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1. Valuation

2. Contents • Introduction – Fundamentals of Where Value Comes From • Discounting and IRR Review • Overview of Alternative Valuation Methods • Valuation Using Multiples • Valuation Using Discounted Free Cash Flow • Valuation Using Projected Earnings and Equity Cash Flow • 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 those cash flows, whether it be the cash flow from assets, debt or equity • Measurement value – forecasting and risk assessment -- is a very complex and difficult problem. • Intrinsic value is an estimate and not observable Reference: Chapter 4

4. Market Value of Debt, Credit Spreads and Par Value • Before thinking about valuation of a company, consider the value of debt • The par value or the value on the balance sheet does not determine the value of debt • Rather the value depends on the future level of cash flows (par value x coupon rate) and the risk applied to cash flows • Credit spreads are driven by the risk and can be measured by the One of the few things we know is that there is a tradeoff between risk and return. • Key idea is to use future cash flows and incremental discount rate in measuring market value Reference: Folder on Yield Spreads

5. The fundamental issue in any valuation problem is how to assess the risk of future cash flow projections. Financial theory Financial theory dictates that the CAPM should be used to compute the WACC, that the un-levered beta should be used to estimate equity returns, that options pricing models should be used for credit spreads, debt capacity and covenants. Mathematical Models Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk. Practical Market Information Practical market information can be used to gauge required equity returns, required credit spreads, required financial ratios to achieve investment grade rating and other issues. Consider Investment Alternatives A and B, where A has a higher project IRR than B. Assume A has a return of 11% and B has a return of 9%. Project A or Project B would be selected through assessing the return on the projects relative to the weighted average cost of capital for each project. If the WACC for A is 10% and for B is 9.5% then A is selected. One must computed beta for each investment. Compute the distributions in cash flow of project A and project B to equity holders. If the standard deviation is lower for project B, then assess the risk relative to the return. Compute the achieved rate of return from the ability to raise debt and then assess the return earned on equity. If the return on equity is greater for B then A, select project A. Measurement of Risk in Financial Models

6. Problems with CAPM • Ke = Rf + Beta x EMRP • Difficulty in establishing Rf • Can’t find Betas • Betas performed horribly during financial crisis • EPRM cannot be measured and changes with perceptions over time

7. Problems with Betas – Confirmed by Financial Crisis

8. CAPM Post Financial Crisis • The cost of equity was calculated using the capital asset pricing model, which is a theoretical financial model that estimates the cost of equity capital based on a company’s “beta” which is a measure of a company’s volatility relative to the overall market, a 6% market risk premium and a relevant predicted beta and risk-free rate. The public market trading price targets published by securities research analysts do not necessarily reflect current market trading prices for Wyeth’s and Pfizer’s common stock and these estimates are subject to uncertainties, including the future financial performance of Wyeth and Pfizer and future financial market conditions. • Academic studies – 2-3% • Pre-Crisis Bankers – 4-5% • Historical U.S. premium pre-crisis 6-8%

9. Problems with Growth • Typical assumption that growth equals inflation means world economy would stop • Time period before which reach stable growth is impossible to estimate • Evidence that sell-side analysts chronically over-estimate short-term growth rates

10. Example of Method 1: Financial Theory Fundamental parameters are almost impossible to measure Differences in Beta, Rm and Terminal Growth have an Immense Effect on the Value of the Investment

11. Method 2: Stochastic Mathematics If only we could measure these things Case 1: 15% Volatility; 40% Mean Reversion; 4.5 Long-run Marginal Cost Case 2: 25% Volatility; 10% Mean Reversion; 4.0 Long-run Marginal Cost The probability of earning below the risk free rate is about 5% The probability of earning below the risk free rate is about 55%

12. Example of Method 3: Debt Capacity Let Bankers Assess the Risk – That is Their Job

13. Project A Project B Comparison of Approaches: Which Investment would you Select Project A has a higher rate of return relative to its cost of capital, but Project B has a higher equity return

