asset valuation[1]

8/6/2019 ASSET Valuation[1]

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ValuationOct 24, 20081

Valuation


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Contents

Introduction Where Value Comes From

Discounting Basics

Overview of Alternative Valuation Methods

Valuation Using Multiples

Valuation Using Projected Earnings

Case Studies


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Valuation, Decision Making and Risk

Every major decision a company makes is in one way or anotherderived from how much the outcome of the decision is worth. Itis widely recognized that valuation is the single financialanalytical 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


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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 ProjectionsTerminal Value Method and Calculation

Use several vantage points

Do not assume false precision


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Tools for Valuation

Financial Models:

Valuation model with project earnings or cash flows

Statistical Data:

Industry Comparative Data to establish Multiples and Cost ofCapital

Industry, company knowledge and judgment

Knowledge about risks and economic outlook to assess risksand value drivers in the forecasts

Valuation should not be intimidating


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Valuation Basics

A Companys 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.


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Analytical framework for Valuation Combine Forecasts

of Economic Performance with Cost of Capital

In financial terms, valuecomes from ROIC andgrowth versus cost of capital

Competitive positionsuch as pricing powerand cost structureaffects ROIC

P/E ratioand othervaluationcome fromROIC andGrowth


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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 withquantifying the risk of those cash flows

Value comes from the ability to earn higher returns than the opportunity costof capital

One of the few things we know is that there is a tradeoff between risk andreturn.

Reference: Folder on YieldSpreads


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Valuation and Cash Flow

Ultimately, value comes from cash flow in any model:

DCF directly measure cash flow from explicit cash flow andcash 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 thatmust be understood

Replacement Cost cash from selling assets

Growth rate in cash flow is a key issue in any of the modelsInvestors cannot buy a house with earnings oruse earnings for consumption or investment


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Valuation Diagram

Valuation using discounted cash flows requires forecasted cashflows, application of a discount rate and measurement ofcontinuing value (also referred to as horizon value or terminalvalue)

Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value

Discount Rate is WACC

Enterprise Value

Net Debt

Equity Value

Reference: PrivateValuation; ValuationMistakes


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Value Comes from Economic Profit and Growth

Capital Junkies Power House

Capital Killers Cash Cows

Growth +

Growth -

ROIC/WACC +-

Economic profit is

the differencebetween profit andopportunity cost

Once you have agood thing, youshould grow

This implies thatthere are three

variables return,growth and cost ofcapital that arecentral to valuationanalysis


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The Value Matrix - Stock Categorisation

Perennial under achiever or future prospects

Stretched balance sheet

Restructuring

May look expensive

Power House

High industry growth

Franchise value

Pricing power Clear Investment strategy

How sustainable?

Capital Killers

Look cheap but for good reason

Cyclical or permanent

Industry or company specific factors

Cash Cows

Low industry growth

Cash generative and rich

Risk/opportunity of diversification

Low rating with strong yield support

Growth +

Growth -

ROIC/WACC +-

Throwing good money afterbad

Try to get out of thebusiness

What is the economicreason for gettinghere and how longcan the performancebe maintained

Give the moneyto investors


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ROIC Issues

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 valuecalculation

Examine the ROIC in models to determine if detailed assumptions areleading to implausible results

Migration table


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Growth Issues

Growth issues include

Growth is difficult to sustain

Law of large numbersmeans that it is more difficultto maintain growth after a

company becomes large

Investment analystsoverestimate growth

Examine sustainable growthformulas from dividend

payout and fromdepreciation rates

IBES Growth and Actual Growth from Chan Article

2.0

6.5 6.5

8.0

9.5

6.0

10.2

12.3

15.1

22.4

0

5

10

15

20

25

Lowest Second Lowest Median Second Highest Highest

Growth Rate Category

AcutalGrowthover5YearsandI/B/E/SMedian

Growth

Actual Growth in Income

I/B/E/S Growth

Optimism in the lowest growth

category is still present.


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Sustaining Growth and ROIC > WACC

Mean Reversion of Long-term Growth

Competition tends to compress margins and growthopportunities, and sub-par performance spurs correctiveactions.

With the passage of time, a firms performance tends to

converge to the industry norm.

Consideration should be given to whether the industry is in agrowth stage that will taper down with the passage of time orwhether 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 erodecompetitive advantage. The typical firm will see the returnspread (ROIC-WACC) shrink over time.

A study by Chan, Karceski,and Lakonishok titled, TheLevel and Persistence ofGrowth Rates, published

in 2003. According to thisstudy, analyst growthforecasts are overlyoptimistic and add littlepredictive power.


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Alternative Valuation Methods


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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 fromTheoretical 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 answersSee the appraisalfolder in thefinancial library


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Example of Comparing Valuation under Alternative

Methods


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Risk Neutral Valuation

Theory If one can establish value with one financial strategy, the valueshould be the same as the value with alternative approaches

In risk neutral valuation, an arbitrage strategy allows one to use the riskfree 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


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Practical Implications of Risk Neutral Valuation

Use market data whenever possible, even if you will not actuallyhedge

Use lower discount rates when applying forward market data inmodels

Valuation with highdiscount rates

AndUncertain cash

flows

Valuation withForward

Markets andLow Discount

Rates


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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 privatevaluation


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Valuation Diagram Venture Capital

Valuation in venture capital focuses on the value when you willget out, the discount rates and how much of the company you willown when you exit.

Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value

Discount Rates

Enterprise Value

Net Debt

Equity Value

Evaluate how much of theequity value that you own

In the extreme, if youhave given away halfof your companyaway, and the cash

flow is the samebefore and after yourgive away, then theamount you wouldpay for the sharemust account for howmuch you will giveaway.


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Venture Capital Method

Determine a time period when the company will receive positive cash flow andearnings.

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 thecompany.

e.g. P/E ratio of 15 terminal value is 20 x 15

Use high discount rate to account for optimistic projections, strategic advice andhigh 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 dividinginvestment 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 theinvestment and must establish the number of shares


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Replacement Cost

First a couple of points regarding replacement cost theory

In theory, one can replace the assets of a company withoutinvesting in the company. If you are valuing a company, youmay think about creating the company yourself.

If you replaced a company and really measured thereplacement cost, the value of the company may be morethan replacement cost because the company manages theassets better than you could.

