1. Valuation

2. Prof. Ian Giddy New York University
NYU
Valuing a Business I
Prof. Ian Giddy
New York University

3. Estimating Growth Rates Applications Option-based models
What’s a Company Worth?
Required returns
Types of Models
Balance sheet models
Comparables
Corporate cash flow models
Estimating Growth Rates
Applications
Option-based models

4. IBM
Source: biz.yahoo.com

5. IBM
Source: biz.yahoo.com

6. IBM’s Financials
Source: morningstar.com

7. Equity Valuation: From the Balance Sheet
Value of Assets
Book
Liquidation
Replacement
Value of Liabilities
Book
Market
Value of Equity

8. 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)

9. Relative Valuation
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
and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios
and variants (Tobin's Q)
• Price/Sales ratios
This is the preferred mode of valuation on Wall Street. Philosophically, it is a different way of thinking about valuation.
In relative valuation, we assume that markets make mistakes on individual investments, but that they are right, on average, in how they price a sector or the market. (In discounted cash flow valuation, we assume that markets make mistakes over time.)

10. Comparables Value Indicator Earnings Cash Flow Revenues Book Average
Industry
Firms
Deals
Target
Company
Numbers or
Projections
Estimated
Value of
Target

11. IBM: Comparables
Source: Reuters

12. What is Conrail Worth?

13. Disney: Relative Valuation
PE ratio divided
by the growth rate
Disney: Relative Valuation
Company PE Expected Growth PEG
King World Productions % 1.49
Aztar % 0.99
Viacom % 0.67
All American Communications % 0.79
GC Companies % 1.35
Circus Circus Enterprises % 1.22
Polygram NV ADR % 1.74
Regal Cinemas % 1.12
Walt Disney % 1.55
AMC Entertainment % 1.48
Premier Parks % 1.18
Family Golf Centers % 0.92
CINAR Films % 1.94
Average % 1.20
Note that when people compare firms across sectors, they implicitly assume that firms in a sector have similar risk and cash flow characteristics. This is clearly a dangerous assumption to make.
The PEG ratio is a simplistic way of controlling for expected growth differences across firms. A low PEG ratio is viewed as a sign of an undervalued firm.
The PEG ratio is based upon the implicit assumption that PE and expected growth are linearly related.

14. IBM: Forward Comparables
Source: morningstar.com

15. Corporate Cash Flow

16. Discounted Cashflow Valuation: Basis for Approach
where
n = Life of the asset
CFt = Cashflow in period t
r = Discount rate reflecting the riskiness of the estimated cashflows
The basics of valuation are no different from the basics of project analysis. The value of any asset is the present value of the expected cash flows over its life.

17. Start with the Weighted Average Cost of Capital
Choice Cost
1. Equity Cost 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. Debt Cost 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
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

18. IBM’s Cost of Capital

19. Valuation: The Key Inputs
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.
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:
In practical terms, this means that we have to estimate detailed cash flows until we expect the firm to be in stable growth.
The alternative way of applying closure, which is to estimate the terminal value by applying a multiple of earnings to the fifth or tenth year’s earnings ends up being a relative valuation rather than a discounted cash flow valuation. (The value is heavily influenced by the multiple used to get terminal value)

20. Dividend Discount Models: General Model
V0 = Value of Stock
Dt = Dividend
k = required return

21. No Growth Model
Stocks that have earnings and dividends that are expected to remain constant
Preferred Stock

22. No Growth Model: Example
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?
E1 = D1 = $5.00
k = .12
V0 = $5.00/0.12 = $41.67

23. g = constant perpetual growth rate
Constant Growth Model
g = constant perpetual growth rate

24. Constant Growth Model: Example
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?
E1 = $5.00 k = 12%
D1 = $3.00 g = 6%
V0 = 3.00 / ( ) = $50.00

25. Estimating Dividend Growth Rates
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
i.e.(1- dividend payout percentage rate)

26. Or Use Analysts’ Expectations?
Source: biz.yahoo.com

27. Shifting Growth Rate Model
g1 = first growth rate
g2 = second growth rate
T = number of periods of growth at g1

28. Shifting Growth Rate Model: Example
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?
D0 = $ g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = D3 = D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3
+ D4 / ( ) ( (1.15)3
V0 = = $30.40

29. Stable Growth and Terminal Value
When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates.
While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time.
When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.
To apply the terminal value approach, the firm has to be in a growth rate that is sustainable forever. Since no firm can grow faster than the economy in which it operates forever, this puts the logical bound of the economy’s growth rate on this number.
If this is done in real terms, it will be the economy’s real growth rate
To the extent that a firm (like Coca Cola) services the world economy the real growth rate of the world economy can be used.
The nominal growth rate that can be used will depend upon the currency in which the cash flows are estimated. The expected inflation rate in that currency can be added to the real growth rate to arrive at the nominal growth rate.
As a simple rule of thumb, this nominal growth rate should not be much higher than the long term government bond rate.

