability

46. Which Multiple to Use • Valuation from multiples uses information from other companies • It is relevant when the company is already in a steady state situation and there is no reason to expect that you can improve estimates of EBITDA or Earnings • One of the challenges is to understand which multiple works in which situation: • Consumer products • EV/EBITDA may be best • Intangible assets make book value inappropriate • Different leverage makes P/E difficult • Banks/Insurance • Market/Book may be best • Not many intangible assets, so book value is meaningful • Book value is the value of loans which is adjusted with loan loss provisions • Cost of capital and financing is very important because of the cost of deposits

47. Multiples in M&A • Public company comparison • Precedent Transactions • Issues • Where to find the data • Finding comparable companies • Timing (changes in multiples with market moves) • What data to apply data to (e.g. next year’s earnings) • What do ratios really mean (e.g. P/E Ratio) • Adjustments for liquidity and control premium

48. Example of Valuation with Multiples – Comparison of Different Transactions Note how multiples cover the cycle in a commodity business Demonstrates that the multiple in the merger is consistent with other transactions

49. Multiples in Pennzoil Merger – Comparison of Merger Consideration to Trading Multiples

50. Comparable companies analysis data in Banking Merger Note the ratios used to value banks are equity based – the Market value to Book Value and the P/E ratio related to various earnings measures