1. FIN449 Valuation Michael Dimond

2. Value & Perspective Where are we going with all this? Risk & Cost of Capital Forecast Financials Recasting & Sustainable OCF DCF Calculations Comps Exam Valuation #2 Valuation #3 Final Project Facts & Information

3. Valuation – The Big Picture

4. Why use Fundamental Analysis? January 2000: Internet Capital Group was trading at $174. “Valuation is often not a helpful tool in determining when to sell hypergrowth stocks”, Henry Blodget, Merrill Lynch Equity Research Analyst in January 2000, in a report on Internet Capital Group. There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers (inefficiencies of the market), and not by anything as prosaic as cash flows or earnings. Perceptions do matter, but they are not everything. Asset prices cannot be justified by merely using the “bigger fool” theory.

5. “Irrational Exuberance” January 2000: Internet Capital Group was trading at $174. January 2001: Internet Capital Group was trading at $ 3.

6. How about mistaken notions of how the market works? January 2000: Internet Capital Group was trading at $174. January 2001: Internet Capital Group was trading at $ 3.

7. Discounted Cash Flow Valuation What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Fundamental Analysis derives those cash flows from the underlying, or fundamental, operations of the business.

8. Discounted Cash Flow Valuation (cont’d) Information Needed: To use discounted cash flow valuation, you need to estimate the life of the asset estimate the cash flows during the life of the asset estimate the discount rate to apply to these cash flows to get present value Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

9. Advantages of DCF Valuation Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm (fundamentals) and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

10. Disadvantages of DCF valuation Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.

11. Disadvantages of DCF Valuation (con’t) In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector equity portfolio managers, who have to be fully (or close to fully) invested in equities

12. When DCF Valuation works best This approach is easiest to use for assets (firms) whose cashflows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to “true” value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm

13. Discounted Cashflow Valuation where CF t is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

14. Equity Valuation versus Firm Valuation Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm

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. First Principle of Valuation Never mix and match cash flows and discount rates. The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.

18. Equity Valuation The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. where, CF to Equity t = Expected Cashflow to Equity in period t k e = Cost of Equity The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends.

19. Firm Valuation The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. where, CF to Firm t = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital

20. Cash Flow Computation Use the following data to compute OCF & FCF

24. Firm Value and Equity Value To get from firm value to equity value, which of the following would you need to do?  Subtract out the value of long term debt  Subtract out the value of all debt  Subtract the value of all non-equity claims in the firm, that are included in the cost of capital calculation  Subtract out the value of all non-equity claims in the firm Doing so, will give you a value for the equity which is  greater than the value you would have got in an equity valuation  lesser than the value you would have got in an equity valuation  equal to the value you would have got in an equity valuation

25. Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to EquityInt Exp (1-t)CF to Firm 1$ 50$ 40$ 90 2$ 60$ 40$ 100 3$ 68$ 40$ 108 4$ 76.2$ 40$ 116.2 5$ 83.49$ 40$ 123.49 Terminal Value$ 1603.0$ 2363.008 Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) The current market value of equity is $1,073 and the value of debt outstanding is $800. Calculate the Equity Value and the Firm Value.

26. Equity versus Firm Valuation Method 1: Discount CF to Equity at Cost of Equity to get value of equity Cost of Equity = 13.625% PV of Equity = 50/1.13625 + 60/1.13625 2 + 68/1.13625 3 + 76.2/1.13625 4 + (83.49+1603)/1.13625 5 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.0994 2 + 108/1.0994 3 + 116.2/1.0994 4 + (123.49+2363)/1.0994 5 = $1873 PV of Equity = PV of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073

27. First Principle of Valuation Never mix and match cash flows and discount rates. The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.

