Corporate Finance: Spring 2014 Aswath Damodaran

Ponderous Thoughts, or maybe not There are few facts and lots of opinions. Even the givens (cash & risk free rate) are not With accounting and market numbers, all bets are off. The real world is a messy place. Money making firms can become money losers Companies can be restructured/ given facelifts Models don’t compute values and optimal paths. You do. Change is the only constant. Numbers don’t match. Different betas from different sources. Book value of equity is negative Optimal debt ratio for Co

The Breakdown in the Classical Objective Function STOCKHOLDERS Managers put their interests above stockholders Have little control over managers Significant Social Costs Lend Money Managers BONDHOLDERS SOCIETY Bondholders can get ripped off Some costs cannot be traced to firm Delay bad news or provide misleading information Markets make mistakes and can over react FINANCIAL MARKETS

I. Where does the power lie?

II. Who is your marginal investor? From Spring 2013

III. Risk Profiles and Costs of Equity

Beta: The Standard Approach

Regression Estimation Approaches Typical reasons My company is unique. I cannot find comparable firms. My company is in only one line of business My bottom-up beta is too different from my regression beta

Beta Distribution   Beta Average 1.09 Median 1.07 High 2.9 Low 0.28

Jensen’s Alpha Distribution   Alpha Average 16% Median 5% High 1310% Keurig Green Mountain Low -379% AMD

R Squared R squared Average 33% Median 20% High 69% Intuitive Surgical   R squared Average 33% Median 20% High 69% Intuitive Surgical Low 0% Many

Cost of Capital

Distribution of Current Market Value Debt Ratios

IV. The Quality of Investments: The Firm View

Return Spreads

VI. The Optimal Financing Mix   Optimal debt ratio Average 31.26% Median 30.00% High 90.00% Samsung, HP, Darden, Conoco Low 0.00% 17 firms

Under versus Over Levered Firms   Under or over levered Average -10.49% Median -7.33% Low -67.86% Samsung High 27.00% Shutterfly

VIII. The Right Kind of Financing

IX. Measuring Potential Dividends

Dividends versus FCFE FCFE/Dividends Average 66.65% Median 12.49% Low   FCFE/Dividends Average 66.65% Median 12.49% Low 0.E+0 High 2164.00%

X. Valuation: Match up cashflows and discount rates…

Getting to equity value per share Approach used To get to equity value per share Discount dividends per share at the cost of equity Present value is value of equity per share Discount aggregate FCFE at the cost of equity Present value is value of aggregate equity. Subtract the value of equity options given to managers and divide by number of shares. Discount aggregate FCFF at the cost of capital PV = Value of operating assets + Cash & Near Cash investments + Value of minority cross holdings Debt outstanding = Value of equity Value of equity options =Value of equity in common stock / Number of shares

Value versus Price Under or over valuation Average 56.88% Median   Under or over valuation Average 56.88% Median 21.44% Low 0.000 High 1578.26%

Ways of changing value… To change value, you have to take actions that affect one of four inputs: Cash flows from existing assets Expected growth Cost of capital Length of the growth period

Brings it all together. Stock looks under valued… or maybe the valuation is wrong… Note that the non operating investment is the value of their minority holdings in Hong Kong Disney (they own 43% and the Chinese government owns 57%) and the minority interests represents the value of external equity investors in fully consolidated ventures. In both cases, we used book value because we had no way of accessing the market value. The equity options is the value of management options, valued using an option pricing model, and adjusted for taxes. Aswath Damodaran

Note that with two changes, a higher return on capital on new investments over the high growth phase (from 9,.91% to 12%) and moving to the optimal debt ratio of 40%, we can raise the value per share from $28.16 to $36.67. The difference of $8.51 can be viewed as the value of control. In general, the better managed a firm is, the lower will be the value of control. Aswath Damodaran

So, how do you explain the price? Its all relative.. Note that when people compare firms across sectors, they implicitly assume that firms in a sector have similar risk and cash flow characteristics. This is clearly a dangerous assumption to make. The PEG ratio is a simplistic way of controlling for expected growth differences across firms. A low PEG ratio is viewed as a sign of an undervalued firm. The PEG ratio is based upon the implicit assumption that PE and expected growth are linearly related.