By replacing the assets and entering the business, you

would receive cash flows. You can reconcile the replacementcost with the discounted cash flow approach


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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 producedfrom replacement cost, the management may be more productive thanothers 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


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Replacement Value and Tobins Q

Recall Tobins Q as:

Q = Enterprise Value / Replacement Cost

Buy assets and talent etc and should receive the ROIC. Earnindustry average ROIC.

If the ROIC > industry average, then Q > 1.

If the ROIC < industry average, then Q < 1


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Real Options and Problems with DCF

The DCF model has many conceptual flaws, the most significantof which is assuming that cash flows are normally distributedaround 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 whentimes are good, but it will be scrapped when times are bad.

An investment decision often involves the possibility toexpand 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 tocancel the construction expenditures and limit the downside ifit becomes clear that the project will not be economic.


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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 noteconomic and re-started when it becomes economic. This allows theasset 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 aboutthe economics of the project.

In deciding when to construct an investment, one can delay theinvestment until it becomes clear that the decision is economic. Thisagain limits the downside cash flows.

In each of these cases, management flexibility provides protection in thedownside which means that DCF model produces biased results.


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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 (thereal GDP)

Keeping P/E constant would have large share price increaseLong-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


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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 ratesand multiples

Different valuation methods should yield similar results

Bangor Hydro Case


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Discounting Basics


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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 debts face value)

r is the interest rate (yield to maturity)

Case exercise to illustrate theeffect of discounting (creditspread) on the value of abond


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Risk Free Discounting

If the world would involve discounting cash flows at the risk free rate,life would be easy and boring


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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 Gordons

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 expecteddividends

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


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Example of Capitalization Rates

Proof of capitalization rates using excel and growing cash flows


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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

FCFt+n is the free cash flow in the period t + n [oftendefined 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

Equity Valuation - Free Cash Flow Model


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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 doinga 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 ofgrowth to the last period in making the calculation

To use mid-year of specific discounting use the IRR orXIRRorsumproduct


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Valuation and Sustainable Growth

Value depends on the growth in cash flow. Growth can beestimated 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 similarconcept can be used for sustainable growth.

Growth = (Capital Expenditures/Depreciation 1) xDepreciation Rate

Unrealistic to assume growth in units above the growth in theeconomy on an ongoing basis.


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Valuation Using Multiples


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Advantages and Disadvantages of Multiples

Advantages

Objective does not requirediscount rate of terminal value

Simple does not requireelaborate forecast

Flexible can use alternativemultiples and make adjustmentsto the multiples

Theoretically correct consistentwith DCF method if there arestable cash flows and constant

growth.

Disadvantages

Implicit Assumptions: Multiples comefrom growth, discount rates andreturns. Valuation depends on theseassumptions.

Too simple: Does not account for

prospective changes in cash flow

Accounting Based: Depends onaccounting adjustments in EBITDA,earnings

Timing Problems: Changing

expectations affect multiples andusing multiples from different timeperiods can cause problems.There are reasons similar companies in an

industry should have different multiples because ofROIC and growth this must be understood


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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


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Mechanics of Multiples

Find market multiple from comparable companies Rarely are there truly comparable companies

Understand economics that drive multiples (growth rate, cost ofcapital 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 toa mean of 15.0


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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


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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 noreason 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 ofdeposits


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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 years earnings)

What do ratios really mean (e.g. P/E Ratio)

Adjustments for liquidity and control premium


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Example of Valuation with Multiples Comparison of

Different Transactions

Demonstrates that themultiple in the merger isconsistent with othertransactions

Note how multiples cover thecycle in a commoditybusiness


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Multiples in Pennzoil Merger Comparison of Merger

Consideration to Trading Multiples


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Comparable companies analysis data in Banking Merger

Statistics on Comparable Companies Citizens Trust Bank

Multiple of Market Value Per Share Implied Per Share Equity Value

LTM High Low Mean Median ActualValues 3,000,000 High Low Mean Median

Total Assets 0.359x 0.093x 0.162x 0.152x $337,932,000 112.64 40.44 10.48 18.25 17.12

Tangible Book Value* 2.490x 1.155x 1.688x 1.719x $35,545,737 11.85 25.28 13.25 18.05 18.33

LTM EPS 85.000x 10.131x 17.181x 13.085x $3,545,737 1.182 100.46 11.97 20.31 15.47

2002 Est EPS 28.333x 9.350x 13.037x 12.195x $5,172,415 1.724 48.85 16.12 22.48 21.03

2003 Est EPS 14.856x 8.611x 11.288x 11.255x $5,883,841 1.961 29.14 16.89 22.14 22.07

*Normalized book value, assuming 8 percent equity as 'normal.'

Source: SNL Securities, 2002 (Pricing as of 3/25/2002).

Summary of 21 comparable banking companies with similar assets, capital and profitability

characteristics.

Note the ratios used to value banks are equitybased the Market value to Book Value andthe P/E ratio related to various earningsmeasures


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Example of Computation of Multiples from Comparative

Data

JPMorgan also calculated an implied range of terminal values for Exelonat the end of 2009 by applying a range of multiples of 8.0x to 9.0x toExelon's 2009 EBITDA assumption.

Note that themedian ispresented beforethe mean


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Comparison with all Acquisitions Since 2001

All US Banking Acquisitions with a total deal value over $200m

SOV-Waypoint Deals in 2004 Deals since 2003 Deals since 2002 Deals since 2001

# of Deals 1 7 16 20 28

Median 238.5 256.1 238.7 238.7

Mean 241.0 249.6 240.8 244.6

Median 304.7 299.2 290.4 299.2

Mean 319.3 309.6 301.4 307.3

Median 20.7 20.4 20.3 20.3Mean 20.9 20.3 19.9 20.2

Median 29.9 30.4 30.1 30.2

Mean 31.4 32.8 32.1 31.4

238.5

251.8

22.0

32.1

Price/Book

Price/Tangible Book

Price/LTM Earnings

Price/Deposits


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Adjustments to Multiples

ProcessFind multiples from similar public companies

Adjust multiples for

Liquidity

Size

Control premium

Developing country discount

Apply adjusted multiples to book value, earnings, and EBITDA

There is often more money in dispute in determining the discounts andpremiums in a business valuation than in arriving at the pre-discount

valuation itself. Discounts and premiums affect not only the value of thecompany, but also play a crucial role in determining the risk involved,control issues, marketability, contingent liability, and a host of otherfactors.


