VALUATION:PACKET2RELATIVEVALUATION,ASSET-BASEDVALUATIONANDPRIVATECOMPANYVALUATIONAswathDamodaranUpdated:September20169/2016

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Test1:Areyoupricingorvaluing?

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Test2:Areyoupricingorvaluing?

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TheEssenceofRelativeValuation(Pricing)

¨ Inrelativevaluation,thevalueofanassetiscomparedtothevaluesassessedbythemarketforsimilarorcomparableassets.

¨ Todorelativevaluationthen,¤ weneedtoidentifycomparableassetsandobtainmarketvaluesfortheseassets

¤ convertthesemarketvaluesintostandardizedvalues,sincetheabsolutepricescannotbecomparedThisprocessofstandardizingcreatespricemultiples.

¤ comparethestandardizedvalueormultiplefortheassetbeinganalyzedtothestandardizedvaluesforcomparableasset,controllingforanydifferencesbetweenthefirmsthatmightaffectthemultiple,tojudgewhethertheassetisunderorovervalued

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Relativevaluationispervasive…

¨ Mostassetvaluationsarerelative.¨ MostequityvaluationsonWallStreetarerelativevaluations.

¤ Almost85%ofequityresearchreportsarebaseduponamultipleandcomparables.

¤ Morethan50%ofallacquisitionvaluationsarebaseduponmultiples¤ Rulesofthumbbasedonmultiplesarenotonlycommonbutareoften

thebasisforfinalvaluationjudgments.¨ Whiletherearemorediscountedcashflowvaluationsin

consultingandcorporatefinance,theyareoftenrelativevaluationsmasqueradingasdiscountedcashflowvaluations.¤ Theobjectiveinmanydiscountedcashflowvaluationsistobackintoa

numberthathasbeenobtainedbyusingamultiple.¤ Theterminalvalueinasignificantnumberofdiscountedcashflow

valuationsisestimatedusingamultiple.

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Whyrelativevaluation?

“IfyouthinkI’mcrazy,youshouldseetheguywholivesacrossthehall”

JerrySeinfeldtalkingaboutKramerinaSeinfeldepisode

“A little inaccuracy sometimes saves tons of explanation”H.H. Munro

“ If you are going to screw up, make sure that you have lots of company”

Ex-portfolio manager

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TheMarketImperative….

¨ Relativevaluationismuchmorelikelytoreflectmarketperceptionsandmoodsthandiscountedcashflowvaluation.Thiscanbeanadvantagewhenitisimportantthatthepricereflecttheseperceptionsasisthecasewhen¤ theobjectiveistosellasecurityatthatpricetoday(asinthecaseofan

IPO)¤ investingon“momentum” basedstrategies

¨ Withrelativevaluation,therewillalwaysbeasignificantproportionofsecuritiesthatareundervaluedandovervalued.

¨ Sinceportfoliomanagersarejudgedbaseduponhowtheyperformonarelativebasis(tothemarketandothermoneymanagers),relativevaluationismoretailoredtotheirneeds

¨ Relativevaluationgenerallyrequireslessinformationthandiscountedcashflowvaluation(especiallywhenmultiplesareusedasscreens)

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Multiplesarejuststandardizedestimatesofprice…

Numerator = What you are paying for the asset

Denominator = What you are getting in return

Market value of equity Market value for the firmFirm value = Market value of equity

+ Market value of debt

Market value of operating assets of firmEnterprise value (EV) = Market value of equity

+ Market value of debt- Cash

Revenuesa. Accounting revenuesb. Drivers- # Customers- # Subscribers= # units

Earningsa. To Equity investors - Net Income - Earnings per shareb. To Firm - Operating income (EBIT)

Book Valuea. Equity= BV of equityb. Firm= BV of debt + BV of equityc. Invested Capital= BV of equity + BV of debt - Cash

Multiple =

Cash flowa. To Equity- Net Income + Depreciation- Free CF to Equityb. To Firm- EBIT + DA (EBITDA)- Free CF to Firm

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TheFourStepstoDeconstructingMultiples

¨ Definethemultiple¤ Inuse,thesamemultiplecanbedefinedindifferentwaysbydifferent

users.Whencomparingandusingmultiples,estimatedbysomeoneelse,itiscriticalthatweunderstandhowthemultipleshavebeenestimated

¨ Describethemultiple¤ Toomanypeoplewhouseamultiplehavenoideawhatitscrosssectional

distributionis.Ifyoudonotknowwhatthecrosssectionaldistributionofamultipleis,itisdifficulttolookatanumberandpassjudgmentonwhetheritistoohighorlow.

¨ Analyzethemultiple¤ Itiscriticalthatweunderstandthefundamentalsthatdriveeachmultiple,

andthenatureoftherelationshipbetweenthemultipleandeachvariable.¨ Applythemultiple

¤ Definingthecomparableuniverseandcontrollingfordifferencesisfarmoredifficultinpracticethanitisintheory.

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DefinitionalTests

¨ Isthemultipleconsistentlydefined?¤ Proposition1:Boththevalue(thenumerator)andthestandardizingvariable(thedenominator)shouldbetothesameclaimholdersinthefirm.Inotherwords,thevalueofequityshouldbedividedbyequityearningsorequitybookvalue,andfirmvalueshouldbedividedbyfirmearningsorbookvalue.

¨ Isthemultipleuniformlyestimated?¤ Thevariablesusedindefiningthemultipleshouldbeestimateduniformlyacrossassetsinthe“comparablefirm” list.

¤ Ifearnings-basedmultiplesareused,theaccountingrulestomeasureearningsshouldbeappliedconsistentlyacrossassets.Thesameruleapplieswithbook-valuebasedmultiples.

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Example1:PriceEarningsRatio:Definition

PE=MarketPriceperShare/EarningsperShare¨ ThereareanumberofvariantsonthebasicPEratioinuse.Theyarebaseduponhowthepriceandtheearningsaredefined.Price: isusuallythecurrentprice

issometimestheaveragepricefortheyearEPS: EPSinmostrecentfinancialyear

EPSintrailing12monthsForecastedearningspersharenextyearForecastedearningspershareinfutureyear

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Example2:StayingonPEratios

¨ AssumingthatyouarecomparingthePEratiosacrosstechnologycompanies,manyofwhichhaveoptionsoutstanding.WhatmeasureofPEratiowouldyieldthemostconsistentcomparisons?a. Price/PrimaryEPS(actualshares,nooptions)b. Price/FullyDilutedEPS(actualshares+alloptions)c. Price/PartiallyDilutedEPS(countingonlyin-the-money

options)d. Other

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Example3:EnterpriseValue/EBITDAMultiple

¨ TheenterprisevaluetoEBITDAmultipleisobtainedbynettingcashoutagainstdebttoarriveatenterprisevalueanddividingbyEBITDA.

1. Whydowenetoutcashfromfirmvalue?2. Whathappensifafirmhascrossholdingswhichare

categorizedas:¤ Minorityinterests?¤ Majorityactiveinterests?

Enterprise ValueEBITDA

=Market Value of Equity + Market Value of Debt - Cash

Earnings before Interest, Taxes and Depreciation

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Example4:AHousingPriceMultiple

Thebubblesandbustsinhousingpriceshasledinvestorstosearchforamultiplethattheycanusetodeterminewhenhousingpricesaregettingoutofline.Onemeasurethathasacquiredadherentsistheratioofhousingpricetoannualnetrentalincome(forrentingoutthesamehouse).Assumethatyoudecidetocomputethisratioandcompareittothemultipleatwhichstocksaretrading.Whichvaluationratiowouldbetheonethatcorrespondstothehouseprice/rentratio?a.PriceEarningsRatiob.EVtoSalesc.EVtoEBITDAd.EVtoEBIT

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DescriptiveTests

¨ Whatistheaverageandstandarddeviationforthismultiple,acrosstheuniverse(market)?

¨ Whatisthemedianforthismultiple?¤ Themedianforthismultipleisoftenamorereliablecomparisonpoint.

¨ Howlargearetheoutlierstothedistribution,andhowdowedealwiththeoutliers?¤ Throwingouttheoutliersmayseemlikeanobvioussolution,butifthe

outliersalllieononesideofthedistribution(theyusuallyarelargepositivenumbers),thiscanleadtoabiasedestimate.

¨ Aretherecaseswherethemultiplecannotbeestimated?Willignoringthesecasesleadtoabiasedestimateofthemultiple?

¨ Howhasthismultiplechangedovertime?

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1.Multipleshaveskeweddistributions…

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0.

100.

200.

300.

400.

500.

600.

700.

0.01To4 4To8 8To12 12To16 16To20 20To24 24To28 28To32 32To36 36To40 40To50 50To75 75To100 100andover

PERatios:UScompaniesinJanuary2016

Current Trailing Forward

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2.Makingstatistics“dicey”

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CurrentPE TrailingPE ForwardPENumberoffirms 7480 7480 7480NumberwithPE 3,344. 3,223. 2,647.Average 59.42 46.04 29.63Median 18.53 18.29 16.98Minimum 0.11 0.28 0.15Maximum 32,269.00 6,900.00 2,748.00Standarddeviation 777.02 256.06 81.27Standarderror 13.44 4.51 1.58Skewness 37.27 19.9 18.7425thpercentile 11.88 12.32 13.175thpercentile 30.25 29.52 24.28

US firms in January 2016

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3.Marketshavealotincommon :ComparingGlobalPEs

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0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

US Europe Japan EmergingMarkets Aus,NZ&Canada Global

TrailingPERatiosbyRegion

<4

4To8

8To12

12To16

16To20

20To24

24To28

28To32

32To36

36To40

40To50

50To75

75To100

100andover

Average 25thperc. Median 75thperc.UnitedStates 46.04 12.32 18.29 29.52Europe 57.57 10.27 16.69 26.76Japan 29.83 9.96 15.08 24.93EmergingMarkets 91.08 9.57 16.77 39.69Aus,NZ&Canada 67.42 8.87 15.69 27.52Global 71.16 10.00 16.69 32.07

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3a.Andthedifferencesaresometimesrevealing…PricetoBookRatiosacrossglobe– January2013

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4.Simplisticrulesalmostalwaysbreakdown…6timesEBITDAwasnotcheapin2010…

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Butitmaybein2016,unlessyouareinJapan,AustraliaorCanada

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0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

<2 2To4 4To6 6To8 8To10 10To12 12To16 16To20 20To25 25To30 30To35 35To40 40To45 45To50 50To75 75To100

>100

EV/EBITDAMultiplesinJanuary2016

US Europe Japan EmergingMarkets Aus,NZ&Canada Global

Average 25thperc. Median 75thperc.UnitedStates 439.06 7.70 11.80 28.00Europe 98.53 6.73 10.12 16.55Japan 69.64 4.67 7.20 11.59EmergingMarkets 112.64 6.76 11.91 28.07Aus,NZ&Canada 77.17 5.24 8.85 15.77Global 148.16 6.43 10.58 21.67

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AnalyticalTests

¨ Whatarethefundamentalsthatdetermineanddrivethesemultiples?¤ Proposition2:Embeddedineverymultipleareallofthevariablesthat

driveeverydiscountedcashflowvaluation- growth,riskandcashflowpatterns.

¨ Howdochangesinthesefundamentalschangethemultiple?¤ Therelationshipbetweenafundamental(likegrowth)andamultiple

(suchasPE)isalmostneverlinear.¤ Proposition3:Itisimpossibletoproperlycomparefirmsonamultiple,

ifwedonotknowhowfundamentalsandthemultiplemove.

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ASimpleAnalyticaldevice

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I.PERatios

¨ Tounderstandthefundamentals,startwithabasicequitydiscountedcashflowmodel.¤ Withthedividenddiscountmodel,

¤ Dividingbothsidesbythecurrentearningspershare,

¤ IfthishadbeenaFCFEModel,

P0 =DPS1r −gn

P0

EPS0

= PE= Payout Ratio*(1+gn )

r-gn

P0 =FCFE1r −gn

P0

EPS0

= PE= (FCFE/Earnings)*(1+gn )

r-gnAswath Damodaran

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UsingtheFundamentalModeltoEstimatePEForaHighGrowthFirm

¨ Theprice-earningsratioforahighgrowthfirmcanalsoberelatedtofundamentals.Inthespecialcaseofthetwo-stagedividenddiscountmodel,thisrelationshipcanbemadeexplicitfairlysimply:

¤ Forafirmthatdoesnotpaywhatitcanaffordtoindividends,substituteFCFE/Earningsforthepayoutratio.