28. The Effects of Mismatching Error 1: Discount CF to Equity at Cost of Capital to get equity value PV of Equity = 50/1.0994 + 60/1.0994 2 + 68/1.0994 3 + 76.2/1.0994 4 + (83.49+1603)/1.0994 5 = $1248 Value of equity is overstated by $175. Error 2: Discount CF to Firm at Cost of Equity to get firm value PV of Firm = 90/1.13625 + 100/1.13625 2 + 108/1.13625 3 + 116.2/1.13625 4 + (123.49+2363)/1.13625 5 = $1613 PV of Equity = $1612.86 - $800 = $813 Value of Equity is understated by $ 260. Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity Value of Equity = $ 1613 Value of Equity is overstated by $ 540

29. Supplementary Material 96 Common Errors in Company Valuations by Pablo Fernandez & Jose Maria Carabias http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151

30. More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to EquityInt Exp (1-t)CF to Firm 1$ 50$ 40$ 90 2$ 60$ 40$ 100 3$ 68$ 40$ 108 4$ 76.2$ 40$ 116.2 5$ 83.49$ 40$ 123.49 Terminal Value$ 1603.0$ 2363.008 Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) What is the growth rate for FCFE assumed for each year? How is terminal value calculated? What is the implied growth rate for the terminal value?

31. More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to Equity 1$ 50 2$ 6020% growth 3$ 6813.3% growth 4$ 76.212.1% growth 5$ 83.499.6% growthCAGR = 13.7% Terminal Value$ 1603.0 TV = CF n x (1+ g) ÷ (K e – g) = 1603.0 TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0 g = ? (83.49 ÷ 50)^(1/4) - 1

32. Terminal Growth Rate TV = CF n x (1+ g) ÷ (K e – g) :. TV x (K e – g) = CF n x (1+ g) :. TV x K e – TV x g = CF n + CF n x g :. TV x K e – TV x g – CF n = CF n x g :. TV x K e – CF n = CF n x g + TV x g :. TV x K e – CF n = g x (CF n + TV) :. (TV x K e – CF n ) ÷ (CF n + TV) = g Since g = (TV x K e – CF n ) ÷ (CF n + TV) g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00%

33. More About Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. YearCF to Equity 1$ 50 2$ 6020% growth 3$ 6813.3% growth 4$ 76.212.1% growth 5$ 83.499.6% growthCAGR = 13.7% Terminal Value$ 1603.0 TV = CF n x (1+ g) ÷ (K e – g) = 1603.0 TV = 83.49 x (1 + g) ÷ ( 13.625% – g) = 1603.0 g = ((1603 x 13.625%) – 83.49) ÷ (83.49 + 1603) = 8.00% (83.49 ÷ 50)^(1/4) - 1

34. Calculating Free Cash Flow to Equity FCFE = Net income – Net investment + Net debt issued

35. Net Investment Net investment = (Capital expenditures – Depreciation) + Increase in noncash working capital

36. CapEx Line item on Statement of Cash Flows? Calculate the changes (from year to year) of ALL long-term assets shown on the balance sheet. Find the total amount (for a given year) shown in the “Investing” section of the Statement of Cash Flows. Issues?

37. Depreciation “Basic definition” of net cash flow = net income + depreciation Non-cash expense In the “balance sheet” approach to define capital expenditures, depreciation is usually not incorporated explicitly. Why not? If the “Statement of Cash Flows” approach is used, one must explicitly subtract depreciation from capital expenditures (shown in the “Operating” section of the Statement of Cash Flows)

38. Non-cash Working Capital Noncash working capital = (current assets – cash) – current liabilities… what else? Noncash working capital = (current assets – cash) – (current liabilities – interest bearing debt included in current liabilities) Why? Why not include cash?

39. Net Debt Issued “Net” debt issued implies that one must take both debt issuances AND repayments into account Discussion: Constant Debt Ratio Suppose a firm always finances new investment with a fixed debt ratio (say, 30% debt and 70% equity, for example). The general equation for FCFE then may be expressed as follows: FCFE = Net income – (1 – debt ratio)(Net investment) OR FCFE = Net income – (equity ratio)(Net investment)

40. Free Cash Flow to Equity FCFE = Net income – Net investment + Net debt issued

41. Data Source: EDGAR http://www.sec.gov