1. FIN449 Valuation
Michael Dimond

2. Where are we going with all this?
Facts & Information
Risk &
Cost of Capital
Forecast Financials
Recasting & Sustainable OCF
DCF Calculations
Exam
Starbucks
Burger King
Comps
Final Project
Value &
Perspective

3. Valuation – The Big Picture

4. Forecasting, continued
What did you learn from the forecasting exercise?
Make the spreadsheet do the work for you
How does the projected growth compare to SGR & IGR, and to economic limitations?
Where are you “plugging” for additional funds needed?
Do the figures make sense?
How does this connect to your knowledge of the company’s strategy?

5. Been to a video store lately?
The 80s video store
Video chains
Delivery
Streaming

6. Netflix Sales $ growth 46%, 21%, 13%, 22% respectively
Sales $ CAGR 25%

7. Netflix Sales Vol growth 51%, 18% 26%, 31% respectively
Sales Vol CAGR 31%

8. Netflix
Sales Price growth…
Sales Price CAGR…

9. Netflix

10. Been to a video store lately?
The 80s video store
Video chains
Delivery
Streaming
Better streaming
NPD, not R&D

11. Been to a video store lately?
The 80s video store
Video chains
Delivery
Streaming
Better streaming
NPD, not R&D
The extra dollar
Customer Satisfaction Proposition (not Customer “Value” Proposition, IMHO)
Forecasting
Graduation

12. Assumptions What assumptions are we making about PepsiCo?
How can we test each?
What segments for sales are you using?
How are you attributing growth to volume & price?
What is PepsiCo’s relationship between sales & assets?
What about costs of raw materials?

13. The Right Tax Rate to Use
The choice really is between the effective and the marginal tax rate. In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books.
What about GE and their zero tax liability?
By using the marginal tax rate, we tend to understate the after-tax operating income in the earlier years, but the after-tax tax operating income is more accurate in later years
If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time.
If you have a choice, you would prefer to do valuation with the tax books in front of you, but since you do not have that choice as an outsider you have to choose between the effective tax rate and the marginal tax rate.
If you use the effective tax rate all the way through, you are assuming that taxes can be deferred forever. This is unrealistic - tax deferrals catch up with you as your growth flags - and will result in an overvaluation of your firm.
If you use a marginal tax rate, you are assuming that you cannot defer taxes from this point on. This is far too conservative and will yield too low a value for your firm.
Suggestion: Start with the effective tax rate in the early years and move towards the marginal tax rate in the terminal year. 13

14. Expected FCF Forecast, then Recast
Start by predicting what is likely to be published on the financial statements.
After that, recast the figures to better reflect the economic realities for operating leases, R&D (if applicable) and sustainability of operating cash flows.
Compute FCFs using more than one formula to ensure you have found all the issues in your figures.

15. Valuation Value = Debt Value + Equity Value
Equity Value / Shares Outstanding = “Correct” Price per Share
Context & perspective come from comparables and other less robust methods
Publicly traded company can be declared to be “overvalued” or “undervalued”

16. What is Free Cash Flow – Really?
Free Cash Flow is cash available to some relevant entity.
OCF refers to cash from a firm’s ongoing operating activities (NI = OCF + Accruals).
FCFF is OCF adjusted for investments and divestments in operating assets, and is available to debt holders and equity holders.
FCFE is FCFF adjusted for changes in the firm’s debt levels, and is available to equity holders.
In both FCFF and FCFE, some or all of this amount may be reinvested in the company.
Why is valuation using Dividends less realistic than using Free Cash Flows?

17. When to use Free Cash Flow to the Firm
Use Firm Valuation (FCFF)
(a) for firms which do not have an optimal capital structure (leverage is too high or too low), and expect to change the leverage over time. Debt payments and issues do not have to be factored into the cash flows and the discount rate (WACC) does not change dramatically over time.
(b) for firms which have only partial information on leverage available (e.g. interest expenses are missing).
(c) in cases where value of the firm is more relevant than the value to the shareholders (e.g. projects which create value).
As a rule, firm valuation (FCFF) is a more flexible approach than equity valuation (FCFE).

18. FCFF – Circular Reasoning?
To discount FCFF we use the WACC, which is calculated using the market values of equity and debt. We then use the present value of the FCFF as our value for the firm and derive an estimated value for equity.
There appears to be some circular reasoning involved because the market values of equity and debt are both inputs in computing the cost of capital and outputs.
To get around this issue, one could use an iterative approach: Re-estimate the WACC using the new estimated values, which would change the inputs and the cost of capital.
There should be convergence at some point in this process, but is cumbersome.

