Valuation Oct 24, 2008 1

Valuation
1 Oct 24, 2008

Valuation
Contents
• Introduction – Where Value Comes From
• Discounting Basics
• Overview of Alternative Valuation Methods
• Valuation Using Multiples
• Valuation Using Projected Earnings
• Case Studies
2 Oct 24, 2008

Valuation
Valuation, Decision Making and Risk
Every major decision a company makes is in one way or another

derived from how much the outcome of the decision is worth. It
is widely recognized that valuation is the single financial
analytical skill that managers must master.
• Valuation analysis involves assessing

 Future cash flow levels, (cash flow is reality) and
 Risks in valuing assets, debt and equity
• Measurement value – forecasting and risk assessment -- is a

very complex and difficult problem.
• Intrinsic value is an estimate and not observable

Reference: Chapter 6
3 Oct 24, 2008

Valuation
Valuation Overview
Valuation is a huge topic. Some Key issues in valuation analysis.

Cost of Capital in DCF or Discounted Earnings
Selection of Market Multiple and Adjustment
Growth Rates in Earnings and Cash Flow Projections
Terminal Value Method and Calculation
 Use several vantage points
 Do not assume false precision
4 Oct 24, 2008

Valuation
Tools for Valuation
• Financial Models:
Valuation model with project earnings or cash flows
• Statistical Data:
Industry Comparative Data to establish Multiples and Cost of

Capital
• Industry, company knowledge and judgment
Knowledge about risks and economic outlook to assess risks

and value drivers in the forecasts
• Valuation should not be intimidating
5 Oct 24, 2008

Valuation
Valuation Basics
• A Company’s value depends on:
Return on Invested Capital
Weighted Average Cost of Capital
Ability to Grow
• All of the other ratios – gross margins, effective tax rates,

inventory turnover etc. are just details.
6 Oct 24, 2008

Valuation
Analytical framework for Valuation – Combine Forecasts
of Economic Performance with Cost of Capital
Competitive position
such as pricing power
and cost structure
affects ROIC
In financial terms, value

comes from ROIC and
growth versus cost of capital
P/E ratio
and other
valuation
come from
ROIC and
Growth
7 Oct 24, 2008

Valuation
Value Comes from Two Things
• What you think future cash flows will be
• How risky are those cash flows

 We will deal with how to measure future cash flows and how to deal with
quantifying the risk of those cash flows
• Value comes from the ability to earn higher returns than the opportunity cost
of capital
• One of the few things we know is that there is a tradeoff between risk and
return.
Reference: Folder on Yield

Spreads
8 Oct 24, 2008

Valuation
Valuation and Cash Flow
• Ultimately, value comes from cash flow in any model:
DCF – directly measure cash flow from explicit cash flow and
cash flow from selling after the explicit period
Multiples – The size of a multiple ultimately depends on cash
flow in formulas
 FCF/(k-g) = Multiple
 They still have implicit cost of capital and growth that

must be understood
Replacement Cost – cash from selling assets
• Growth rate in cash flow is a key issue in any of the models

Investors cannot buy a house with earnings or
use earnings for consumption or investment
9 Oct 24, 2008

Valuation
Valuation Diagram
• Valuation using discounted cash flows requires forecasted cash

flows, application of a discount rate and measurement of
continuing value (also referred to as horizon value or terminal
value)
Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value
Discount Rate is WACC
Enterprise Value
Net Debt Reference: Private

Valuation; Valuation
Mistakes
Equity Value
10 Oct 24, 2008

Valuation
Value Comes from Economic Profit and Growth
Growth + Economic profit is

the difference
between profit and
opportunity cost
Capital Junkies Power House
- ROIC/WACC +
++ve
This implies that

Capital Killers Cash Cows there are three
variables – return,
Once you have a growth and cost of
good thing, you capital that are
should grow central to valuation
Growth - analysis
11 Oct 24, 2008

Valuation
The Value Matrix - Stock Categorisation
Growth +
Power House
Perennial under achiever or futureprospects What is the economic
reason for getting
• Stretched balance sheet • High industry growth here and how long
• Restructuring • “Franchise”value can the performance
be maintained
• Maylook expensive • Pricing power
• Clear Investment strategy
Throwing good money after
bad • Howsustainable?
- ROIC/WACC +
++ve
Capital Killers CashCows
• Look cheap but for good reason • Lowindustry growth
• Cyclical or permanent • Cash generative and rich Give the money
to investors
• Industry or company specific factors • Risk/opportunity of diversification
• Lowrating with strong yield support
Try to get out of the
business
12 Oct 24, 2008
Valuation
Growth -
ROIC Issues
• Issues with ROIC include
Will the ROIC move to WACC because of competitive pressures

 Evidence suggests that ROIC can be sustained for long periods
 Consider the underlying economic characteristics of the firm and the industry
What is the expected change in ROIC

 When ROIC moves to sustainable level, then can move to terminal value
calculation
Examine the ROIC in models to determine if detailed assumptions are

leading to implausible results
Migration table
13 Oct 24, 2008

Valuation
Reasonable Estimates of Growth
The short term The medium term outlook The long run
Based on best •Assessment of industry • Long run

estimate of likely outlook and company assumptions:
outcome position
• ROIC = Cost of
• ROIC fades towards the capital
cost of capital
• Real growth = 0%
• Growth fades towards
GDP
Much of valuation involves implicitly or explicitly

making growth estimates – High P/E comes from
Reference: Level and high growth
persistence of growth rates
14 Oct 24, 2008

Valuation
Growth Issues
• Growth issues include
Growth is difficult to sustain
Law of large numbers

means that it is more difficult IBES Growth and Actual Growth from Chan Article
to maintain growth after a 25
company becomes large 22.4
Acutal Growth over 5 Years and I/B/E/S Median

Actual Growth in Income
20 I/B/E/S Growth
Investment analysts
15.1
overestimate growth 15 Optimism in the lowest growth

category is still present.
Growth
12.3
10.2
Examine sustainable growth 10
8.0
9.5
formulas from dividend 6.0

6.5 6.5
payout and from

5
2.0
depreciation rates 0
Lowest Second Lowest Median Second Highest Highest
Growth Rate Category
15 Oct 24, 2008

Valuation
Sustaining Growth and ROIC > WACC
• Mean Reversion of Long-term Growth

 Competition tends to compress margins and growth
opportunities, and sub-par performance spurs corrective
A study by Chan, Karceski,
and Lakonishok titled, “The
actions.
Level and Persistence of
Growth Rates,” published  With the passage of time, a firm’s performance tends to
in 2003. According to this converge to the industry norm.
study, analyst “growth
forecasts are overly  Consideration should be given to whether the industry is in a
optimistic and add little
predictive power.” growth stage that will taper down with the passage of time or
whether its growth is likely to persist into the future.
 Competition exerts downward pressure on product prices and
product innovations and changes in tastes tend to erode
competitive advantage. The typical firm will see the return
spread (ROIC-WACC) shrink over time.
16 Oct 24, 2008

Valuation
Alternative Valuation Methods
17 Oct 24, 2008

Valuation
Alternative Valuation Models
• There are many valuation techniques for assets and investments including:
 Income Approach
 Discounted Cash Flow
 Venture Capital method
 Risk Neutral Valuation
 Sales Approach
 Multiples (financial ratios) from Comparable Public Companies of from Transactions or from
Theoretical Analysis
 Liquidation Value
 Cost Approach
 Replacement Cost (New) and Reproduction Cost of similar assets
 Other
 Break-up Value
 Options Pricing See the appraisal
• The different techniques should give consistent valuation answers folder in the
financial library
18 Oct 24, 2008

Valuation
Example of Comparing Valuation under Alternative
Methods
19 Oct 24, 2008

Valuation
Risk Neutral Valuation
• Theory – If one can establish value with one financial strategy, the value
should be the same as the value with alternative approaches
• In risk neutral valuation, an arbitrage strategy allows one to use the risk
free rate in valuing hedged cash flows.
• Forward markets are used to create arbitrage
• Risk neutral valuation does not work with risks that cannot be hedged
• Use risk free rate on hedged cash flow
• Example
Valuation of Oil Production Company
Costs Known
No Future Capital Expenditures
20 Oct 24, 2008

Valuation
Practical Implications of Risk Neutral Valuation
• Use market data whenever possible, even if you will not actually
hedge
• Use lower discount rates when applying forward market data in

models
Valuation with high Valuation with

discount rates Forward
And Markets and
Uncertain cash Low Discount
flows Rates
21 Oct 24, 2008

Valuation
Venture Capital Method
• Two Cash Flows
Investment (Negative)
IPO Terminal Value (Positive)

 Terminal Value = Value at IPO x Share of Company Owned
• Valuation of Terminal Value

See the article on private
valuation
Discount Rates of 50% to 75%
 Risky cash flows
 Other services
22 Oct 24, 2008