14. Valuation Diagram – DCF from Free Cash Flow • 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

15. Equity Cash Flow, Debt Cash Flow, Free Cash Flow andCost of Equity, Cost of Debt and WACC Equity Cash Flow and Value of Equity : Dividends less Equity Issued Value of Equity PV of Cash Flows at Cost of Equity + + Debt Cash Flow and Market Value of Debt : Net Interest plus Net Debt Payments Value of Debt PV of Cash Flows at Incremental Cost of Debt = = Free Cash Flow: EBITDA – Op Taxes – Cap Exp – WC Chg Value of Enterprise PV of Cash Flows At WACC

16. Valuation Overview Despite that fact that all we have to do is forecast cash flow and then determine the risk associated with those cash flows, valuation is a huge topic. Some Key issues in valuation analysis include: • Cost of Capital in DCF or Discounted Earnings for Measuring Risk • Selection of Market Multiple and Adjustment that implicitly accounts for growth in cash flow and risk • Determination of Growth Rates in Earnings and Cash Flow Projections • How to Compute Terminal Value when Cash Flow Lasts for an Indefinite Period

17. Tools for Valuation • There is no magic answer as to whether one valuation approach is better than others. But virtually all valuation analyses involve the following work: • Financial Models: • Valuation model used to 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

18. Problems with Traditional Finance and Discounted Free Cash Flow • The entire process is dependent on WACC and the CAPM • Rm is one of the most debated issues in finance • Beta is difficult to measure • The model doesn’t work • Valuation is highly dependent on terminal values and growth rates • Often zero real growth is used, implying that if all companies had zero growth, economies around the world would be stagnant • If multiples are used, they can be very subjective • Comparable companies are not comparable at all • Arbitrary adjustments are made to the P/E and EV/EBITDA valuation ratios

19. 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

20. Reasonable Estimates of Growth – Is this Graph Reasonable The short term Based on best estimate of likely outcome • The medium term transition to tranquillity • Assessment of industry outlook and company position • ROIC fades towards the cost of capital • Growth fades towards GDP • The long run – tranquillity and equilibrium • 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

21. How Long will Growth Last • Some Theoretical Issues with Growth: • The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high growth period; although the growth rate may drop off during the period. Thus, a firm that is growing at 40% should have a longer high-growth period than one growing at 14%. • The larger the size of the firm, the shorter the high growth period. Size remains one of the most potent forces that push firms towards stable growth; the larger a firm, the less likely it is to maintain an above-normal growth rate. • The greater the barriers to entry in a business, e.g. patents or strong brand name, should lengthen the high growth period for a firm. • Look at the combination of the three factors A,B,C and make a judgment. Few firms can achieve an expected growth period longer than 10 years

22. Terminal value is reached when a company has reached maturity – it grows at the overall rate of the economy. This should be nominal growth in the economy since all of the currency in models is in nominal terms. For immature companies, the reaching of equilibrium will exceed the standard five year forecast Extending the forecast forces one to make assumptions for more than one year which become very speculative Some suggest a fade growth period to address this issue Terminal Value and Growth

23. Fade Period • The fade period is the length of time it takes for the long-term growth rate to be reached after from the growth in the last year of the forecast. • For example, the last year growth is 10% • The terminal growth is 3% • The time to get from 10% to 3% is 5 years • You can use the formula • Growth = Growtht-1 x [(Long term/Short term)]^(1/Fade) • Note: This does not work with negative growth rates

24. Growth When Companies are Earning More than their Cost of Capital • It is a lot more difficult to maintain growth when you are earning 40% return on investment than when you are earning 10% in the terminal period • 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.”

25. 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

26. Valuation Basics – Inclusion of Returns • The future cash flow of a company and the risk of that company’s cash flow can be measured by: • Return on Invested Capital • Ability to Grow • Weighted Average Cost of Capital • It is in the formula: Cash Flow (ROIC x Inv)/(k-g) which is the basis for multiples • All of the other ratios – gross margins, effective tax rates, inventory turnover etc. are just details. ROIC = EBIT x (1-tax rate) (NOPLAT) Investment

27. 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

28. 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

29. 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.