19. When to use Free Cash Flow to Equity
When leverage is stable, you can use the short cut for estimating free cash flows to equity (Firm Value – MV of Debt).
Use Equity Valuation (FCFE)
(a) for firms which have stable leverage, whether high or not, and
(b) if equity (stock) is being valued
When leverage is changing, modeling cash flows to equity becomes problematic (How much cash will be raised from new debt issues? How much old debt will be paid off each year?).

20. Measuring Cash Flows
To go from reported to actual earnings we may have to:
Update earnings & data to the date of interest
Make corrections from Accounting Earnings
Adjust for One-Time and Non-recurring Charges

21. From Reported to Actual Earnings
Very seldom can you use the reported earnings in the annual report in valuation. This lays out the three adjustments that you usually have to make before you start doing valuation:
You might need to update the accounting information for most recent reports that have come from the firm or other sources.
If you have a cyclical or commodity firm, you have to adjust the earnings for where in the cycle (of the economy, for a cyclical firm, or for the commodity price, for a commodity firm) you are currently.
You have to clean up for obvious shortcomings in accounting rules.

22. Updating Earnings
When valuing companies, we often depend upon financial statements for inputs on earnings and assets. Annual reports are often outdated and can be updated by using-
Trailing 12-month data, constructed from quarterly earnings reports.
Informal and unofficial news reports, if quarterly reports are unavailable.
Updating makes the most difference for smaller and more volatile firms, as well as for firms that have undergone significant restructuring.
For larger and more mature firms, you can get away with using the most recent annual report. The younger the firm and the more tumultuous the times (the economy entering a recession, for instance), the more you have to worry about using dated information.
Your objective in valuation is simple. You want to use the most recent information you can get for every input, even if it means that your inputs are observed at different points in time - the market values may be from today and the accounting information from the most recent quarterly report.

23. Recasting Financial Statements

24. One-Time and Non-recurring Charges
Assume that you are valuing a firm that is reporting a loss of $ 500 million, due to a one-time charge of $ 1 billion. What is the earnings you would use in your valuation?
A loss of $ 500 million
A profit of $ 500 million
Would your answer be any different if the firm had reported one-time losses like these once every five years?
Yes No
If it is truly a one-time change, you should use a profit of $ 500 million.
If the firm is playing games (consolidating expenses and reporting them as one-time charges every five years), you should take the average annual expense of $ 200 million (1/5 of $ 1 billion) and estimate a profit of $ 300 million.
Don’t take company characterizations of non-recurring charges at face value. Look at the firm’s history. 24

25. Correcting Accounting Earnings
COGS Adjustment: Inventory costs are associated with particular goods using one of several formulas, including specific identification, last-in first-out (LIFO), first-in first-out (FIFO), or average cost. This may affect the value of a firm compared to the accounting information presented.
The Operating Lease Adjustment: While accounting convention treats operating leases as operating expenses, they are really financial expenses and need to be reclassified as such. This has no effect on equity earnings but does change the operating earnings
The R & D Adjustment: Since R&D is a capital expenditure (rather than an operating expense), the operating income has to be adjusted to reflect its treatment (only if there is significant intellectual property).
These are fairly standard adjustments you have to make to almost every firm that you encounter though the consequences are going to be larger for some firms than others. 25

26. From the Statement of Cash Flows
Begin with Net Income
Adjust for Net Interest After Tax
Adjust for cash requirements for liquidity
= Free Cash Flow from Operations
Adjust for Capital Expenditures
= Free Cash Flow to the Firm
Adjust for Debt Cash Flows
Adjust for Financial Asset Cash Flows
Adjust for Preferred Stock Cash Flows
= Free Cash Flow to Equity

27. Adjust for Net interest after tax
Begin with Net Income
Adjust for Net interest after tax
Add back cash outflows for interest expense net of tax effects
Subtract cash inflows for interest income net of tax effects
Adjust for cash requirements for liquidity
Subtract an increase of cash required for operational liquidity (or add back a decrease in cash required).
= Free Cash Flow from Operations

28. From Free Cash Flow from Operations
Adjust for Capital Expenditures: PP&E, Affiliated Companies, Intangible Assets, possibly for R&D
Subtract cash outflows for purchase assets which are part of the productive capacity of the firm’s operations.
Add cash inflows from sales of assets which are part of the productive capacity of the firm’s operations.
Add current year’s R&D expenses - Amortization of Research Asset
= Free Cash Flow to the Firm
ONLY if the firm is creating significant intellectual property from R&D