Valuation
Valuation Diagram – Venture Capital
• Valuation in venture capital focuses on the value when you will

get out, the discount rates and how much of the company you will
own when you exit.
Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value
•In the extreme, if you

have given away half
of your company
Discount Rates
away, and the cash
Enterprise Value flow is the same
before and after your
Evaluate how much of the give away, then the
Net Debt
equity value that you own amount you would
pay for the share
Equity Value must account for how
much you will give
23 away. Oct 24, 2008
Valuation
Venture Capital Method
• Determine a time period when the company will receive positive cash flow and
earnings.
e.g. projection of earnings in year 7 is 20 million.
• At the positive cash flow period, apply a multiple to determine the value of the
company.
e.g. P/E ratio of 15 – terminal value is 20 x 15
• Use high discount rate to account for optimistic projections, strategic advice and
high risk;
e.g. 50% discount rate – [20 x 15]/[1+50%]^7 = 17.5 million
• Establish percentage of ownership you will have in the future value through dividing
investment by total value
e.g. 5 million investment / 17.5 million = 28.5%
• You make an investment and receive shares (your current percent). You know the
investment and must establish the number of shares
24 Oct 24, 2008

Valuation
Venture Capital Method Continued
• In the venture capital method, there are only two cash flows
The investment
The value when the company is sold
• The value received when the company is sold depends on the percentage
of the company that is owned. If there is dilution in ownership, the value
is less.
• Therefore, an adjustment must be made for dilution and the percent of the
company retained. See the Cost of Capital folder for and example
e.g. Share value without dilution = 17.5/700,000 = 25 per share
If an additional 30% of shares is floated, the value per share must
be increased by 30% to maintain the value.
Value per share = 17.5/((500,000+VC shares) x 1.3)
VC Shares: (25 x 1.3)/17.5-500,000 = 343,373
25 Oct 24, 2008

Valuation
Replacement Cost
• First a couple of points regarding replacement cost theory
In theory, one can replace the assets of a company without

investing in the company. If you are valuing a company, you
may think about creating the company yourself.
If you replaced a company and really measured the
replacement cost, the value of the company may be more
than replacement cost because the company manages the
assets better than you could.
By replacing the assets and entering the business, you
would receive cash flows. You can reconcile the replacement
cost with the discounted cash flow approach
26 Oct 24, 2008

Valuation
Measuring Replacement Cost
• Replacement cost includes:

Value of hard assets
Value of patents and other intangibles
Cost of recruiting and training management
• Analysis
Begin with balance sheet categories, account for the age of the plant
Add: cost of hiring and training management
• If the company is generating more cash flow than that would be produced
from replacement cost, the management may be more productive than
others in managing costs or be able to realize higher prices through
differentiation of products.
• The ratio of market value to replacement cost is a theoretical ratio that
measures the value of management contribution
27 Oct 24, 2008

Valuation
Replacement Value and Tobin’s Q
• Recall Tobin’s Q as:
Q = Enterprise Value / Replacement Cost
• Buy assets and talent etc and should receive the ROIC. Earn
industry average ROIC.
If the ROIC > industry average, then Q > 1.
If the ROIC < industry average, then Q < 1
28 Oct 24, 2008

Valuation
Real Options and Problems with DCF
• The DCF model has many conceptual flaws, the most significant
of which is assuming that cash flows are normally distributed
around the mean or base case level.
• For many investments, the cash flows are skewed:
When an asset is to be retired, there is more upside than
downside because the asset will continue to operate when
times are good, but it will be scrapped when times are bad.
An investment decision often involves the possibility to
expand in the future. When the expansion decision is made,
it will only occur when the economics are good.
During the period of constructing an asset, it is possible to
cancel the construction expenditures and limit the downside if
it becomes clear that the project will not be economic.
29 Oct 24, 2008

Valuation
Real Options and DCF Problems - Continued
• Problems with DCF because of flexibility in managing assets:
In operating an asset, the asset can be shut down when it is not
economic and re-started when it becomes economic. This allows the
asset to retain the upside but not incur negative cash flows.
When developing a project, there is a possibility to abandon the
project that can limit the downside as more becomes known about
the economics of the project.
In deciding when to construct an investment, one can delay the
investment until it becomes clear that the decision is economic. This
again limits the downside cash flows.
• In each of these cases, management flexibility provides protection in the

downside which means that DCF model produces biased results.
30 Oct 24, 2008

Valuation
Fundamental Valuation
• What was behind the bull market of 1980-1999
EPS rose from 15 to 56
Nominal growth of 6.9% -- about the growth in the real economy (the
real GDP)
Keeping P/E constant would have large share price increase
Long-term interest rates fell – lower cost of capital increases the P/E
ratio
• Real Market
Value by ROIC versus growth
Select strategies that lead to economic profit
Market value from expected performance
31 Oct 24, 2008

Valuation
Three Primary Methods Discussed in Remainder of
Slides
• Market Multiples
• Discounted Free Cash Flow
• Discounted Earnings and Dividends
• Warning: No method is perfect or completely precise
• Use industry expertise and judgement in assessing discount rates

and multiples
• Different valuation methods should yield similar results
• Bangor Hydro Case
32 Oct 24, 2008

Valuation
Discounting Basics
33 Oct 24, 2008

Valuation
Debt (Bond) Valuation
Bt = It +1 + It +2 + It +3 + ... + It +n + F
(1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)n
• Bt is the value of the bond at time t Case exercise to illustrate the

effect of discounting (credit
spread) on the value of a
• Discounting in the NPV formula assumes END of period bond
• It +n is the interest payment in period t+n
• F is the principal payment (usually the debt’s face value)
• r is the interest rate (yield to maturity)
34 Oct 24, 2008

Valuation
Risk Free Discounting
• If the world would involve discounting cash flows at the risk free rate,
life would be easy and boring
35 Oct 24, 2008

Valuation
Equity – Dividend Discount Valuation and Gordon’s
Model
Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ... + E(Dt +n) + ...
(1+k)1 (1+k)2 (1+k)3 (1+k)n
• Vt is the value of an equity security at time t

• Dt +n is the dividend in period t+n
• k is the equity cost of capital – difficult to find (CAPM)
• E() refers to expected dividends
• If dividends had no growth the value is D/k
• If dividends have constant growth the value is D/(k-g)
• Terminal Value is logically a multiple of book value per share
36 Oct 24, 2008

Valuation
Example of Capitalization Rates
• Proof of capitalization rates using excel and growing cash flows
37 Oct 24, 2008

Valuation
Equity Valuation - Free Cash Flow Model
Vt = E(FCFt +1) + E(FCFt +2) + E(FCFt +3) + ... + E(FCFt +n) + ...
(1+k)1 (1+k)2 (1+k)3 (1+k)n
• FCFt+n is the free cash flow in the period t + n [often

defined as cash flow from operations less capital
expenditures]
• k is the weighted average or un-leveraged cost of capital
• E(•) refers to an expectation
• Alternative Terminal Value Methods
38 Oct 24, 2008

Valuation
Practical Discounting Issues in Excel
• NPV formula assumes end of period cash flow
• Growth rate is ROE x Retention rate
• If you are selling the stock at the end of the last period and doing
a long-term analysis, you must use the next period EBITDA or the
next period cash flow.
• If there is growth in a model, you should use the add one year of
growth to the last period in making the calculation
• To use mid-year of specific discounting use the IRR or XIRR or

sumproduct
39 Oct 24, 2008

Valuation
Valuation and Sustainable Growth
• Value depends on the growth in cash flow. Growth can be

estimated using alternative formulas:
 Growth in EPS = ROE x (1 – Dividend Payout Ratio)
 Growth in Investment = ROIC x (1-Reinvestment Rate)
 Growth = (1+growth in units) x (1+inflation) – 1
• When evaluating NOPLAT rather than earnings, a similar

concept can be used for sustainable growth.
 Growth = (Capital Expenditures/Depreciation – 1) x
Depreciation Rate
• Unrealistic to assume growth in units above the growth in the
economy on an ongoing basis.
40 Oct 24, 2008

Valuation
Valuation Using Multiples
41 Oct 24, 2008

Valuation
Advantages and Disadvantages of Multiples
• Advantages • Disadvantages
Objective – does not require Implicit Assumptions: Multiples come

discount rate of terminal value from growth, discount rates and
returns. Valuation depends on these
Simple – does not require assumptions.
elaborate forecast
Too simple: Does not account for
Flexible – can use alternative prospective changes in cash flow
multiples and make adjustments
to the multiples Accounting Based: Depends on
accounting adjustments in EBITDA,
Theoretically correct – consistent earnings
with DCF method if there are
stable cash flows and constant Timing Problems: Changing
growth. expectations affect multiples and
using multiples from different time
There are reasons similar companies in an periods can cause problems.
industry should have different multiples because of
ROIC and growth – this must be understood
42 Oct 24, 2008

Valuation
Multiples - Summary
• Useful sanity check for valuation from other methods
• Use multiples to avoid subjective forecasts
• Among other things, well done multiple that accounts for
Accounting differences
Inflation effects
Cyclicality
• Use appropriate comparable samples
• Use forward P/E rather than trailing
• Comprehensive analysis of multiples is similar to forecast
• Use forecasts to explain why multiples are different for a specific company
43 Oct 24, 2008

