Investments 101: Valuing Assets September 15, 2013

Laney Sanders, CFA Manager of Private Equity Louisiana State Employees’ Retirement System 2

Overview What is security valuation? Value versus price Who values securities? Importance of valuing securities Implementing securities valuation 3

Simplified Valuation Process 1.Determine value of asset 2.Look to market for price 3.Compare price to value and determine if asset is worth buying or selling 4.Repeat process 4

1. Valuation of Assets What is an asset? – Simply: anything that has value – In investment terms: Stocks Bonds Physical assets: commodities, real estate, etc. Ownership in a profitable company 5

1. Valuation of Assets Valuation is the process that links risk and return to determine the worth of an asset – the value that is determined is often called INTRINSIC VALUE Three key inputs required for valuing the asset: – Cash flows – Timing – Required return The greater the risk, the greater the rate of expected return and vice-versa 6

1. Valuation of Assets The value of any investment is the PRESENT VALUE OF FUTURE CASH FLOWS 7

“[Intrinsic value is] an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and business. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple” 8 - Warren Buffet (1997)

2. Look at market price Price is not always equal to value Price is what you can buy/sell the asset for in the market 9

3. Compare: Valuation vs. Price VALUE: Present Value of Future Cash Flows PRICE: What the asset is selling for in the market Compare price to value: – Is price greater than the value? Sell (or don’t buy) – Is value greater than the price? Buy (or don’t sell) 10

4. Repeat the Process The concept of investment valuation must be repeated periodically – Frequency of valuation depends on the type of investment Publically traded investments – are valued by investment analysts constantly around the world Private investments – are valued less often, as they are not traded as frequently 11

4. Repeat the Process Why would an investment analyst and/or investor choose to value an investment? – New Information has entered the market Information can be specific to the investment or security Information can be specific to the sector or industry Information that affects “all” investments such as change in interest rates, economic data, tax rules, political changes, etc. 12

Present Value of Future Cash Flows The value of any investment is the present value of future cash flows What are future cash flows? – Cash flows to be received by virtue of holding a security or investment 13

Present Value of Future Cash Flows Finding the present value of future cash flows requires a mathematical equation The simplified version: 14

Present Value of Future Cash Flows 15 (FV) Future Value: the cash flow value to be received in the future (r) Rate of Return: the rate you want to receive given the riskiness of the asset (t) Time: when you expect to receive the future cash flow (PV) Present Value: what the future cash flow is worth today

Present Value of Future Cash Flows Future Cash Flows, FV, must be estimated – Predicting the future – An inexact science – Estimating the revenues, expenses, and returns of a business – Effect of the economy Rate of Return, R, must also be estimated – An investment’s riskiness affects its value – The greater the uncertainty of cash flows, the lower their value, and thus the greater “r” will be in the equation 16

Present Value of Future Cash Flows Growth Rate, G, must be estimated – It is common to break “growth” into two phases High Growth Period: when company is growing rapidly, not sustainable over the long term Low/Stable Growth Period: when company is growing at a sustainable rate for the long term – How long will high growth period last? – What is the growth estimate for both high and low growth period? – Will dividend payout structure affect growth? How much will company retain to fund growth? How much will company pay out to shareholders? 17

Present Value of Future Cash Flows Examples: – Stock: Cash flow received from dividend Cash flow received from difference in purchase and sale price (this can be positive or negative) – Bond: Cash flow received from interest payment Cash flow received from difference in purchase and sale price (this can be positive or negative) – Real Estate Rent income Sale of property – Private Equity Sale of company – Commodities Sale after change in price 18

Valuation: Stocks vs. Bonds With a stock – cash flows occur from dividends and selling the security (at a profit or loss) – Future dividends may be estimated – Value and timing of dividend is not known with certainty – Sale price of stock at future date is also not known 19

Valuation: Stocks vs. Bonds Since future sales price is unknown, valuation methods concentrate on the dividend cash flows Dividend estimation methods can be categorized into three methods: 1.Zero Growth Model 2.Constant Growth Model 3.Non-constant (or Supernormal) Growth Model 20

Valuation: Stocks vs. Bonds 1.Zero Growth – Assumes dividend will remain the same throughout the investment period – Example: Last dividend paid was $1.00 Will remain $1.00 for as far as we can predict – An “easy” method, but not a robust method 21