¨ Dividingbothsidesbytheearningspershare:

P0 =EPS0*Payout Ratio*(1+g)* 1− (1+g)n

(1+r)n

"

#$

%

&'

r-g+ EPS0*Payout Ration*(1+g)n*(1+gn )

(r-gn )(1+r)n

P0EPS0

=Payout Ratio * (1 + g) * 1 − (1 + g)n

(1+ r)n"

# $ %

& '

r - g+

Payout Ratio n *(1+ g)n * (1 + gn )(r - gn )(1+ r)n

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ASimpleExample

¨ AssumethatyouhavebeenaskedtoestimatethePEratioforafirmwhichhasthefollowingcharacteristics:

Variable HighGrowthPhase StableGrowthPhaseExpectedGrowthRate 25% 8%PayoutRatio 20% 50%Beta 1.00 1.00Numberofyears 5years Foreverafteryear5Riskfree rate=T.Bond Rate=6%Requiredrateofreturn=6%+1(5.5%)=11.5%

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P0

EPS0

=.20*(1.25)* 1− (1.25)5

(1.115)5

"

#$

%

&'

.115-.25+ .50*(1.25)5*(1.08)

(.115-.08)(1.115)5 = 28.75

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a.PEandGrowth:Firmgrowsatx%for5years,8%thereafter

PE Ratios and Expected Growth: Interest Rate Scenarios

0

20

40

60

80

100

120

140

160

180

5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Expected Growth Rate

PE

Rati

o r=4%

r=6%

r=8%

r=10%

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b.PEandRisk:AFollowupExample

PE Ratios and Beta: Growth Scenarios

0

5

10

15

20

25

30

35

40

45

50

0.75 1.00 1.25 1.50 1.75 2.00

Beta

PE

Rati

o g=25%

g=20%

g=15%

g=8%

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Example1:ComparingPEratiosacrossEmergingMarkets- March2014(pre- Ukraine)

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Russia looks really cheap, right?

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Example2:AnOldExamplewithEmergingMarkets:June2000

Country PE Ratio Interest Rates

GDP Real Growth

Country Risk

Argentina 14 18.00% 2.50% 45Brazil 21 14.00% 4.80% 35Chile 25 9.50% 5.50% 15Hong Kong 20 8.00% 6.00% 15India 17 11.48% 4.20% 25Indonesia 15 21.00% 4.00% 50Malaysia 14 5.67% 3.00% 40Mexico 19 11.50% 5.50% 30Pakistan 14 19.00% 3.00% 45Peru 15 18.00% 4.90% 50Phillipines 15 17.00% 3.80% 45Singapore 24 6.50% 5.20% 5South Korea 21 10.00% 4.80% 25Thailand 21 12.75% 5.50% 25Turkey 12 25.00% 2.00% 35Venezuela 20 15.00% 3.50% 45

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RegressionResults

¨ TheregressionofPEratiosonthesevariablesprovidesthefollowing–PE=16.16 - 7.94InterestRates

+154.40GrowthinGDP- 0.1116CountryRisk

RSquared=73%

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PredictedPERatios

Country PE Ratio Interest Rates

GDP Real Growth

Country Risk

Predicted PE

Argentina 14 18.00% 2.50% 45 13.57Brazil 21 14.00% 4.80% 35 18.55Chile 25 9.50% 5.50% 15 22.22Hong Kong 20 8.00% 6.00% 15 23.11India 17 11.48% 4.20% 25 18.94Indonesia 15 21.00% 4.00% 50 15.09Malaysia 14 5.67% 3.00% 40 15.87Mexico 19 11.50% 5.50% 30 20.39Pakistan 14 19.00% 3.00% 45 14.26Peru 15 18.00% 4.90% 50 16.71Phillipines 15 17.00% 3.80% 45 15.65Singapore 24 6.50% 5.20% 5 23.11South Korea 21 10.00% 4.80% 25 19.98Thailand 21 12.75% 5.50% 25 20.85Turkey 12 25.00% 2.00% 35 13.35Venezuela 20 15.00% 3.50% 45 15.35

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Example3:PEratiosfortheS&P500overtime

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0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

PERatiosfortheS&P500:1969-2015

PE NormalizedPE CAPE

PE NormalizedPE CAPE1969-2015 16.06 20.70 17.081986-2015 18.52 24.00 20.341996-2015 19.61 25.61 22.292006-2015 16.90 20.88 18.45

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Islow(high)PEcheap(expensive)?

¨ AmarketstrategistarguesthatstocksareexpensivebecausethePEratiotodayishighrelativetotheaveragePEratioacrosstime.Doyouagree?a. Yesb. No

¨ Ifyoudonotagree,whatfactorsmightexplainthehigherPEratiotoday?

¨ WouldyouresponddifferentlyifthemarketstrategisthasaNobelPrizeinEconomics?

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E/PRatios,T.BondRatesandTermStructure

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-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

EarningstoPriceversusInterestRates:S&P500

EarningsYield T.BondRate Bond-Bill

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RegressionResults

¨ ThereisastrongpositiverelationshipbetweenE/PratiosandT.Bond rates,asevidencedbythecorrelationof0.66betweenthetwovariables.,

¨ Inaddition,thereisevidencethatthetermstructurealsoaffectsthePEratio.

¨ Inthefollowingregression,using1960-2014data,weregressE/PratiosagainstthelevelofT.Bond ratesandatermstructurevariable(T.Bond - T.Bill rate)E/P=3.51%+0.5598T.Bond Rate– 0.1374(T.Bond Rate-T.Bill Rate)

(4.93) (6.23) (-0.65)Rsquared=41.28%

¨ Goingbackto2008,thisiswhattheregressionlookedlike:E/P=2.56%+0.7044T.Bond Rate– 0.3289(T.Bond Rate-T.Bill Rate)

(4.71) (7.10) (1.46)Rsquared=50.71%TheR-squaredhasdroppedandtheT.Bond rateandthedifferentialwiththeT.Billratehavenoth lostsignificance.Howwouldyoureadthisresult?

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II.PEGRatio

¨ PEGRatio=PEratio/ExpectedGrowthRateinEPS¤ Forconsistency,youshouldmakesurethatyourearningsgrowth

reflectstheEPSthatyouuseinyourPEratiocomputation.¤ Thegrowthratesshouldpreferablybeoverthesametimeperiod.

¨ TounderstandthefundamentalsthatdeterminePEGratios,letusreturnagaintoa2-stageequitydiscountedcashflowmodel:

¨ DividingbothsidesoftheequationbytheearningsgivesustheequationforthePEratio.Dividingitagainbytheexpectedgrowth‘g:

P0 =EPS0*Payout Ratio*(1+g)* 1− (1+g)n

(1+r)n

"

#$

%

&'

r-g+ EPS0*Payout Ration*(1+g)n*(1+gn )

(r-gn )(1+r)n

PEG=Payout Ratio*(1+g)* 1− (1+g)n

(1+r)n

"

#$

%

&'

g(r-g)+ Payout Ration*(1+g)n*(1+gn )

g(r-gn )(1+r)n

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PEGRatiosandFundamentals

¨ Riskandpayout,whichaffectPEratios,continuetoaffectPEGratiosaswell.¤ Implication:WhencomparingPEGratiosacrosscompanies,wearemakingimplicitorexplicitassumptionsaboutthesevariables.

¨ DividingPEbyexpectedgrowthdoesnotneutralizetheeffectsofexpectedgrowth,sincetherelationshipbetweengrowthandvalueisnotlinearandfairlycomplex(evenina2-stagemodel)

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ASimpleExample

¨ AssumethatyouhavebeenaskedtoestimatethePEGratioforafirmwhichhasthefollowingcharacteristics:

Variable HighGrowthPhase StableGrowthPhaseExpectedGrowthRate 25% 8%PayoutRatio 20% 50%Beta 1.00 1.00¨ Riskfree rate=T.Bond Rate=6%¨ Requiredrateofreturn=6%+1(5.5%)=11.5%¨ ThePEGratioforthisfirmcanbeestimatedasfollows:

PEG =0.2 * (1.25) * 1− (1.25)5

(1.115)5

"

#$

%

&'

.25(.115 - .25)+ 0.5 * (1.25)5*(1.08)

.25(.115-.08) (1.115)5 = 115 or 1.15

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PEGRatiosandRisk

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PEGRatiosandQualityofGrowth

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PERatiosandExpectedGrowth

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PEGRatiosandFundamentals:Propositions

¨ Proposition1:HighriskcompanieswilltradeatmuchlowerPEGratiosthanlowriskcompanieswiththesameexpectedgrowthrate.¤ Corollary1:ThecompanythatlooksmostundervaluedonaPEGratio

basisinasectormaybetheriskiestfirminthesector¨ Proposition2:Companiesthatcanattaingrowthmoreefficiently

byinvestinglessinbetterreturnprojectswillhavehigherPEGratiosthancompaniesthatgrowatthesameratelessefficiently.¤ Corollary2:CompaniesthatlookcheaponaPEGratiobasismaybe

companieswithhighreinvestmentratesandpoorprojectreturns.¨ Proposition3:Companieswithveryloworveryhighgrowthrates

willtendtohavehigherPEGratiosthanfirmswithaveragegrowthrates.Thisbiasisworseforlowgrowthstocks.¤ Corollary3:PEGratiosdonotneutralizethegrowtheffect.

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III.PricetoBookRatio

¨ Goingbacktoasimpledividenddiscountmodel,

¨ Definingthereturnonequity(ROE)=EPS0/BookValueofEquity,thevalueofequitycanbewrittenas:

¨ Ifthereturnonequityisbaseduponexpectedearningsinthenexttimeperiod,thiscanbesimplifiedto,

P0 =DPS1r −gn

P0 = BV0*ROE*Payout Ratio*(1+gn )r-gn

P0

BV0

= PBV= ROE*Payout Ratio*(1+gn )r-gn

P0

BV0

= PBV= ROE*Payout Ratior-gnAswath Damodaran

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PriceBookValueRatio:StableGrowthFirmAnotherPresentation

¨ Thisformulationcanbesimplifiedevenfurtherbyrelatinggrowthtothereturnonequity:

g=(1- Payoutratio)*ROE¨ SubstitutingbackintotheP/BVequation,

¨ Theprice-bookvalueratioofastablefirmisdeterminedbythedifferentialbetweenthereturnonequityandtherequiredrateofreturnonitsprojects.

¨ Buildingonthisequation,acompanythatisexpectedtogenerateaROEhigher(lowerthan,equalto)itscostofequityshouldtradeatapricetobookratiohigher(lessthan,equalto)one.

P0

BV0

= PBV= ROE - gn

r-gn

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NowchangingtoanEnterprisevaluemultipleEV/BookCapital

¨ Toseethedeterminantsofthevalue/bookratio,considerthesimplefreecashflowtothefirmmodel:

¨ Dividingbothsidesbythebookvalue,weget:

¨ Ifwereplace,FCFF=EBIT(1-t)- (g/ROC)EBIT(1-t),weget:

V0 = FCFF1 WACC - g

V0

BV= FCFF1/BV

WACC-g

V0

BV= ROC - g

WACC-g

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IV.EVtoEBITDA- Determinants

¨ Thevalueoftheoperatingassetsofafirmcanbewrittenas:

¨ Nowthevalueofthefirmcanberewrittenas

¨ DividingbothsidesoftheequationbyEBITDA,

¨ ThedeterminantsofEV/EBITDAare:¤ Thecostofcapital¤ Expectedgrowthrate¤ Taxrate¤ Reinvestmentrate(orROC)

€

EV0 = FCFF1 WACC - g

€

EV = EBITDA (1- t) + Depr (t) - Cex - Δ Working Capital

WACC - g

€

EVEBITDA

= (1- t)

WACC - g +

Depr (t)/EBITDAWACC - g

- CEx/EBITDA

WACC - g -

Δ Working Capital/EBITDAWACC - g

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ASimpleExample

¨ Considerafirmwiththefollowingcharacteristics:¤ TaxRate=36%¤ CapitalExpenditures/EBITDA=30%¤ Depreciation/EBITDA=20%¤ CostofCapital=10%¤ Thefirmhasnoworkingcapitalrequirements¤ Thefirmisinstablegrowthandisexpectedtogrow5%ayearforever.

¨ Inthiscase,theValue/EBITDAmultipleforthisfirmcanbeestimatedasfollows:

ValueEBITDA

= (1- .36) .10 -.05

+ (0.2)(.36).10 -.05

- 0.3.10 - .05

- 0.10 - .05

= 8.24

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TheDeterminantsofEV/EBITDA

¨TaxRates Reinvestment

Needs

ExcessReturns

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V.EV/SalesRatio

¨ Ifpre-taxoperatingmarginsareused,theappropriatevalueestimateisthatofthefirm.Inparticular,ifonemakesthereplacestheFCFFwiththeexpandedversion:¤ FreeCashFlowtotheFirm=EBIT(1- taxrate)(1- ReinvestmentRate)

¨ ThentheValueoftheFirmcanbewrittenasafunctionoftheafter-taxoperatingmargin=(EBIT(1-t)/Sales

g=Growthrateinafter-taxoperatingincomeforthefirstnyearsgn=Growthrateinafter-taxoperatingincomeafternyearsforever(Stablegrowthrate)RIRGrowth,Stable=ReinvestmentrateinhighgrowthandstableperiodsWACC=Weightedaveragecostofcapital

Value Sales0

=After-tax Oper. Margin*(1-RIRgrowth )(1+g)* 1− (1+g)n

(1+WACC)n

"

#$

%

&'

WACC-g+ (1-RIRstable )(1+g)n*(1+gn )

(WACC-gn )(1+WACC)n

(

)

****

+

,

----

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Thevalueofabrandname

¨ Oneofthecritiquesoftraditionalvaluationisthatisfailstoconsiderthevalueofbrandnamesandotherintangibles.