Valuation
Mechanics of Multiples
• Find market multiple from comparable companies

 Rarely are there truly comparable companies
 Understand economics that drive multiples (growth rate, cost of
capital and return)
In the long-term P/E ratios tend to revert to
• P/E Ratio (forward versus trailing) a mean of 15.0
 Value/Share = P/E x Projected EPS

 P/E trailing and forward multiples
• Market to Book
 Value/Share = Market to Book Ratio x Book Value/Share
• EV/EBITDA
 Value/Share = (EV/EBITDA x EBITDA – Debt) divided by shares
• P/E and M/B use equity cash flow; EV/EBITDA uses free cash flow
44 Oct 24, 2008

Valuation
Valuation from Multiples
• Financial Multiples
P/E Ratio
EV/EBITDA
Price/Book
• Industry Specific
Value/Oil Reserve
Value/Subscriber
Value/Square Foot
• Issues
Where to find the multiple data – public companies
What income or cash flow base to use
15-20% Discount for lack of marketability
45 Oct 24, 2008

Valuation
Which Multiple to Use
• Valuation from multiples uses information from other companies

• It is relevant when the company is already in a steady state situation and there is no
reason to expect that you can improve estimates of EBITDA or Earnings
• One of the challenges is to understand which multiple works in which situation:
Consumer products
 EV/EBITDA may be best
 Intangible assets make book value inappropriate
 Different leverage makes P/E difficult
Banks/Insurance
 Market/Book may be best
 Not many intangible assets, so book value is meaningful
 Book value is the value of loans which is adjusted with loan loss provisions
 Cost of capital and financing is very important because of the cost of
deposits
46 Oct 24, 2008

Valuation
Multiples in M&A
• Public company comparison
• Precedent Transactions
• Issues
Where to find the data
Finding comparable companies
Timing (changes in multiples with market moves)
What data to apply data to (e.g. next year’s earnings)
What do ratios really mean (e.g. P/E Ratio)
Adjustments for liquidity and control premium
47 Oct 24, 2008

Valuation
Example of Valuation with Multiples – Comparison of
Different Transactions
Note how multiples cover the

cycle in a commodity
business
Demonstrates that the

multiple in the merger is
consistent with other
transactions
48 Oct 24, 2008

Valuation
Multiples in Pennzoil Merger – Comparison of Merger
Consideration to Trading Multiples
49 Oct 24, 2008

Valuation
Comparable companies analysis data in Banking Merger
Statistics on Comparable Companies Citizens Trust Bank

Multiple of Market Value Per Share Implied Per Share Equity Value
LTM High Low Mean Median ActualValues 3,000,000 High Low Mean Median
Total Assets 0.359x 0.093x 0.162x 0.152x $337,932,000 112.64 40.44 10.48 18.25 17.12
Tangible Book Value* 2.490x 1.155x 1.688x 1.719x $35,545,737 11.85 25.28 13.25 18.05 18.33
LTM EPS 85.000x 10.131x 17.181x 13.085x $3,545,737 1.182 100.46 11.97 20.31 15.47
2002 Est EPS 28.333x 9.350x 13.037x 12.195x $5,172,415 1.724 48.85 16.12 22.48 21.03
2003 Est EPS 14.856x 8.611x 11.288x 11.255x $5,883,841 1.961 29.14 16.89 22.14 22.07
*Normalized book value, assuming 8 percent equity as 'normal.'
Source: SNL Securities, 2002 (Pricing as of 3/25/2002).
Summary of 21 comparable banking companies with similar assets, capital and profitability
characteristics.
Note the ratios used to value banks are equity

based – the Market value to Book Value and
the P/E ratio related to various earnings
measures
50 Oct 24, 2008

Valuation
Example of Computation of Multiples from Comparative
Data
• JPMorgan also calculated an implied range of terminal values for Exelon

at the end of 2009 by applying a range of multiples of 8.0x to 9.0x to
Exelon's 2009 EBITDA assumption.
Note that the

median is
presented before
the mean
51 Oct 24, 2008

Valuation
Comparison with all Acquisitions Since 2001
All US Banking Acquisitions with a total deal value over $200m

SOV-Waypoint Deals in 2004 Deals since 2003 Deals since 2002 Deals since 2001
# of Deals 1 7 16 20 28
Median 238.5 256.1 238.7 238.7

Price/Book 238.5
Mean 241.0 249.6 240.8 244.6
Median 304.7 299.2 290.4 299.2

Price/Tangible Book 251.8
Mean 319.3 309.6 301.4 307.3
Median 20.7 20.4 20.3 20.3

Price/LTM Earnings 22.0
Mean 20.9 20.3 19.9 20.2
Median 29.9 30.4 30.1 30.2

Price/Deposits 32.1
Mean 31.4 32.8 32.1 31.4
52 Oct 24, 2008
Valuation
Adjustments to Multiples
• Process
Find multiples from similar public companies
Adjust multiples for
 Liquidity
 Size
 Control premium
 Developing country discount
Apply adjusted multiples to book value, earnings, and EBITDA
• There is often more money in dispute in determining the discounts and
premiums in a business valuation than in arriving at the pre-discount
valuation itself. Discounts and premiums affect not only the value of the
company, but also play a crucial role in determining the risk involved,
control issues, marketability, contingent liability, and a host of other
factors.
53 Oct 24, 2008

Valuation
Adjustments to Multiples – Marketability and Liquidity
Discount
• If the entity were closely held with no (or little) active market for the
shares or interest in the company, then a non-marketability discount
would be subtracted from the value.
• Non-marketabiliy Discounts – ranges from 10% to 30%
• …represents the reduction in value from a marketable interest level
of value to compensate an investor for illiquidity of the security, all
else equal.
• The size of the discount varies base on:
 relative liquidity (such as the size of the shareholder base);
 the dividend yield, expected growth in value and holding period;
 and firm specific issues such as imminent or pending initial public
offering (IPO) of stock to be freely traded on a public market.
54 Oct 24, 2008

Valuation
Studies of Liquidity Discount
• Private and public transactions
Attempt to compute EV/EBITDA in public and private transactions
Adjust so that the transactions are comparable
Compute the ratio in pubic and private transactions
Discount of 20 to 28 percent for US firms
Discount of 44 to 54 percent for non-US firms
• Other studies
Value in IPO versus value of private trades before IPO
High liquidity in 40-50% range, but selection bias
Theory involves control by public board
55 Oct 24, 2008

Valuation
Adjustments to Multiples – Controlling Interest Premium
• Controlling interest value

…the value of the enterprise as a whole assuming that the
stock is freely traded in a public market and includes a
control premium.
 Control premium
…reflects the risks and rewards of a majority or
controlling interest.
 A controlling interest is assumed to have control power over
the minority interests.
• Minority interest value
…represents the value of a minority interest “as if freely
tradable” in a public market.
 Minority interest discount
…represents the reduction in value from an absence of
control of the enterprise.
56 Oct 24, 2008

Valuation
P/E Analysis – Use of P/E Ratio in Valuation
• J.P. Morgan performed an analysis comparing Exxon's price to earnings

multiples with Mobil's price to earnings multiples for the past five years.
• The source for these price to earnings multiples was the one and two year
prospective price to earnings multiple estimates by I/B/E/S International
Inc. and First Call, organizations which compile brokers' earnings
estimates on public companies. Such analysis indicated that Mobil has
been trading in the recent past at an 8% to 15% discount to Exxon.
• J.P. Morgan's analysis indicated that if Mobil were to be valued at
price to earnings multiples comparable to those of Exxon, there
would be an enhancement of value to its shareholders of
approximately $11 billion.
• Finally, this analysis suggested that the combined company might enjoy
an overall increase in its price to earnings multiple due to the potential for
improved capital productivity and the expected strategic benefits of the
merger. According to J.P. Morgan's analysis, a price to earnings multiple
increase of 1 for Exxon Mobil would result in an enhancement of value to
shareholders of approximately $10 billion.
57 Oct 24, 2008

Valuation
Where to Find Data Yahoo Finance.com
58 Oct 24, 2008

Valuation
Company Profile in website
59 Oct 24, 2008

Valuation
Price Earnings Ratio
• The price earnings ratio is obviously very important in stock

evaluation. Therefore, I describe some background related to the
ratio and some theory with regards to the P/E ratio. Subjects
related to the P/E ratio include:
Dividend growth Model
Theory of price earnings ratio and growth
P/E ratio and the EV/EBITDA ratio
 The PE ratio depends more on accounting
 The PE is affected by leverage
 The EV/EBITDA ignores depreciation and capital expenditure
Case exercise on P/E and EV/EBITDA
60 Oct 24, 2008