Most undervalued stocks!!

The Triple Whammy: Underlevered, Cash Build-up and Under valued? Company Power Jensen's Alpha ROC - WACC Current Debt ratio Optimal Debt Ratio Dividends FCFE Value/share Price/Share AGCO 1 -8.58% 5.85% 22.36% 50.00% 57.5 241.6 $166.41 $55.15 AMCX 6.08% 15.42% 31.10% 80% $29,584.00 $(7.34) $58.00 Apple 77.00% 54.23% 3.79% 80.00% 35912 120184 $720.97 $585.54 26.20% 22.61% 3.35% 70.00% 27172 48729 $1,293.71 $592.58 Chevron -0.50% 6.51% 7.63% 60.00% 9532 9537.14 $148.94 $118.91 CISCO -0.80% 2.27% 11.81% 3310.00 5458.00 26.73 23.03 Coca-Cola -5.25% 0.58% 16.60% 30.00% 21732 54026 $40.91 $31.80 eBay 5.10% 1.41% 6.18% 40.00% 2036 $61.11 $50.54 Express -9.77% 7.78% 49.43% 70.98 $17.68 $14.62 Express, Inc. 32.97 111.02 Francesca's 2.10% 16.86% 22.29% $18,291 $73,592 $27.69 $16.27 FujiFilm Holdings Corporation -0.04% -1.27% 24.13% 40 2,681,154 $4,956.22 $2,570.00 Google 0.06% 20.13% 2.29% 20.00% 801 30809 $589.56 $518.73 Gran Tierra Energy 3.44% -1.00% 7.80% 136.7 $9.28 $7.25 HP -0.19% 5.74% 27.40% $900.20 $9,644.40 $35.88 $32.23 Intel -6.40% 6.26% 9.73% 3913 5744 $37.51 $26.30 Intuitive Surgical -10.21% 15.31% 0.14% 2027.9 2152 $487.66 $363.50 LVMH 1.16% 4.94% 15.97% 1242 € 6,143.60 € 176.46 € 140.10 Michael Kors 33.02% 98.12% 3.06% $397.60 116.25 91.82 Newmont Mining -7.80% 5.11% 35.70% $448 1999 $51.73 $24.02 NOV 17.00% 1.63% 203 249.29 $91.77 $77.87 Qualcomm -2.98% 54.62% 0.25% 1450.8 5790.2 $88.81 $79.50 Samsung 1.43% 5.38% 90.00% $1,226.14 $11,231.18 $2,475,433.50 $1,350,000.00 Schlumberger -0.10% 2.85% 9.80% 50% $15,169.00 $29,784.00 $99.91 $69.10 Tyson Foods, Inc 22.84% 8.81% 18.43% 304 3708 $49.89 $38.44 Verizon -0.2517 8.30% 34.08% 5936 18918 $55.08 $47.60   11.46% 39.74% 51031 71987 $78.27 $48.49 Viacom 1.11% 10.25% 26.01% 509 3703 $101.64 $83.64 World Fuel Services 2 32.30% 2.60% 16.76% 17.32 87.12 $49.96 $43.17 ZuoAn -31.14% 20.92% 12.14% $90 $6.82 $1.70

First Principles As we begin, so we end.

Objectives of this class If you get the big picture, the details will come (sooner or later) Tools are useful but only in the larger context of answering bigger questions. Corporate finance is not so bad !!!

And don’t forget your CFEs… 1. This course was mentally challenging/intellectually stimulating. 1 2 3 4 5 6 7 No-brainer! Brilliant insights! 2. This course was demanding of my time. 1 2 3 4 5 6 7 What work? Haven’t slept all semester. 3. This course provided me with tools and information that I will find useful in the future. 1 2 3 4 5 6 7 Only in prison Completely relevant 4. Overall evaluation of the course 1 2 3 4 5 6 7 Horrible! ( I want my money back) Stupendous! 5. The instructor was organized and well prepared for class. Had trouble finding classroom Scarily efficient! 6. The instructor communicated his/her ideas and material well. Garbled gobbledygook! Should have own TV show 7. The instructor was enthusiastic about his/her subject matter. Dead man talking! I am a convert 8. Overall evaluation of the instructor 2 3 4 5 6 7 Dog! Star!