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## Valuation

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**Valuation Overview**• Valuation • Discounted cash flow models • DDM • FCFE • Relative valuation • over time • across assets at a given time • relative to comparables • relative to the market**General Thoughts on Valuation**• We will be using quantitative models. • But one size does not fit all. • Obviously, a DDM won’t work for a company that doesn’t pay dividends. • Estimating growth for a cyclical company is problematic. • Sometimes, it’s easier to compare ratios with comparables. • But this comparison should be both across comparables and across time. • Use more than one valuation metric • The more metrics that produce the same answer, the better. • Sensitivity analysis is vital.**Valuation Models**• Discounted Cash Flow • DDM • FCFE • Relative Valuation • P/E • P/B • Other ratios (some predict better than others for different industries.**Valuation Methods**• Valuation Versus Own History • Is it relatively cheap now? • Valuation Versus Peer Group • Is it undervalues relative to peers now? • How has that relationship evolved over time? • If a company always sells at a discount, there’s probably a reason. • Valuation Versus Market • Is it undervalued relative to the market now? • How has that relationship evolved over time? • Absolute Valuation**What you may find**• Companies that look cheap, and always have. • Firms that look good in industries that look bad. • That is, the industry currently looks expensive but the firm is the cheapest thing in the industry. • Industries that look good with firms that are average for the industry. • How can you tell?**DCF**• DDM’s • FCFE • The holy grail: the numerator should be the cash flows that can be distributed to shareholders while retaining enough cash to support the assumed growth rate • The holy grail 2: your discount rate should match your numerator type**Basic Dividend Discount Model**P= D1 (r-g)**Two Stage DDM**• Pо=∑ D1_____+ ___Pn___ (1+Khg)† (1+Khg)ⁿ Where Pn=DPSn+1 (Kst-Gn)**DDM Challenges**• Certainty and Growth Rate of Dividends • Appropriate Discount Rates • Length of Growth Period(s) • Normal growth is what??? • Small Changes in Assumptions Lead to Widely Disparate Values • Outliers Most likely to be Mis-specified**Growth Failure: Persistence of Excessive Growth**Seventh Year First Year**Discount Model Applications**• Testing of Assumptions: Solve for Implied Values. • Take P as given, pick R and solve for g. • Must have Stable Growth and Leverage Companies • Cross Sectional, Time Series Analysis • DDM may produce low values for a particular industry. • Prefers Low PE/High Dividend Payers over High PE Cash Retainers • The high P/E cash retainers can perhaps be better valued by FCF. • FCF is often a good Alternative to Dividends**Free Cash Flow Valuation**• Simple Definition: FCF= Operating Earnings+Depreciation -Capital Expenditure-∆Working Capital • You may be able to do better, but this is useful for forecasting. Why Could This Be More Effective than DDM?**Relative Valuation**• Measure Comparable Assets with a Common Measure • Evaluate Price vs. Fundamental Factors (P/E, P/FCF, P/S, P/Bk, EV/EBITDA) • Look at Time Series Data**Relative Valuation**• Commonly Used against Company Historical Range, Peers, or Market • Easy to Access, Easy to Misuse • Yields Different Answers Than DCF • If it Looks Too Good to be True it Probably is…Too Good to Be True**Comparable Assets**• Similar Cash Flow, Growth and Risk • Generally in Similar Industries • Complicating Issues: Size, Business Mix, Leverage, Profitability • Understand Implicit Assumptions**GE ($33.75)**2004 estimate $1.57 LTG estimate 9.4% PTax Margin 15.12% Mkt Cap $356bn ROE 21% Debt/Tot Cap 43.6% 2004 PE 21.4x C ($47.00) 2004 estimate $4.01 LTG estimate 11.36% PTax Margin 27.8% Mkt Cap $243bn ROE 19.52% Debt/Tot Cap 23.3% 2004 PE 11.7x Comparable Assets 2004?**GE ($31.79)**2003 estimate $1.56 LTG estimate 11.3% Op Margin 14.14% Mkt Cap $318bn ROE 23.8% Debt/Equity 214% 2003 PE 23x Price 9/13/04 $33.75 UTX ($79.48) 2003 estimate $4.64 LTG estimate 11.6% Op Margin 12.26% Mkt Cap $37.2bn ROE 26.6% Debt/Equity 51% 2003 PE 18x Price 9/13/04 $94.64 Comparable Assets 9/03**When to use what?**• P/E • P/FCF • P/B • P/Sales • EV/EBITDA • Other measures???**1. PE Ratio**Sensitive to Volatility, Growth, Profitability • P/E = 1/r + PVGO/E • Affected by Accounting Issues • Multiple Definitions (Operating Eps, Historic, Forward, Pro-forma, Fully Diluted vs Basic) • Affected by leverage**2. Free Cash Flow Yield(instead of earnings)**• Operating Earnings+Depreciation Expense- Cap Ex-∆Working CAP • Cash Available for Distribution to Shareholders • Strips Back Some Accounting Artifice • Incorporates Info from Balance Sheet • Note that we are still stuck with perpetual growth assumption**3. Price to Book Value**• Useful in Distressed Situations • Useful in Lower Growth Industries (Energy, Utilities, Financials)**Value of Firm**Going Concern Value Liquidation Value Going Concern Value 3. Price to Book Value**Value of Firm**Going Concern Value Liquidation Value Going Concern Value 3. Price to Book Value**3. Price to Book Value**• Useful in Financials Where Reserves can be Manipulated • Influenced by ROE and Cost of Equity • Significant Accounting Issues (Buybacks, Restructuring) • Can be Useful in Mean Reverting Mature Industries (Energy, Utilities)**4. Price to Sales**• Tougher to Manipulate • Revenues Tend to be Positive! • Useful in Absence of Profitability (Highly Cyclical Situations) • Enterprise Value to Sales (MV of Equity+MV of Debt-Cash)/Sales Corrects for Companies with Different Leverage**5. Enterprise Value to Ebitda**• (Market Value of Equity+Debt-Cash)/(Earnings Before Interest, Taxes, Depreciation, and Amortization) • Used in the Absence of Profits • Used Where EBITDA is Free Cash • Corrects For Varying Leverage • But Ignores Depreciation as Real Expense**6. Alternative Measures?**• PE to Growth Ratio • Market Value per Subscriber • Market Value per Home Passed • Market Value per Member • Market value per Pet HOLD ON TO YOUR WALLET!**Why Are Comparables/Relative Value So Important?**• Arbitrage • Relies on “close substitutes” • Be careful of stocks “obviously” cheaper than comparables**Why Use Multiples Analysis?**• Used prevalently in practice • Research reports full of multiples • Rules of thumb based on multiples • Quick – can evaluate large #s of stocks • Understandable/sellable/defensible • Current market data • DCF relies on multiples in the end • Terminal value**Problem with Multiples Analysis**• Quick can be too quick – and dirty**Issues When Using Multiples**• Definitions • What are “earnings”? • Consistency • Equity versus Firm (enterprise) • Uniform • Over time • Cross-section (across firms) • Scaling • Common sizing is useful • Range/Distribution • Mean versus median • outliers