Valuation
P/E Ratio versus EV/EBITDA
• Use the EV/EBITDA when the funding does not make much difference in
valuation
Many companies in an industry with different levels of gearing and
companies do not attempt to maximize leverage
Very high levels of gearing and wildly fluctuating earnings
When the earnings are affected by accounting policy and account
adjustments
• Use the P/E ratio when cost of funding clearly affects valuation and/or
when the level of gearing is stable and similar for different companies
Debt capacity can provide essential information on valuation
EBITDA does not account for taxes, capital expenditures to replace
existing assets, depreciation and other accounting factors that can
affect value.
61 Oct 24, 2008

Valuation
P/E Ratio
• If you use the P/E ratio for valuation, the ratio implies that only
this year or last years earnings matter
• Cash matters to investors in the end, not earnings (different

lifetime of earnings)
• When earnings reflect cash flow, P/E is reasonable for valuation
• High P/E causes treadmill and does not necessary imply that
companies are performing well
• Earnings can be managed and manipulated
62 Oct 24, 2008

Valuation
P/E Ratio, Growth and Reconciliation to Cash Flow
• P/E = (1-g/r)/(k-g)
 g -- long term growth rate in earnings and cash flow
 r -- rate of return earned on new investment
 k -- discount rate
• (k-g) = (1-g/r)/(P/E)
• k = (1-g/r)/(P/E) + g
• Example: if r = k than the formula boils down to 1/(k)
• If the g = 0, the formula is P/E = 1/k
• P = E/(k-g) x (1-g/r)
 If, for some reason, g = r, then the Gordon model could be applied
to compute k.
63 Oct 24, 2008

Valuation
Microsoft P/E , ROE Etc
• Microsoft’s P/E has fallen even though EPS has Grown. The PE
is explained by ROE falling and growth falling as implied in the PE
formula.
Microsoft EPS and ROE Microsoft P/E and Growth

1.4 45% 60 60.00%
1.2 40%
35% 50 50.00%
1
30%
40 40.00%
Growth Rate
0.8 25%
P/E Ratio
EPS
ROE
0.6 20% 30 30.00%

15%
0.4
10% 20 20.00%
0.2 PE Ratio
5%
10 Past 3 Year Growth 10.00%
0 0%
0 0.00%
91
92
01
03
95
93
94
96
97
98
99
00
02
04
05
19
19
19
20
20
20
20
19
19
19
19
19
19
20
20
1991 1992 19931994 1995 1996 1997 1998 1999 20002001 2002 2003
64 Oct 24, 2008

Valuation
Illustration of Drivers with Trucking Companies
What should drive the difference

in P/E Ratios. Could this analysis
be applied to a private company
65 Oct 24, 2008

Valuation
PE Ratio Formula when k = r – There is no economic
profit on new investments
• P/E = (1-g/r)/(k-g)
If k = r
P/E = (1-g/k)/(k-g)
P/E = (k/k-g/k)/(k-g)
P/E = ((k-g)/k)/(k-g)
P/E = 1/k
• PEG Ratio  P/E divided by g

If the g and the r were the same, the ratio would be a
benchmark
Should consider the r and the k
66 Oct 24, 2008

Valuation
Use of P/E Ratio Formula to Compute the Required
Return on Equity Capital
• It will become apparent later that one cannot get away from estimating the
cost of equity capital and the CAPM technique is inadequate from a theoretical
and a practical standpoint.
• The following example illustrates how the formula can be used in practice:
k = (1-g/r)/(P/E) + g
67 Oct 24, 2008

Valuation
P/E Notes
• High ROE does not mean high PE – Hence the existence of high
ROE stocks with low PEs
• Growth and value are not always positively correlated
• Growth from improvement will always be value enhancing

whereas growth from reinvestment depends upon the return
against the benchmark return
• Reinvestment should also include “ Cash hoarding”
• PB is better at differentiating ROE differences than PE
68 Oct 24, 2008

Valuation
Relationship Between Multiples
• The P/E, EV/EBITDA and Cash Flow Multiples should be

consistent and you should understand why one multiple gives you
a different answer than another multiple.
• Each of the multiples is affected by
The discount rate – the risk of the cash flow
The ability of the company to earn more than its cost of
capital
The growth rate in cash flow or earnings
• Differences in the ratios are a function of

Leverage, Depreciation Rates, Taxes, Capital Expenditures
relative to cash flow
69 Oct 24, 2008

Valuation
Relationship Between Multiples
• Enterprise Value = NOPLAT x (1-g/ROIC)/(WACC – g)

• NOPLAT = Investment x ROIC
• NOPLAT = EBIT x (1-t)
• EBITDA = EBIT + Depreciation
EV/EBITDA
• EBT = EBIT – Interest

• NI = EBT x (1-t)
NI/Market Cap
• Market Cap = EV – Debt
MB = Market Cap/Equity
70 Oct 24, 2008

Valuation
Relationship Between Multiples - Illustration
• Assume
Value = NOPLAT x (1-g/ROIC)/(WACC –g)
This is the EVA Formula
• Assume
No Taxes
No Leverage
No Depreciation
No Growth Rate
ROIC = 10%
71 Oct 24, 2008

Valuation
Comparative Multiples
• With the simple assumptions, each of the multiples is the same as shown
below
Exercise: Data table with alternative
parameters to investigate P/E and
EV/EBITA
72 Oct 24, 2008

Valuation
Comparative Multiples
• Once taxes, leverage and

depreciation are added, the
multiples diverge as shown on
the table below:
73 Oct 24, 2008

Valuation
Problems in Applying Multiples
• If you assume that the company has been growing at a high rate
and apply the P/E ratio will be overstated in valuation.
• When comparing companies, the operating leverage and financial

risks should be similar and there should be an understanding of
why P/E ratios are different.
• In applying multiples for comparable transactions, if synergy

values are added, there is double counting
• If industry has cycles, must be careful in application
74 Oct 24, 2008

Valuation
Market and sector PE ratios – The danger of averages
• This chart illustrates issues associate with computing averages. In

practice, the number of comparable firms is small and choosing the
median is advisable.
75 Oct 24, 2008

Valuation
Valuation From Discounted Free Cash Flow
76 Oct 24, 2008

Valuation
Advantages and Disadvantages of DCF
• Advantages • Disadvantages
Theoretically Valid – value comes Assumptions: Requires WACC

from free cash flow and assessing assumptions and residual value
risk of the free cash flow. assumptions. There are major
problems with WACC estimation.
Operating and Financial Values –
explicitly separates value from Forecasting Problems: Complex
operating the company with value forecasting models can easily be
of financial obligations and value manipulated
from cash Growth: The residual value depends
Sensitivity – forces an on growth rates which can easily
understanding of key drivers and distort value
allows sensitivity and scenario Real Options: Discussed above
analysis
77 Oct 24, 2008

Valuation
Discounted Flow
• Use the discounted cash flow when you know something more
about the company that can be obtained with a forecast
• Any cash flow forecast involves:
Value =
 Cash flow during explicit forecast period +
 Present of cash flow after explicit forecast period
• The second item generally involves some kind of growth

projection.
• Value of Equity = Value of Enterprise – Value of Net Debt
78 Oct 24, 2008

Valuation
Discounted Cash Flow
• Why would you make a cash flow forecast of more than one year
If the company is stable and you know the stable level of
earnings and cash flow, then a cash flow forecast does not
add anything to the valuation analysis
If you do not know what the future earnings will be, then a
cash flow forecast is helpful as long as you have information
to make the forecast
If you know earnings and cash flow will fluctuate and then
reach a stable amount, then discounted cash flow will be
better than multiple analysis
79 Oct 24, 2008

Valuation
Step by Step Valuation with Free Cash Flow
• Step by Step valuation using free cash flow:
Step 1: Compute projected free cash flow over the explicit forecast
period and discount the free cash flow at the WACC
Step 2: Make adjustments to free cash flow in the last forecast year
Step 3: Add terminal value to cash flow to establish enterprise value
Step 4: Make other balance sheet adjustments for balance sheet

liabilities and assets that are not in cash flow but affect value
Step 5: Subtract current value of debt net of surplus cash to
establish the total equity value.
Step 6: Divided the equity value by the current outstanding shares to
establish value per share
80 Oct 24, 2008

Valuation
Assets and Liabilities that Escape DCF Valuation
• Any asset or liability that has no cash flow consequences
• Carefully Analyze the Balance Sheet::
Assets  Add to Enterprise Value

 Un-utilized Land
 Un-utilized Equipment
 Legal Claims
Liabilities  Subtract From Enterprise Value

 Environmental
 Contract Provisions
 Unrecorded unfunded Liabilities
 Net Pension Liabilities not Funded
81 Oct 24, 2008

Valuation
Unfunded Pension Liabilities
• Defined benefit versus defined contribution

No issue with defined contribution since contribution covers future
obligations and there is no future obligation that is not covered
Defined benefit can lead to requirements to fund that are not
included in investment reserves
Difference is unfunded liability or asset
Unfunded liability is like debt – it will be a future fixed obligation like
future debt service
 Note that this assumes the current level of free cash flow does not
already consider the fixed obligation
• If a company runs a defined-benefit pension plan for its employees, it

must fund the plan each year. If the company funds its plan faster then
expenses dictate, the company can recognise a portion of the excess
assets on the balance sheet.
82 Oct 24, 2008