30. Gordon’s Model and Valuation • Gordon’s model is • P0 = D1/(k-g) • Example

31. 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

32. 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

33. Microsoft Value Creation and Earnings Earnings are a good indicator of value; but not always as shown by the recent increases which resulted from share buybacks

34. Microsoft Return and Revenue Growth Strong Returns plus growth resulted in increased price; when return fell, the price fell

35. General Motors – Slow Growth and Low ROE GM had low growth and low returns and the stock price did not increase.

36. 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

37. Practical Growth Rate Issues: Growth Rate Estimation vs. ROE and Retention Rate • What we really need to estimate are reinvestment rates and marginal returns on equity and capital in the future (the change in income over the change in equity). • Those who use analyst’s or historical growth rates are implicitly assuming something about reinvestment rates and returns, but they are either unaware of these assumptions or do not make them explicit. This means, look at the ROE and the dividends to make sure that the growth is consistent. • Future ROE depends on changes in economic variables affecting the existing investment and new projects with incremental returns.

38. Alternative Valuation Methods

39. Valuation Ranges • Do not claim to derive a single number – unrealistic to derive one number • Forecasting uncertainty • Cost of capital uncertainty • Bigger ranges for growth companies and for emerging economies

40. General Valuation Approaches • Typical Valuation Approaches are Differentiated According to: • Relative Valuation • Multiples, Comparative Transactions • Absolute Valuation • DCF, APV, Risk Neutral Valuation, Option Pricing • We Differentiate by • Direct Valuation • DCF, Multiples etc. • Indirect Valuation • Equity IRR from LBO Multiples, Accretion/Dilution in EPS from integrated merger analysis, IRR and debt capacity in project finance

41. Direct 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

42. Indirect Valuation from Modelling Transactions • Instead of using DCF or multiples, back into the value of a company: • Leveraged buyout • Entry and exit multiples, debt capacity and EBITDA Growth. See how much you can pay an finance and obtain an equity rate or return consistent general benchmarks such as 20%. • Project Finance • Given contracts and assumptions about cash flows over the life of the asset and debt capacity, see how much investment can be made to generate and equity rate of return. • Merger Integration • Given assumptions about financing and accounting in a mergers, see how much you can afford to pay and still achieve accretion in earnings per share.

43. Example of Comparing Valuation under Alternative Methods

44. Sum of the Parts Analysis • Morgan Stanley performed a sum of the parts analysis, which is designed to imply a value of a company based on the separate valuation of the company’s business segments. Morgan Stanley calculated ranges of implied equity values per share for Wyeth, assuming a hypothetical disposition of Wyeth’s Nutrition, Consumer and Animal Health divisions. • Morgan Stanley valued Wyeth’s divisions using multiple ranges derived from comparable precedent transactions. • Morgan Stanley used a 3.5x to 4.5x multiple of aggregate value to estimated 2008 revenue for Wyeth’s Nutrition and Consumer divisions, and • 11.0x to 13.0x multiple of aggregate value to estimated 2009 EBITDA for the Animal Health division. • The Pharmaceutical division was valued at a public market trading multiple range of 9.0x to 11.0x estimated 2009 P/E multiple. • Based on the multiple ranges described above, and including the net present value of the step-up in the tax basis of the assets which would result from such a theoretical transaction, this analysis implied a range for Wyeth’s common stock of approximately \$33 to \$40 per share. Morgan Stanley noted that the merger consideration had an implied value of \$50.19 per share.

45. 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

46. 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

47. Examples of Risk Neutral Valuation • Risk neutral valuation means that one attempts to remove the risk from the cash flow and then discount the adjusted cash flow at the risk free rate. (This is how options pricing models were developed.) • There are various examples of risk neutral valuation that can be applied in valuation: • If there is a construction contract that includes a premium – say 20% to eliminate cost over-run and delay risk; this verifies the risk rather than attempts to simulate the risk or use of a high discount rate. • If there is a long-term contract that fixes the price, the project can be financed with a lower discount rate. • If a project can secure political risk insurance to eliminate political and currency conversion risk, a lower discount rate can be used rather than attempting to measure political risk. • Other examples …

48. 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

49. 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

50. 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