valuation materials

7/29/2019 Valuation materials

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Valuation Analysis

Judson W. Russell, Ph.D., CFA

University of North Carolina-Charlotte


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Agenda

Equity Valuation Fundamentals: Intrinsic Value

Enterprise Valuation Fundamentals: Free Cash Flow

Equity Valuation Fundamentals: Relative Value


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Introduction

Valuation is both artand science

Art through reasonable, defensible:Assumptions Judgment and interpretation of data

Science through application of analytical formulae

Valuation is based on future performance


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Introduction

Two main valuation questions:

1)What is a company worth by valuation metrics?

2) What can or will a potential buyer pay?


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Introduction

Three main valuation methodologies

Intrinsic Value Approach: A stocks price equals the netpresent value of its dividends.

Relative Value Approach: A stocks value is determinedby comparing similar stock values.

Acquisition Value Approach: Calculate a companysstock price by determining its worth to a third partyacquirer.

Golden Rule: Footnoteyour assumptions


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Introduction

EQUITY VALUE:

Value of shareholders interest Afterinterest expense, preferred dividends and

minority interest expense Multiples of net income, book value, EPS Other common terms:

Market Value, Market Capitalization,Offer Value (in an acquisition context)


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Introduction

ENTERPRISE VALUE:

Includes all forms of capital Market value of equity, debt, preferred stock,

minority interest Beforeinterest expense, preferred dividends andminority interest expense

Multiples of sales, EBITDA, EBIT or any otherapplicable metric (per subscriber, per bed, etc.)

Other common terms:Aggregate Value, Firm Value, Total Capitalization,Adjusted Market Value, Transaction Value


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Introduction

EnterpriseValue =Equity Market Cap.

Net Debt

Preferred Stock

Minority Interest

Equity Market Cap.


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Introduction

COMPARABLE (or similar) in terms of:

Operations Financial Aspects

Industry Size

Products Leverage

Markets Margins & Profitability

Distribution channels Growth prospects

Customers Shareholder baseSeasonality Market conditions (acquisitions)

Cyclicality Consideration paid (acquisitions)

Circumstances surrounding thetransaction


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Equity Valuation Process

The Graham and Dodd Approach to Security Selection

1. Study the available facts

2. Prepare an organized report

3. Project earnings and related data

4. Draw valuation conclusions based on established principlesand sound logic

5. Make a decision


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Valuation Process

The top-down approach starts withan analysis of alternative economiesand security markets.

The initial objective is to decide howto allocate investment funds among

countries and within countries tobonds, stocks, and cash.

The second phase is the analysis ofalternative industries. The objectiveat this stage is to determine whichindustries will prosper based on

your analysis of the economy. The final, third, phase focuses on

security selection. The objective isto determine which companieswithin the selected industries willprosper and which stocks are

undervalued.

Analysis of Alternative

Economies and Security

Markets

Analysis of Alternative

Industries

Analysis of

Individual

Companies

and Stocks


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Valuation Process Example The top-down analysis for a U.S. homebuilder:

Economy GDP will increase 3%

Capital Markets Interest rates will remainlow

Industry Backlog of existinghomes, build new starts togrow

Homebuilding Company Homebuilder to gainmarket share based on

location

Target homebuilder sales will increase by 15% versus theindustry average of 10%. Steady profit margins signify a 15%earnings increase.


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Economic Cycles

RECESSION:Consumer staples (food,drugs, cosmetics, tobacco),

utilities, software, andbiotechnology firms

RECOVERY: Early stage

Consumer Cyclicals (autos,apparel, media, retailers),

Consumer Credit (savings andloans), and Transportation(airlines, trucking, railroads)

EXPANSION: Late Stage

Basic Materials (chemicals,plastics, paper, wood,

metals), Capital Goods(equipment and machinerymanufacturers)


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Industry Analysis

Forecast Sales

An insightful analysis when predicting industry sales is to view theindustry over time and divide its development into stages.

Pioneering development - A

Rapid accelerating growth - B

Mature growth - C Stabilization and market maturity - D Deceleration of growth and decline - E

Time

Rate of

Sales

Growth

B

A

DC

E


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Porters Five Forces

INDUSTRY

COMPETITORS

POTENTIALENTRANTS

SUBSTITUTES

SUPPLIERS BUYERS


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Valuation Approach Intrinsic Value


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Valuation ApproachesIntrinsic Value

The value of an asset is the present value of its expected returns.