¨ Theapproachesusedbyanalyststovaluebrandnamesareoftenad-hocandmaysignificantlyoverstateorunderstatetheirvalue.

¨ Oneofthebenefitsofhavingawell-knownandrespectedbrandnameisthatfirmscanchargehigherpricesforthesameproducts,leadingtohigherprofitmarginsandhencetohigherprice-salesratiosandfirmvalue.Thelargerthepricepremiumthatafirmcancharge,thegreateristhevalueofthebrandname.

¨ Ingeneral,thevalueofabrandnamecanbewrittenas:¤ Valueofbrandname={(V/S)b-(V/S)g }*Sales¤ (V/S)b =ValueofFirm/Salesratiowiththebenefitofthebrandname¤ (V/S)g =ValueofFirm/Salesratioofthefirmwiththegenericproduct

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ValuingBrandName

CocaCola WithCott MarginsCurrentRevenues= $21,962.00 $21,962.00Lengthofhigh-growthperiod 10 10ReinvestmentRate= 50% 50%OperatingMargin(after-tax) 15.57% 5.28%Sales/Capital(Turnoverratio) 1.34 1.34Returnoncapital(after-tax) 20.84% 7.06%Growthrateduringperiod(g)= 10.42% 3.53%CostofCapitalduringperiod= 7.65% 7.65%StableGrowthPeriodGrowthrateinsteadystate= 4.00% 4.00%Returnoncapital= 7.65% 7.65%ReinvestmentRate= 52.28% 52.28%CostofCapital= 7.65% 7.65%ValueofFirm= $79,611.25 $15,371.24

Valueofbrandname=$79,611-$15,371=$64,240million

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TheDeterminantsofMultiples…

Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio (1+g)/(r-g)

PEG=Payout ratio (1+g)/g(r-g)

PBV=ROE (Payout ratio) (1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF 1/(WACC -g)

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

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ApplicationTests

¨ Giventhefirmthatwearevaluing,whatisa“comparable” firm?¤ Whiletraditionalanalysisisbuiltonthepremisethatfirmsinthesamesectorarecomparablefirms,valuationtheorywouldsuggestthatacomparablefirmisonewhichissimilartotheonebeinganalyzedintermsoffundamentals.

¤ Proposition4:Thereisnoreasonwhyafirmcannotbecomparedwithanotherfirminaverydifferentbusiness,ifthetwofirmshavethesamerisk,growthandcashflowcharacteristics.

¨ Giventhecomparablefirms,howdoweadjustfordifferencesacrossfirmsonthefundamentals?¤ Proposition5:Itisimpossibletofindanexactlyidenticalfirmtotheoneyouarevaluing.

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Valuingonecompanyrelativetoothers…Relativevaluationwithcomparables

¨ Ideally,youwouldliketofindlotsofpubliclytradedfirmsthatlookjustlikeyourfirm,intermsoffundamentals,andcomparethepricingofyourfirmtothepricingoftheseotherpubliclytradedfirms.Since,theyarealljustlikeyourfirm,therewillbenoneedtocontrolfordifferences.

¨ Inpractice,itisverydifficult(andperhapsimpossible)tofindfirmsthatsharethesamerisk,growthandcashflowcharacteristicsofyourfirm.Evenifyouareabletofindsuchfirms,theywillveryfewinnumber.Thetradeoffthenbecomes:

Small sample of firms that are “just like” your firm

Large sample of firms that are similar in some dimensions but different on others

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Techniquesforcomparingacrossfirms

1. Directcomparisons:Ifthecomparablefirmsare“justlike” yourfirm,youcancomparemultiplesdirectlyacrossthefirmsandconcludethatyourfirmisexpensive(cheap)ifittradesatamultiplehigher(lower)thantheotherfirms.

2. Storytelling:Ifthereisakeydimensiononwhichthefirmsvary,youcantellastorybaseduponyourunderstandingofhowvaluevariesonthatdimension.Anexample:Thiscompanytradesat12timesearnings,whereastherestofthesectortradesat10timesearnings,butIthinkitischeapbecauseithasamuchhighergrowthratethantherestofthesector.

3. Modifiedmultiple:Youcanmodifythemultipletoincorporatethedimensiononwhichtherearedifferencesacrossfirms.

4. Statisticaltechniques:Ifyourfirmsvaryonmorethanonedimension,youcantryusingmultipleregressions(orvariantsthereof)toarriveata“controlled” estimateforyourfirm.

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Example1:Let’strysomestorytellingComparingPEratiosacrossfirmsinasector

CompanyName TrailingPE ExpectedGrowth StandardDeviationCoca-ColaBottling 29.18 9.50% 20.58%MolsonInc.Ltd.'A' 43.65 15.50% 21.88%Anheuser-Busch 24.31 11.00% 22.92%CorbyDistilleriesLtd. 16.24 7.50% 23.66%Chalone WineGroup 21.76 14.00% 24.08%AndresWinesLtd.'A'8.96 3.50% 24.70%Todhunter Int'l 8.94 3.00% 25.74%Brown-Forman'B'10.07 11.50% 29.43%Coors(Adolph)'B' 23.02 10.00% 29.52%PepsiCo,Inc. 33.00 10.50% 31.35%Coca-Cola 44.33 19.00% 35.51%BostonBeer'A' 10.59 17.13% 39.58%WhitmanCorp. 25.19 11.50% 44.26%Mondavi (Robert)'A'16.47 14.00% 45.84%Coca-ColaEnterprises37.14 27.00% 51.34%HansenNaturalCorp9.70 17.00% 62.45%

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AQuestion

¨ Youarereadinganequityresearchreportonthissector,andtheanalystclaimsthatAndresWineandHansenNaturalareundervaluedbecausetheyhavelowPEratios.Wouldyouagree?a. Yesb. No

¨ Whyorwhynot?

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Example2:Fact-basedstorytellingComparingPERatiosacrossaSector:PE

Company Name PE GrowthPT Indosat ADR 7.8 0.06Telebras ADR 8.9 0.075Telecom Corporation of New Zealand ADR 11.2 0.11Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08Hellenic Telecommunication Organization SA ADR 12.8 0.12Telecomunicaciones de Chile ADR 16.6 0.08Swisscom AG ADR 18.3 0.11Asia Satellite Telecom Holdings ADR 19.6 0.16Portugal Telecom SA ADR 20.8 0.13Telefonos de Mexico ADR L 21.1 0.14Matav RT ADR 21.5 0.22Telstra ADR 21.7 0.12Gilat Communications 22.7 0.31Deutsche Telekom AG ADR 24.6 0.11British Telecommunications PLC ADR 25.7 0.07Tele Danmark AS ADR 27 0.09Telekomunikasi Indonesia ADR 28.4 0.32Cable & Wireless PLC ADR 29.8 0.14APT Satellite Holdings ADR 31 0.33Telefonica SA ADR 32.5 0.18Royal KPN NV ADR 35.7 0.13Telecom Italia SPA ADR 42.2 0.14Nippon Telegraph & Telephone ADR 44.3 0.2France Telecom SA ADR 45.2 0.19Korea Telecom ADR 71.3 0.44

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PE,GrowthandRisk

Dependentvariableis: PERsquared=66.2%Rsquared(adjusted)=63.1%

Variable Coefficient SE t-ratio ProbabilityConstant 13.1151 3.471 3.78 0.0010Growthrate121.223 19.27 6.29 ≤0.0001EmergingMarket -13.8531 3.606 -3.84 0.0009

EmergingMarketisadummy: 1ifemergingmarket0ifnot

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IsTelebrasundervalued?

¨ PredictedPE=13.12+121.22(.075)- 13.85(1)=8.35

¨ Atanactualpricetoearningsratioof8.9,Telebrasisslightlyovervalued.

¨ Bottomline:JustbecauseacompanytradesatalowPEratiodoesnotmakeitcheap.

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Example3:AnEyeballingExercisewithP/BVRatiosEuropeanBanksin2010

Name PBV Ratio Return on Equity Standard DeviationBAYERISCHE HYPO-UND VEREINSB 0.80 -1.66% 49.06%COMMERZBANK AG 1.09 -6.72% 36.21%DEUTSCHE BANK AG -REG 1.23 1.32% 35.79%BANCA INTESA SPA 1.66 1.56% 34.14%BNP PARIBAS 1.72 12.46% 31.03%BANCO SANTANDER CENTRAL HISP 1.86 11.06% 28.36%SANPAOLO IMI SPA 1.96 8.55% 26.64%BANCO BILBAO VIZCAYA ARGENTA 1.98 11.17% 18.62%SOCIETE GENERALE 2.04 9.71% 22.55%ROYAL BANK OF SCOTLAND GROUP 2.09 20.22% 18.35%HBOS PLC 2.15 22.45% 21.95%BARCLAYS PLC 2.23 21.16% 20.73%UNICREDITO ITALIANO SPA 2.30 14.86% 13.79%KREDIETBANK SA LUXEMBOURGEOI 2.46 17.74% 12.38%ERSTE BANK DER OESTER SPARK 2.53 10.28% 21.91%STANDARD CHARTERED PLC 2.59 20.18% 19.93%HSBC HOLDINGS PLC 2.94 18.50% 19.66%LLOYDS TSB GROUP PLC 3.33 32.84% 18.66%Average 2.05 12.54% 24.99%Median 2.07 11.82% 21.93%

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Themediantest…

¨ Wearelookingforstocksthattradeatlowpricetobookratios,whilegeneratinghighreturnsonequity,withlowrisk.Butwhatisalowpricetobookratio?Orahighreturnonequity?Oralowrisk

¨ Onesimplemeasureofwhatisparforthesectorarethemedianvaluesforeachofthevariables.Asimplisticdecisionruleonunderandovervaluedstockswouldthereforebe:¤ Undervaluedstocks:Tradeatpricetobookratiosbelowthemedianfor

thesector,(2.07),generatereturnsonequityhigherthanthesectormedian(11.82%)andhavestandarddeviationslowerthanthemedian(21.93%).

¤ Overvaluedstocks:Tradeatpricetobookratiosabovethemedianforthesectorandgeneratereturnsonequitylowerthanthesectormedian.

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Howaboutthismechanism?

¨ Wearelookingforstocksthattradeatlowpricetobookratios,whilegeneratinghighreturnsonequity.Butwhatisalowpricetobookratio?Orahighreturnonequity?

¨ Takingthesampleof18banks,weranaregressionofPBVagainstROEandstandarddeviationinstockprices(asaproxyforrisk).

PBV= 2.27 + 3.63ROE - 2.68Std dev(5.56) (3.32) (2.33)

Rsquaredofregression=79%

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Andthesepredictions?

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AfollowuponUSBanks

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Example4:AlargersamplePricetoBookversusROE:LargestfirmsintheUS:January2010

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Missinggrowth?

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PBV,ROEandRisk:LargeCapUSfirms

Cheapest

Most overvalued

Most undervalued

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Bringingitalltogether…LargestUSstocksinJanuary2010

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UpdatedPBVRatios– LargestMarketCapUScompaniesUpdatedtoJanuary2015

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Example5:Overlookedfundamentals?EV/EBITDAMultipleforTruckingCompanies

Company Name Value EBITDA Value/EBITDAKLLM Trans. Svcs. 114.32$ 48.81$ 2.34Ryder System 5,158.04$ 1,838.26$ 2.81Rollins Truck Leasing 1,368.35$ 447.67$ 3.06Cannon Express Inc. 83.57$ 27.05$ 3.09Hunt (J.B.) 982.67$ 310.22$ 3.17Yellow Corp. 931.47$ 292.82$ 3.18Roadway Express 554.96$ 169.38$ 3.28Marten Transport Ltd. 116.93$ 35.62$ 3.28Kenan Transport Co. 67.66$ 19.44$ 3.48M.S. Carriers 344.93$ 97.85$ 3.53Old Dominion Freight 170.42$ 45.13$ 3.78Trimac Ltd 661.18$ 174.28$ 3.79Matlack Systems 112.42$ 28.94$ 3.88XTRA Corp. 1,708.57$ 427.30$ 4.00Covenant Transport Inc 259.16$ 64.35$ 4.03Builders Transport 221.09$ 51.44$ 4.30Werner Enterprises 844.39$ 196.15$ 4.30Landstar Sys. 422.79$ 95.20$ 4.44AMERCO 1,632.30$ 345.78$ 4.72USA Truck 141.77$ 29.93$ 4.74Frozen Food Express 164.17$ 34.10$ 4.81Arnold Inds. 472.27$ 96.88$ 4.87Greyhound Lines Inc. 437.71$ 89.61$ 4.88USFreightways 983.86$ 198.91$ 4.95Golden Eagle Group Inc. 12.50$ 2.33$ 5.37Arkansas Best 578.78$ 107.15$ 5.40Airlease Ltd. 73.64$ 13.48$ 5.46Celadon Group 182.30$ 32.72$ 5.57Amer. Freightways 716.15$ 120.94$ 5.92Transfinancial Holdings 56.92$ 8.79$ 6.47Vitran Corp. 'A' 140.68$ 21.51$ 6.54Interpool Inc. 1,002.20$ 151.18$ 6.63Intrenet Inc. 70.23$ 10.38$ 6.77Swift Transportation 835.58$ 121.34$ 6.89Landair Services 212.95$ 30.38$ 7.01CNF Transportation 2,700.69$ 366.99$ 7.36Budget Group Inc 1,247.30$ 166.71$ 7.48Caliber System 2,514.99$ 333.13$ 7.55Knight Transportation Inc 269.01$ 28.20$ 9.54Heartland Express 727.50$ 64.62$ 11.26Greyhound CDA Transn Corp 83.25$ 6.99$ 11.91Mark VII 160.45$ 12.96$ 12.38Coach USA Inc 678.38$ 51.76$ 13.11US 1 Inds Inc. 5.60$ (0.17)$ NA

Average 5 .61

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ATestonEBITDA

¨ RyderSystemlooksverycheaponaValue/EBITDAmultiplebasis,relativetotherestofthesector.Whatexplanation(otherthanmisvaluation)mighttherebeforthisdifference?