Valuation
Double Counting of Assets and Obligations
• Work through simple examples to make sure that the cash flow
and the adjustments to valuation are consistent.
• Work through simple examples
• Examples minority interest
Income from minorities is included in free cash flow, then the

financing of minorities must be included in invested capital
If diluted shares are deducted in earnings than do not also
include the diluted shares when computing share value
Deferred tax treatment depends on how future deferred
taxes are forecast
83 Oct 24, 2008

Valuation
DCF Valuation – Length of Forecast
• Short-run
Forecast all financial statement items

 Gross-margin, selling expenses, Etc.
• Further out
Individual line items more difficult
Focus on key drivers

 Operating margin, tax rate, capital efficiency
• Continuing Value
When ROIC and growth stabalise
84 Oct 24, 2008

Valuation
DCF Example to Compute Equity Value from Free Cash Flow –
Net Debt is Bank and Minority Interest minus Cash and Listed
Investments
Explicit forecasts 8,924.43

Terminal valuation 17,811.59
Appraised Enterprise Value (AEV) 26,736.02
Treatment of other
Plus: Listed investments 3,416.00
investments depend
Plus: Other investments 4,356.00
on definition of free
Plus: Cash 20,316.00 cash flow. Here,
Total Appraised Value 54,824.02 income from other
investments must not
Less: Bank & other debt 24,282.00 be in free cash flow
Less: Minorities 78.00
Equity value 30,464.02
Note how investments are added

and debt is deducted in arriving
at equity value
85 Oct 24, 2008

Valuation
Continuing Value
86 Oct 24, 2008

Valuation
Estimating Continuing Value
• Continuing value is important aspect of valuation
• In actual valuations compiled by McKinsey, the terminal value is –

56% to 125% of valuation
• High terminal values are reasonable if cash flow in early years is

offset by outflows for capital spending that should generate higher
cash flows in later years
The terminal value should reflect cash flow and earnings that is at
the middle of the business cycle, or in the case of commodities,
where prices reflect long-run marginal production cost, or in the
case of high growth companies, when the market is saturated
87 Oct 24, 2008

Valuation
Continuing Value to Add to Free Cash Flow
• Terminal or continuing value is analogous to dividends and capital gains.

Free cash flow is dividends, residual value is capital gain.
• A few methods of computing residual value include:
Perpetuity First, high growth firms with high net capital

expenditures are assumed to keep
EBITDA Multiple reinvesting at current rates, even as growth
drops off. Not surprisingly, these firms are
not valued very highly in these models.
P/E Ratio
Second, the net capital expenditures are
Market to Book Ratio reduced to zero in stable growth, even as
the firm is assumed to grow at some rate
Replacement Cost forever. Here, the valuations tend to be too
high.
NOPLAT
• Present value of residual amount to add to present value of cash flow to

establish enterprise value
88 Oct 24, 2008

Valuation
Sustainable Growth and Plowback Rate
• In the P/E ratio, the sustainable growth of earnings per share is:
g = ROE x (1 – dividend payout ratio)
This depends on assumptions with respect to constant

payout and constant ROE. It also assumes that either there
are no new share issues, or if new share issues occur, the
market to book ratio is one.
• Growth in free cash flow:
g = Dep Rate x [(Cap Exp/Dep) – 1]
Capital expenditures can be greater than depreciation

because historic depreciation is low from historic accounting
or because company has opportunities for growth.
89 Oct 24, 2008

Valuation
Discounted Cash Flow Example
• JPMorgan conducted a discounted cash flow analysis to determine a range of

estimated equity values per diluted share for Exelon common stock.
• JPMorgan calculated the present value of the Exelon cash flow streams from 2005
through 2009, assuming it continued to operate as a stand-alone entity, based on
financial projections for 2005 through 2007 and extensions of those projections from
2008 through 2009 in each case provided by Exelon's management.
• JPMorgan also calculated an implied range of terminal values for Exelon at the end
of 2009 by applying a range of multiples of 8.0x to 9.0x to Exelon's 2009 EBITDA
assumption.
• The cash flow streams and the range of terminal values were then discounted to
present values using a range of discount rates from 5.25% to 5.75%, which was
based on Exelon's estimated weighted average cost of capital, to determine a
discounted cash flow value range.
• The value of Exelon's common stock was derived from the discounted cash flow
value range by subtracting Exelon's debt and adding Exelon's cash and cash
equivalents outstanding as of December 31, 2004.
90 Oct 24, 2008

Valuation
Example of Discounted Cash Flow Analysis
• For the Exelon discounted cash flow analysis, Lehman Brothers

calculated terminal values by applying a range of terminal multiples to
assumed 2009 EBITDA of 7.72x to 8.72x. This range was based on the
firm value to 2004 estimated EBITDA multiple range derived in the
comparable companies analysis. The cash flow streams and terminal
values were discounted to present values using a range of discount rates
of 5.43% to 6.43%. From this analysis, Lehman Brothers calculated a
range of implied equity values per share of Exelon common stock.
• PSE&G: For PSEG's regulated utility subsidiary, Morgan Stanley

calculated a range of terminal values at the end of the projection period by
applying a multiple to PSE&G's projected 2009 earnings and then adding
back the projected debt and preferred stock amounts in 2009. The price to
earnings multiple range used was 14.0x to 15.0x and the weighted
average cost of capital was 5.5% to 6.0%.
91 Oct 24, 2008

Valuation
Discounted Cash Flow Analysis – Real World Example
• Credit Suisse First Boston estimated the present value of the stand-alone,
Unlevered, after-tax free cash flows that Texaco could produce over
calendar years 2001 through 2004 and that Chevron could produce over
the same period. The analysis was based on estimates of the
managements of Texaco and Chevron adjusted, as reviewed by or
discussed with Texaco management, to reflect, among other things,
differing assumptions about future oil and gas prices.
• Ranges of estimated terminal values were calculated by multiplying
estimated calendar year 2004 earnings before interest, taxes,
depreciation, amortization and exploration expense, commonly referred to
as EBITDAX, by terminal EBITDAX multiples of 6.5x to 7.5x in the case of
both Texaco and Chevron.
• The estimated un-levered after-tax free cash flows and estimated terminal
values were then discounted to present value using discount rates of
9.0 percent to 10.0 percent.
• That analysis indicated an implied exchange ratio reference range of
0.56x to 0.80x.
92 Oct 24, 2008

Valuation
Problems with Use of Multiples in DCF
• Multiples can cause problems
Sustainable growth once stable period has been reached is

probably less than the growth used in the explicit forecast
period. This means that the multiple should be less as well.
The multiples for evaluating a merger transaction may
include synergies and other current market items. The use of
similar multiples in terminal value is highly inappropriate.
93 Oct 24, 2008

Valuation
Continuing Cash Flow from NOPLAT and ROIC
• Using a multiple of NOPLAT has a couple of advantages

It is not distorted by large of small capital expenditures
Continuing value directly relates to assumptions about ROIC
For companies with low leverage, the NOPLAT multiplier is similar to the P/E
ratio
• Formulas for Computing Continuing Value with NOPLAT
Free Cash = NOPLAT – Capital Expenditure + Depreciation
Free Cash = ROIC x Investment – Capital Expenditure + Depreciation
The equation becomes:
Free Cash = (1-Real Growth/Real ROIC) x NOPLAT
 In this formulation
 G = ROIC x Plowback Rate
 Similar to ROE x Retention Rate
94 Oct 24, 2008

Valuation
Reasons for Multiplying by (1+g) in Perpetuity Method
• Assume
Company is sold on last day in the cash flow period
Valuation is determined from cash flow in the year after the residual period
This cash flow is final year x (1+g)
• Discounting
Since the value is brought back to final period, the discount factor should be the
final year period
Without growth, the value is the cash flow (cf x 1+g)) divided by the discount
growth
The discounting should also reflect the growth rate
• Formula
1. Cash Flow for Valuation – CF x (1+g)
2. Value at Last Day of Forecast – CF x (1+g)/(WACC –g)
3. PV of the Value -- discount rate must be at last day of forecast, not mid year
95 Oct 24, 2008

Valuation
Formulas for Continuing Value
• A common method for computing cash flow is using the final cash flow in the
corporate model and assuming the company is sold at the end of the
Perpetuity Value at beginning of final year = FCF/WACC
Perpetuity Adjusted for Growth = FCF(1+g)/(WACC - g)
Perpetuity using investment returns =
 NOPLAT x (1-g/ROIC)/(WACC - g)
• Once the Perpetuity Value is established for in the last year, it must be discounted
to the current value:
Current Perpetuity Value = PV(Perpetuity Value that occurs at beginning of
final year)
• NPV in excel assumes flows occur at the end of the year. Adjustments can be
made to assume that flows occur in the middle of the year.
In this case, the discounting of the residual is different from discounting of the
individual cash flows
96 Oct 24, 2008