The process of valuation requires estimates of (1) the stream ofexpected returns and (2) the required rate of return on the

investment.

The value of a preferred stock (perpetuity) is simply the statedannual dividend divided by the required rate of return on preferredstock (kp).

A preferred stock with an $8 per year dividend and required return of9% is valued as:

V = $8 / 0.09 = $88.89


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The valuation of common stock is more difficult thanbonds or preferred stock because an investor isuncertain about the size of the returns, the time patternof returns, and the required rate of return (ke).

However, the value of common stock is still the presentvalue of its future cash flows. The only cash flows anequity investor ever gets are dividends (cash orliquidating).

A model to value common stock is the dividenddiscount model (DDM).



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The DDM assumes that the value of a share ofcommon stock is the present value of all futuredividends as;

V = [D1/(1+ke)1 + D2/(1+ke)

2+ + D/(1+ke)

]

Since estimating D

is impossible, other methods haveevolved based upon a terminal stock value, or aconstant rate of growth.



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Assume an investor wants to buy a stock, hold it for one year, and then sellit. We must evaluate the dividend cash flows as well as the terminal valuein one year. These cash flows are then discounted at the investorsrequired rate of return.

A company earned $2.50 a share last year and paid a $1 dividend (40%

dividend payout). The firm has a consistent record regarding payout andwe expect it to earn $2.75 per share during the coming year. We expect thestock to trade at $22 at the end of the coming year. Further, the risk-freerate is 5%, the market return is 10%, and the stocks beta is 1.2.

ke = rf + b(E(rm) rf ) = 5 + 1.2 (10-5) = 11%,

D1 = E1(dividend payout) = $2.75(.4) = $1.10

V = [D1/(1+ke)1 + Stock Value1/(1+ke)

1]

V = [$1.10/(1+.11)1 + $22/(1+.11)1]

V = 0.99 + 19.82 = $20.81



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When valuing a firm with an infinite holding period we assume thatdividends, at some point, exhibit a constant rate of growth.

Assume that a firm is in a state of constant growth, we can valuethe infinite stream of cash flows using the following abbreviatedformula:

V = D1/(ke - g)

For instance, in our previous example lets assume that the holdingperiod is infinite and the firms dividends are growing at 6% per year

perpetually. The dividend in one year was $1.10 and the requiredrate of return was 11%.

V = $1.10/(.11- .06) = $22.00



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We can employ the same technique for firms that have varyingrates of growth by assuming that the growth rate becomes constant,at some point.

For instance, suppose we have a firm experiencing rapid growth

due to its position in the product cycle. At some point the growthrate has to slow or the firm will become the market!

We can accommodate this scenario with a multistage model bydiscounting the rapid growth phase dividends individually and thendetermining the terminal value using the constant growthmethodology.

V = [D1/(1+ke)1 + D2/(1+ke)

2+ + (Dn+1/(ke-g)) /(1+ke)n]



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Suppose that ABC Company has a current dividend of $1.00 pershare with growth expectations of 20% for each of the next twoyears. After that point, the firm expects dividends to grow at 4%each year indefinitely. Given a cost of equity of 11%, calculate thevalue of the firms shares.

V = [D1/(1+ke)1 + D2/(1+ke)

2 + V2/(1+ke)2]

where V2= D3/(keg)

V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2]

V = $1.08 + $1.17 + $17.39 = $19.64



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Suppose that ABC Company has a current dividend of $0.75 pershare with growth expectations of 15% for each of the next threeyears. After that point, the firm expects dividends to grow at 4%each year indefinitely. Given a cost of equity of 12%, calculate

the value of the firms shares.

Exercise One


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Valuation ApproachIntrinsic Value

DISCOUNTED CASH FLOW ANALYSIS

Intrinsicvalue of the company Unlevered free cash flows

Independent of capital structure Free cash flows generated by the assets that are available to all

capital holders

Present value of:(1) free cash flows and(2) projected terminal value

Terminal value is used to estimate value beyondthe forecast period Exit Multiple Method (assumes the sale of the business) Perpetuity Growth Rate Method

(3) Discount rate = Weighted average cost of capital (WACC)

WACC = ka = wdkd(1-t) + weke


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Discounted Cash Flow Analysis

Using the DCF technique, BAC constructed a valuation for the Company by adding the present

value of the Company's projected after-tax cash flows to the present value of the Company's

terminal va lue.

