1. VALUATIONS CHAPTER 6

2. © Correia, Flynn, Uliana & Wormald 2 Objectives n At the end of the chapter, you should be able to: u Outline the concepts applied in the valuation of assets u Understand the effects of risk and return on valuations u Value debentures u Value preference shares u Use the constant dividend growth model to value ordinary shares u Apply a two stage valuation dividend model to value ordinary shares u Use the Free Cash flow model to value a company and the ordinary equity of a company u Use relative valuation methods such as the price-earnings (P/E) ratio to value ordinary shares u Use the EVA approach to value the ordinary equity of a firm u Understand how valuations affect the role of the financial manager

3. © Correia, Flynn, Uliana & Wormald 3 Outline n What are valuations? u Some valuation myths u What is the effect of the risk and return relationship on value? n Valuation of debentures u Debentures in perpetuity and redeemable debentures n Valuation of preference shares u Cumulative and non-cumulative preference shares, redeemable and convertible preference shares n Valuation of ordinary shares u Dividend Growth model – constant growth and two stage valuation model u Free Cash Flow model F Free cash flow to the Firm F Free cash flow to Equity u Relative valuations – P/E ratio (earnings yield) approach u The EVA approach to valuations

4. © Correia, Flynn, Uliana & Wormald 4 What are Valuations? n Determination of the value of an asset stated in monetary terms n Value = present value of future cash flows n As the future is uncertain, valuations are subject to uncertainty n An active market for assets creates a value due to the actions of many buyers and sellers

5. © Correia, Flynn, Uliana & Wormald 5 Valuation Myths n Valuations based on quantitative models are always accurate n Valuations are objective n Valuations are precise n Valuations are valid over extended time periods n The valuation number is the most important aspect of any valuation

6. © Correia, Flynn, Uliana & Wormald 6 What are the Building Blocks of a Valuation? n n The amount of each future cash flow n n The timing of such cash flows n n The riskiness of future cash flows n n The required rate of return

7. © Correia, Flynn, Uliana & Wormald 7 How does Risk and Return Affect Value? n Effect of Return on Value u If asset A is returning R1m per year and asset B is returning R1.2m per year, then asset B will have a HIGHER value if the assets are of similar risk n Effect of Risk on Value u If asset C and asset D are both offering R1m per year, but C is more risky, then asset D will have a HIGHER value n Value and rates of return u Assume cost = R10m and annual return (forever) = R1m. If required return = 12%, then value < 10m. Why? Because the actual return is only 10%. To offer 12%, the price must fall to R8.333m.

8. © Correia, Flynn, Uliana & Wormald 8 Required Return n To determine the present value of future cash flows, we need a discount rate? How do we determine the discount rate or required rate of return? n Are there similar assets trading on financial markets? n Comparison of debentures to ordinary shares n The required return on ordinary shares is called the cost of equity n This is dealt with in Chapter 7 on the cost of capital

9. © Correia, Flynn, Uliana & Wormald 9 Valuation of Debentures / Bonds n TERMS u Par Value (Face Value) u Coupon interest rate u Maturity date (redemption date) u Yield to Maturity u Yield to Call

10. © Correia, Flynn, Uliana & Wormald 10 Valuation of Debentures / Bonds n Debentures in perpetuity (non-redeemable debentures) u No redemption date u Face value = R100 and coupon rate = 15% per year. If the required return is 9%, then the value is; F R15/0.09 = R166.67 n Redeemable debentures / bonds u Face value is repaid on the set maturity date, plus interest until that date. u Face value of R100, the coupon rate is 15% and the redemption date is in 5 years time. Market yield = 9%. u PV of interest: R15 x 3.8897 = R58.34 u PV of redemption of face value: R100 x 0.6499 = R64.99 u Total value = R58.34 + R64.99 = R123.34 (slight rounding difference)

11. © Correia, Flynn, Uliana & Wormald 11 Valuation of Debentures / Bonds n Formula n Using Excel

12. © Correia, Flynn, Uliana & Wormald 12 Debentures – Yield to Maturity n Assume that the debenture (bond) is trading at R118. What is the yield to maturity (YTM)? n Use the IRR function on a financial calculator OR use Excel. You can also use trial and error (not recommended) n YTM = IRR. In Excel you need to indicate an estimate of IRR. Then Excel starts with this will do many trial and error calculations (iterations) super quickly until it gets to IRR

13. © Correia, Flynn, Uliana & Wormald 13 Preference Shares n Preference shareholders receive a fixed dividend whilst debenture (bond) holders receive interest. n Dividends are paid only after all expenses have been incurred, including interest. This means that dividends are more risky and therefore preference shares need to offer a higher return. n What is the effect of taxation? n Types of preference shares u Cumulative u Redeemable u Participating u Convertible