¨ WhatgenerallessonswouldyoudrawfromthisontheEV/EBITDAmultiplesforinfrastructurecompaniesastheirinfrastructureages?

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Example6:RelativevaluationacrosstimePricetoSalesMultiples:GroceryStores- USinJanuary2007

Net Margin

543210-1-2-3

PS_R

ATIO

1 .6

1.4

1.2

1.0

.8

.6

.4

.2

0.0

-.2 Rsq = 0.5947

WFMI

ARD

RDKSWYWMK

AHOOATS

PTMKMARSA

Whole Foods: In 2007: Net Margin was 3.41% and Price/ Sales ratio was 1.41Predicted Price to Sales = 0.07 + 10.49 (0.0341) = 0.43

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Reversiontonormalcy:GroceryStores- USinJanuary2009

Whole Foods: In 2009, Net Margin had dropped to 2.77% and Price to Sales ratio was down to 0.31.

Predicted Price to Sales = 0.07 + 10.49 (.0277) = 0.36

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Andagainin2010..

Whole Foods: In 2010, Net Margin had dropped to 1.44% and Price to Sales ratio increased to 0.50.Predicted Price to Sales = 0.06 + 11.43 (.0144) = 0.22

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Hereis2011…

PS Ratio= - 0.585 + 55.50 (Net Margin) R2= 48.2%PS Ratio for WFMI = -0.585 + 55.50 (.0273) = 0.93At a PS ratio of 0.98, WFMI is slightly over valued.

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GroceryStores:January2015

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PS = 0.557 + 0.085 Net MarginWhole Foods = 0.557 + 8.50 (0.0408) = 0.90At 1.35 times sales, Whole Foods is overvalued (again)

There is a new star in town (Sprouts)

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Example7:DesperationTimeNothing’sworking!!!InternetStocksinearly2000..

ROWEGSVIPPODTURF BUYX ELTXGEEKRMIIFATB TMNTONEM ABTL INFO ANETITRAIIXLBIZZ EGRPACOMALOYBIDSSPLN EDGRPSIX ATHY AMZN

CLKS PCLNAPNT SONENETO

CBIS NTPACSGPINTW RAMP

DCLKCNETATHMMQST FFIV

SCNT MMXIINTM

SPYGLCOS

PKSI

-0

10

20

30

-0.8 -0.6 -0.4 -0.2

AdjMargin

AdjPS

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PSRatiosandMarginsarenothighlycorrelated

¨ RegressingPSratiosagainstcurrentmarginsyieldsthefollowingPS=81.36 - 7.54(NetMargin) R2=0.04

(0.49)

¨ Thisisnotsurprising.Thesefirmsarepricedbaseduponexpectedmargins,ratherthancurrentmargins.

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Solution1:Useproxiesforsurvivalandgrowth:Amazoninearly2000

¨ Hypothesizingthatfirmswithhigherrevenuegrowthandhighercashbalancesshouldhaveagreaterchanceofsurvivingandbecomingprofitable,weranthefollowingregression:(Thelevelofrevenueswasusedtocontrolforsize)

PS=30.61- 2.77ln(Rev)+6.42(RevGrowth)+5.11(Cash/Rev)(0.66) (2.63) (3.49)

Rsquared=31.8%¨ PredictedPS=30.61- 2.77(7.1039)+6.42(1.9946)+5.11

(.3069)=30.42¨ ActualPS=25.63

Stockisundervalued,relativetootherinternetstocks.

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Solution2:UseforwardmultiplesWatchoutforbumpsintheroad(Tesla)

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Solution3:Letthemarkettellyouwhatmatters..SocialmediainOctober2013

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Company MarketCapEnterprisevalue Revenues EBITDA NetIncome

Numberofusers(millions) EV/User EV/Revenue EV/EBITDA PE

Facebook $173,540.00 $160,090.00 $7,870.00 $3,930.00 $1,490.00 1230.00 $130.15 20.34 40.74 116.47Linkedin $23,530.00 $19,980.00 $1,530.00 $182.00 $27.00 277.00 $72.13 13.06 109.78 871.48Pandora $7,320.00 $7,150.00 $655.00 -$18.00 -$29.00 73.40 $97.41 10.92 NA NAGroupon $6,690.00 $5,880.00 $2,440.00 $125.00 -$95.00 43.00 $136.74 2.41 47.04 NANetflix $25,900.00 $25,380.00 $4,370.00 $277.00 $112.00 44.00 $576.82 5.81 91.62 231.25Yelp $6,200.00 $5,790.00 $233.00 $2.40 -$10.00 120.00 $48.25 24.85 2412.50 NAOpenTable $1,720.00 $1,500.00 $190.00 $63.00 $33.00 14.00 $107.14 7.89 23.81 52.12Zynga $4,200.00 $2,930.00 $873.00 $74.00 -$37.00 27.00 $108.52 3.36 39.59 NAZillow $3,070.00 $2,860.00 $197.00 -$13.00 -$12.45 34.50 $82.90 14.52 NA NATrulia $1,140.00 $1,120.00 $144.00 -$6.00 -$18.00 54.40 $20.59 7.78 NA NATripadvisor $13,510.00 $12,860.00 $945.00 $311.00 $205.00 260.00 $49.46 13.61 41.35 65.90

Average $130.01 11.32 350.80 267.44Median $97.41 10.92 44.20 116.47

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Readthetealeaves:Seewhatthemarketcaresabout

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Market Cap

Enterprise value Revenues EBITDA

Net Income

Number of users (millions)

Market Cap 1.

Enterprise value 0.9998 1.

Revenues 0.8933 0.8966 1.

EBITDA 0.9709 0.9701 0.8869 1.

Net Income 0.8978 0.8971 0.8466 0.9716 1.

Number of users (millions) 0.9812 0.9789 0.8053 0.9354 0.8453 1.

Twitter had 240 million users at the time of its IPO. What price would you attach to the company?

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Relativevaluationacrosstheentiremarket:Whynot?

¨ Incontrasttothe'comparablefirm'approach,theinformationintheentirecross-sectionoffirmscanbeusedtopredictPEratios.

¨ Thesimplestwayofsummarizingthisinformationiswithamultipleregression,withthePEratioasthedependentvariable,andproxiesforrisk,growthandpayoutformingtheindependentvariables.

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I.PERatioversusthemarketPEversusExpectedEPSGrowth:January2016

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PERatio:StandardRegressionforUSstocks-January2016

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The regression is run with growth and payout entered as decimals, i.e., 25% is entered as 0.25)

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Problemswiththeregressionmethodology

¨ ThebasicregressionassumesalinearrelationshipbetweenPEratiosandthefinancialproxies,andthatmightnotbeappropriate.

¨ ThebasicrelationshipbetweenPEratiosandfinancialvariablesitselfmightnotbestable,andifitshiftsfromyeartoyear,thepredictionsfromthemodelmaynotbereliable.

¨ Theindependentvariablesarecorrelatedwitheachother.Forexample,highgrowthfirmstendtohavehighrisk.Thismulti-collinearitymakesthecoefficientsoftheregressionsunreliableandmayexplainthelargechangesinthesecoefficientsfromperiodtoperiod.

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TheMulticollinearityProblem

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UsingthePEratioregression

¨ AssumethatyouweregiventhefollowinginformationforDisney.Thefirmhasanexpectedgrowthrateof15%,abetaof1.25anda20%dividendpayoutratio.Basedupontheregression,estimatethepredictedPEratioforDisney.¤ PredictedPE=8.76-4.08Beta+75.24Growth+19.73(Payout)

¨ Disneyisactuallytradingat20timesearnings.WhatdoesthepredictedPEtellyou?

¨ AssumenowthatyouvalueDisneyagainstjustitspeergroup.Willyoucometothesamevaluationjudgmentasyoudidwhenyoulookedatitrelativetothemarket?Whyorwhynot?

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Thevalueofgrowth

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Date Marketpriceofextra%growth ImpliedERP

Jan-16 0.75 6.12%Jan-15 0.99 5.78%Jan-14 1.49 4.96%Jan-13 0.577 5.78%Jan-12 0.408 6.04%Jan-11 0.836 5.20%Jan-10 0.55 4.36%Jan-09 0.78 6.43%Jan-08 1.427 4.37%Jan-07 1.178 4.16%Jan-06 1.131 4.07%Jan-05 0.914 3.65%Jan-04 0.812 3.69%Jan-03 2.621 4.10%Jan-02 1.003 3.62%Jan-01 1.457 2.75%Jan-00 2.105 2.05%

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II.PEGRatioversusthemarketPEGversusGrowth

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PEGversusln(ExpectedGrowth)

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PEGRatioRegression- USstocksJanuary2016

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Negativeintercepts…andproblemforecasts..

¨ Whentheinterceptinamultiplesregressionisnegative,thereisthepossibilitythatforecastedvaluescanbenegativeaswell.Oneway(albeitimperfect)istore-runtheregressionwithoutanintercept.

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I.PEratioregressionsacrossmarkets–January2016

Region Regression – January 2016 R2

US PE = 8.76 + 75.24 gEPS + 19.73 Payout – 4.08 Beta 40.5%

Europe PE = 13.43 + 54.46 gEPS + 17.63 Payout - 4.16 Beta 24.7%

Japan PE = 20.10+ 26.46 gEPS + 24.87 Payout – 7.60 Beta 28.4%

Emerging Markets

PE = 15.13 + 40.99 gEPS + 9.03 Payout - 2.14 Beta 11.5%

Australia, NZ, Canada

PE = 7.31 + 73.42 gEPS + 13.94 Payout – 3.73 Beta 26.8%

Global PE = 12.51 + 87.48 gEPS + 11.48 Payout - 3.96 Beta 27.5%

gEPS=Expected Growth: Expected growth in EPS or Net Income: Next 5 yearsBeta: Regression or Bottom up BetaPayout ratio: Dividends/ Net income from most recent year. Set to zero, if net income < 0

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II.PricetoBookRatio:Fundamentalsholdineverymarket

Region Regression – January 2016 R2

US PBV= -1.68 + 14.59 gEPS – 0.99 Beta + 3.79 Payout + 19.58 ROE 50.2%

Europe PBV = 2.66 + 6.30 gEPS – 1.40 Beta + 9.39 ROE + 1.80 Payout 40.6%

Japan PBV= 2.01 + 2.15 gEPS – 1.18 Beta + 0.97 Payout + 8.28 ROE 29.1%

Emerging Markets

PBV= -0.43 + 2.71 gEPS - 0.74 Beta + 2.48 Payout + 18.91 ROE 34.1%

Australia, NZ, Canada

PBV= -1.20 + 8.97 gEPS - 0.69 Beta + 1.01 Payout + 21.90 ROE 55.4%

Global PBV= 0.22 + 5.41 gEPS - 0.95 Beta + 2.68 Payout +16.09 ROE 43.1%

gEPS=Expected Growth: Expected growth in EPS/ Net Income: Next 5 yearsBeta: Regression or Bottom up BetaPayout ratio: Dividends/ Net income from most recent year. Set to zero, if net income < 0ROE: Net Income/ Book value of equity in most recent year.