Valuation
Practical Issues and Continuing Value
• Book Value – when book value means something from an economic

standpoint •It seems foolish to
assume that current
Banks multiples will remain
constant as the
Utility Companies industry matures and
changes and that
• EV/EBITDA, P/E – companies without lumpy investments investors will continue
to pay high multiples,
even if the
Telcom fundamentals do not
justify them. If there
Manufacturing is stable growth, the
P/E multiple in the
• Replacement Cost – when replacement cost can be established terminal value should
be lower.
Oil, Gas and Mining
Airlines
97 Oct 24, 2008

Valuation
Issues in Summarising DCF
• Whether to divided by diluted or non-diluted shares depends on

the treatment of employee stock options and convertible bonds
• Work through simple examples
• Three ways to model options
Deduct options from EBITDA and do not use non-diluted

shares – problem, how to handle existing options.
Ignore options and use diluted shares
Explicitly value options as a claim on cash flows and include

as debt – here would use the non-diluted shares
98 Oct 24, 2008

Valuation
Example of Residual Value Analysis
Exercise on ROIC in Financial Ratio

Folder
99 Oct 24, 2008

Valuation
Valuation from Projected EPS and Dividend per
Share
100 Oct 24, 2008

Valuation
Valuation from Projected Earnings and Dividends
• Earnings Valuation
 PV of EPS over forecast horizon discounted at the equity discount
rate
 Add the present value of the perpetuity EPS value reflecting the
growth rate
• Dividend Valuation
 PV of Dividend per share over the forecast horizon
 Add present value of book value per share rather than perpetuity of
earnings because book value grows when dividends are not paid
 Can multiply the book value per share by market to book multiple
101 Oct 24, 2008

Valuation
Price Earnings and Gordon Model
Gordon Dividend Discount Model.
P = D1/(K – G)
 P = the "correct" share price
 D = dividend payment for the next period (recall from discounting exercise that the next
period must be used)
 K = Required rate of return (based largely on market interest rates a adjusted for equity
risk)
 G = anticipate rate of dividend growth
The model can be used to compute the cost of capital where:
R = D/P + G
Problem: D is not EPS and G is affected by payout ratio
102 Oct 24, 2008

Valuation
Illustration of EPS and DPS Valuation
• Demonstrate that incorporation of growth reduces to the formula

EPS/(k-g)
• Compute present value of the EPS over the forecast horizon
103 Oct 24, 2008

Valuation
Corporate Modeling and Valuation of Business
Segments
• Compute free cash flow for segments of the business
• Compute EBITA by segment to evaluate the value with

comparables
• Can use different residual value assumptions for different

segments of the business
104 Oct 24, 2008

Valuation
Use of Relationship between Multiples and Financial
Ratios in Residual Value
• The financial model projects the return on equity and the

relationship between ROE and the Market to book ratio can be
used to make projections of multiples
Market to Book Ratio versus Return on Equity
4.00
Exelon
3.50
y = 13.102x + 0.2595
R2 = 0.786
3.00
2.50
Market to Book
2.00
Return on equity associated
with a market to book ratio of
1.0
1.50
1.00
0.50
-
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 22.0%
ROE
105 Oct 24, 2008

Valuation
Example of Business Segment Analysis in Corporate
Models
106 Oct 24, 2008

Valuation
Reference: Selected Valuation Issues
107 Oct 24, 2008

Valuation
Valuation Issues
• 1. How do you choose between firm and equity valuation

(DCF valuation versus Earnings Growth)
• Done right, firm and equity valuation should yield the same
values for the equity with consistent assumptions. Choosing
between firm (DCF) and equity valuation (PE x EPS
forecasts) boils down to the pragmatic issue of ease.
• For banks, firm valuation does not work because small

differences in WACC can have dramatic effects on valuation
while and if the market value of debt differs from the book
value, firm value can cause distortions.
108 Oct 24, 2008

Valuation
Firm Valuation versus Equity Valuation Multiples –
Depreciation Rate
Assumptions Results
Return and Cost of Capital Enterprise Value - NOPLAT 100,000.00
Required Equity Return 10% Enterprise Value - FCF 100,000.00
Growth Rate 0%
Return on Invested Capital 10% WACC 10.0%
Leverage Return on Invested Capital 10.0%
Leverage (Book Value) 0% Return on Equity 10.0%
Interest Rate 8%
Other P/E Ratio 10.00
Deprecitation Rate 5% EV/EBITDA 6.7
Cap Exp/Depreciation 100% Market to Book 1.00
Investment 100,000 ROIC Multiple - [(1-(g/ROIC))/(WACC-g)] 10.00
Tax Rate 0% FCF Multiple - 1/(WACC-g) 10.00
109 Oct 24, 2008

Valuation
Equity vs Firm Valuation – Income Taxes and
Depreciation
Assumptions Results
Growth Rate 0%
Interest Rate 8%
110 Oct 24, 2008

Valuation
Equity vs Firm Valuation – Leverage, Depreciation and
Taxes
Assumptions Results
Growth Rate 0%
Interest Rate 8%
111 Oct 24, 2008

Valuation
Firm versus Equity Valuation
• From the perspective of convenience, it is often easier to

estimate equity than the DCF, especially when leverage is
changing significantly over time (for example, in project
finance and in leveraged buyouts where equity IRR is used).
• Equity value measures a real cash flow to owners, rather

than an abstraction (free cash flows to the firm exist only on
paper). Free cash flow is affected to a large extent by capital
expenditures which can cause problems.
112 Oct 24, 2008

Valuation
Measurement of Expected Growth Rate
• While there are many who use historical (past) growth as a

measure of expected growth, or choose to trust analysts
(with their projections), try using fundamentals.
• Think about the two factors that determine growth - the

firm's reinvestment policy and its rate of return.
For expected growth in earnings = Retention Ratio * ROE,

where Retention Ratio is 1 – Dividend Payout
For expected growth in EBIT = Reinvestment Rate * ROC,
where reinvestment rate is Cap Exp/Depreciation
113 Oct 24, 2008

Valuation
At 100% Payout – Growth Equals ROE
Price to Earnings Computation

Long-Term Growth Rate 0.00% Total Value (Sum of Annual Value) 5.96
Long-Term Return Return on Equity 15.0% Initial Earnings 1.03
Equity Cost of Capital 15.0% PE Ratio - Value/Net Income 5.80
P/E Formula: (1-g/r)/(k-g) 6.67 PEG: PE/Growth 0.39
Year 1 2 3 4 5 6 7 8 9
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Holding Period 10
Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE
Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE
Investment
Beginning Investment 6.85
Beginning Equity (Last Period Ending) 6.85 7.88 9.06 10.42 11.98 13.78 15.84 18.22 20.95
Add: Earnings (ROE x Beginning Equity) 1.03 1.18 1.36 1.56 1.80 2.07 2.38 2.73 3.14
Less: Dividends (NI x Payout Ratio) - - - - - - - - -
Ending Equity (Beg + Income - Payout) 7.88 9.06 10.42 11.98 13.78 15.84 18.22 20.95 24.10
Cash Flow to Equity and Valuation
Cash flow from Dividends from Above - - - - - - - - -
Terminal Multiple of Earnings from Above 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67
Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - -
Total Cash Flow (Terminal + Dividends) - - - - - - - - -
Required Return on Equity 15.00% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
Discount Factor [1/(required return + 1)^yr] 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28
Value of Cash Flow [CF x Discount Fac] x Switch - - - - - - - - -
Growth over Forecast Horizon

Period Future Earn Current Growth
10 3.61 1.03 15.00%
114 Oct 24, 2008

Valuation
At 50% Payout – Growth is ½ of the ROE

Stable Growth Rate 7.5% Initial Earnings 1.03
Year 1 2 3 4 5 6 7 8 9 10
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%
Holding Period 10
Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE TRUE
Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE
Investment
Beginning Equity (Last Period Ending) 6.85 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13
Add: Earnings (ROE x Beginning Equity) 1.03 1.10 1.19 1.28 1.37 1.48 1.59 1.70 1.83 1.97
Less: Dividends (NI x Payout Ratio) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98
Ending Equity (Beg + Income - Payout) 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 14.12
Cash flow from Dividends from Above 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98
Terminal Multiple of Earnings from Above 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67
Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 14.12
Total Cash Flow (Terminal + Dividends) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 15.10
Required Return on Equity 15.00% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
Discount Factor [1/(required return + 1)^yr] 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
Value of Cash Flow [CF x Discount Fac] x Switch 0.45 0.42 0.39 0.36 0.34 0.32 0.30 0.28 0.26 3.73

10 1.97 1.03 7.50%
115 Oct 24, 2008

Valuation
Growth Rate Estimation vs ROE and Retention Rate
• Note that what we really need to estimate are reinvestment

rates and marginal returns on equity and capital in the future
(the change in Income over the change in Equity).
• Note that those who use analyst’s or historical growth rates

are implicitly assuming something about reinvestment rates
and returns, but they are either unaware of these
assumptions or do not make them explicit. This means, look
at the ROE and the dividends to make sure that the growth is
consistent.
• Future ROE depends on changes in economic variables

affecting the existing investment and new projects with
incremental returns.
116 Oct 24, 2008