14. © Correia, Flynn, Uliana & Wormald 14 Cumulative Preference Shares In Arrears n 100 preference shares with an issue price of R1 each, is two years in arrears. The preference dividend rate is 12% and similar shares are offering yields of 14%. n If non-redeemable and will be paid in the future, then the value would be; R12/0.14 = R85.71 n If the next two years’ dividends will not be paid, then the value will be determined in two parts; u Value of perpetuity at end of year 3 = R12/0.14 = R85.71 u Dividend at end of year 3 = R12 x 3 = R36 u Present value today: (R36.00 + R85.71) x 0.675 = R82.71 n Note: u In terms of the new Companies Act, which is expected to come into force sometime in 2011, preference shares will no longer have a face value (par value). It will have an issue price and a redemption value (if applicable).

15. © Correia, Flynn, Uliana & Wormald 15 Valuation of Ordinary Equity n Dividend Discount Model n Free Cash Flow Model n Price Multiples (relative valuation) n EVA Discount Model

16. © Correia, Flynn, Uliana & Wormald 16 Valuation of Ordinary Equity – Zero Dividend Growth n Assume a company is expected to maintain the same dividend in future years. What are we valuing? n We are valuing a perpetuity. n Value = D / k n If dividend is R0.80 and the Cost of Equity is 11%, then the value is 0.80/.11 = R7.27

17. © Correia, Flynn, Uliana & Wormald 17 Valuation of Ordinary Equity n Dividend Growth Model u Value = PV of future dividends u If dividends are growing at a constant rate, then; u PV = D(1+g)/(k-g) F Where D(1+g) = next year’s dividendD(1+g) = next year’s dividend k = cost of equityk = cost of equity g = future constant growth rate in dividendsg = future constant growth rate in dividends

18. © Correia, Flynn, Uliana & Wormald 18 Dividend Growth Model n How do we estimate growth in dividends? n Use surrogates such as; u Growth in earnings u Growth in cash flow n Sustainable growth rate formula as a check n Growth in dividends over the long term should reflect earnings growth. If EPS is growing at 10% per year, and if current dividend growth is 20%, then this is not sustainable over the long term. Earnings growth is a long-term anchor for dividends.

19. © Correia, Flynn, Uliana & Wormald 19 Dividend Growth – Two Stage Model n How do we value a company which is experiencing a high growth in dividends which is followed later by a lower but stable growth rate in dividends? n Example: HiFly Ltd is expected to experience a growth rate of 30% for the next 3 years and thereafter will experience a growth rate of 6% per year. The cost of equity is 12% and the current dividend is 60 cents.

20. © Correia, Flynn, Uliana & Wormald 20 Two Stage Valuation n Dividend per share in year 1, 2 and 3 will be ; u Yr 1: 0.60 x 1.3 = 0.78 u Yr 2: 0.78 x 1.3 = 1.01 u Yr 3: 1.01 x 1.3 = 1.31 n Present Value of future dividends in years 1-3 = R2.43 n What is the value of the ordinary equity at the end of year 3? u Value 3 = D 3 (1+g)/(k-g) u Value 3 = 1.31(1.06)/(0.12-.06) = 23.17 u Present value today = 23.17/(1.12) 3 = 16.49 n Total Value of the shares = 16.49 + 2.43 = 18.92

21. © Correia, Flynn, Uliana & Wormald 21 Valuations – Distant Dividends n What about a company that is growing at a rapid rate in terms of market share and will only pay a dividend in the distant future? n Example: A biotech company expects to only start making a profit from year 8 and paying a dividend from year 11, which will double until year 13 and then grow at 7.5% per year. n Cost of Equity = 14%. If Cost of Equity falls to 11%, then value will rise to R6.71

22. © Correia, Flynn, Uliana & Wormald 22 Dividend Growth – From the real world n Let’s apply the dividend growth model to Woolworths n Assume a long-term sustainable growth rate of 8% (approximately 4.5% inflation and 3.5% real growth). Assume the cost of equity is 13% (Risk free rate of 7.2% + risk premium of 5%). n Assume that the high growth in earnings and dividends will continue for the next 5 years, before falling to 8% per year. Expected growth rate for 5 years is 15% per year, which reflects the growth in earnings and dividends 2004-2010. n Compare to current listed price

23. © Correia, Flynn, Uliana & Wormald 23 n Use of price multiples such as price-earnings (P/E) ratios and market to book ratios to determine whether shares are over or under-valued. n A Co. with a high growth rate will normally have a high P/E ratio. Yet this may also be due to very low earnings for a particular year. n High P/E ratios may indicate that shares are over valued. Use P/E ratios of comparable companies. n Use of listed company P/E ratios to value unlisted companies n P/E is based on historical earnings n P/E is based on accounting earnings Price Multiples - Price Earnings

24. © Correia, Flynn, Uliana & Wormald 24 Price Earnings n Assume a company has an EPS of 1.50 and comparable firms have an average P/E ratio of 10. Value = R15.00 n Do high P/E ratios indicate that company shares are overvalued? n Research by Schiller of Yale indicates that high P/E ratios generally do indicate over-valued shares n Refer to Internet Bubble in year 2000. n Average P/E ratio in South Africa is about 17.

