Copyright ©2003 Ian H. Giddy Valuation 1

Raising Equity Finance & Valuing a Business Prof. Ian GIDDY Stern School of Business New York University

Copyright ©2003 Ian H. Giddy Valuation 3 Telkom South Africa 1. Why did South Africa follow its initial 30% privatization of Telkom with an initial public offering? What are the advantages and disadvantages of a public listing for a company? 2. What is an ADR? Why did Telkom use the ADR technique in conjunction with its Johannesburg IPO? 3. What does a company have to do to ensure a successful IPO? What makes shares attractive to investors? 4. Was the Telkom IPO priced correctly? How would you value a company in order to judge the price for an IPO?

Copyright ©2003 Ian H. Giddy Valuation 4 Valuing a Firm with DCF Historical financial results Adjust for nonrecurring aspects Gauge future growth Adjust for noncash items Projected sales and operating profits Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF Stable growth model or P/E comparable Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity … Discount to present using weighted average cost of capital (WACC)

Copyright ©2003 Ian H. Giddy Valuation 5 What’s a Company Worth? l Required returns l Types of Models  Balance sheet models  Comparables  Corporate cash flow models l Estimating Growth Rates l Applications l Option-based models

Copyright ©2003 Ian H. Giddy Valuation 6

Copyright ©2003 Ian H. Giddy Valuation 7 IBM’s Financials

Copyright ©2003 Ian H. Giddy Valuation 8 Equity Valuation: From the Balance Sheet Value of Assets  Book  Liquidation  Replacement Value of Liabilities  Book  Market Value of Equity

Copyright ©2003 Ian H. Giddy Valuation 9 Equity Valuation: From the Balance Sheet Value of Assets  Book  Liquidation  Replacement  Or what? A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)

Copyright ©2003 Ian H. Giddy Valuation 10 Relative Valuation l In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include: Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) Price/Book (P/BV) ratios q and variants (Tobin's Q) Price/Sales ratios

Copyright ©2003 Ian H. Giddy Valuation 11 Comparables  Value Indicator  Earnings  Cash Flow  Revenues  Book  Value Indicator  Earnings  Cash Flow  Revenues  Book  Average  Comparable  Industry  Firms  Deals  Average  Comparable  Industry  Firms  Deals Target Company Numbers or Projections Target Company Numbers or Projections Estimated Value of Target Estimated Value of Target

Copyright ©2003 Ian H. Giddy Valuation 12 IBM: Comparables

Copyright ©2003 Ian H. Giddy Valuation 13 Corporate Cash Flow

Copyright ©2003 Ian H. Giddy Valuation 14 Discounted Cashflow Valuation: Basis for Approach  where  n = Life of the asset  CF t = Cashflow in period t  r = Discount rate reflecting the riskiness of the estimated cashflows

Copyright ©2003 Ian H. Giddy Valuation 15 Start with the Weighted Average Cost of Capital ChoiceCost 1. EquityCost of equity - Retained earnings- depends upon riskiness of the stock - New stock issues- will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. DebtCost of debt - Bank borrowing- depends upon default risk of the firm - Bond issues- will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capitalcost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]

Copyright ©2003 Ian H. Giddy Valuation 16 IBM’s Cost of Capital

Copyright ©2003 Ian H. Giddy Valuation 17 Valuation: The Key Inputs l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. l Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

Copyright ©2003 Ian H. Giddy Valuation 18 Dividend Discount Models: General Model l V 0 = Value of Stock l D t = Dividend l k = required return

Copyright ©2003 Ian H. Giddy Valuation 19 No Growth Model l Stocks that have earnings and dividends that are expected to remain constant l Preferred Stock

Copyright ©2003 Ian H. Giddy Valuation 20 No Growth Model: Example E 1 = D 1 = $5.00 k =.12 V 0 = $5.00/0.12 = $41.67  Burlington Power & Light has earnings of $5 per share and pays out 100% dividend  The required return that shareholders expect is 12%  The earnings are not expected to grow but remain steady indefinitely  What’s a BPL share worth?  Burlington Power & Light has earnings of $5 per share and pays out 100% dividend  The required return that shareholders expect is 12%  The earnings are not expected to grow but remain steady indefinitely  What’s a BPL share worth?

Copyright ©2003 Ian H. Giddy Valuation 21 Constant Growth Model l g = constant perpetual growth rate

Copyright ©2003 Ian H. Giddy Valuation 22 Constant Growth Model: Example E 1 = $5.00k = 12% D 1 = $3.00 g = 6% V 0 = 3.00 / ( ) = $50.00  Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend  The required return that shareholders expect is 12%  The earnings are expected to grow at 6% per annum  What’s an M6 share worth?  Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend  The required return that shareholders expect is 12%  The earnings are expected to grow at 6% per annum  What’s an M6 share worth?