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III.EV/EBITDA– January2016

Region Regression – January 2016 R squared

United States EV/EBITDA= 19.54 + 3.64 g - 1.97 WACC – 12.71 DFR – 3.30 Tax Rate

2.3%

Europe EV/EBITDA= 17.28 + 18.82 g - 17.94 WACC – 7.55 DFR –9.10 Tax Rate

9.0%

Japan EEV/EBITDA= 22.49 + 1.75 g - 79.45 WACC – 6.03 DFR –19.00 Tax Rate

%

Emerging Markets

EV/EBITDA= 50.71 + 9.57 g - 212.55 WACC – 18.27 DFR –21.40 Tax Rate

5.9%

Australia, NZ & Canada

EV/EBITDA= 25.86+ 10.10 g - 162.14 WACC – 1.41 DFR –10.50 Tax Rate

8.6%

Global EV/EBITDA= 27.42 + 6.90 g -55.15 WACC – 12.03 DFR –16.20 Tax Rate

3.7%

g = Expected Revenue Growth: Expected growth in revenues: Near term (2 or 5 years)DFR = Debt Ratio : Total Debt/ (Total Debt + Market value of equity)Tax Rate: Effective tax rate in most recent year WACC = Cost of capital (in US$)

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IV.EV/SalesRegressionsacrossmarkets…

Region Regression – January 2016 R SquaredUnited States EV/Sales = 7.42 + 2.47 g+ 2.96 Operating Margin – 2.20

DFR- 9.90 Tax rate10.1%

Europe EV/Sales = -0.89 + 9.81 g+ 14.63 Operating Margin + 14.91 DFR- 6.10 Tax rate

31.4%

Japan EV/Sales = 2.02 - 0.48 g+ 8.73 Operating Margin +2.50 DFR- 5.00 Tax rate

13.6%

Emerging Markets

EV/Sales = 5.66 + 5.05 g+ 7.86 Operating Margin -0.55 DFR- 9.80 Tax rate

14.3%

Australia, NZ & Canada

EV/Sales = -0.35 + 12.03 g+ 5.34 Operating Margin + 13.95 DFR- 2.60 Tax rate

36.3%

Global EV/Sales =4.73+ 3.53 g+ 6.92 Op. Margin + 3.83 DFR- 9.20 Tax rate

11.5%

g =Expected Revenue Growth: Expected growth in revenues: Near term (2 or 5 years)ERP: ERP for country in which company is incorporatedTax Rate: Effective tax rate in most recent year; Operating Margin: Operating Income/ Sales

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RelativeValuation:Someclosingpropositions

¨ Proposition1:Inarelativevaluation,allthatyouareconcludingisthatastockisunderorovervalued,relativetoyourcomparablegroup.¤ Yourrelativevaluationjudgmentcanberightandyourstockcanbehopelesslyovervaluedatthesametime.

¨ Proposition2:Inassetvaluation,therearenosimilarassets.Everyassetisunique.¤ Ifyoudonotcontrolforfundamentaldifferencesinrisk,cashflowsandgrowthacrossfirmswhencomparinghowtheyarepriced,yourvaluationconclusionswillreflectyourflawedjudgmentsratherthanmarketmisvaluations.

¨ Bottomline:Relativevaluationispricing,notvaluation.

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ChoosingBetweentheMultiples

¨ Aspresentedinthissection,therearedozensofmultiplesthatcanbepotentiallyusedtovalueanindividualfirm.

¨ Inaddition,relativevaluationcanberelativetoasector(orcomparablefirms)ortotheentiremarket(usingtheregressions,forinstance)

¨ Sincetherecanbeonlyonefinalestimateofvalue,therearethreechoicesatthisstage:¤ Useasimpleaverageofthevaluationsobtainedusinganumberof

differentmultiples¤ Useaweightedaverageofthevaluationsobtainedusinganmberof

differentmultiples¤ Chooseoneofthemultiplesandbaseyourvaluationonthatmultiple

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PickingoneMultiple

¨ Thisisusuallythebestwaytoapproachthisissue.Whilearangeofvaluescanbeobtainedfromanumberofmultiples,the“bestestimate” valueisobtainedusingonemultiple.

¨ Themultiplethatisusedcanbechoseninoneoftwoways:¤ Usethemultiplethatbestfitsyourobjective.Thus,ifyouwantthe

companytobeundervalued,youpickthemultiplethatyieldsthehighestvalue.

¤ UsethemultiplethathasthehighestR-squaredinthesectorwhenregressedagainstfundamentals.Thus,ifyouhavetriedPE,PBV,PS,etc.andrunregressionsofthesemultiplesagainstfundamentals,usethemultiplethatworksbestatexplainingdifferencesacrossfirmsinthatsector.

¤ Usethemultiplethatseemstomakethemostsenseforthatsector,givenhowvalueismeasuredandcreated.

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AMoreIntuitiveApproach

¨ Managersineverysectortendtofocusonspecificvariableswhenanalyzingstrategyandperformance.Themultipleusedwillgenerallyreflectthisfocus.Considerthreeexamples.¤ Inretailing:Thefocusisusuallyonsamestoresales(turnover)andprofitmargins.Notsurprisingly,therevenuemultipleismostcommoninthissector.

¤ Infinancialservices:Theemphasisisusuallyonreturnonequity.BookEquityisoftenviewedasascarceresource,sincecapitalratiosarebaseduponit.Pricetobookratiosdominate.

¤ Intechnology:Growthisusuallythedominanttheme.PEGratioswereinventedinthissector.

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Conventionalusage…

Sector Multiple Used RationaleCyclical Manufacturing PE, Relative PE Often with normalized

earningsGrowth firms PEG ratio Big differences in growth

ratesYoung growth firms w/ losses

Revenue Multiples What choice do you have?

Infrastructure EV/EBITDA Early losses, big DA

REIT P/CFE (where CFE = Net income + Depreciation)

Big depreciation charges on real estate

Financial Services Price/ Book equity Marked to market?Retailing Revenue multiples Margins equalize sooner

or later

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RelativeversusIntrinsicValue

¨ Ifyoudointrinsicvalueright,youwillbringinacompany’srisk,cashflowandgrowthcharacteristicsintotheinputs,preserveinternalconsistencyandderiveintrinsicvalue.Ifyoudorelativevalueright,youwillfindtherightsetofcomparables,controlwellfordifferencesinrisk,cashflowandgrowthcharacteristics.AssumeyouvaluethesamecompanydoingbothDCFandrelativevaluationcorrectly,shouldyougetthesamevalue?¤ Yes¤ No

¨ Ifnot,howwouldyouexplainthedifference?¨ Ifthenumbersaredifferent,whichvaluewouldyouuse?

¤ Intrinsicvalue¤ Relativevalue¤ Acompositeofthetwovalues¤ Thehigherofthetwovalues¤ Thelowerofthetwovalues¤ Dependsonwhatmyvaluation“mission” is.

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Reviewing:TheFourStepstoUnderstandingMultiples

¨ Definethemultiple¤ Checkforconsistency¤ Makesurethattheyareestimateduniformly

¨ Describethemultiple¤ Multipleshaveskeweddistributions:Theaveragesareseldomgoodindicatorsoftypicalmultiples

¤ Checkforbias,ifthemultiplecannotbeestimated¨ Analyzethemultiple

¤ Identifythecompanionvariablethatdrivesthemultiple¤ Examinethenatureoftherelationship

¨ Applythemultiple

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ADETOUR:ASSETBASEDVALUATION

Valueassets,notcashflows?

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Whatisassetbasedvaluation?

¨ Inintrinsicvaluation,youvalueabusinessbaseduponthecashflowsyouexpectthatbusinesstogenerateovertime.

¨ Inrelativevaluation,youvalueabusinessbaseduponhowsimilarbusinessesarepriced.

¨ Inassetbasedvaluation,youvalueabusinessbyvaluingitsindividualassets.Theseindividualassetscanbetangibleorintangible.

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Whywouldyoudoassetbasedvaluation?

¨ Liquidation:Ifyouareliquidatingabusinessbysellingitsassetspiecemeal,ratherthanasacompositebusiness,youwouldliketoestimatewhatyouwillgetfromeachassetorassetclassindividually.

¨ Accountingmission:AsbothUSandinternationalaccountingstandardshaveturnedto“fairvalue”accounting,accountantshavebeencalledupontoredobalancesheettoreflecttheassetsattheirfairratherthanbookvalue.

¨ Sumoftheparts: Ifabusinessismadeupofindividualdivisionsorassets,youmaywanttovaluethesepartsindividuallyforoneoftwogroups:¤ Potentialacquirersmaywanttodothis,asaprecursortorestructuringthe

business.¤ Investorsmaybeinterestedbecauseabusinessthatissellingforlessthan

thesumofitspartsmaybe“cheap”.

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Howdoyoudoassetbasedvaluation?

¨ Intrinsicvalue:Estimatetheexpectedcashflowsoneachassetorassetclass,discountbackatariskadjusteddiscountrateandarriveatanintrinsicvalueforeachasset.

¨ Relativevalue:Lookforsimilarassetsthathavesoldintherecentpastandestimateavalueforeachassetinthebusiness.

¨ Accountingvalue:Youcouldusethebookvalueoftheassetasaproxyfortheestimatedvalueoftheasset.

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Whenisasset-basedvaluationeasiesttodo?

¨ Separableassets:Ifacompanyisacollectionofseparableassets(asetofrealestateholdings,aholdingcompanyofdifferentindependentbusinesses),asset-basedvaluationiseasiertodo.Iftheassetsareinterrelatedordifficulttoseparate,asset-basedvaluationbecomesproblematic.Thus,whilerealestateoralongtermlicensing/franchisingcontractmaybeeasilyvalued,brandname(whichcutsacrossassets)ismoredifficulttovalueseparately.

¨ Standaloneearnings/cashflows:Anassetismuchsimplertovalueifyoucantraceitsearnings/cashflowstoit.Itismuchmoredifficulttovaluewhenthebusinessgeneratesearnings,buttheroleofindividualassetsingeneratingtheseearningscannotbeisolated.

¨ Activemarketforsimilarassets:Ifyouplantodoarelativevaluation,itiseasierifyoucanfindanactivemarketfor“similar”assetswhichyoucandrawonfortransactionsprices.

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I.LiquidationValuation

¨ Inliquidationvaluation,youaretryingtoassesshowmuchyouwouldgetfromsellingtheassetsofthebusinesstoday,ratherthanthebusinessasagoingconcern.

¨ Consequently,itmakesmoresensetopricethoseassets(i.e.,dorelativevaluation)thanitistovaluethem(dointrinsicvaluation).Forassetsthatareseparableandtraded(example:realestate),pricingiseasytodo.Forassetsthatarenot,youoftenseebookvalueusedeitherasaproxyforliquidationvalueorasabasisforestimatingliquidationvalue.

¨ Totheextentthattheliquidationisurgent,youmayattachadiscounttotheestimatedvalue.

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II.AccountingValuation:GlimmersfromFAS157

¨ Theubiquitous“marketparticipant”:ThroughFAS157,accountantsareaskedtoattachvaluestoassets/liabilitiesthatmarketparticipantswouldhavebeenwillingtopay/receive.

¨ Tilttowardsrelativevalue:“Thedefinitionfocusesonthepricethatwouldbereceivedtoselltheassetorpaidtotransfertheliability(anexitprice),notthepricethatwouldbepaidtoacquiretheassetorreceivedtoassumetheliability(anentryprice).” Thehierarchyputs“marketprices”,ifavailableforanasset,atthetopwithintrinsicvaluebeingacceptedonlyifmarketpricesarenotaccessible.

¨ Splitmission:Whileaccountingfairvalueistitledtowardsrelativevaluation,accountantsarealsorequiredtobacktheirrelativevaluationswithintrinsicvaluations.Often,thisleadstoreverseengineering,whereaccountantsarriveatvaluesfirstanddevelopvaluationslater.

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III.Sumofthepartsvaluation

¨ Youcanvalueacompanyinpieces,usingeitherrelativeorintrinsicvaluation.Whichoneyouusewilldependonwhoyouareandyourmotivesfordoingthesumofthepartsvaluation.

¨ Ifyouarelongterm,passiveinvestorinthecompany,yourintentmaybetofindmarketmistakesthatyouhopewillgetcorrectedovertime.Ifthatisthecase,youshoulddoanintrinsicvaluationoftheindividualassets.

¨ Ifyouareanactivistinvestorthatplanstoacquirethecompanyorpushforchange,youshouldbemorefocusedonrelativevaluation,sinceyourintentistogetthecompanytosplitupandgaintheincreaseinvalue.

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Let’strythisUnitedTechnologies:RawData- 2009

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Division Business Revenues

EBITDA

Pre-tax Operating

Income Capital

Expenditures Depreciation Total Assets

Carrier Refrigeration systems $14,944 $1,510 $1,316 $191 $194 $10,810

Pratt & Whitney Defense $12,965 $2,490 $2,122 $412 $368 $9,650 Otis Construction $12,949 $2,680 $2,477 $150 $203 $7,731 UTC Fire & Security Security $6,462 $780 $542 $95 $238 $10,022 Hamilton Sundstrand Manufacturing $6,207 $1,277 $1,099 $141 $178 $8,648 Sikorsky Aircraft $5,368 $540 $478 $165 $62 $3,985

The company also had corporate expenses, unallocated to the divisions of $408 million in the most recent year.