25. © Correia, Flynn, Uliana & Wormald 25 What Returns do High PE companies Achieve in Subsequent Years? Low PE = High return in next 10 yrs High PE = Low return in next 10 yrs

26. © Correia, Flynn, Uliana & Wormald Enterprise Value n P/E ratio used to value ordinary equity n Use EBIT or EBITDA multiples to determine the value of the firm or enterprise value n Use of EBITDA enables us to ignore differences in depreciation policies and use of EBIT or EBITDA multiples means we can ignore differences in financial leverage n EBITDA of R240m x 7.5 = R1800m. Deduct value of debt to get to value of equity 26

27. © Correia, Flynn, Uliana & Wormald 27 Market to Book Ratio n Book value per share = shareholders equity/no. of shares n High growth companies will have high market to book ratios n Market to book ratios are dependent on the industry sector n Is the sector capital intensive? n Specific sectors u Pharmaceutical sector – High R&D – is this an asset or expense? u Branded products – advertising costs – asset or expense? u Are Tiger Brands and Shoprite capital intensive? u Market to Book is an important ratio in the valuation of banks

28. © Correia, Flynn, Uliana & Wormald 28 Free Cash Flow Model n Value of the Firm = present value of future operating cash flows discounted at the firm’s cost of capital (WACC) n FCF = Net operating profit after tax (NOPAT) + depreciation – capital expenditure –increase in net working capital n Value of Ordinary Equity = Value of Firm less value of debt

29. © Correia, Flynn, Uliana & Wormald 29 Alternative: Free Cash Flow to Equity n We can determine the value of ordinary equity by discounting the cash flows due to shareholders after financing costs and changes in financing flows n FCFE = NOPAT + depreciation – capital expenditure – increase in net working capital – financing costs plus (minus) increase (decrease) in debt financing n Discount rate = cost of equity n Recommended for valuing firms with high levels of debt and banks. For other firms, use FCF to operations to value the firm and then deduct debt.

30. © Correia, Flynn, Uliana & Wormald 30 Free Cash Flow - Continuing Values n Using the Free Cash Flow Model, we estimate the future cash flows for an explicit period, normally 7- 10 years, and determine a continuing value after the initial period, assuming a constant sustainable growth rate and margin. n Continuing values (terminal values) are determined at the end of the initial period as follows; n Note that FCF 1 or FCFE 1 in this context is the following year’s cash flow (at the end of the initial period).

31. © Correia, Flynn, Uliana & Wormald 31 Free Cash Flows - Example n Assume a company, Stop-to-Shop Ltd, has current earnings before interest and tax (EBIT) of R72m on sales of R600m. The following parameters apply;

32. © Correia, Flynn, Uliana & Wormald 32 Stop-to-Shop Ltd

33. © Correia, Flynn, Uliana & Wormald 33 Free Cash Flow - Workings n Stop-to-Shop Ltd

34. © Correia, Flynn, Uliana & Wormald 34 EVA Approach n EVA = NOPAT – (WACC x Asset Book Value) Assume Asset Book Value = Invested Capital Assume Asset Book Value = Invested Capital n Value of firm = Book value + PV of future EVAs n Example: GoFlow Ltd is earning a return of 25% for next 3 years and its WACC is 10%. The book value of its assets is expected to remain at R180m. The return after year 3 will be 10%.

35. © Correia, Flynn, Uliana & Wormald 35 The Process of Valuation n Value what is and what could be. n Valuation Questions

36. © Correia, Flynn, Uliana & Wormald 36 Valuations and the Financial Manager n Focus on shareholder value means that the financial manager will focus on value maximisation. n Why is valuation important? u Valuation of company and divisions for listing purposes u Valuations for purpose of divestures or acquisitions u Valuation for purpose of determining an optimal capital structure u Valuation for determining cost of equity and WACC u Share buybacks u Managerial remuneration

37. © Correia, Flynn, Uliana & Wormald 37 Valuations - Pitfalls n Confusing the valuation of equity with the valuation of the firm n Using the wrong discount rate - use the cost of equity for cash flows to ordinary equity and the WACC for cash flows to the firm n Adjusting for risk in the cash flows and the discount rate n Not recognising the risk of a changing capital structure in the discount rate n No comparable firms n Double counting for synergy by increasing cash flows and reducing the discount rate n Increasing the discount rate for country risk when this is already included in the risk free rate n Misestimating the value of control.