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If the entity were closely held with no (or little) active market for theshares or interest in the company, then a non-marketability discountwould be subtracted from the value.

Non-marketabiliy Discounts ranges from 10% to 30%

represents the reduction in value from a marketable interest levelof value to compensate an investor for illiquidity of the security, all

else equal. The size of the discount varies base on:

relative liquidity (such as the size of the shareholder base);

the dividend yield, expected growth in value and holding period;

and firm specific issues such as imminent or pending initial public

offering (IPO) of stock to be freely traded on a public market.

Adjustments to Multiples Marketability and Liquidity

Discount


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Controlling interest valuethe value of the enterprise as a whole assuming that thestock is freely traded in a public market and includes acontrol premium.

Control premiumreflects the risks and rewards of a majority or

controlling interest. A controlling interest is assumed to have control power over

the minority interests.

Minority interest valuerepresents the value of a minority interest as if freelytradable in a public market.

Minority interest discountrepresents the reduction in value from an absence ofcontrol of the enterprise.

Adjustments to Multiples Controlling Interest Premium


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P/E Analysis Use of P/E Ratio in Valuation

J.P. Morgan performed an analysis comparing Exxon's price to earningsmultiples with Mobil's price to earnings multiples for the past five years.

The source for these price to earnings multiples was the one and two yearprospective price to earnings multiple estimates by I/B/E/S InternationalInc. and First Call, organizations which compile brokers' earningsestimates on public companies. Such analysis indicated that Mobil hasbeen trading in the recent past at an 8% to 15% discount to Exxon.

J.P. Morgan's analysis indicated that if Mobil were to be valued atprice to earnings multiples comparable to those of Exxon, therewould be an enhancement of value to its shareholders ofapproximately $11 billion.

Finally, this analysis suggested that the combined company might enjoyan overall increase in its price to earnings multiple due to the potential forimproved capital productivity and the expected strategic benefits of the

merger. According to J.P. Morgan's analysis, a price to earnings multipleincrease of 1 for Exxon Mobil would result in an enhancement of value toshareholders of approximately $10 billion.


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Company Profile in website


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Price Earnings Ratio

The price earnings ratio is obviously very important in stockevaluation. Therefore, I describe some background related to theratio and some theory with regards to the P/E ratio. Subjectsrelated to the P/E ratio include:

Dividend growth Model

Theory of price earnings ratio and growth

P/E ratio and the EV/EBITDA ratio

The PE ratio depends more on accounting

The PE is affected by leverage

The EV/EBITDA ignores depreciation and capital expenditure

Case exercise on P/E and EV/EBITDA


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P/E Ratio versus EV/EBITDA

Use the EV/EBITDA when the funding does not make much difference invaluation

Many companies in an industry with different levels of gearing andcompanies do not attempt to maximize leverage

Very high levels of gearing and wildly fluctuating earnings

When the earnings are affected by accounting policy and accountadjustments

Use the P/E ratio when cost of funding clearly affects valuation and/orwhen the level of gearing is stable and similar for different companies

Debt capacity can provide essential information on valuation

EBITDA does not account for taxes, capital expenditures to replaceexisting assets, depreciation and other accounting factors that canaffect value.


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P/E Ratio

If you use the P/E ratio for valuation, the ratio implies that onlythis year or last years earnings matter

Cash matters to investors in the end, not earnings (differentlifetime of earnings)

When earnings reflect cash flow, P/E is reasonable for valuation

High P/E causes treadmill and does not necessary imply thatcompanies are performing well

Earnings can be managed and manipulated


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P/E Ratio, Growth and Reconciliation to Cash Flow

P/E = (1-g/r)/(k-g) g -- long term growth rate in earnings and cash flow

r -- rate of return earned on new investment

k -- discount rate

(k-g) = (1-g/r)/(P/E)

k = (1-g/r)/(P/E) + g

Example: if r = k than the formula boils down to 1/(k)

If the g = 0, the formula is P/E = 1/k

P = E/(k-g) x (1-g/r)

If, for some reason, g = r, then the Gordon model could be appliedto compute k.


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Microsoft P/E , ROE Etc

Microsofts P/E has fallen even though EPS has Grown. The PEis explained by ROE falling and growth falling as implied in the PEformula.

Microsoft EPS and ROE

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

EPS

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

ROE

Microsoft P/E and Growth

0

10

20

30

40

50

60

1991199219931994 19951996 199719981999 2000200120022003

P/ERatio

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

GrowthRate

PE Ratio

Past 3 Year Growth


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Illustration of Drivers with Trucking Companies

What should drive the differencein P/E Ratios. Could this analysisbe applied to a private company


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PE Ratio Formula when k = r There is no economic

profit on new investments

P/E = (1-g/r)/(k-g)If k = r

P/E = (1-g/k)/(k-g)

P/E = (k/k-g/k)/(k-g)

P/E = ((k-g)/k)/(k-g)

P/E = 1/k

PEG Ratio P/E divided by g

If the g and the r were the same, the ratio would be abenchmark

Should consider the r and the k


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Use of P/E Ratio Formula to Compute the Required

Return on Equity Capital

It will become apparent later that one cannot get away from estimating thecost of equity capital and the CAPM technique is inadequate from a theoreticaland a practical standpoint.

The following example illustrates how the formula can be used in practice:

k = (1-g/r)/(P/E) + g


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P/E Notes

High ROE does not mean high PE Hence the existence of highROE stocks with low PEs

Growth and value are not always positively correlated

Growth from improvement will always be value enhancingwhereas growth from reinvestment depends upon the returnagainst the benchmark return

Reinvestment should also include Cash hoarding

PB is better at differentiating ROE differences than PE


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Relationship Between Multiples

The P/E, EV/EBITDA and Cash Flow Multiples should beconsistent and you should understand why one multiple gives youa different answer than another multiple.

Each of the multiples is affected by

The discount rate the risk of the cash flow

The ability of the company to earn more than its cost ofcapital

The growth rate in cash flow or earnings

Differences in the ratios are a function of

Leverage, Depreciation Rates, Taxes, Capital Expendituresrelative to cash flow


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Relationship Between Multiples - Illustration

Assume

Value = NOPLAT x (1-g/ROIC)/(WACC g)

This is the EVA Formula

Assume

No Taxes

No Leverage

No Depreciation

No Growth Rate

ROIC = 10%


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Comparative Multiples

With the simple assumptions, each of the multiples is the same as shownbelow

Exercise: Data table with alternativeparameters to investigate P/E andEV/EBITA


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Comparative Multiples

Once taxes, leverage anddepreciation are added, themultiples diverge as shown onthe table below:


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Problems in Applying Multiples

If you assume that the company has been growing at a high rateand apply the P/E ratio will be overstated in valuation.