Valuation: Stocks vs. Bonds 2. Constant Growth – Assumes dividend will increase at a constant rate in the future – Example: Constant growth at 5% Last dividend paid was $1.00 Next dividend will be 5% higher – so $1.05 This pattern continues indefinitely – A “better” method, but not very robust 22

Valuation: Stocks vs. Bonds 3. Supernormal Growth – Assumes dividend will increase at a variable rate in the short term, and then level out to a constant growth rate in the future – Example: Dividend growth will be 5%, 10%, and 12% for the next three years After these years it will level off at 6% for remaining years – A more accurate depiction of dividends 23

Valuation: Stocks vs. Bonds Calculating Present Value of Stock – Inputs into equation: Future estimated cash flows Timing of dividends (when they will be received) Discount rate – Discount rate reflects the level of risk associated with the asset – The riskier the asset, the higher the discount rate – Output of the equation: Value of security – Compare calculated value to the price in the market 24

Valuation: Stocks vs. Bonds With a bond– cash flows occur from interest (coupon), receiving the par value at maturity, or selling the security before maturity (at a profit or loss) – Unlike a stock, value of coupon payment and timing of coupon payment are known with certainty (excluding default for our purposes) – Maturity value of bond is also known 25

Valuation: Stocks vs. Bonds Calculating Present Value of Bond – Inputs into equation: Future coupon payments to be received Timing of coupon payments – this is stated on bond indenture Discount rate – Discount rate reflects the level of risk associated with the asset – The riskier the asset, the higher the discount rate – Output of the equation: Value of security – Compare calculated value to the price in the market 26

Valuation: Stocks vs. Bonds 27

Valuation: Alternative Assets Valuing alternative assets, such as private equity, are more difficult than publically traded securities Methods to value Private Equity include: – Discounted cash flow analysis: for companies with significant operating history – Relative value/market approach: applies a price multiple against the company’s earnings. Requires predictable cash flow. Multiple of EBITDA 28

Valuation: Alternative Assets Selecting alternative asset managers: Much of the value in a Private Equity firm lies in the team managing the investments – The ultimate value of the partnership is going to be determined by the team’s decision making skills – Evaluating these teams is subjective, but try to make as objective as possible Background History of deals Exit strategies Contacts in specific industries Ability to judge character of portfolio companies management (direct funds) Ability to judge character of another private equity firm (fund of funds) 29

Who values assets for a Pension Plan? In short, the plan’s active investment managers – This is what the plan pays them to do (among other things) – Each manager may utilize a different strategy to value investments – Managers have different analysts, some are better than others at valuation – Some use complex computer models 30

Who values assets for a Pension Plan? New information changes the value of a security Successful valuation includes knowing where to get the information, how to process new information, and how that information affects the value of a given security Information regarding: – Growth rate of the company itself – The economy – Political changes – Tax changes – Industry changes – Commodity prices – Consumer demand for the good or service – Pending litigation – Company financial health – And so on 31

Who values assets for a Pension Plan? With this information, active investment managers decide which securities to buy/sell/hold in the portfolio Example: A plan hires two money managers, each running an active portfolio with the S&P 500 as the benchmark – Will the two managers likely hold the exact same securities? No – See Warren Buffet comment 32

What makes a great securities analyst? WSJ Article (May 10, 2013) asked some experts: – Must not have a preconceived notion if stock is winner or loser – Do not allow behavioral finance to affect your decision making process – concentrate on fundamentals – Goal is not to identify great companies – you must find companies, perhaps great, that are underpriced – Think independently – don’t follow the herd 33

When Valuation is Ignored Securities trade at values that no longer reflect present value of future cash flows – so what is the value based upon? Valuations can be based on emotion and not company fundamentals Bubbles can form – Dot com bubble – Housing bubble – Fundamentals do not support price Growth rate implied in valuation is unreasonable 34

Summary Difference between value and price – Value: Present value of future cash flows – Price: Determined in market Any asset can be thought of as a stream of cash flows Finding present value of future cash flows requires a calculation. Inputs include: – Timing of cash flows – Amount of cash flows – Discount rate (reflects risk of asset) 35

Summary For most public pension plans, professional asset managers are hired to choose assets – Analysts and/or computer models at these companies help determine which assets to purchase/sell – The process is quite complex and requires constantly processing of new information at it enters the market Warren Buffett comment – valuation is difficult, and with the same information, multiple valuations may be obtained Both science and art Ignoring valuation can have serious consequences 36