Valuation
How Long will Growth Last
• There is no single answer to the question, so look at the following

characteristics:
• A. The greater the current growth rate in earnings of a firm, relative to the
stable growth rate, the longer the high growth period; although the growth
rate may drop off during the period. Thus, a firm that is growing at 40% should
have a longer high-growth period than one growing at 14%.
• B. The larger the size of the firm, the shorter the high growth period. Size
remains one of the most potent forces that push firms towards stable growth;
the larger a firm, the less likely it is to maintain an above-normal growth rate.
• C. The greater the barriers to entry in a business, e.g. patents or strong brand
name, should lengthen the high growth period for a firm.
• Look at the combination of the three factors A,B,C and make a judgment. Few
firms can achieve an expected growth period longer than 10 years
117 Oct 24, 2008

Valuation
Effect of Growth – Microsoft Example – Long-term
Equals the Current Growth – P/E is 20

Long-term Return 15.0% Initial Earnings 1.03
Year 1 2 3 4 5 6 7 8 9 10
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%
Holding Period 10
Investment

10 1.97 1.03 7.50%
118 Oct 24, 2008

Valuation
Long-Term Growth is 3% instead of 7.5% - P/E Ratio
Falls to 13.19

Long-Term Stable Growth Rate 3.00% Total Value (Sum of Annual Value) 13.55
Year 1 2 3 4 5 6 7 8 9 10
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00%
Holding Period 10
Investment

10 1.97 1.03 7.50%
119 Oct 24, 2008

Valuation
Estimation of Terminal Value
• Terminal value refers to the value of the firm (or equity) at the
end of the high growth period. Estimate terminal value, with
DCF, by assuming a stable growth rate that the firm can
sustain forever. If we make this assumption, the terminal
value becomes:
• Terminal Value in year n = Cash Flow in year n+1 / (r - g)
• This approach requires the assumption that growth is

constant forever, and that the cost of capital will not change
over time.
120 Oct 24, 2008

Valuation
Growth Rate and Discount Rate
• A stable growth rate is a growth rate that can be sustained

forever. Since no firm, in the long term, can grow faster than
the economy which it operates it - a stable growth rate
cannot be greater than the growth rate of the economy.
• It is important that the growth rate be defined in the same

currency as the cash flows and that be in the same term (real
or nominal) as the cash flows.
• In theory, this stable growth rate cannot be greater than the

discount rate because the risk-free rate that is embedded in
the discount rate will also build on these same factors - real
growth in the economy and the expected inflation rate.
121 Oct 24, 2008

Valuation
Exit multiple in DCF valuation
• In some discounted cash flow valuations, the terminal value

is estimated using a multiple, usually of earnings. In an
equity valuation model, the exit multiple may be the PE ratio.
In firm valuation models, the exit multiple is often of EBIT or
EBITDA.
• Analysts who use these multiples argue that it saves them

from the dangers of having to assume a stable growth rate
and that it ties in much more closely with their objective of
selling the firm or equity to someone else at the end of the
estimation period.
• Problems arise if the PE assumes a higher growth than is

sustainable after the holding period.
122 Oct 24, 2008

Valuation
Exit multiples and DCF valuation
• On the contrary, exit multiples may introduce relative

valuation into discounted cash flow valuation, and that you
create a hybrid, which is neither DCF nor relative valuation.
These exit multiples use the biggest single assumption made
in these valuation models.
• It seems foolish to assume that current multiples will remain

constant as the industry matures and changes and that
investors will continue to pay high multiples, even if the
fundamentals do not justify them. If there is stable growth,
the P/E multiple in the terminal value should be lower.
123 Oct 24, 2008

Valuation
Length of Time Until Stable Growth – 10 Years – P/E is
15

Year 1 2 3 4 5 6 7 8 9 10
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00%
Holding Period 10
Investment

10 2.52 1.03 10.50%
124 Oct 24, 2008

Valuation
Length of Time Until Stable Growth – 20 Years is 19

Year 1 2 3 4 5 6 7 8 9 10
Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
Dividend Payout 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00%
Holding Period 20
Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE
Investment
Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - -

20 6.85 1.03 10.50%
125 Oct 24, 2008

Valuation
Common errors in FCFE/FCFF model valuation
• These models have assumptions about net capital

expenditures and growth that are strongly linked. When one
changes, so should the other. There are two types of errors
that show up in these valuations.
• First, high growth firms with high net capital expenditures
are assumed to keep reinvesting at current rates, even as
growth drops off. Not surprisingly, these firms are not valued
very highly in these models.
• Second, the net capital expenditures are reduced to zero in
stable growth, even as the firm is assumed to grow at some
rate forever. Here, the valuations tend to be too high.
Avoid errors and make the assumptions about reinvestment
a function of the growth and the return on capital. As growth
changes, the reinvestment rate must change.
126 Oct 24, 2008

Valuation
Valuation of Firms that are Losing Money
• There are a number of reasons why a firm might have

negative earnings, and the response will vary depending
upon the reason:
- If the earnings of a cyclical firm are depressed due to a
recession, the best response is to normalize earnings by
taking the average earnings over a entire business cycle.
- Normalized Net Income = Average ROE * Current Book
Value of Equity
- Normalized after-tax Operating Income = Average ROC *
Current Book Value of Assets
- Once earnings are normalized, the growth rate used
should be consistent with the normalized earnings, and
should reflect the real growth potential of the firm rather
than the cyclical effects.
127 Oct 24, 2008

Valuation
Valuation of a firm that is Losing Money
• - If the earnings of a firm are depressed due to a one-time

charge, the best response is to estimate the earnings without
the one-time charge and value the firm based upon these
earnings.
- If the earnings of a firm are depressed due to poor quality
management, the average return on equity or capital for the
industry can be used to estimate normalized earnings for the
firm. The implicit assumption is that the firm will recover
back to industry averages, once management has been
removed.
- Normalized Net Income = Industry-average ROE * Current Book
Value of Equity
- Normalized after-tax Operating Income = Industry-average ROC
* Current Book Value of Assets
128 Oct 24, 2008

Valuation
Valuation of a firm that is losing money
• - If the negative earnings over time have caused the book

value to decline significantly over time, use the average
operating or profit margins for the industry in conjunction
with revenues to arrive at normalized earnings. Thus, a firm
with negative operating income today could be assumed to
converge on the normalized earnings five years from now. -
If the earnings of a firm are depressed or negative because it
operates in a sector which is in its early stages of its life
cycle, the discounted cash flow valuation will be driven by
the perception of what the operating margins and returns on
equity (capital) will be when the sector matures.
• - If the equity earnings are depressed due to high leverage,
the best solution is to value the firm rather than just the
equity, factoring in the reduction in leverage over time.
129 Oct 24, 2008

Valuation
Valuation of a private firms
• The valuation of a private firm is more difficult than stock in

a publicly traded firm. In particular,
A. The information available on private firms will be
sketchier than the information available on publicly
traded firms.
B. Past financial statements, even when available, might
not reflect the true earnings potential of the firm. Many
private businesses understate earnings to reduce their
tax liabilities, and the expenses at many private
businesses often reflect the blurring of lines between
private and business expenses.
130 Oct 24, 2008

Valuation
Valuation of a private firm
• C. The owners of many private businesses are taxed on the

salary they make and the dividends they take out of the
business; often do not try to distinguish between the two.
The limited availability of information does make the
estimation of cash flows impossible; past financial
statements might need to be restated to make them reflect
the true earnings of the firm. Once the cash flows are
estimated, the choice of a discount rate might be affected by
the identity of the potential buyer of the business. If the
potential buyer of the business is a publicly traded firm, the
valuation should be done using the discount rates based
upon market risk
131 Oct 24, 2008

Valuation
EPS Measures – Establishing a reliable starting point
• Reported EPS – EPS reported by the company using generally

accepted accounting principles. Therefore includes earnings from
recurring and non-recurring items
• Recurring EPS – Reported EPS adjusted to exclude non-recurring

items
• Fully diluted EPS – EPS adjusted to reflect dilution to existing

shareholders as a result of future increases in equity shares
132 Oct 24, 2008

Valuation
EPS adjustments
133 Oct 24, 2008

Valuation
Issue of shares during the year - Rights issue
134 Oct 24, 2008

Valuation
Share buy back
• Redeem Ltd made earnings of $ 33 million dollars for the year

ended March 2004. The number of shares issued at the start of
the year was 200 million. In September 2003 Redeem Ltd bought
back 20 million shares at market price.
Date Shares Weighted Average
Start of year 200 million x 6/12 100 million
After Buy Back 180 million x 6/12 90 million
Weighted Average 190 million
EPS = $33 million/ 190 million = 17. 3 CENTS
135 Oct 24, 2008