When comparing companies, the operating leverage and financialrisks should be similar and there should be an understanding ofwhy P/E ratios are different.

In applying multiples for comparable transactions, if synergyvalues are added, there is double counting

If industry has cycles, must be careful in application


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Market and sector PE ratios The danger of averages

This chart illustrates issues associate with computing averages. Inpractice, the number of comparable firms is small and choosing themedian is advisable.


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Valuation From Discounted Free Cash Flow


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Advantages and Disadvantages of DCF

Advantages

Theoretically Valid value comesfrom free cash flow and assessingrisk of the free cash flow.

Operating and Financial Values

explicitly separates value fromoperating the company with valueof financial obligations and valuefrom cash

Sensitivity forces anunderstanding of key drivers and

allows sensitivity and scenarioanalysis

Disadvantages

Assumptions: Requires WACCassumptions and residual valueassumptions. There are majorproblems with WACC estimation.

Forecasting Problems: Complexforecasting models can easily bemanipulated

Growth: The residual value dependson growth rates which can easilydistort value

Real Options: Discussed above


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Discounted Flow

Use the discounted cash flow when you know something moreabout the company that can be obtained with a forecast

Any cash flow forecast involves:

Value =

Cash flow during explicit forecast period +

Present of cash flow after explicit forecast period

The second item generally involves some kind of growthprojection.

Value of Equity = Value of Enterprise Value of Net Debt


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Step by Step Valuation with Free Cash Flow

Step by Step valuation using free cash flow:Step 1: Compute projected free cash flow over the explicit forecast

period and discount the free cash flow at the WACC

Step 2: Make adjustments to free cash flow in the last forecast year

Step 3: Add terminal value to cash flow to establish enterprise value

Step 4: Make other balance sheet adjustments for balance sheetliabilities and assets that are not in cash flow but affect value

Step 5: Subtract current value of debt net of surplus cash toestablish the total equity value.

Step 6: Divided the equity value by the current outstanding shares toestablish value per share


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Assets and Liabilities that Escape DCF Valuation

Any asset or liability that has no cash flow consequences

Carefully Analyze the Balance Sheet::

Assets Add to Enterprise Value

Un-utilized Land

Un-utilized Equipment

Legal Claims

Liabilities Subtract From Enterprise Value

Environmental

Contract Provisions

Unrecorded unfunded Liabilities

Net Pension Liabilities not Funded


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Unfunded Pension Liabilities

Defined benefit versus defined contributionNo issue with defined contribution since contribution covers future

obligations and there is no future obligation that is not covered

Defined benefit can lead to requirements to fund that are notincluded in investment reserves

Difference is unfunded liability or assetUnfunded liability is like debt it will be a future fixed obligation like

future debt service

Note that this assumes the current level of free cash flow does notalready consider the fixed obligation

If a company runs a defined-benefit pension plan for its employees, itmust fund the plan each year. If the company funds its plan faster thenexpenses dictate, the company can recognise a portion of the excessassets on the balance sheet.


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Double Counting of Assets and Obligations

Work through simple examples to make sure that the cash flowand the adjustments to valuation are consistent.

Work through simple examples

Examples minority interest

Income from minorities is included in free cash flow, then thefinancing of minorities must be included in invested capital

If diluted shares are deducted in earnings than do not alsoinclude the diluted shares when computing share value

Deferred tax treatment depends on how future deferredtaxes are forecast


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DCF Valuation Length of Forecast

Short-run

Forecast all financial statement items

Gross-margin, selling expenses, Etc.

Further out

Individual line items more difficult

Focus on key drivers

Operating margin, tax rate, capital efficiency

Continuing Value

When ROIC and growth stabalise


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$

Explicit forecasts 8,924.43Terminal valuation 17,811.59Appraised Enterprise Value (AEV) 26,736.02

Plus: Listed investments 3,416.00Plus: Other investments 4,356.00

Plus: Cash 20,316.00Total Appraised Value 54,824.02

Less: Bank & other debt 24,282.00Less: Minorities 78.00Equity value 30,464.02

DCF Example to Compute Equity Value from Free Cash Flow

Net Debt is Bank and Minority Interest minus Cash and Listed

Investments

Note how investments are addedand debt is deducted in arrivingat equity value

Treatment of otherinvestments depend

on definition of freecash flow. Here,income from otherinvestments must notbe in free cash flow


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Continuing Value


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C ti i V l t Add t F C h Fl


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Terminal or continuing value is analogous to dividends and capital gains.Free cash flow is dividends, residual value is capital gain.

A few methods of computing residual value include:

Perpetuity

EBITDA Multiple

P/E Ratio

Market to Book Ratio

Replacement Cost

NOPLAT Present value of residual amount to add to present value of cash flow to

establish enterprise value

Continuing Value to Add to Free Cash Flow

First, high growth firms with high net capital

expenditures are assumed to keep

reinvesting at current rates, even as growth

drops off. Not surprisingly, these firms arenot valued very highly in these models.

Second, the net capital expenditures are

reduced to zero in stable growth, even as

the firm is assumed to grow at some rate

forever. Here, the valuations tend to be too

high.

S t i bl G th d Pl b k R t


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Sustainable Growth and Plowback Rate

In the P/E ratio, the sustainable growth of earnings per share is:

g = ROE x (1 dividend payout ratio)

This depends on assumptions with respect to constantpayout and constant ROE. It also assumes that either thereare no new share issues, or if new share issues occur, themarket to book ratio is one.

Growth in free cash flow:

g = Dep Rate x [(Cap Exp/Dep) 1]

Capital expenditures can be greater than depreciationbecause historic depreciation is low from historic accounting

or because company has opportunities for growth.

Di t d C h Fl E l


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Discounted Cash Flow Example

JPMorgan conducted a discounted cash flow analysis to determine a range ofestimated equity valuesper diluted share for Exelon common stock.