30. Choosing a Growth Pattern: Examples
Company Valuation in Growth Period Stable Growth
PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth rate in the world economy
DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term US growth rate
Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth rate in the European economy
I would not be inclined to use growth periods longer than 10 years. While there are firms like IBM, Microsoft and Coca Cola which have been able to sustain growth for much longer periods, they are more the exception than the rule. Most firms are able to maintain high growth for shorter periods.
I am going to use firm valuation for Disney, because I expect leverage to change, and firm valuation is simpler when that occurs
For Aracruz, I will use FCFE, since I do not expect leverage to change, and do the analysis in real terms, to avoid having to deal with expected inflation in BR
For Deutsche Bank, where it is difficult to estimate free cash flows, I will use dividends and make the assumptions that dividends over time will be equal to FCFE.

31. The Building Blocks of Valuation
Valuation models represent some combination of these three choices - a cash flow, a discount rate and a growth pattern.

32. Estimating Future Cash Flows
Dividends?
Free cash flows to equity?
Free cash flows to firm?

33. 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

34. Deriving IBM’s Free Cash Flows
IBMvaluation.xls

35. Two Applications

36. Equity Valuation: Two Applications
Prof. Ian Giddy
New York University

37. Equity Valuation in Practice
Estimating discount rate
Estimating cash flows
Estimating growth
Application with constant growth: Optika
Application with shifting growth: Fong

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

39. Optika: Facts
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.
Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%.
The market value of equity is €1.3b.
Is this firm fairly valued in the market? What assumptions might be changed?

40. Optika
optika.xls

41. Optika WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) CAPM:
7%+1(5.50%)
Equity Value:
Firm Value - Debt Value
= = 2431
Debt cost
(7%+1.5%)(1-.35)
optika.xls

42. Valuing a Firm with DCF: The Extended Version
Historical financial results
Adjust for nonrecurring aspects
Gauge future growth
Projected sales and operating profits
Adjust for noncash items
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
Discount to present using weighted average cost of capital (WACC)
Present value of free cash flows
+ cash, securities & excess assets
- Market value of debt
Value of shareholders equity

43. Valuation Example: Shifting Growth

44. Valuation Example: Shifting Growth
fong.xls

45. Case Study: IBM

46. Case Study: IBM
IBMvaluation.xls

47. Summary: The Building Blocks of Valuation
Valuation models represent some combination of these three choices - a cash flow, a discount rate and a growth pattern.

48. Alternatives

49. Equity Valuation: Alternatives
Prof. Ian Giddy
New York University

50. What’s a Company Worth? Alternative Models
The options approach
Option to expand
Option to abandon
Creation of key resources that another company would pay for
Patents or trademarks
Teams of employees
Customers
Examples?

51. What’s a Company Worth? The Options Approach
Value of the Firm or project
Present Value of Expected
Cash Flows if Option Excercised

52. The Value of a Corporate Option
Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today.
The value of these rights increases with the volatility of the underlying business.
The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits.

53. Extreme Situations: Equity is Like an Option
Assets
Liabilities
Debt
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Equity
Residual payments
Upside and downside
Residual claims
Voting control rights

54. Marvel in Trouble, 1996 Secured and senior Get fully repaid under plan
Banks
Secured and senior
Get fully repaid under plan
Icahn et al.
Choices:
Accept Perelman’s plan
Sell the debt at $.14-$.17
Reject plan and propose own
Perelman
Controls Marvel equity
NPV is negative
Option value may be positive

55. Next…
Valuation
Acquisition
LBOs
Restructuring

58. Contact Prof. Ian Giddy NYU Stern School of Business
44 West 4th Street
New York, NY 10012
Tel ; Fax

59. Valuation
Acquisition
LBOs
Restructuring
More to come…