Dollars in Millions

Projected FYE 12/31

2006 2007 2008 2009 2010

Sales 500.0 469.8 499.6 531.1 565.3

-Cash COGS and SG&A 400.0 375.8 399.7 424.9 452.2

589,680,386$ EBITDA 100.0 94.0 99.9 106.2 113.1

-Tax Basis Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9

Operating Income 85.9 77.8 82.1 86.6 91.2

1 -Taxes 34.4 31.1 32.8 34.6 36.5 40.00%Net Operating Profit After Taxes 51.5 46.7 49.3 52.0 54.7

+Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9

-Capex for P,P&E 17.2 17.3 17.3 17.3 17.3

-Working Capital Changes 2.2 2.1 3.5 3.4 3.8

Operating Cash Flow 46.2 43.5 46.3 50.9 55.5

Cost of Capital 12.0% 12.0% 12.0% 12.0% 12.0%

Present Value of Cash Flows 41.3 34.6 32.9 32.3 31.5

1.0$ 2.0$ 3.0$ 4.0$ 5.0$

Exit Multiple

Exit Mult iple Valuation Method 589.7 5.5x 6.5x 7.5xCumulative Present Value of Cash Flows 172.7 11.0% 546.2 613.3 680.4

Present Value of Exit Price 417.0 WACC 12.0% 525.5 589.7 653.8

Enterprise Value 589.7 13.0% 505.8 567.2 628.6

Exit Multiple: 6.5x Exit Var. 1.0x

WACC: 12.0% WACC Var. 1.0%

Notes:

(1) A 40% tax rate was assumed Large Cap Co.? Y

505847.76 680423.4

DCF analysis

implies the

Company's

Enterprise

Value is:


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FCF1 FCF2 FCF3 FCF4 FCF5

How do we account forthe remaining cash flows

of the firm?

Terminal Value Approach

Constant Growth Method

Free Cash Flow Analysis

FCFn


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Terminal Value Calculation

A. The Exit Multiple Method


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The Present Value of the Terminal ValueDiscounted Cash Flow Analysis

1 2010 EBITDA (Terminal Value) $113.10

2 x Exit multiple 6.5x

3= Pretax Sales Proceeds (futurevalue) $735.15

4

/ discount factor (back 5 years at

12%) 0.5674

5 Present value of terminal value $417.14


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Terminal Value as % of Enterprise Value

Provides a reality check of the DCF value

Higher the %, more of the Enterprise Value is beingrealized with the assumed sale of the business at theend of the forecast period

Confidence level in the 70-85% range, depending onthe company and situation



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Terminal Value as % of Enterprise Value

How much of the Enterprise Value for the Company isbeing generated by the Terminal Value?

What is your comfort level with this percentage?


Present Value of Exit Multiple = $417

Enterprise Value = $589.7

Percentage = $417/$589.7 = 70.7%


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Terminal Value Calculation

B. The Perpetuity Growth Method


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Now well look at the perpetuity growth technique to

capture the terminal value of Company.

The terminal value captures all future cash flows of the

firm assuming a constant growth factor. The operating cash flow of the firm in 2010 is $55.5.

Assuming a growth rate of 4% the operating cash flow in2011 would be $57.72.

We have a discount factor of 12% and a growth factor of4% with a cash flow of $57.72.


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Perpetuity Growth Formula

Terminal Value = FCFN+1

(ka - g)

where:

FCFN+1

= steady-state free cash flow in period N+1

g = nominal perpetual growth rate

ka = discount rate

Terminal Value = $55.5(1.04)

=$57.72= $721.5.12-.04 0.08

Present Value of Perpetuity Growth Terminal Value =$721.5/(1.12^5) = $409.40



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Exercise Two: Discounted Cash Flow Analysis

A Simple Example

Criteria:

Calculate: WACC Present Value of the Free Cash Flows Terminal Value based upon Perpetuity Growth Rate and Exit Multiple Equity Value based upon Exit Multiple Terminal Value

Perpetuity growth rate of 3.3% Cost of Debt of 7.5%

Terminal Exit Multiple of 8.0x Debt to Capital ratio of 35%

Industry average beta of 1.1 Total Debt of $1,190

20-year risk free rate of 5.4% Tax Rate of 40%

Market risk premium of 8.0%

XYZ Company Relevant Free Cash Flow ItemsProjection Year 1 Year 2 Year 3EBITDA $450.00 $475.00 $500.00Free Cash Flow $271.70 $280.70 $290.00


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Relative Value Analysis


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How do we use relative value?

