1. Valuation FIN 449 Michael Dimond

2. Michael Dimond School of Business Administration 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 Facts & Information Final Project Valuation #1

3. Michael Dimond School of Business Administration Valuation – The Big Picture

4. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration “Irrational Exuberance” January 2000: Internet Capital Group was trading at $174. January 2001: Internet Capital Group was trading at $ 3.

6. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration 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. Michael Dimond School of Business Administration Cash Flow Computation Use the following data to compute OCF & FCF

21. Michael Dimond School of Business Administration Cash Flow Computation So far, so good. Now we need to get to Damodaran’s cash flows: FCFF & FCFE FCFE = Free Cash Flow to Equity FCFF = Free Cash Flow to the Firm

22. Michael Dimond School of Business Administration Calculating Free Cash Flow to Equity On a conceptual level, FCFE = Net income – Net investment + Net debt issued

23. Michael Dimond School of Business Administration Net Investment Net investment = (Capital expenditures – Depreciation) + Increase in noncash working capital

24. Michael Dimond School of Business Administration 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?

25. Michael Dimond School of Business Administration 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)

26. Michael Dimond School of Business Administration 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?

27. Michael Dimond School of Business Administration 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) What effect does Net Debt Issued have on CF available to equity holders?

28. Michael Dimond School of Business Administration Cash Flow Computation So far, so good. Now we need to get to Damodaran’s cash flows: FCFF & FCFE FCFE = Free Cash Flow to Equity FCFF = Free Cash Flow to the Firm From Damodaran, we get the following: FCFE = NI + Depr - ΔFA - ΔNWC + ΔDebt - PfdDiv (pp 352-353) FCFF = FCFE + Int(1-t) - ΔDebt + PfdDiv (pg 380) :. FCFE = FCFF - Int(1-t) + ΔDebt - PfdDiv and :. FCFF = NI + Int(1-t) + Depr - ΔFA - ΔNWC

29. Michael Dimond School of Business Administration

30. Cash Flow Computation

31. Michael Dimond School of Business Administration Useful Formulas: FCFE = NI + Depr - ΔFA - ΔNWC + ΔDebt - PfdDiv FCFF = FCFE + Int(1-t) - ΔDebt + PfdDiv FCFE = FCFF - Int(1-t) + ΔDebt - PfdDiv FCFF = NI + Int(1-t) + Depr - ΔFA - ΔNWC In the above… –NWC represents Non-cash, Net Operating Working Capital –ΔFA represents the capital expenditure (net change in gross fixed assets) Computing these cash flows from financial figures is the next step Cash Flow Computation

32. Michael Dimond School of Business Administration FCFE Valuation

33. Michael Dimond School of Business Administration FCFE Valuation

34. Michael Dimond School of Business Administration 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

35. Michael Dimond School of Business Administration 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.

36. Michael Dimond School of Business Administration 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

37. Michael Dimond School of Business Administration 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.

38. Michael Dimond School of Business Administration 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

39. Michael Dimond School of Business Administration Supplementary Material 96 Common Errors in Company Valuations by Pablo Fernandez & Jose Maria Carabias http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151

40. Michael Dimond School of Business Administration 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?

41. Michael Dimond School of Business Administration 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

42. Michael Dimond School of Business Administration 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%

43. Michael Dimond School of Business Administration 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

44. Michael Dimond School of Business Administration Are you using your resources? What helpful parts of the book have you found so far? Where are you looking? (Table of Contents? Index?) –Part of Ch 2 (DCF) –Ch 10 (From Earnings to Cash Flows) –Ch 14 (FCFE Discount Models) –...and other places. This is a reference book, not a textbook. You need to dig into it. 96 Common Errors in Company Valuations by Pablo Fernandez & Jose Maria Carabias http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151 Damodaran’s website http://pages.stern.nyu.edu/~adamodar/http://pages.stern.nyu.edu/~adamodar/ Data source: EDGAR (SEC) http://www.sec.govhttp://www.sec.gov

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