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UnitedTechnologies:RelativeValuationMedianMultiples

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Division Business EBITDA EV/EBITDAforsector ValueofBusinessCarrier Refrigerationsystems $1,510 5.25 $7,928Pratt&Whitney Defense $2,490 8.00 $19,920Otis Construction $2,680 6.00 $16,080UTCFire&Security Security $780 7.50 $5,850HamiltonSundstrand IndustrialProducts $1,277 5.50 $7,024Sikorsky Aircraft $540 9.00 $4,860Sumofthepartsvalueforbusiness= $61,661

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UnitedTechnologies:RelativeValuationPlusScalingvariable&ChoiceofMultiples

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Division Business Revenues EBITDA Operating Income Capital Invested Carrier Refrigeration systems $14,944 $1,510 $1,316 $6,014 Pratt & Whitney Defense $12,965 $2,490 $2,122 $5,369 Otis Construction $12,949 $2,680 $2,477 $4,301 UTC Fire & Security Security $6,462 $780 $542 $5,575 Hamilton Sundstrand Industrial Products $6,207 $1,277 $1,099 $4,811 Sikorsky Aircraft $5,368 $540 $478 $2,217 Total $58,895 $9,277 $8,034 $28,287

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UnitedTechnologies:RelativeValuationSumofthePartsvalue

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Division Scaling Variable

Current value for scaling variable ROC

Operating Margin

Tax Rate Predicted Multiple

Estimated Value

Carrier EBITDA $1,510 13.57% 8.81% 38% 5.35 – 3.55 (.38) + 14.17 (.1357) =5.92 $8,944.47

Pratt & Whitney Revenues $12,965 24.51% 16.37% 38% 0.85 + 7.32 (.1637) =2.05 $26,553.29

Otis EBITDA $2,680 35.71% 19.13% 38% 3.17 – 2.87 (.38)+14.66 (.3571) =7.31 $19,601.70

UTC Fire & Security Capital $5,575 6.03% 8.39% 38% 0.55 + 8.22 (.0603) =1.05 $5,828.76 Hamilton Sundstrand Revenues $6,207 14.16% 17.71% 38% 0.51 + 6.13 (.1771) =1.59 $9,902.44 Sikorsky Capital $2,217 13.37% 8.90% 38% 0.65 + 6.98 (.1337) =1.58 $3,509.61

Sum of the parts value for operating assets = $74,230.37

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UnitedTechnologies:DCFpartsvaluationCostofcapital,bybusiness

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Division Unlevered Beta

Debt/Equity Ratio

Levered beta

Cost of equity

After-tax cost of debt

Debt to Capital

Cost of capital

Carrier 0.83 30.44% 0.97 9.32% 2.95% 23.33% 7.84% Pratt & Whitney 0.81 30.44% 0.95 9.17% 2.95% 23.33% 7.72% Otis 1.19 30.44% 1.39 12.07% 2.95% 23.33% 9.94% UTC Fire & Security 0.65 30.44% 0.76 7.95% 2.95% 23.33% 6.78% Hamilton Sundstrand 1.04 30.44% 1.22 10.93% 2.95% 23.33% 9.06% Sikorsky 1.17 30.44% 1.37 11.92% 2.95% 23.33% 9.82%

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UnitedTechnologies:DCFvaluationFundamentals,bybusiness

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Division Total Assets

Capital Invested Cap Ex

Allocated Reinvestment

Operating income after taxes

Return on capital

Reinvestment Rate

Carrier $10,810 $6,014 $191 $353 $816 13.57% 43.28% Pratt & Whitney $9,650 $5,369 $412 $762 $1,316 24.51% 57.90% Otis $7,731 $4,301 $150 $277 $1,536 35.71% 18.06% UTC Fire & Security $10,022 $5,575 $95 $176 $336 6.03% 52.27% Hamilton Sundstrand $8,648 $4,811 $141 $261 $681 14.16% 38.26% Sikorsky $3,985 $2,217 $165 $305 $296 13.37% 102.95%

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UnitedTechnologies,DCFvaluationGrowthChoices

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Division Cost of capital

Return on capital

Reinvestment Rate

Expected growth

Length of growth period

Stable growth rate

Stable ROC

Carrier 7.84% 13.57% 43.28% 5.87% 5 3% 7.84% Pratt & Whitney 7.72% 24.51% 57.90% 14.19% 5 3% 12.00% Otis 9.94% 35.71% 18.06% 6.45% 5 3% 14.00% UTC Fire & Security 6.78% 6.03% 52.27% 3.15% 0 3% 6.78% Hamilton Sundstrand 9.06% 14.16% 38.26% 5.42% 5 3% 9.06% Sikorsky 9.82% 13.37% 102.95% 13.76% 5 3% 9.82%

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UnitedTechnologies,DCFvaluationValuesoftheparts

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Business Cost of capital

PV of FCFF

PV of Terminal Value

Value of Operating Assets

Carrier 7.84% $2,190 $9,498 $11,688 Pratt & Whitney 7.72% $3,310 $27,989 $31,299 Otis 9.94% $5,717 $14,798 $20,515 UTC Fire & Security 6.78% $0 $4,953 $4,953 Hamilton Sundstrand 9.06% $1,902 $6,343 $8,245 Sikorsky 9.82% -$49 $3,598 $3,550 Sum $80,250

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UnitedTechnologies,DCFvaluationSumoftheParts

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Valueoftheparts =$80,250Valueofcorporateexpenses

=$4,587

Valueofoperatingassets(sumofpartsDCF)=$75,663Valueofoperatingassets(sumofpartsRV) =$74,230Valueofoperatingassets(companyDCF) =$71,410Enterprisevalue(basedonmarketprices) =$52,261

=Corporate ExpensesCurrent (1− t)(1+ g)

(Cost of capitalCompany − g)=408(1−.38)(1.03)(.0868−.03)

PRIVATECOMPANYVALUATION

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ProcessofValuingPrivateCompanies

¨ Theprocessofvaluingprivatecompaniesisnotdifferentfromtheprocessofvaluingpubliccompanies.Youestimatecashflows,attachadiscountratebasedupontheriskinessofthecashflowsandcomputeapresentvalue.Aswithpubliccompanies,youcaneithervalue¤ Theentirebusiness,bydiscountingcashflowstothefirmatthecostof

capital.¤ Theequityinthebusiness,bydiscountingcashflowstoequityatthe

costofequity.¨ Whenvaluingprivatecompanies,youfacetwostandard

problems:¤ Thereisnotmarketvalueforeitherdebtorequity¤ Thefinancialstatementsforprivatefirmsarelikelytogobackfewer

years,havelessdetailandhavemoreholesinthem.

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1.NoMarketValue?

¨ Marketvaluesasinputs:Sinceneitherthedebtnorequityofaprivatebusinessistraded,anyinputsthatrequirethemcannotbeestimated.1. Debtratiosforgoingfromunleveredtoleveredbetasandfor

computingcostofcapital.2. Marketpricestocomputethevalueofoptionsandwarrants

grantedtoemployees.¨ Marketvalueasoutput:Whenvaluingpubliclytradedfirms,themarketvalueoperatesasameasureofreasonableness.Inprivatecompanyvaluation,thevaluestandsalone.

¨ Marketpricebasedriskmeasures,suchasbetaandbondratings,willnotbeavailableforprivatebusinesses.

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2.CashFlowEstimationIssues

¨ Shorterhistory:Privatefirmsoftenhavebeenaroundformuchshortertimeperiodsthanmostpubliclytradedfirms.Thereisthereforelesshistoricalinformationavailableonthem.

¨ DifferentAccountingStandards:Theaccountingstatementsforprivatefirmsareoftenbasedupondifferentaccountingstandardsthanpublicfirms,whichoperateundermuchtighterconstraintsonwhattoreportandwhentoreport.

¨ Interminglingofpersonalandbusinessexpenses:Inthecaseofprivatefirms,somepersonalexpensesmaybereportedasbusinessexpenses.

¨ Separating“Salaries” from“Dividends”:Itisdifficulttotellwheresalariesendanddividendsbegininaprivatefirm,sincetheybothendupwiththeowner.

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PrivateCompanyValuation:Motivematters

¨ Youcanvalueaprivatecompanyfor¤ ‘Show’ valuations

n Curiosity:Howmuchismybusinessreallyworth?n Legalpurposes:Estatetaxanddivorcecourt

¤ Transactionvaluationsn Saleorprospectivesaletoanotherindividualorprivateentity.n Saleofonepartner’sinteresttoanothern Saletoapubliclytradedfirm

¤ Aspreludetosettingtheofferingpriceinaninitialpublicoffering¨ Youcanvalueadivisionordivisionsofapubliclytradedfirm

¤ Aspreludetoaspinoff¤ Forsaletoanotherentity¤ Todoasum-of-the-partsvaluationtodeterminewhetherafirmwillbe

worthmorebrokenuporifitisbeingefficientlyrun.

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Privatecompanyvaluations:Fourbroadscenarios

¨ Privatetoprivatetransactions:Youcanvalueaprivatebusinessforsalebyoneindividualtoanother.

¨ Privatetopublictransactions:Youcanvalueaprivatefirmforsaletoapubliclytradedfirm.

¨ PrivatetoIPO:Youcanvalueaprivatefirmforaninitialpublicoffering.

¨ PrivatetoVCtoPublic:Youcanvalueaprivatefirmthatisexpectedtoraiseventurecapitalalongthewayonitspathtogoingpublic.

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I.PrivatetoPrivatetransaction

¨ Inprivatetoprivatetransactions,aprivatebusinessissoldbyoneindividualtoanother.Therearethreekeyissuesthatweneedtoconfrontinsuchtransactions:¨ Neitherthebuyernorthesellerisdiversified.Consequently,risk

andreturnmodelsthatfocusonjusttheriskthatcannotbediversifiedawaywillseriouslyunderestimatethediscountrates.

¨ Theinvestmentisilliquid.Consequently,thebuyerofthebusinesswillhavetofactorinan“illiquiditydiscount” toestimatethevalueofthebusiness.

¨ Keypersonvalue:Theremaybeasignificantpersonalcomponenttothevalue.Inotherwords,therevenuesandoperatingprofitofthebusinessreflectnotjustthepotentialofthebusinessbutthepresenceofthecurrentowner.

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Anexample:Valuingarestaurant

¨ AssumethatyouhavebeenaskedtovalueaupscaleFrenchrestaurantforsalebytheowner(whoalsohappenstobethechef).Boththerestaurantandthechefarewellregarded,andbusinesshasbeengoodforthelast3years.

¨ Thepotentialbuyerisaformerinvestmentbanker,whotiredoftheratrace,hasdecidetocashoutallofhissavingsandusetheentireamounttoinvestintherestaurant.

¨ Youhaveaccesstothefinancialstatementsforthelast3yearsfortherestaurant.Inthemostrecentyear,therestaurantreported$1.2millioninrevenuesand$400,000inpre-taxoperatingprofit.Whilethefirmhasnoconventionaldebtoutstanding,ithasaleasecommitmentof$120,000eachyearforthenext12years.

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Pastincomestatements…

3 years ago

2 years ago Last year

Revenues $800 $1,100 $1,200 Operating at full capacity- Operating lease expense $120 $120 $120 (12 years left on the lease)

- Wages $180 $200 $200(Owner/chef does not draw salary)

- Material $200 $275 $300 (25% of revenues)- Other operating expenses $120 $165 $180 (15% of revenues)Operating income $180 $340 $400- Taxes $72 $136 $160 (40% tax rate)Net Income $108 $204 $240

All numbers are in thousands

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Step1:Estimatingdiscountrates

¨ Conventionalriskandreturnmodelsinfinancearebuiltonthepresumptionthatthemarginalinvestorsinthecompanyarediversifiedandthattheythereforecareonlyabouttheriskthatcannotbediversified.Thatriskismeasuredwithabetaorbetas,usuallyestimatedbylookingatpastpricesorreturns.

¨ Inthisvaluation,bothassumptionsarelikelytobeviolated:¤ Asaprivatebusiness,thisrestauranthasnomarketpricesorreturnstouseinestimation.

¤ Thebuyerisnotdiversified.Infact,hewillhavehisentirewealthtiedupintherestaurantafterthepurchase.

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Nomarketprice,noproblem…Usebottom-upbetastogettheunleveredbeta

¨ Theaverageunleveredbetaacross75publiclytradedrestaurantsintheUSis0.86.

¨ Acaveat:Mostofthepubliclytradedrestaurantsonthislistarefast-foodchains(McDonald’s,BurgerKing)ormassrestaurants(Applebee’s,TGIF…)Thereisanargumenttobemadethatthebetaforanupscalerestaurantismorelikelytobereflecthigh-endspecialtyretailersthanitisrestaurants.Theunleveredbetafor45high-endretailersis1.18.