JPMorgan calculated the present value of the Exelon cash flow streams from 2005through 2009, assuming it continued to operate as a stand-alone entity, based onfinancial projections for 2005 through 2007 and extensions of those projections from2008 through 2009 in each case provided by Exelon's management.

JPMorgan also calculated an implied range of terminal values for Exelon at the end

of 2009 by applying a range of multiples of 8.0x to 9.0xto Exelon's 2009 EBITDAassumption.

The cash flow streams and the range of terminal values were then discounted topresent values using a range of discount rates from 5.25% to 5.75%, which wasbased on Exelon's estimated weighted average cost of capital, to determine adiscounted cash flow value range.

The value of Exelon's common stock was derived from the discounted cash flow

value range by subtracting Exelon's debt and adding Exelon's cash and cashequivalents outstanding as of December 31, 2004.

E l f Di t d C h Fl A l i


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Example of Discounted Cash Flow Analysis

For the Exelon discounted cash flow analysis, Lehman Brotherscalculated terminal values by applying a range of terminal multiples toassumed 2009 EBITDA of 7.72x to 8.72x. This range was based on thefirm value to 2004 estimated EBITDA multiple range derived in thecomparable companies analysis. The cash flow streams and terminalvalues were discounted to present values using a range of discount ratesof 5.43% to 6.43%. From this analysis, Lehman Brothers calculated a

range of implied equity values per share of Exelon common stock.

PSE&G: For PSEG's regulated utility subsidiary, Morgan Stanleycalculated a range of terminal values at the end of the projection period byapplying a multiple to PSE&G's projected 2009 earnings and then addingback the projected debt and preferred stock amounts in 2009. The price toearnings multiple range used was 14.0x to 15.0x and the weighted

average cost of capital was 5.5% to 6.0%.

Di t d C h Fl A l i R l W ld E l


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Discounted Cash Flow Analysis Real World Example

Credit Suisse First Boston estimated the present value of the stand-alone,Unlevered, after-tax free cash flows that Texaco could produce overcalendar years 2001 through 2004 and that Chevron could produce overthe same period. The analysis was based on estimates of themanagements of Texaco and Chevron adjusted, as reviewed by ordiscussed with Texaco management, to reflect, among other things,differing assumptions about future oil and gas prices.

Ranges of estimated terminal values were calculated by multiplying

estimated calendar year 2004 earnings before interest, taxes,depreciation, amortization and exploration expense, commonly referred toas EBITDAX, by terminal EBITDAX multiples of 6.5x to 7.5x in the case ofboth Texaco and Chevron.

The estimated un-levered after-tax free cash flows and estimated terminalvalues were then discounted to present value using discount rates of9.0 percent to 10.0 percent.

That analysis indicated an implied exchange ratio reference range of0.56x to 0.80x.

Problems with Use of Multiples in DCF


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Problems with Use of Multiples in DCF

Multiples can cause problemsSustainable growth once stable period has been reached isprobably less than the growth used in the explicit forecastperiod. This means that the multiple should be less as well.

The multiples for evaluating a merger transaction mayinclude synergies and other current market items. The use ofsimilar multiples in terminal value is highly inappropriate.


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Reasons for Multiplying by (1+g) in Perpetuity Method


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Reasons for Multiplying by (1+g) in Perpetuity Method

Assume

Company is sold on last day in the cash flow periodValuation is determined from cash flow in the year after the residual period

This cash flow is final year x (1+g)

Discounting

Since the value is brought back to final period, the discount factor should be thefinal year period

Without growth, the value is the cash flow (cf x 1+g)) divided by the discountgrowth

The discounting should also reflect the growth rate

Formula

1. Cash Flow for Valuation CF x (1+g)

2. Value at Last Day of Forecast CF x (1+g)/(WACC g)

3. PV of the Value -- discount rate must be at last day of forecast, not mid year

Formulas for Continuing Value


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Formulas for Continuing Value

A common method for computing cash flow is using the final cash flow in thecorporate model and assuming the company is sold at the end of the

Perpetuity Value at beginning of final year = FCF/WACC

Perpetuity Adjusted for Growth = FCF(1+g)/(WACC - g)

Perpetuity using investment returns =

NOPLAT x (1-g/ROIC)/(WACC - g)

Once the Perpetuity Value is established for in the last year, it must be discountedto the current value:

Current Perpetuity Value = PV(Perpetuity Value that occurs at beginning offinal year)

NPV in excel assumes flows occur at the end of the year. Adjustments can bemade to assume that flows occur in the middle of the year.

In this case, the discounting of the residual is different from discounting of theindividual cash flows

Practical Issues and Continuing Value


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Practical Issues and Continuing Value

Book Value when book value means something from an economicstandpoint

Banks

Utility Companies

EV/EBITDA, P/E companies without lumpy investments

Telcom

Manufacturing

Replacement Cost when replacement cost can be established

Oil, Gas and Mining

Airlines

It seems foolish toassume that current

multiples will remain

constant as the

industry matures and

changes and that

investors will continue

to pay high multiples,even if the

fundamentals do not

justify them. If there

is stable growth, the

P/E multiple in the

terminal value should

be lower.


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Example of Residual Value Analysis


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Example of Residual Value Analysis

Exercise on ROIC in Financial RatioFolder


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Valuation from Projected EPS and Dividend perShare

Valuation from Projected Earnings and Dividends


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Valuation from Projected Earnings and Dividends

Earnings Valuation

PV of EPS over forecast horizon discounted at the equity discountrate

Add the present value of the perpetuity EPS value reflecting thegrowth rate

Dividend Valuation PV of Dividend per share over the forecast horizon

Add present value of book value per share rather than perpetuity ofearnings because book value grows when dividends are not paid

Can multiply the book value per share by market to book multiple

Price Earnings and Gordon Model


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Price Earnings and Gordon Model

Gordon Dividend Discount Model.