Copyright ©2003 Ian H. Giddy Valuation 23 Shifting Growth Rate Model l g 1 = first growth rate l g 2 = second growth rate l T = number of periods of growth at g 1

Copyright ©2003 Ian H. Giddy Valuation 24  Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%  The dividends are expected to grow at 20% for 3 years and 5% thereafter  What’s a Mindspring share worth?  Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%  The dividends are expected to grow at 20% for 3 years and 5% thereafter  What’s a Mindspring share worth? Shifting Growth Rate Model: Example D 0 = $2.00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2.40 D 2 = 2.88 D 3 = 3.46 D 4 = 3.63 V 0 = D 1 /(1.15) + D 2 /(1.15) 2 + D 3 /(1.15) 3 + D 4 / ( ) ( (1.15) 3 V 0 = = $30.40

Copyright ©2003 Ian H. Giddy Valuation 25 Choosing a Growth Pattern: Examples CompanyValuation in Growth PeriodStable Growth PWC Nominal U.S. $10 years6%(long term Firm(3-stage)nominal growth rate in the world economy DirecTV Nominal US$5 years4%: based upon Equity: FCFE(2-stage)expected long term US growth rate AllianzNominal Euro0 years3%: set equal to Equity: Dividendsnominal growth rate in the European economy

Copyright ©2003 Ian H. Giddy Valuation 26 Better Than Dividends: Free Cash Flows Revenue - Expenses - Depreciation = EBIT Adjust for tax: EBIT(1-T) + Depreciation - Capex - Ch working capital = Free Cash Flows to Firm

Copyright ©2003 Ian H. Giddy Valuation 27 Deriving IBM’s Free Cash Flows IBMvaluation.xls

Copyright ©2003 Ian H. Giddy Valuation 28 Equity Valuation in Practice l Estimating discount rate l Estimating cash flows l Estimating growth l Application with constant growth: Optika l Application with shifting growth: IBM

Copyright ©2003 Ian H. Giddy Valuation 29 Valuing a Firm with DCF: The Short Version Historical financial results Adjust for noncash items Projected sales and operating profits Free cash flows to the firm (FCFF) Calculate weighted average cost of capital (WACC) Estimate stable growth rate (g) Present value of free cash flows - Market value of debt Value of shareholders equity Discount to present using constant growth model FCFF(1+g)/(WACC-g)

Copyright ©2003 Ian H. Giddy Valuation 30 Optika: Facts l The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m. l Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%. l The market value of equity is €1.3b. l Is this firm fairly valued in the market? What assumptions might be changed?

Copyright ©2003 Ian H. Giddy Valuation 31 Optika optika.xls

Copyright ©2003 Ian H. Giddy Valuation 32 Optika CAPM: 7%+1(5.50%) Debt cost (7%+1.5%)(1-.35) WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) Equity Value: Firm Value - Debt Value = = 2431 optika.xls

Copyright ©2003 Ian H. Giddy Valuation 33 Valuing a Firm with DCF: The Extended Version Historical financial results Adjust for nonrecurring aspects Gauge future growth Adjust for noncash items Projected sales and operating profits Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF Stable growth model or P/E comparable Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity … Discount to present using weighted average cost of capital (WACC)

Copyright ©2003 Ian H. Giddy Valuation 34 Case Study: IBM

Copyright ©2003 Ian H. Giddy Valuation 35 Case Study: IBM IBMvaluation.xls

Copyright ©2003 Ian H. Giddy Valuation 36 Mt Cameroon Ecotours

Copyright ©2003 Ian H. Giddy Valuation 37 Case Study: Mt Cameroon Ecotours l What alternative financing sources are available to Mount Cameroon Ecotours? l How would foreign investors assess the risks of investing in this private venture in Cameroon? What could be done to reduce the risks to foreign investors? What might be their exit plan? l What is a reasonable estimate of the company's value? l How much of the company's equity shares would have to be given up in order to raise the required EUR5 million?

Copyright ©2003 Ian H. Giddy Valuation 38 Banpu Thursday: Structured Financing Cap des Biches LBO Korea Asset Funding Finance Co. Bhd

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Copyright ©2003 Ian H. Giddy Valuation 40 Contact Info Ian H. Giddy NYU Stern School of Business Tel ; Fax