Fundamental Valuation-2

GROWTH AND THE P/E RATIO   Can rework the dividend growth model as: Po = El /k + PVGO (PV of growth opportunities). Think of the first term as the value of assets in place (discounting at perpetuity) and the second term as growth opportunities. Rearrange as: Po / El = (1/k) * [1 + PVGO /(E/k)] The firm is no-growth where PVGO is zero, growth expands the P/E ratio. The last term is a ratio of the growth opportunities to assets in place and is a conceptual way to think of how value might be created.

Sustainable Growth Think of this g as an “equilibrium” or “target” growth rate. So, attempt to maintain all financial ratios at “optimal” levels. Any growth away from this sustainable growth causes imbalances. Beginning-of-year balance sheet Income statement CA 300 CL 200 Sales 1000 NFA 400 Debt 150 Cost of Goods 800 Equity 350 Earnings before tax 200 TA 700 TL 700 EAT 100 Dividends 30 Retained Earnings 70 For simplicity, assume full capacity, so that 10% growth requires a proportional increase in assets from 700 to 770. Financed only by retained earnings. Thus, end-of-year balance sheet will look like: End-of-year balance sheet CA 330 CL 200 NFA 440 Debt 150 Equity 420 (350 +70) TA 770 TL 770 Represents sales growth of 10% from previous year. Costs increase proportionately

Sustainable Growth Retained earnings provided all the funds needed to grow at 10%. More funds available from “spontaneous” sources i.e. CL. Not using them causes ratios to change. So, can possibly achieve more growth (above 10%) Suppose growth of 15% in sales (and assets) is possible and funds are also generated from CL and debt from 15% spontaneous growth. The end-of-year balance sheet will look like: End-of-year balance sheet CA 345 CL 230.0 Spontaneous NFA 460 Debt 172.5 liability change Equity 420.0 (350 +70) TA 805 TL 822.5 Now have too much money. Still more growth possible!  

Sustainable Growth Suppose growth of 20% in sales was reflected in the previous income statement. Asset levels now need to be 20% higher. End-of-year balance sheet CA 360 (300) CL 240 (200) NFA 480 (400) Debt 180 (150) Equity 420 (350) TA 840 (700) TL 840 (700) Notice that all the ratios remain unchanged! This 20% rate is the sustainable growth rate. It is the rate of growth that is manageable without resort to additional equity financing. Debt and current liabilities have increased “spontaneously.”

MANAGING EARNINGS… Recording revenue before its earned   Stuff the channel: force customer to take more than they need, pay later, return whenever (hard to prove) book as revenue at sale, even LT contracts, aggressive vendor financing (what looks like growth is really bad receivables, various telcos)

MANAGING EARNINGS… 2. Inventing revenue McKesson had two books   McKesson had two books Revenue swap arrangements between firms with different quarterly reporting months. Boosting profits with non-recurring items gains from investments were treated as income during the bubble, now losses are treated as non-operating. Gains and losses from currency translation, is operational but not treated as such.

MANAGING EARNINGS…. 3. Shifting expenses to later periods   Capitalize software development costs for many years, rather than booking as expenses, makes earnings look better. E.g many software companies Raise assumed rate of return on pension fund, so decrease in funding costs, increase in profits,GE. Failing to disclose or record liabilities: Rite Aid reduced payables because of discounts it “felt” was due though they never got it

MANAGING EARNINGS…. 4. Shifting income to later periods   MSFT used to postpone revenue recognition till long after software sale, (unearned revenue). WR Grace maintained excess earnings in all-purpose reserve. 5. Shifting future expenses to earlier periods Front-load write-off of unproductive assets to make future E look good and create “growth”. Asset restructuring: match unusual gain from asset sale with restructuring charges (GE)

Is all this a good thing or a bad thing?   Ok if compatible with GAAP ? New industries with evolving acctg practices ? Don’t we do smooth things at the personal level too ? Can’t investors figure this out ? So why bother with earnings at all? Why not use free cash flow as to equity as above ? Companies then began to redefine free cash flow in their reports to suit their purposes…

DISCOUNTED CASH FLOW VALUATION   Could value equity directly or value the firm and then take out the non-equity claims. The DDM’s we did earlier are an illustration of the former, where dividend flows to equity holders are discounted at the cost of equity. Estimate life: Usually as 1 or 2 stages, high growth + stable. Estimate Cash flows to the firm Earnings before interest and taxes * ( 1- tax rate) Plus: Depreciation Minus: Capital Expenditure Minus: Change in Working Capital Equals: Cash flow to the firm

I. EBIT = Earnings before interest and taxes   must reflect only income and expenses from operations, not finance. If there are no earnings, use revenue * operating margin Operating leases are treated as financial expenses but should operating expenses (so adjust EBIT) R&D is treated as operating but could be a capital expense. Some tech companies have argued that SG&A is a capital expense not operating (AOL and free-CDs Tax rate: Marginal or effective? Marginal understates income early but more accurate later. Effective rate really measures the difference between acctg and tax books. Estimate growth rate for this over time as: a) historical growth in EPS and/or dividends, b) arithmetic or geometric; c) sustainable growth).

II. Net capital expenditures = Capex –Depreciation   Includes research and development expenses, acquisitions (look in SOCF under investment activities, can normalize). Think of the depreciation as a cash flow that finances capital expense Firms in high growth phase need more, for mature firms, this may net to zero. III. Change in Net Working Capital Increases in NWC ties up cash and reduces cash flow Cleaner to think of it as Non Cash CA – Non Debt CL

IV. Estimate discount rate Weighted average cost of capital (WACC) using MV weights as this reflects the cost of issuing securities to finance projects.   As usual, the cost of debt = After-tax yield to maturity, AND the cost of equity = Risk-free + Equity beta * Risk Premium. Estimating components of the latter are especially tricky. a) Risk-free rate => no default risk, no reinvestment risk, match duration of instrument with life use real rates on inflation indexed bond ? 10-year bond yield presently 4.1% For some countries. There may not even be a risk-free security.

b) Risk premium => even historical has some variance.   Stocks – T-bills Stocks – T-bonds Arith. Geom. Arith. Geom. 1928-2015 8.4 7.2 6.6 5.6 1990-2015 11.3 8.4 12.7 8.9 Are investor risk patterns are changing When the Fed stays accommodative, there is an implicit reduction in the risk premium (the Fed put) Could reverse the logic and estimate an “implied” risk premium from current stock prices, e.g E(R) = D1/P0 + g and take out a risk free rate. Has varied from 2% in 2000s, 3% in the 1960’s and 6.25% in the late 1970’s.

c) BETA ESTIMATION   Slope of regression of stock return against market return Higher with both operating and financial leverage Adjust for leverage, βl = βu * [1 + {(1-t) * D/E} Depends on the time frame, Value line uses adjusted betas, probably the easiest to use and reflect changes over time as firm matures Could also do it bottom-up or fundamental betas (take weighted beta of different lines of business)

FINALLY, THE VALUE OF THE FIRM IS:   PV of operating assets, (the CF’s above, discounted at the WACC)  Plus: Cash and Non operating assets. AND The Value of the Equity = Value of the Firm – Value of Debt. CAVEATS Models are geared more towards traditional manufacturing firms. Cash flow fluctuations for financial firms and cyclical firms are tied more closely to economic activity, so time cycle? he business cycle. Firms in trouble/ restructuring/acquisition make CF estimation difficult. Because of the accounting games that companies play, tremendous attention is devoted to getting the cash flow estimates right. However, valuations are often much more sensitive to small variations in the market-driven estimates that comprise the discount rate. c) Even after such care, considerable sensitivity analysis is warranted.