Spring 2010 Market-Based Valuation: Price Multiples (contd..)

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 2 Price/Cash Flow: Rationales and Drawbacks  Rationales for using P/CF multiple  Less subject to manipulation  More stable than EPS  Addresses the issue of accounting differences  Differences in P/CF may relate to differences in long-run returns  Drawbacks of using CF derive from the characteristics of CF  Earnings plus noncash charges, definition of cash flow ignores the changes in working capital  FCFE is more volatile and more frequently negative

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 3 P/CF based on forecasted fundamentals D 0 = FCFE 0

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 4 Example: justified P/CF  As a technology analyst, you are working on the valuation of Dell Computer. You have calculated per-share FCFE for DELL of $1.39. Your estimate of CF (earnings + noncash charges) is $0.75. Your other estimates are 14.5% required rate of return and an 8.5% expected growth rate of FCFE. 1. What is the intrinsic value of DELL, as per the constant growth FCFE model? 2. What is the justified P/CF, based on forecasted fundamentals? 3. What is the justified P/FCFE, base on forecasted fundamentals? P/CF = V 0 / CFP/CF = / 0.75 = 33.5

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 5 Example: P/CF comparables  You have been asked to compare the valuation of Compaq with Gateway. One valuation metric you are considering is P/cash flow. You have gathered following data for the two companies. Which stock appears to be relatively undervalued? Compaq appears to be relatively undervalued. It is selling at lower P/CF multiple of while having the higher earnings growth forecast of the two. Positive FCFE for Compaq suggests that growth was funded internally; negative for Gateway suggests the need for external funding for growth.

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 6 EV/EBITDA Multiple: Rationales and Drawbacks  EV is total company value including market value of debt, equity and preferred stock minus the value of cash and investments.  Rationales for using EV/EBITDA multiple  More appropriate for comparison between companies with different financial leverage.  EBITDA controls for differences in depreciation policies across companies.  EBITDA is generally positive even when EPS is negative.  Drawbacks of using derive from the characteristics of EBITDA  EBITDA overestimates CF when working capital is growing.  EBITDA ignores differences in revenue policies across companies.  FCFF has stronger theoretical link to valuation then EBITDA.

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 7 Examples: Enterprise Value Equity multiples vary due to capital structure as well and business differences Total EV produces more comparable multiples but can be distorted by non- core assets Core EV is the most comparable... but is also the most subjective!

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA 8 Using EV/EBITDA multiples  Valuation based on forecasted fundamentals  Justified EV/EBITDA is arrived at by dividing the Enterprise Value of a company based on a valuation model such as discounted FCFF by the company’s actual or forecasted EBITDA.  Justified EV/EBITDA is positively correlated to expected growth rate in FCFF and negatively correlated to the company’s WACC.  Valuation using comparables  All else equal, a lower EV/EBITDA value relative to peers indicates relative undervaluation.

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA Example – 2:  You are analyzing CellOne – a mobile cellular company for inclusion in your portfolio as of end March A research analyst has provided you following forecasts for CellOne.  Your experience tells you that mobile companies in more mature regional telecom markets with similar country risks as that for CellOne trade at trailing EV/EBITDA of around 8.0 times. In your view, such companies have revenue growth of 8-10% pa and relatively stable operating margins. The company has 4,000 million shares outstanding. Your required return on equity is 20%. What would be your estimate of current fair value for CellOne? 9 Amounts in PKR Mn Year ending 30thJun-09Jun-10eJun-11eJun-12eJun-13e Net Revenue35,10045,63055,66962,34967,337 EBITDA14,04017,33920,04121,82223,568 Net Profit2,7007,42514,47919,54622,478 Dividends-1,5002,0002,5003,000 Net Debt27,20028,10026,20024,10022,000

Security Analysis (Spring 2010)Asif Ali Qureshi, CFA Example – 2: Solution 10 Amounts in PKR Mn Year ending 30thJun-09Jun-10eJun-11eJun-12eJun-13e Net Revenue 35,100 45,630 55,669 62,349 67,337 EBITDA 14,040 17,339 20,041 21,822 23,568 Net Profit 2,700 7,425 14,479 19,546 22,478 Dividends - 1,500 2,000 2,500 3,000 Net Debt 27,200 28,100 26,200 24,100 22,000 Revenue growth 30.0%22.0%12.0%8.0% EBITDA margin40.0%38.0%36.0%35.0% Net Profit growth 175.0%95.0%35.0%15.0% EV/EBITDA 8.00 Exit EV 188,544 Equity Value 166,544 Dividends 1,500 2,000 2,500 3,000 Cash Flows 1,500 2,000 2, ,544 PV (total) [Jun-09] 85,849 PV (total) [Mar-10] 98,428 PV (per share) [Mar-10] 24.61