P = D1/(K G)

P = the "correct" share price

D = dividend payment for the next period (recall from discounting exercise that the nextperiod must be used)

K = Required rate of return (based largely on market interest rates a adjusted for equity

risk) G = anticipate rate of dividend growth

The model can be used to compute the cost of capital where:

R = D/P + G

Problem: D is not EPS and G is affected by payout ratio


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Use of Relationship between Multiples and Financial


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Use of Relationship between Multiples and Financial

Ratios in Residual Value

The financial model projects the return on equity and therelationship between ROE and the Market to book ratio can beused to make projections of multiples

Market to Book Ratio versus Return on Equity

y = 13.102x + 0.2595

R2

= 0.786

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0%

ROE

MarkettoBook

Return on equity associated

with a market to book ratio of

1.0

Exelon

Example of Business Segment Analysis in Corporate


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Example of Business Segment Analysis in Corporate

Models


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Reference: Selected Valuation Issues

Valuation Issues


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1. How do you choose between firm and equity valuation(DCF valuation versus Earnings Growth)

Done right, firm and equity valuation should yield the samevalues for the equity with consistent assumptions. Choosing

between firm (DCF) and equity valuation (PE x EPSforecasts) boils down to the pragmatic issue of ease.

For banks, firm valuation does not work because smalldifferences in WACC can have dramatic effects on valuationwhile and if the market value of debt differs from the book

value, firm value can cause distortions.

Firm Valuation versus Equity Valuation Multiples


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q y p

Depreciation Rate

Return and Cost of Capital Enterprise Value - NOPLAT 100,000.00

Required Equity Return 10% Enterprise Value - FCF 100,000.00

Growth Rate 0%

Return on Invested Capital 10% WACC 10.0%

Leverage Return on Invested Capital 10.0%

Leverage (Book Value) 0% Return on Equity 10.0%

Interest Rate 8%

Other P/E Ratio 10.00

Deprecitation Rate 5% EV/EBITDA 6.7

Cap Exp/Depreciation 100% Market to Book 1.00

Investment 100,000 ROIC Multiple - [(1-(g/ROIC))/(WACC-g)] 10.00

Tax Rate 0% FCF Multiple - 1/(WACC-g) 10.00

ResultsAssumptions


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Equity vs Firm Valuation Leverage, Depreciation and


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q y g , p

Taxes

Return and Cost of Capital Enterprise Value - NOPLAT 128,205.13

Required Equity Return 10% Enterprise Value - FCF 143,589.74

Growth Rate 0%

Return on Invested Capital 10% WACC 7.8%

Leverage Return on Invested Capital 10.0%

Leverage (Book Value) 50% Return on Equity 14.4%

Interest Rate 8%

Other P/E Ratio 10.86

Deprecitation Rate 5% EV/EBITDA 6.6

Cap Exp/Depreciation 100% Market to Book 1.56

Investment 100,000 ROIC Multiple - [(1-(g/ROIC))/(WACC-g)] 12.82

Tax Rate 30% FCF Multiple - 1/(WACC-g) 12.82

ResultsAssumptions

Firm versus Equity Valuation


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From the perspective of convenience, it is often easier toestimate equity than the DCF, especially when leverage ischanging significantly over time (for example, in projectfinance and in leveraged buyouts where equity IRR is used).

Equity value measures a real cash flow to owners, ratherthan an abstraction (free cash flows to the firm exist only onpaper). Free cash flow is affected to a large extent by capitalexpenditures which can cause problems.

q y

Measurement of Expected Growth Rate


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While there are many who use historical (past) growth as ameasure of expected growth, or choose to trust analysts(with their projections), try using fundamentals.

Think about the two factors that determine growth - thefirm's reinvestment policy and its rate of return.

For expected growth in earnings = Retention Ratio * ROE,where Retention Ratio is 1 Dividend Payout

For expected growth in EBIT = Reinvestment Rate * ROC,where reinvestment rate is Cap Exp/Depreciation

p

At 100% Payout Growth Equals ROE


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Price to Earnings ComputationLong-Term Growth Rate 0.00% Total Value (Sum of Annual Value) 5.96

Long-Term Return Return on Equity 15.0% Initial Earnings 1.03

Equity Cost of Capital 15.0% PE Ratio - Value/Net Income 5.80

P/E Formula: (1-g/r)/(k-g) 6.67 PEG: PE/Growth 0.39

Year 1 2 3 4 5 6 7 8 9

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Holding Period 10

Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE

Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE

InvestmentBeginning Investment 6.85

Beginning Equity (Last Period Ending) 6.85 7.88 9.06 10.42 11.98 13.78 15.84 18.22 20.95

Add: Earnings (ROE x Beginning Equity) 1.03 1.18 1.36 1.56 1.80 2.07 2.38 2.73 3.14

Less: Dividends (NI x Payout Ratio) - - - - - - - - -

Ending Equity (Beg + Income - Payout) 7.88 9.06 10.42 11.98 13.78 15.84 18.22 20.95 24.10

Cash Flow to Equity and ValuationCash flow from Dividends from Above - - - - - - - - -

Terminal Multiple of Earnings from Above 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67

Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - -

Total Cash Flow (Terminal + Dividends) - - - - - - - - -

Required Return on Equity 15.00% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%

Discount Factor [1/(required return + 1)^yr] 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28

Value of Cash Flow [CF x Discount Fac] x Switch - - - - - - - - -

Per iod Future Earn Current Growth

10 3.61 1.03 15.00%

Growth over Forecast Horizon

At 50% Payout Growth is of the ROE


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Stable Growth Rate 7.5% Initial Earnings 1.03



Year 1 2 3 4 5 6 7 8 9 10

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%

Holding Period 10

Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE TRUESwitch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE

InvestmentBeginning Investment 6.85

Beginning Equity (Last Period Ending) 6.85 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13Add: Earnings (ROE x Beginning Equity) 1.03 1.10 1.19 1.28 1.37 1.48 1.59 1.70 1.83 1.97Less: Dividends (NI x Payout Ratio) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98Ending Equity (Beg + Income - Payout) 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 14.12

Cash Flow to Equity and ValuationCash flow from Dividends from Above 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98Terminal Multiple of Earnings from Above 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 14.12Total Cash Flow (Terminal + Dividends) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 15.10

Required Return on Equity 15.00% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%

Discount Factor [1/(required return + 1)^yr] 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25Value of Cash Flow [CF x Discount Fac] x Switch 0.45 0.42 0.39 0.36 0.34 0.32 0.30 0.28 0.26 3.73

P eri od Fu tu re Ea rn Current Growth10 1.97 1.03 7.50%


Growth Rate Estimation vs ROE and Retention Rate


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Note that what we really need to estimate are reinvestmentrates and marginal returns on equity and capital in the future(the change in Income over the change in Equity).

Note that those who use analysts or historical growth ratesare implicitly assuming something about reinvestment ratesand returns, but they are either unaware of theseassumptions or do not make them explicit. This means, lookat the ROE and the dividends to make sure that the growth isconsistent.