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80 unitsof firm specificrisk

20 units of market risk

Private owner of businesswith 100% of your weatlthinvested in the business

Publicly traded companywith investors who are diversified

Is exposedto all the riskin the firm

Demands acost of equitythat reflects thisrisk

Eliminates firm-specific risk in portfolio

Demands acost of equitythat reflects only market risk

Market Beta measures justmarket risk

Total Beta measures all risk= Market Beta/ (Portion of the total risk that is market risk)

Private Owner versus Publicly Traded Company Perceptions of Risk in an Investment

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Estimatingatotalbeta

¨ Togetfromthemarketbetatothetotalbeta,weneedameasureofhowmuchoftheriskinthefirmcomesfromthemarketandhowmuchisfirm-specific.

¨ Lookingattheregressionsofpubliclytradedfirmsthatyieldthebottom-upbetashouldprovideananswer.¤ TheaverageR-squaredacrossthehigh-endretailerregressionsis25%.¤ Sincebetasarebasedonstandarddeviations(ratherthanvariances),

wewilltakethecorrelationcoefficient(thesquarerootoftheR-squared)asourmeasureoftheproportionoftheriskthatismarketrisk.

¨ TotalUnleveredBeta=MarketBeta/Correlationwiththemarket=1.18/0.5=2.36

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Thefinalstepinthebetacomputation:EstimateaDebttoequityratioandcostofequity

¨ Withpubliclytradedfirms,were-leverthebetausingthemarketD/Eratioforthefirm.Withprivatefirms,thisoptionisnotfeasible.Wehavetwoalternatives:¤ Assumethatthedebttoequityratioforthefirmissimilartotheaverage

marketdebttoequityratioforpubliclytradedfirmsinthesector.¤ Useyourestimatesofthevalueofdebtandequityastheweightsinthe

computation.(Therewillbeacircularreasoningproblem:youneedthecostofcapitaltogetthevaluesandthevaluestogetthecostofcapital.)

¨ Wewillassumethatthisprivatelyownedrestaurantwillhaveadebttoequityratio(14.33%)similartotheaveragepubliclytradedrestaurant(eventhoughweusedretailerstotheunleveredbeta).¤ Leveredbeta=2.36(1+(1-.4)(.1433))=2.56¤ Costofequity=4.25%+2.56(4%)=14.50%(TBondratewas4.25%atthetime;4%istheequityriskpremium)

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Estimatingacostofdebtandcapital

¨ Whilethefirmdoesnothavearatingoranyrecentbankloanstouseasreference,itdoeshaveareportedoperatingincomeandleaseexpenses(treatedasinterestexpenses)CoverageRatio=OperatingIncome/Interest(Lease)Expense

=400,000/120,000=3.33Ratingbasedoncoverageratio=BB+ Defaultspread=3.25%After-taxCostofdebt=(Riskfree rate+Defaultspread)(1– taxrate)

=(4.25%+3.25%)(1- .40)=4.50%¨ Tocomputethecostofcapital,wewillusethesameindustry

averagedebtratiothatweusedtoleverthebetas.¤Costofcapital=14.50%(100/114.33)+4.50%(14.33/114.33)=13.25%¤(Thedebttoequityratiois14.33%;thecostofcapitalisbasedonthedebttocapitalratio)

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Step2:Cleanupthefinancialstatements

Stated AdjustedRevenues $1,200 $1,200- Operating lease expenses $120 Leases are financial expenses- Wages $200 $350 ! Hire a chef for $150,000/year- Material $300 $300- Other operating expenses $180 $180Operating income $400 $370- Interest expnses $0 $69.62 7.5% of $928.23 (see below)Taxable income $400 $300.38- Taxes $160 $120.15Net Income $240 $180.23

Debt 0 $928.23 ! PV of $120 million for 12 years @7.5%

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Step3:Assesstheimpactofthe“key” person

¨ Partofthedrawoftherestaurantcomesfromthecurrentchef.Itispossible(andprobable)thatifhesellsandmoveson,therewillbeadropoffinrevenues.Ifyouarebuyingtherestaurant,youshouldconsiderthisdropoffwhenvaluingtherestaurant.Thus,if20%ofthepatronsaredrawntotherestaurantbecauseofthechef’sreputation,theexpectedoperatingincomewillbelowerifthechefleaves.¤ Adjustedoperatingincome(existingchef)=$370,000¤ Operatingincome(adjustedforchefdeparture)=$296,000

¨ Astheowner/chefoftherestaurant,whatmightyoubeabletodotomitigatethislossinvalue?

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Step4:Don’tforgetvaluationfundamentals

¨ Tocompletethevaluation,youneedtoassumeanexpectedgrowthrate.Aswithanybusiness,assumptionsaboutgrowthhavetobeconsistentwithreinvestmentassumptions.Inthelongterm,Reinvestmentrate=Expectedgrowthrate/Returnoncapital

¨ Inthiscase,wewillassumea2%growthrateinperpetuityanda20%returnoncapital.

Reinvestmentrate=g/ROC=2%/20%=10%¨ Eveniftherestaurantdoesnotgrowinsize,thisreinvestment

iswhatyouneedtomaketokeeptherestaurantbothlookinggood(remodeling)andworkingwell(newovensandappliances).

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Step5:Completethevaluation

¨ Inputstovaluation¤ AdjustedEBIT=$296,000¤ Taxrate=40%¤ Costofcapital=13.25%¤ Expectedgrowthrate=2%¤ Reinvestmentrate(RIR)=10%

¨ ValuationValueoftherestaurant=ExpectedFCFFnextyear/(Costofcapital–g)=ExpectedEBITnextyear(1- taxrate)(1- RIR)/(Costofcapital–g)

=296,000(1.02)(1-.4)(1-.10)/(.1325- .02)=$1.449million

Valueofequityinrestaurant=$1.449million- $0.928million(PVofleases)b=$0.521million

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Step6:Considertheeffectofilliquidity

¨ Inprivatecompanyvaluation,illiquidityisaconstanttheme.Allthetalk,though,seemstoleadtoaruleofthumb.Theilliquiditydiscountforaprivatefirmisbetween20-30%anddoesnotvaryacrossprivatefirms.

¨ Butilliquidityshouldvaryacross:¤ Companies:Healthierandlargercompanies,withmoreliquidassets,shouldhavesmallerdiscountsthanmoney-losingsmallerbusinesseswithmoreilliquidassets.

¤ Time:Liquidityisworthmorewhentheeconomyisdoingbadlyandcreditistoughtocomebythanwhenmarketsarebooming.

¤ Buyers:Liquidityisworthmoretobuyerswhohaveshortertimehorizonsandgreatercashneedsthanforlongerterminvestorswhodon’tneedthecashandarewillingtoholdtheinvestment.

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TheStandardApproach:Illiquiditydiscountbasedonilliquidpubliclytradedassets

¨ Restrictedstock:ThesearestockissuedbypubliclytradedcompaniestothemarketthatbypasstheSECregistrationprocessbutthestockcannotbetradedforoneyearaftertheissue.

¨ Pre-IPOtransactions:Thesearetransactionspriortoinitialpublicofferingswhereequityinvestorsintheprivatefirmbuy(sell)eachother’sstakes.

¨ Inbothcases,thediscountisestimatedthebethedifferencebetweenthemarketpriceoftheliquidassetandtheobservedtransactionpriceoftheilliquidasset.¤ DiscountRestrictedstock=Stockprice– Priceonrestrictedstockoffering

¤ DiscountIPO =IPOofferingprice– Priceonpre-IPOtransaction

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TheRestrictedStockDiscount

¨ Aggregatediscountstudies¤ Maherexaminedrestrictedstockpurchasesmadebyfourmutualfundsinthe

period1969-73andconcludedthattheytradedanaveragediscountof35.43%onpubliclytradedstockinthesamecompanies.

¤ Moroney reportedameandiscountof35%foracquisitionsof146restrictedstockissuesby10investmentcompanies,usingdatafrom1970.

¤ Inastudyofrestrictedstockofferingsfromthe1980s,Silber(1991)findsthatthemediandiscountforrestrictedstockis33.75%.

¨ Silberrelatedthesizeofthediscounttocharacteristicsoftheoffering:LN(RPRS)=4.33+0.036LN(REV)- 0.142LN(RBRT)+0.174DERN+0.332DCUST¤ RPRS=Relativepriceofrestrictedstock(topubliclytradedstock)¤ REV=Revenuesoftheprivatefirm(inmillionsofdollars)¤ RBRT=RestrictedBlockrelativetoTotalCommonStockin%¤ DERN=1ifearningsarepositive;0ifearningsarenegative;¤ DCUST=1ifthereisacustomerrelationshipwiththeinvestor;0otherwise;

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CrosssectionaldifferencesinIlliquidity:ExtendingtheSilberregression

Figure 24.1: Illiquidity Discounts: Base Discount of 25% for profitable firm with $ 10 million in revenues

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

5 10 15 20 25 30 35 40 45 50 100 200 300 400 500 1000Revenues

Dis

coun

t as %

of V

alue

Profitable firm Unprofitable firm

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TheIPOdiscount:Pricingonpre-IPOtransactions(in5monthspriortoIPO)

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The“sampling” problem

¨ WithbothrestrictedstockandtheIPOstudies,thereisasignificantsamplingbiasproblem.¤ Thecompaniesthatmakerestrictedstockofferingsarelikelytobe

small,troubledfirmsthathaverunoutofconventionalfinancingoptions.

¤ ThetypesofIPOswhereequityinvestorsselltheirstakeinthefivemonthspriortotheIPOatahugediscountarelikelytobeIPOsthathavesignificantpricinguncertaintyassociatedwiththem.

¨ Withrestrictedstock,themagnitudeofthesamplingbiaswasestimatedbycomparingthediscountonallprivateplacementstothediscountonrestrictedstockofferings.Onestudyconcludedthatthe“illiquidity” aloneaccountedforadiscountoflessthan10%(leavingthebalanceof20-25%tobeexplainedbysamplingproblems).

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Analternativeapproach:Usethewholesample¨ Alltradedassetsareilliquid.Thebidaskspread,measuringthe

differencebetweenthepriceatwhichyoucanbuyandselltheassetatthesamepointintimeistheilliquiditymeasure.

¨ Wecanregressthebid-askspread(asapercentoftheprice)againstvariablesthatcanbemeasuredforaprivatefirm(suchasrevenues,cashflowgeneratingcapacity,typeofassets,varianceinoperatingincome)andarealsoavailableforpubliclytradedfirms.

¨ Usingdatafromtheendof2000,forinstance,weregressedthebid-askspreadagainstannualrevenues,adummyvariableforpositiveearnings(DERN:0ifnegativeand1ifpositive),cashasapercentoffirmvalueandtradingvolume.Spread=0.145– 0.0022ln(AnnualRevenues)-0.015(DERN)– 0.016(Cash/FirmValue)– 0.11($Monthlytradingvolume/FirmValue)Youcouldpluginthevaluesforaprivatefirmintothisregression(withzerotradingvolume)andestimatethespreadforthefirm.

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EstimatingtheilliquiditydiscountfortherestaurantApproach used Estimated discount Value of restaurantBludgeon (Fixed discount) 25% $0.521 (1- .25) = $0.391

millionRefined Bludgeon (Fixed discount with adjustment for revenue size/ profitability)

28.75% (Silber adjustment for small revenues and positive profits to a base discount of 25%)

$0.521 (1-.2875) = $0.371 million

Bid-ask spread regression = 0.145 – 0.0022 ln (1.2) -0.015 (1) –0.016 (.05) – 0.11 (0)= 12.88%

$0.521 (1-.1288) = $0.454 million

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II.Privatecompanysoldtopubliclytradedcompany¨ Thekeydifferencebetweenthisscenarioandthepreviousscenarioisthatthesellerofthebusinessisnotdiversifiedbutthebuyeris(oratleasttheinvestorsinthebuyerare).Consequently,theycanlookatthesamefirmandseeverydifferentamountsofriskinthebusinesswiththesellerseeingmoreriskthanthebuyer.

¨ Thecashflowsmayalsobeaffectedbythefactthatthetaxratesforpubliclytradedcompaniescandivergefromthoseofprivateowners.

¨ Finally,thereshouldbenoilliquiditydiscounttoapublicbuyer,sinceinvestorsinthebuyercanselltheirholdingsinamarket.

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Revisitingthecostofequityandcapital:RestaurantValuation

Private Public

Unlevred beta 2.36 1.18

Debt to equity ratio 14.33% 14.33%

Tax rate 40% 40%

Pre-tax cost of debt 7.50% 7.50%

Levered beta 2.56 1.28

Riskfree rate 4.25% 4.25%

Equity risk premium 4% 4%

Cost of equity 14.5% 9.38%

After-tax cost of debt 4.50% 4.50%

Cost of capital 13.25% 8.76%

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Revaluingtherestauranttoa“public”buyer

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So,whatpriceshouldyouaskfor?