29. From the Statement of Cash Flows
From Free Cash Flow to the Firm
Adjust for Debt Cash Flows
Add cash inflows from new borrowings – short-term and long-term interest-bearing debt capital.
Subtract cash outflows from repayments short-term and long-term interest-bearing debt capital.
Adjust for Financial Asset Cash Flows
Subtract cash outflows invested in cash, short-term or long-term investment securities which are part of the financial capital structure of the firm (not part of the operating activities of the firm)
Add cash inflows from short-term or long-term investment securities which are part of the financial capital structure of the firm
Adjust for Net Interest After Tax
Subtract cash outflows for interest expense net of tax effects
Add back cash inflows for interest income net of tax effects
Adjust for Preferred Stock Cash Flows
Add cash inflows from new issues of preferred stock
Subtract cash outflows from preferred stock retirements and dividend payments
= Free Cash Flow to Equity

30. Dealing with Operating Lease Expenses
Operating Lease Expenses are treated as operating expenses in computing operating income. In reality, operating lease expenses should be treated as financing expenses, with the following adjustments to earnings and capital:
Debt Value of Operating Leases = PV of Operating Lease Expenses at the pre-tax cost of debt
Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses - Depreciation on Leased Asset
As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases.
From an intuitive standpoint, there is little difference between a term loan (where you pay off a loan in equal annual installments) and an operating lease. It may be more like unsecured debt than secured debt but it is debt.
It is not just debt that is affected when you convert operating leases to debt. The operating income also will change.

31. Effects of Capitalizing Operating Leases
Debt : will increase, leading to an increase in debt ratios used in the cost of capital and levered beta calculation
Operating income: will increase, since operating leases will now be before the imputed interest on the operating lease expense
Net income: will be unaffected since it is after both operating and financial expenses anyway
Return on Capital will generally decrease since the increase in operating income will be proportionately lower than the increase in book capital invested
Traces the effect of converting operating leases to debt. Both operating income and capital invested increase. The net effect on return on captial will depend upon which increases more.

32. The Magnitude of Operating Leases
The firms where operating leases matter the most are retail firms…

33. Dealing with Operating Leases
In 1998, Home Depot did not carry much in terms of traditional debt on its balance sheet. However, it did have significant operating leases.
When doing firm valuation, these operating leases have to be treated as debt. This, in turn, will mean that operating income has to get restated.
Operating leases are debt and have to be treated as such all the way through the valuation.

34. Operating Leases at Home Depot in 1998
The pre-tax cost of debt at the Home Depot is 5.80%
Year Commitment Present Value
1 $ $277.88
2 $ $259.97
3 $ $222.92
4 $ $195.53
5 $ $178.03
6 and beyond $ $1,513.37
Debt Value of leases = $2,647.70
The Home Depot reports its lease commitments in its financial statements. The present value of operating lease expenses is computed using the pre-tax cost of debt. (An argument can be made that the unsecured cost of debt should be used.)

35. Other Adjustments from Op. Leases
Operating Lease Operating Lease
Expensed converted to Debt
EBIT $ 2,661mil $ 2,815 mil
EBIT (1-t) $1,730 mil $1,829 mil
Debt $1,433 mil $ 4,081 mil
What else?
Everything changes… Since operating income and book debt both change, the return on capital will also change.

37. Capitalizing R&D Expenses
Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures.
To capitalize R&D,
Specify an amortizable life for R&D ( years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from five years ago, 2/5th of the R&D expense from four years ago...:
The argument used by accountants - that R&D yields uncertain benefits - is specious. You could make the same argument about other investments - investing in a factory in an emerging market, deciding to build a concept car - and you are forced to treat these as capital expenditures.
To capitalize R&D, you need to specify
On average, how long it takes between the time you do research and a commercial product emerges from the research. (This is the amortizable life)
R&D expenses from the past (for a period equivalent to the amortizable life). If your firm has not been in existence for that long, you would go back for as many years as you can.
Depreciation schedules - stick with the simplest which is straight line depreciation.

38. The Magnitude of R&D Expenses
Again, the effects of R& D expensing are uneven. They matter more for technology firms and pharmaceutical firms than for the rest of the market. However, you could argue that training expenses are the equivalent of R&D for a financial services or consulting firm.

39. Capitalizing R&D Expenses: Cisco
R & D was assumed to have a 5-year life.
(all figures as of 1999 data)
Year R&D Expense Unamortized portion Amortization this year
$205.20
$139.60
$79.80
$42.20
$17.80
Total $ 3, $
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1998 = $ million
Adjustment to Operating Income = $ 1,594 million million = 1,109.4 million
The amortizable life is an assumption based upon Cisco’s business (telecom equipment and software). It would be shorter in other businesses (such as computer chips) and longer in businesses that need regulatory approval (such as pharmaceuticals).
Note that the amortization is 1/5 of the R&D expense each year.
We are also assuming that R&D expenses are spent at the end of each year - not realistic, but simplifies analysis - that is why there is no amortization of the current year’s expense.
The effect of capitalizing R&D will be greatest at firms where R&D is growing over time and be non-existent at firms with flat R&D.