Future ROE depends on changes in economic variables

affecting the existing investment and new projects withincremental returns.

How Long will Growth Last


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There is no single answer to the question, so look at the following

characteristics:

A. The greater the current growth rate in earnings of a firm, relative to thestable growth rate, the longer the high growth period; although the growthrate may drop off during the period. Thus, a firm that is growing at 40% shouldhave a longer high-growth period than one growing at 14%.

B. The larger the size of the firm, the shorter the high growth period. Sizeremains 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.

C. The greater the barriers to entry in a business, e.g. patents or strong brandname, should lengthen the high growth period for a firm.

Look at the combination of the three factors A,B,C and make a judgment. Fewfirms can achieve an expected growth period longer than 10 years

Effect of Growth Microsoft Example Long-term


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Equals the Current Growth P/E is 20


Long-term Return 15.0% Initial Earnings 1.03



Year 1 2 3 4 5 6 7 8 9 10

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%

Holding Period 10


Investment

Beginning Investment 6.85Beginning Equity (Last Period Ending) 6.85 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13Add: Earnings (ROE x Beginning Equity) 1.03 1.10 1.19 1.28 1.37 1.48 1.59 1.70 1.83 1.97Less: Dividends (NI x Payout Ratio) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98Ending Equity (Beg + Income - Payout) 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 14.12






Long-Term Growth is 3% instead of 7.5% - P/E Ratio


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Falls to 13.19

Price to Earnings ComputationLong-Term Stable Growth Rate 3.00% Total Value (Sum of Annual Value) 13.55




Year 1 2 3 4 5 6 7 8 9 10

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%

Holding Period 10


Investment


Cash Flow to Equity and ValuationCash flow from Dividends from Above 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98Terminal Multiple of Earnings from Above 11.43 11.43 11.43 11.43 11.43 11.43 11.43 11.43 11.43 11.43Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 24.20Total Cash Flow (Terminal + Dividends) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 25.19Required Return on Equity 10.00% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%


P eri od Fu tu re Ea rn Curr en t Growth10 1.97 1.03 7.50%


Estimation of Terminal Value


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Terminal value refers to the value of the firm (or equity) at theend of the high growth period. Estimate terminal value, withDCF, by assuming a stable growth rate that the firm cansustain forever. If we make this assumption, the terminalvalue becomes:

Terminal Value in year n = Cash Flow in yearn+1 / (r - g)

This approach requires the assumption that growth isconstant forever, and that the cost of capital will not changeover time.

Growth Rate and Discount Rate


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A stable growth rate is a growth rate that can be sustainedforever. Since no firm, in the long term, can grow faster thanthe economy which it operates it - a stable growth ratecannot be greater than the growth rate of the economy.

It is important that the growth rate be defined in the samecurrency as the cash flows and that be in the same term (realor nominal) as the cash flows.

In theory, this stable growth rate cannot be greater than thediscount rate because the risk-free rate that is embedded inthe discount rate will also build on these same factors - realgrowth in the economy and the expected inflation rate.

Exit multiple in DCF valuation


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In some discounted cash flow valuations, the terminal valueis estimated using a multiple, usually of earnings. In anequity valuation model, the exit multiple may be the PE ratio.In firm valuation models, the exit multiple is often of EBIT orEBITDA.

Analysts who use these multiples argue that it saves themfrom the dangers of having to assume a stable growth rateand that it ties in much more closely with their objective ofselling the firm or equity to someone else at the end of theestimation period.

Problems arise if the PE assumes a higher growth than is

sustainable after the holding period.

Exit multiples and DCF valuation


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On the contrary, exit multiples may introduce relativevaluation into discounted cash flow valuation, and that youcreate a hybrid, which is neither DCF nor relative valuation.These exit multiples use the biggest single assumption madein these valuation models.

It seems foolish to assume that current multiples will remainconstant as the industry matures and changes and thatinvestors will continue to pay high multiples, even if thefundamentals do not justify them. If there is stable growth,the P/E multiple in the terminal value should be lower.

Length of Time Until Stable Growth 10 Years P/E is

15


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15





Year 1 2 3 4 5 6 7 8 9 10

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00%

Holding Period 10


Investment







Length of Time Until Stable Growth 20 Years is 19


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Year 1 2 3 4 5 6 7 8 9 10

Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Dividend Payout 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00%

Holding Period 20

Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSESwitch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE

Investment


Cash Flow to Equity and ValuationCash flow from Dividends from Above 0.31 0.34 0.38 0.42 0.46 0.51 0.56 0.62 0.69 0.76Terminal Multiple of Earnings from Above 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - -Total Cash Flow (Terminal + Dividends) 0.31 0.34 0.38 0.42 0.46 0.51 0.56 0.62 0.69 0.76






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Valuation of Firms that are Losing Money


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There are a number of reasons why a firm might havenegative earnings, and the response will vary dependingupon the reason:- If the earnings of a cyclical firm are depressed due to arecession, the best response is to normalize earnings bytaking the average earnings over a entire business cycle.

- Normalized Net Income = Average ROE * Current BookValue of Equity- Normalized after-tax Operating Income = Average ROC *Current Book Value of Assets- Once earnings are normalized, the growth rate usedshould be consistent with the normalized earnings, andshould reflect the real growth potential of the firm ratherthan the cyclical effects.

Valuation of a firm that is Losing Money


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- If the earnings of a firm are depressed due to a one-timecharge, the best response is to estimate the earnings withoutthe one-time charge and value the firm based upon theseearnings.- If the earnings of a firm are depressed due to poor qualitymanagement, the average return on equity or capital for the

industry can be used to estimate normalized earnings for thefirm. The implicit assumption is that the firm will recoverback to industry averages, once management has beenremoved.- Normalized Net Income = Industry-average ROE * Current BookValue of Equity

- Normalized after-tax Operating Income = Industry-average ROC* Current Book Value of Assets

Valuation of a firm that is losing money


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- If the negative earnings over time have caused the bookvalue to decline significantly over time, use the averageoperating or profit margins for the industry in conjunctionwith revenues to arrive at normalized earnings. Thus, a firmwith negative operating income today could be assumed toconverge on the normalized earnings five years from now. -If the earnings of a firm are depressed or negative because it

operates in a sector which is in its early stages of its lifecycle, the discounted cash flow valuation will be driven bythe perception of what the operating margins and returns onequity (capital) will be when the sector matures.