The hardest part of relative value is finding comparablefirms.

Once you have a decent list of comparables you need to

determine which scaling variable to? Next, you want to compare your target firms multiple to the

average of the comparable set.

Finally, make sure that you account for differences, e.g.leverage, market position, patents, etc.


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Comparing PE Ratios across a Sector


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Investors prefer to estimate the value of common stock using anearnings multiplier model.

P0 = D1/(ke - g)

Divide both sides by next years projected earnings:

P0/E1 = (D1/E1)(1/(ke - g))

The P/E ratio (forward) is determined by:

The expected dividend payout ratio (D1/E1) The required rate of return on the stock (ke) The expected growth rate of dividends (g)

Relative Value


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Assume that a firm has an expected dividend payout of40%, a required rate of return of 11%, and a growth rateof dividends of 6%. Next years earnings (E1) are

expected to be $2.75.

P0/E1 = (.40)(1/(.11-.06)) = 8.0x

The value of the stock today is based on the P/E1 andestimate of E1.

P0 = P0/E1 x E1 = 8.0 x $2.75 = $22.00

Relative Value


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The best known measure of relative value for common stock is theP/E ratio or the earnings multiplier.

Analysts have also turned their attention to other measures ofrelative value:

Price/book value (P/BV) : market value of the company dividedby its book value. This metric is used a great deal with financialstocks since many of their assets are carried at values veryclose to market value. This metric can be used for firms withnegative earnings or cash flows. Several studies haveindicated that P/BV is a good indicator of future performance.

Price/cash flow (P/CF) : market value of the company dividedby its cash flow.

Price/sales (P/S) : market value of the company divided by itssales.

Relative Value


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Expected Growth Rate

When a firm retains earnings and acquires assets, if it earns some positiverate of return on these additional assets, the total earnings of the firm willincrease.

The rate of earnings growth depends on the proportion of earnings retainedand the rate of return it earns on the new assets acquired.

Specifically, the growth rate (g) of equity earnings without externalfinancing is equal to the percentage of net earnings retained (retention rate,b) times the rate of return on equity capital (ROE).

g = (retention rate)(return on equity)

g = (b)(ROE)

This growth rate is called the internal or sustainable growth rate.

The firm can increase its rate of growth by 1) retaining a larger portion of itsearnings for reinvestment in the firm or 2) increasing its ROE (recall, ROE= profit margin x total asset turnover x financial leverage).

Exercise 3 Analysis of Selected Publicly Traded Companies


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Exercise 3: Analysis of Selected Publicly Traded Companies

A Simple Example

Criteria: Company XYZ closing stock price is $18.00/share

XYZ has 1,000 shares outstanding, and 100 exercisable optionsoutstanding with an average exercise price of $4.50

XYZ has total debt of $8,000 and cash of $350

Calculate: XYZ Enterprise and Equity Value Multiples of Sales, EBITDA, EBIT and Net Income

XYZ Income Statement Items Stated

Sales $12,000

Cost of Goods Sold 8,000

Gross Profit 4,000

Sales, General, and Administrative (a) 2,000

Depreciation 1,000

Operating Income 1,000

Interest Expense 710

Pre-Tax Income 290

Taxes 116

Net Income $174

(a) Includes a one-time legal sett lement of $1,000 ($600 after-tax)

E ercise 4 Anal sis of Selected Acq isitions


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Exercise 4: Analysis of Selected Acquisitions

A Simple Example

Criteria: Company A has agreed to buy Company B for $20.00/share in stock Company A and Company Bs stock prices on the day before announcement were

$35.00 and $16.00 respectively Company B has 15,000 shares outstanding, 2,000 exercisable options outstanding

with an average exercise price of $7.50, $150,000 in net debt to be assumed byCompany A and minority interests of $25,000 to be acquired for cash

Company B Income Statement Items

LTM Revenue $625,000

LTM EBITDA 40,000

LTM Net Income 14,440

Calculate: Implied Exchange Ratio Premium Paid Enterprise and Equity Values of transaction Multiples of Revenues, EBITDA and Net Income

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