40. The Effect of Capitalizing R&D
Operating Income will generally increase, though it depends upon whether R&D is growing or not. If it is flat, there will be no effect since the amortization will offset the R&D added back. The faster R&D is growing the more operating income will be affected.
Net income will increase proportionately, depending again upon how fast R&D is growing
Book value of equity (and capital) will increase by the capitalized Research asset
Capital expenditures will increase by the amount of R&D; Depreciation will increase by the amortization of the research asset; For all firms, the net cap ex will increase by the same amount as the after-tax operating income.
Traces out the effects of capitalizing R&D. The key aspect is that operating income will be increased by exactly the same amount that net capital expenditures will be increased, with the increase being:
Change in operating income and net cap ex = Current year’s R&D expense - R&D amortization
In other words, the free cashflow to the firm will not change as a result of this capitalization. So why do it? It allows us to
Get a better sense of the profitability of the firm (operating income and return on capital.
Better estimate how much the firm is reinvesting for future growth.

42. Net Capital Expenditures
Net capital expenditures represent the difference between capital expenditures and depreciation. Depreciation is a cash inflow that pays for some or a lot (or sometimes all of) the capital expenditures.
In general, the net capital expenditures will be a function of how fast a firm is growing or expecting to grow. High growth firms will have much higher net capital expenditures than low growth firms.
Assumptions about net capital expenditures can therefore never be made independently of assumptions about growth in the future.
It is dangerous to have three separate (and unconnected) line items for capital expenditures, depreciation and growth in a valuation. Analysts very quickly discover the secret of value creation (at least on paper) - decrease cap ex, increase depreciation and increase growth.

43. Capital expenditures should include
Research and development expenses, once they have been re-categorized as capital expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D expenses - Amortization of Research Asset
Acquisitions of other firms, since these are like capital expenditures. The adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms - Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually categorized under other investment activities
The accounting definition of cap ex is too narrow. It excludes external cap ex (which is what acquisitions are) and intangible cap ex (which is what R&D is).
We would include all acquisitions, including stock swaps acquisitions. To those who would argue that there is no cashflow associated with stock swaps, we would suggest that all that has occurred is that the firm has just skipped a step - the firm could have issued the stock to the market and used the cash on the acquisitions.
It is true that incorporating acquisitions into valuation can be messy for firms that do relatively few and very diverse acquisitions over time. You have the option of ignoring these acquisitions when you do valuation but make sure that the expected growth rate in earnings does not then include the expected growth from acquisitions. You are implicitly assuming that acquisitions in the future will be done at fair value and hence have no value impact.

44. Cisco’s Acquisitions: 1999
Acquired Method of Acquisition Price Paid
GeoTel Pooling $1,344
Fibex Pooling $318
Sentient Pooling $103
American Internet Purchase $58
Summa Four Purchase $129
Clarity Wireless Purchase $153
Selsius Systems Purchase $134
PipeLinks Purchase $118
Amteva Tech Purchase $159
$2,516
You have to dig to find this. Cisco’s 10K yielded this. To estimate the price paid for the pooling acquisitions - which were funded with stock - we multiplied the shares offered in the acquisition by the share price at the time of the acquisition.

45. Cisco’s Net Capital Expenditures in 1999
Cap Expenditures (from statement of CF) = $ 584 mil
- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil
(Amortization was included in the depreciation number)
The true net cap ex of $ 3.7 billion is well in excess of the net cap ex from the accounting statement ($98 million).

47. Working Capital Investments
In accounting terms, the working capital is the difference between current assets (inventory, cash and accounts receivable) and current liabilities (accounts payables, short term debt and debt due within the next year)
A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable)
Any investment in this measure of working capital ties up cash. Therefore, any increases (decreases) in working capital will reduce (increase) cash flows in that period.
When forecasting future growth, it is important to forecast the effects of such growth on working capital needs, and building these effects into the cash flows.
We remove cash from current assets because cash is not a wasting asset for most firms with substantial cash balances. Cash today tends to be invested in treasuries or commercial paper which yields a fair return for the risk taken (which is little or none). There are some analysts who still use operating cash (which they estimate as a percent of revenues) as part of working capital, but we believe that this is no longer appropriate for firms in markets with well developed banking systems and investment alternatives.
The debt in current liabilities is included in the debt used for cost of capital.

48. Assignment See online document
Due Wednesday . You may turn it in to me directly or to the SBA Faculty Services office on the 5th Floor.