- If the equity earnings are depressed due to high leverage,the best solution is to value the firm rather than just the

equity, factoring in the reduction in leverage over time.

Valuation of a private firms


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The valuation of a private firm is more difficult than stock ina publicly traded firm. In particular,

A. The information available on private firms will besketchier than the information available on publiclytraded firms.

B. Past financial statements, even when available, mightnot reflect the true earnings potential of the firm. Manyprivate businesses understate earnings to reduce theirtax liabilities, and the expenses at many privatebusinesses often reflect the blurring of lines betweenprivate and business expenses.

Valuation of a private firm


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C. The owners of many private businesses are taxed on thesalary they make and the dividends they take out of thebusiness; often do not try to distinguish between the two.The limited availability of information does make theestimation of cash flows impossible; past financialstatements might need to be restated to make them reflect

the true earnings of the firm. Once the cash flows areestimated, the choice of a discount rate might be affected bythe identity of the potential buyer of the business. If thepotential buyer of the business is a publicly traded firm, thevaluation should be done using the discount rates basedupon market risk

EPS Measures Establishing a reliable starting point


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Reported EPS EPS reported by the company using generallyaccepted accounting principles. Therefore includes earnings fromrecurring and non-recurring items

Recurring EPS Reported EPS adjusted to exclude non-recurringitems

Fully diluted EPS EPS adjusted to reflect dilution to existingshareholders as a result of future increases in equity shares

EPS adjustments


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j


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Share buy back


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190 millionWeighted Average

90 million180 million x 6/12After Buy Back

100 million200 million x 6/12Start of year

Weighted AverageSharesDate

EPS = $33 million/ 190 million = 17. 3 CENTS

Redeem Ltd made earnings of $ 33 million dollars for the yearended March 2004. The number of shares issued at the start ofthe year was 200 million. In September 2003 Redeem Ltd boughtback 20 million shares at market price.

Dilution Factors and treatment


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Contingently issuable shares - Include shares in the calculation ofbasic EPS if the contingency has been met.

Options or warrants in existence over as yet un-issued shares Assume exercise of outstanding dilutive options and warrants

Loan stock or preference shares convertible into equity shares in

the future Assume that instruments are converted thereforesaving interest but increasing the number of shares in issue

Diluted Shares


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If you have agreed to give away shares to someone, then yourclaim to the cash flow of the company is reduced.

In the extreme, if you have given away half of your companyaway, and the cash flow is the same before and after your giveaway, then the amount you would pay for the share must accountfor how much you will give away.

In this extreme example, you should reduce the value by .

This can be accomplished by using diluted shares rather thanbasic shares.

Option dilution


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Calculation of the number of shares in the dilution calculation is

illustrated below:

Multiple share classes


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Employee Stock options Latest developments


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$ 900,000

$ 500,000

$ 250,000

Cumulative expense

$ 400,000100 x 180 x $50 x 3/3 less $500,0003

$ 250,000100 x (200 x 75%) x $50 x 2/3 less $ 250,0002

$ 250,000100 x (200 x 75%) x $50 x 1/31

ExpenseCalculationYear

IFRS 2 Requires companies to measure the fair value of share-based

payments at the grant date and expense over the vesting period FAS 123 The above treatment is optional

A company grants 100 options to 200 employees. The estimated fair value is$ 50 per option. The options are contingent on the employees working at theCompany in 3 years time. The company estimates that 25% of the employeesWill leave over the 3 year period. No employees leave in year 1 and 2 but10% leave In year 3.

Issues in the application of PEs


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Accounting Policy differences Particularly significant for cross border

comparisons where companies may follow local, international or USGAAP

Loss making companies No earnings therefore no PE

Cyclical companies PEs volatile through the cycle and therefore difficultto benchmark

Finding a suitable benchmark Difficult to find companies that are perfectmatches in all determinants of a PE

Growth As discussed value and growth are not always the same

Capital market conditions The cost of equity will vary depending onunderlying interest rate environment that is likely to be different in differentcountries

Financing The greater the gearing of a company the greater the cost ofequity and therefore, all other things being equal, the lower the value andthe lower the PE

Valuation of Subsidiary Companies in Different

Countries


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How would things differ if we are valuing companies from different

countries, different sectors etc. The basic rule is:

Cash flows should be nominal

Cash flows should be stated in the currency where the subsidiary islocated

If there are multiple currencies, use the future expected spot exchangerates to translate cash flows

Cash flows should be discounted at cost of capital that reflects theinterest rates where the country is located

This means that the risk free rate in the country where the subsidiary islocated should be used.

Once the value is established, translate the amount to the homecountry at the spot exchange rate


Countries


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How would things differ if we are valuing companies from

different countries, different sectors etc.

Example:

Subsidiary is located in Malaysia

Parent Company is in Hong Kong

Subsidiary company sells in Malaysia and Thailand

Subsidiary company produces in Malaysia and Thailand

Exchange Rates and Interest Rates

Spot Exchange Rates

HK Dollars to Ringet Baht to Ringet


Countries


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How would things differ if we are valuing companies from different

countries, different sectors etc.

Cash flows should be stated in the currency where the subsidiary islocated (Malaysian Ringgit)

Compute prices and costs in Baht and Ringgit and then translate therevenues and costs in Baht to Ringgit

To convert the Baht to Ringgit, use the expected future spotRinget/Baht exchange rates

Since, as a practical matter, forward exchange rates are notavailable beyond 18 months, compute future spot rates from interestrate parity

Interest rate parity means that if you invest in risk free securities ofdifferent currencies, the spot exchange rate must reflect the futurevalues.


Countries


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How would things differ if we are valuing companies from

different countries, different sectors etc.

Example of future expected spot exchange rates:

Example of Foreign Valuation


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Free Cash Flow


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We often talk about free cash flow, sometimes, it is challengingto assess what is "free cash flow or not, may wish toelaborate on that rather than just defining free cash flow in atext book term.

The basic point is to keep things consistent. If you define FCF asEBITDA without other income, then the valuation does not include

other investments.

On the other hand if FCF is defined using Cash B/4 Financing thatincludes other income, the other investments are included in thevaluation

In-the-money Options and Convertibles


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Can the trainer also cover dealing with in-the moneyoptions and

asset valuation[1]

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