1. Fin 4201/8001 Topic 4a: Valuing Companies The adventure continues….

2. The Project Next few classes, little reading = time to get organized Next few classes, little reading = time to get organized Sources – usual suspects Sources – usual suspects Analyze with tenets, spread sheet w/ forecasts, ratios…. Analyze with tenets, spread sheet w/ forecasts, ratios…. Play from your strengths Play from your strengths

3. Another look Abstract Abstract Introduce firm and environment Introduce firm and environment Operations Operations Industry Industry

4. Another look Ratio analysis Ratio analysis Buffett’s tenets Buffett’s tenets Equity Valuation Equity Valuation Recommendation Recommendation References, Tables, Charts,… References, Tables, Charts,…

5. Valuation Objective: Investment decision Objective: Investment decision Price < Estimated value = BUY Price < Estimated value = BUY Three step approach (Top-down) Three step approach (Top-down) Analysis of economies and markets Analysis of economies and markets Analysis of Industry Analysis of Industry Analysis of individual firm Analysis of individual firm

6. Valuation (The softer side) Most of the 12 tenets Most of the 12 tenets Macro economic implications Macro economic implications Corporate governance and the market for corporate control Corporate governance and the market for corporate control Buffett = cost < value Buffett = cost < value How do you know? Valuation How do you know? Valuation Our focus ≈ ROIC, NOPLAT, and DCF Our focus ≈ ROIC, NOPLAT, and DCF

7. Return On Invested Capital = Profit/capital ROIC is after tax profit divided by (working capital + PPE) ROIC is after tax profit divided by (working capital + PPE) Scorecard vs. some benchmark Scorecard vs. some benchmark Goal ≠ maximize Goal ≠ maximize But can’t just look at $ either – Capital costs money (growth for growths sake) But can’t just look at $ either – Capital costs money (growth for growths sake) ROIC > Opportunity cost of capital ROIC > Opportunity cost of capital Ultimate = stock performance or value creation Ultimate = stock performance or value creation

8. NOPLAT = Net Operating Profit Less Adjusted Taxes ≈ Owner earnings ≈ Owner earnings Look at example in a couple of slides Look at example in a couple of slides

9. DCF – Discounted Cash Flow Returns depend on market expectations Returns depend on market expectations The great equalizer The great equalizer Goal = Maximize PV of cash or economic profit Goal = Maximize PV of cash or economic profit Ultimate measure is stock performance Ultimate measure is stock performance Problems Problems Predict future (Buffett KISS and stable) Predict future (Buffett KISS and stable) Earnings can be manipulated Earnings can be manipulated

10. Historical Analysis Need to understand past to be able to predict the future Need to understand past to be able to predict the future Reorganize statements to reflect economic vs. accounting performance Reorganize statements to reflect economic vs. accounting performance Measure and analyze ROIC = ability to create value Measure and analyze ROIC = ability to create value Assess financial health and capital structure for short and long term Assess financial health and capital structure for short and long term

11. Historical Analysis ROIC = NOPLAT / Invested capital ROIC = NOPLAT / Invested capital Reorg Balance Sheet to create invested capital Reorg Balance Sheet to create invested capital Reorg Income statement to get NOPLAT Reorg Income statement to get NOPLAT How much cash can be taken out? How much cash can be taken out? FCF = NOPLAT + noncash Op exp – invested capital FCF = NOPLAT + noncash Op exp – invested capital

12. ROIC = NOPLAT / Invested Capital Invested capital = Balance sheet = Debt + Equity? Invested capital = Balance sheet = Debt + Equity? Debt equivalents = unfunded retirement liabilities, restructuring reserves,… Debt equivalents = unfunded retirement liabilities, restructuring reserves,… Equity equivalents = deferred taxes… Equity equivalents = deferred taxes…

13. Operating liabilities netted against operating assets Non op assets not included in capital

14. ROIC = NOPLAT / Invested Capital Now to Income statement = NOPLAT Now to Income statement = NOPLAT Interest expense not subtracted Interest expense not subtracted Exclude non operating income Exclude non operating income Adjust taxes to reflect exclusions Adjust taxes to reflect exclusions What you have is basically an all equity, operations only firm What you have is basically an all equity, operations only firm

15. Taxes calc’d on operating profits If not in capital = not in NOPLAT Interest = payout to investor, not expense

16. ROIC = NOPLAT / Invested Capital Now what about Free Cash Flow? Now what about Free Cash Flow? Basically the same as tenet #8 in Topic 3 ≈ FCF = NOPLAT + Non cash opexpense – investment in capital Basically the same as tenet #8 in Topic 3 ≈ FCF = NOPLAT + Non cash opexpense – investment in capital Intangibles and goodwill – usually exclude Intangibles and goodwill – usually exclude Other Long Term assets Other Long Term assets Hidden Assets – leases, R&D Hidden Assets – leases, R&D Cash if large ≠ operating Cash if large ≠ operating

17. Taxes calc’d on operating profits CF from non-op treated separate Interest = payout to investor, not expense

18. Forecasting Models = try to reduce to simple numbers Models = try to reduce to simple numbers Make realistic assumptions on sales and costs Make realistic assumptions on sales and costs Look for the “drivers” Look for the “drivers” Two-stage growth model Two-stage growth model

19. The Forecast 1) Analyze historicals  Aggregate items or add more lines  CNBC, Yahoo, Edgar, Compustat (WRDS),… 2) Start with IS  Revenue forecast consistent with historical and economy-wide growth

20. The Forecast 3) Forecast rest of income statement consistent with “drivers”  COGS – function of sales adjusted for competition and/or productivity  Depreciation = % of revenue or % of PPE or historical equipment purchase  Interest exp or income tied to asset or liability that generates it  Taxes – look to historical or just plug 39% 4) Forecast Balance sheet, invested capital, and non-op assets  E.g. working capital tied to COGS or PPE tied to revenue or depreciation

21. The Forecast 5) Forecast investor funds  Retained earnings = old RE + NI - dividends  Other equity accounts 6) Calculate ROIC and FCF to generate value  Can use WACC or do like Buffett (long treasury rate) 7) Other issues