¨ Assumethatyourepresentthechef/owneroftherestaurantandthatyouwereaskingfora“reasonable” pricefortherestaurant.Whatwouldyouaskfor?

a. $454,000b. $1.484millionc. Somenumberinthemiddle¨ Ifitis“somenumberinthemiddle”,whatwilldetermine

whatyouwillultimatelygetforyourbusiness?

¨ Howwouldyoualtertheanalysis,ifyourbestpotentialbidderisaprivateequityorVCfundratherthanapubliclytradedfirm?

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III.Privatecompanyforinitialpublicoffering

¨ Inaninitialpublicoffering,theprivatebusinessisopeneduptoinvestorswhoclearlyarediversified(oratleasthavetheoptiontobediversified).

¨ Therearecontrolimplicationsaswell.Whenaprivatefirmgoespublic,itopensitselfuptomonitoringbyinvestors,analystsandmarket.

¨ Thereportingandinformationdisclosurerequirementsshifttoreflectapubliclytradedfirm.

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Terminal year (11)EBIT (1-t) $1,849

- Reinvestment $ 416FCFF $1,433

Terminal Value10= 1433/(.08-.027) = $27.036

Cost of capital = 11.32% (.983) + 5.16% (.017) = 11.22%

90% advertising (1.44) + 10% info svcs (1.05)

Risk Premium6.15%

Operating assets $9,611+ Cash 375+ IPO Proceeds 1000- Debt 207Value of equity 10,779- Options 805Value in stock 9,974/ # of shares 574.44Value/share $17.36

Cost of Debt(2.7%+5.3%)(1-.40)= 5.16%

Stable Growthg = 2.7%; Beta = 1.00;

Cost of capital = 8% ROC= 12%;

Reinvestment Rate=2.7%/12% = 22.5%

Cost of Equity11.32% Weights

E = 98.31% D = 1.69%

Riskfree Rate:Riskfree rate = 2.7% +

Beta 1.40 X

Cost of capital decreases to 8% from years 6-10

D/E=1.71%

Twitter Pre-IPO Valuation: October 5, 2013

Revenue growth of 55% a year for 5 years, tapering down to 2.7% in year

10

Pre-tax operating

margin increases to 25% over the next 10 years

Sales to capital ratio of

1.50 for incremental

sales

Starting numbers

75% from US(5.75%) + 25% from rest of world (7.23%)

2012 Trailing+2013Revenues $316.9 $448.2Operating+Income ?$77.1 ?$92.9Adj+Op+Inc $4.3Invested+Capital $549.1Operating+Margin 0.96%Sales/Capital 0.82

1 2 3 4 5 6 7 8 9 10Revenues 694.7$33333333 1,076.8$3333 1,669.1$3333 2,587.1$3333 4,010.0$3333 5,796.0$3333 7,771.3$3333 9,606.8$3333 10,871.1$33 11,164.6$33Operating3Income 23.3$3333333333 62.0$3333333333 136.3$33333333 273.5$33333333 520.3$33333333 891.5$33333333 1,382.2$3333 1,939.7$3333 2,456.3$3333 2,791.2$3333Operating3Income3after3taxes 23.3$3333333333 62.0$3333333333 136.3$33333333 265.3$33333333 364.2$33333333 614.2$33333333 937.1$33333333 1,293.8$3333 1,611.4$3333 1,800.3$3333Reinvestment 164.3$33333333 254.7$33333333 394.8$33333333 612.0$33333333 948.6$33333333 1,190.7$3333 1,316.8$3333 1,223.7$3333 842.8$33333333 195.7$33333333FCFF (141.0)$333333 (192.7)$333333 (258.5)$333333 (346.6)$333333 (584.4)$333333 (576.5)$333333 (379.7)$333333 70.0$3333333333 768.5$33333333 1,604.6$3333

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Thetwistsinaninitialpublicoffering

¨ Valuationissues:¤ Useoftheproceedsfromtheoffering:Theproceedsfromtheoffering

canbeheldascashbythefirmtocoverfutureinvestmentneeds,paidtoexistingequityinvestorswhowanttocashoutorusedtopaydowndebt.

¤ Warrants/Specialdealswithpriorequityinvestors:Ifventurecapitalistsandotherequityinvestorsfromearlieriterationsoffundraisinghaverightstobuyorselltheirequityatpre-specifiedprices,itcanaffectthevaluepershareofferedtothepublic.

¨ Pricingissues:¤ Institutionalset-up:MostIPOsarebackedbyinvestmentbanking

guaranteesontheprice,whichcanaffecthowtheyarepriced.¤ Follow-upofferings:Theproportionofequitybeingofferedatinitial

offeringandsubsequentofferingplanscanaffectpricing.

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A.UseoftheProceeds

¨ Theproceedsfromaninitialpublicofferingcanbe¤ Takenoutofthefirmbytheexistingowners¤ Usedtopaydowndebtandotherobligations¤ Heldascashbythecompanytocoverfuturereinvestmentneeds

¨ Howyoudealwiththeissuancewilldependuponhowtheproceedsareused.¤ Iftakenoutofthefirm->Ignoreinvaluation¤ Ifusedtopaydowndebt->Changethedebtratio,whichmaychangethecostofcapitalandthevalueofthefirm

¤ Ifheldascashtocoverfuturereinvestmentneeds->AddthecashproceedsfromtheIPOtotheDCFvaluationofthecompany.

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TheIPOProceeds:Twitter

¨ Howmuch? Newsstoriessuggestthatthecompanyisplanningonraisingabout$1billionfromtheoffering.

¨ Use:IntheTwitterprospectusfiling,thecompanyspecifiesthatitplanstokeeptheproceedsinthecompanytomeetfutureinvestmentneeds.¤ Inthevaluation,Ihaveaddedabilliontotheestimatedvalueoftheoperatingassetsbecausethatcashinfusionwillaugmentthecashbalance.

¨ Howwouldthevaluationhavebeendifferentiftheownersannouncedthattheyplannedtowithdrawhalfoftheofferingproceeds?

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B.Claimsfrompriorequityinvestors

¨ Whenaprivatefirmgoespublic,therearealreadyequityinvestorsinthefirm,includingthefounder(s),venturecapitalistsandotherequityinvestors.Insomecases,theseequityinvestorscanhavewarrants,optionsorotherspecialclaimsontheequityofthefirm.

¨ Ifexistingequityinvestorshavespecialclaimsontheequity,thevalueofequitypersharehastobeaffectedbytheseclaims.Specifically,theseoptionsneedtobevaluedatthetimeoftheofferingandthevalueofequityreducedbytheoptionvaluebeforedeterminingthevaluepershare.

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TheclaimsonTwitter’sequity

¨ TheoverallvaluethatweestimateforTwitter’sequityis$10,779million.Therearemultipleclaimsonthisequity.¤ Theownersofthecompanyownthecommonsharesinthecompany¤ Twitterhassevenclassesofconvertible,preferredstockonthecompany

(fromdifferentVCs).¤ Twitterhas86millionrestrictedstockunitsthatithasusedinemployee

compensation.¤ Twitterhas44.16millionunitsofemployeeoptions,alsousedin

compensationcontracts.(Strikeprice=$1.82,life=6.94years)¤ TwitterhasagreedtopayMoPubstockholderswith14.791millionshares.

¨ Theconvertiblepreferredshareswillbeconvertedatthetimeoftheofferingandthecommonsharesoutstandingwillbe472.61million,notcountingRSUsandoptions.Inthevaluation:¤ Numberofcommonsshares=574.44million(allbutoptions)¤ Optionvalue=$805million(withmaturitysetto3.47years)

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C.TheInvestmentBankingguarantee…

¨ AlmostallIPOsaremanagedbyinvestmentbanksandarebackedbyapricingguarantee,wheretheinvestmentbankerguaranteestheofferingpricetotheissuer.

¨ Ifthepriceatwhichtheissuanceismadeislowerthantheguaranteedprice,theinvestmentbankerwillbuythesharesattheguaranteedpriceandpotentiallybeartheloss.

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PricingversusValue

¨ EarlierIassessedthevalueofequityatTwittertobe$9.97billion(withavaluepershareof$17.36/share).

¨ Assume,however,thatthemarketappetiteforsocialmediastocksishighandthatyoupullupthevaluationsofotherpubliclytradedstocksinthemarket:

¨ Whatwouldyoubaseyourofferpriceon?Howwouldyousellit?

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TheevidenceonIPOpricing

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Aninvestmentopportunity?

¨ Assumethatinvestmentbankstrytounderpriceinitialpublicofferingsbyapproximately10-15%.Asaninvestor,whatstrategywouldyouadopttotakeadvantageofthisbehavior?

¨ Whymightitnotwork?

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D.Theofferingquantity

¨ AssumenowthatyouaretheownerofTwitterandwereoffering100%ofthesharesincompanyintheofferingtothepublic?Ifinvestorsarewillingtopay$20billionforthecommonstock,howmuchdoyoulosebecauseoftheunderpricing(15%)?

¨ Assumethatyouwereofferingonly10%ofthesharesintheinitialofferingandplantosellalargeportionofyourremainingstakeoverthefollowingtwoyears?Wouldyourviewsoftheunderpricinganditseffectonyourwealthchangeasaconsequence?

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IV.AnIntermediateProblemPrivatetoVCtoPublicoffering…¨ Assumethatyouhaveaprivatebusinessoperatinginasector,wherepubliclytraded

companieshaveanaveragebetaof1andwheretheaveragecorrelationoffirmswiththemarketis0.25.Considerthecostofequityatthreestages(Riskfreerate=4%;ERP=5%):

¨ Stage1:Thenascentbusiness,withaprivateowner,whoisfullyinvestedinthatbusiness.

PerceivedBeta=1/0.25=4

CostofEquity=4%+4(5%)=24%

¨ Stage2:Angelfinancingprovidedbyspecializedventurecapitalist,whoholdsmultipleinvestments,inhightechnologycompanies.(Correlationofportfoliowithmarketis0.5)

PerceivedBeta=1/0.5=2

CostofEquity=4%+2(5%)=14%

¨ Stage3:Publicoffering,whereinvestorsareretailandinstitutionalinvestors,withdiversifiedportfolios:

PerceivedBeta=1

CostofEquity=4%+1(5%)=9%

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Tovaluethiscompany…

1 2 3 4 5Terminal

year

E(Cash flow) $100 $125 $150 $165 $170 $175Market beta 1 1 1 1 1 1Correlation 0.25 0.25 0.5 0.5 0.5 1Beta used 4 4 2 2 2 1Cost of equity 24.00% 24.00% 14.00% 14.00% 14.00% 9.00%Terminal value $2,500Cumulated COE 1.2400 1.5376 1.7529 1.9983 2.2780 2.4830PV $80.65 $81.30 $85.57 $82.57 $1,172.07

Value of firm $1,502 (Correct value, using changing costs of equity)

Value of firm $1,221 (using 24% as cost of equity forever. You will undervalue firm)

Value of firm $2,165 (Using 9% as cost of equity forever. You will overvalue firm)

Assume that this company will be fully owned by its current owner for two years, will access the technology venture capitalist at the start of year 3 and that is expected to either go public or be sold to a publicly traded firm at the end of year 5.

Growth rate 2% forever after year 5

175/ (.09-.02)

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Implications

¨ Proposition1:Thevalueofaprivatebusinessthatisexpectedtotransitiontoapubliclytradedcompanywillbehigherthanthevalueofanotherwisesimilarprivatebusinessthatdoesnotexpecttomakethistransition.¤ Privatebusinessesinsectorsthatare“hot”intermsofgoingpublic(social

mediain2014)willbeworthmorethanprivatebusinessesinlesssexysectors.

¤ AsIPOsboom(bust)privatecompanyvaluationswillincrease(decrease).¤ Privatecompaniesincountriesthathaveeasyaccesstopublicmarketswill

havehighervaluethancompaniesincountrieswithoutthataccess.¨ Proposition2:Thevalueofaprivatebusinessthatexpectstomake

thetransitiontoapubliccompanysoonerwillbehigherthanthevalueofanotherwisesimilarcompanythatwilltakelonger.¤ Privatebusinesseswillbeworthmoreifcompaniesareabletogopublic

earlierintheirlifecycle.

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Privatecompanyvaluation:Closingthoughts¨ Thevalueofaprivatebusinesswilldependonthepotentialbuyer.¨ Ifyouarethesellerofaprivatebusiness,youwillmaximizevalue,

ifyoucansellto¤ Alongterminvestor¤ Whoiswelldiversified(orwhoseinvestorsare)¤ Anddoesnotthinktoohighlyofyou(asaperson)

¨ Ifyouarevaluingaprivatebusinessforlegalpurposes(taxordivorcecourt),theassumptionsyouuseandthevalueyouarriveatwilldependonwhichsideofthelegaldivideyouareon.

¨ Asafinalproposition,alwayskeepinmindthattheownerofaprivatebusinesshastheoptionofinvestinghiswealthinpubliclytradedstocks.Therehastobearelationshipbetweenwhatyoucanearnonthoseinvestmentsandwhatyoudemandasareturnonyourbusiness.

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