Valuation
Dilution – Factors and treatment
• Contingently issuable shares - Include shares in the calculation of

basic EPS if the contingency has been met.
• Options or warrants in existence over as yet un-issued shares –

Assume exercise of outstanding dilutive options and warrants
• Loan stock or preference shares convertible into equity shares in

the future – Assume that instruments are converted therefore
saving interest but increasing the number of shares in issue
136 Oct 24, 2008

Valuation
Diluted Shares
• If you have agreed to give away shares to someone, then your

claim to the cash flow of the company is reduced.
• In the extreme, if you have given away half of your company

away, and the cash flow is the same before and after your give
away, then the amount you would pay for the share must account
for how much you will give away.
• In this extreme example, you should reduce the value by ½.
• This can be accomplished by using diluted shares rather than

basic shares.
137 Oct 24, 2008

Valuation
Option dilution
• Calculation of the number of shares in the dilution calculation is

illustrated below:
138 Oct 24, 2008

Valuation
Multiple share classes
139 Oct 24, 2008

Valuation
Multiple Listings
• Fungible shares listed on different exchanges – EPS calculated

on the basis of total shares - Value equity based on shares held
by the investor group to whom your research is directed
State owned “H” Shares “A” Shares Total
Number ( million) 300 156.7 30 486.7
Price - local HKD 1.50 RMB 5
Price - RMB 1.58 5
Equity Value – RMB million 769 2433
140 Oct 24, 2008

Valuation
Employee Stock options – Latest developments
• IFRS 2 – Requires companies to measure the fair value of share-based

payments at the grant date and expense over the vesting period
• FAS 123 – The above treatment is optional
• A company grants 100 options to 200 employees. The estimated fair value is
$ 50 per option. The options are contingent on the employees working at the
Company in 3 years time. The company estimates that 25% of the employees
Will leave over the 3 year period. No employees leave in year 1 and 2 but
10% leave In year 3.
Year Calculation Cumulative expense Expense
1 100 x (200 x 75%) x $50 x 1/3 $ 250,000 $ 250,000
2 100 x (200 x 75%) x $50 x 2/3 less $ 250,000 $ 500,000 $ 250,000
3 100 x 180 x $50 x 3/3 less $500,000 $ 900,000 $ 400,000
141 Oct 24, 2008

Valuation
Issues in the application of PEs
• Accounting Policy differences – Particularly significant for cross border

comparisons where companies may follow local, international or US
GAAP
• Loss making companies – No earnings therefore no PE
• Cyclical companies – PEs volatile through the cycle and therefore difficult
to benchmark
• Finding a suitable benchmark – Difficult to find companies that are perfect
matches in all determinants of a PE
• Growth – As discussed value and growth are not always the same
• Capital market conditions – The cost of equity will vary depending on
underlying interest rate environment that is likely to be different in different
countries
• Financing – The greater the gearing of a company the greater the cost of
equity and therefore, all other things being equal, the lower the value and
the lower the PE
142 Oct 24, 2008

Valuation
Valuation of Subsidiary Companies in Different
Countries
• How would things differ if we are valuing companies from different
countries, different sectors etc.
• The basic rule is:
Cash flows should be nominal
Cash flows should be stated in the currency where the subsidiary is
located
 If there are multiple currencies, use the future expected spot exchange
rates to translate cash flows
Cash flows should be discounted at cost of capital that reflects the
interest rates where the country is located
 This means that the risk free rate in the country where the subsidiary is
located should be used.
Once the value is established, translate the amount to the home
country at the spot exchange rate
143 Oct 24, 2008

Valuation
Countries
• How would things differ if we are valuing companies from

different countries, different sectors etc.
Example:
 Subsidiary is located in Malaysia
 Parent Company is in Hong Kong
 Subsidiary company sells in Malaysia and Thailand
 Subsidiary company produces in Malaysia and Thailand
Exchange Rates and Interest Rates

 Spot Exchange Rates
 HK Dollars to Ringet
 Baht to Ringet
144 Oct 24, 2008

Valuation
Countries
• How would things differ if we are valuing companies from different

countries, different sectors etc.
• Cash flows should be stated in the currency where the subsidiary is
located (Malaysian Ringgit)
Compute prices and costs in Baht and Ringgit and then translate the
revenues and costs in Baht to Ringgit
To convert the Baht to Ringgit, use the expected future spot
Ringet/Baht exchange rates
Since, as a practical matter, forward exchange rates are not
available beyond 18 months, compute future spot rates from interest
rate parity
Interest rate parity means that if you invest in risk free securities of
different currencies, the spot exchange rate must reflect the future
values.
145 Oct 24, 2008

Valuation
Countries
• How would things differ if we are valuing companies from

different countries, different sectors etc.
• Example of future expected spot exchange rates:
146 Oct 24, 2008

Valuation
Example of Foreign Valuation
147 Oct 24, 2008

Valuation
Free Cash Flow
We often talk about free cash flow, sometimes, it is challenging

to assess what is "free“ cash flow or not, may wish to
elaborate on that rather than just defining free cash flow in a
text book term.
The basic point is to keep things consistent. If you define FCF as

EBITDA without other income, then the valuation does not include
other investments.
On the other hand if FCF is defined using Cash B/4 Financing that
includes other income, the other investments are included in the
valuation
148 Oct 24, 2008

Valuation
In-the-money Options and Convertibles
• Can the trainer also cover dealing with in-the money

options and convertibles?
• Convertibles can trade as straight debt if it is unlikely that the

convertibles will be converted to common shares, or if the
conversion option is in the money, it is clear that the convertibles
will be switched into common shares. In this case, the
ownership share of current shareholders is diluted.
• If you buy the current shares, you are not really getting the whole
company because you will have to give a share of the cash flow
to the convertible bondholders.
149 Oct 24, 2008

Valuation
In the Money Convertibles
• Can the trainer also cover dealing with in-the money options
and convertibles?
150 Oct 24, 2008

Valuation
Terminal Value
Terminal value, and the use of a stable growth rate. How do you
determine that, what is the rule of thumb and how do you
determine which year onwards should be terminal year (i.e. how
long should your forecasted period be).
On how to calculate a WACC, rather than just providing the formula

of WACC, it would be useful to give instructions on where to find
the market premium data, betas and what is the best method vs
the most practical method.
Should we include country risk, exchange rate risks etc and
how to get them.
Also there is no mentioning of cash revolver and how to calculate it.
151 Oct 24, 2008

Valuation
LBO Valuation
• How can LBO’s be valued by making an assumption on

target IRRs for the venture cap / private equity investor.
• Recall the very first simple case that was developed in the class.
In this case the equity IRR was driven by the level of leverage
and the structure of the debt.
• Valuation is realistically driven by the equity IRR criteria of

developers and not free cash flow or WACC
• The risk metric boils down to the debt capacity of the LBO and
the value of the investment depends on the debt structure.
• In this case, risk is driven by bankers outside of the company

rather than the management or advisors to the company.
152 Oct 24, 2008

Valuation
Comparative Multiple Assignment
• Compute Value from NOPLAT and Free Cash Flow and then
compare the multiples that result
• First compute WACC
• NOPLAT is the ROIC x Investment
• Next Compute Value from NOPLAT x (1-g/ROIC)/(WACC-g)
• Compute the EBITDA from NOPLAT and then work through

income tax and income statement
• Compute the Enterprise Value and the Equity Value
• Compute Alternative Multiples
153 Oct 24, 2008

Valuation
First, Find the File
154 Oct 24, 2008

Valuation
Work through the formulas
• Compute WACC
• Compute NOPLAT
• NOPLAT = EBIT x (1-t)
• This Means EBIT = NOPLAT/(1-t)
• EBITDA = EBIT + Depreciation Expense
• Depreciation Expense = Investment x Depreciation Rate
• Debt = Investment x Debt Percent
• Interest Expense = Debt x Interest Rate
155 Oct 24, 2008

Valuation
Data Table with Multiples
156 Oct 24, 2008

Valuation
P/E Ratio, Growth and Required Return
• P/E = (1/r) + PVGO/EPS

 PVGO -- present value per share of future growth
opportunities
 r -- required rate of return on equity
• This formula does not include the component of whether

earnings are greater than cost of capital
157 Oct 24, 2008

Valuation
Industry by Industry P/E Analysis
• High P/E companies have relatively low ROE, where ROE is expected to
increase.
• Computer Hardware and Recreational Products have high P/E and high
ROE – expect a lot of economic profit and treadmill
• Low P/E companies have low and growth such as utility companies or
high ROE that cannot be maintained such as tobacco companies
158 Oct 24, 2008

Valuation
Industry by Industry P/E Ratio – Sorted from Highest to Lowest
159 Oct 24, 2008

Valuation
160 Oct 24, 2008

Valuation
161 Oct 24, 2008

Valuation
162 Oct 24, 2008

Valuation
Finance Professor
• A finance professor received a call from a large financial institution in New York, asking him to
interview for a position on their scientific advisory committee. He agreed to go up and interview,
knowing that such a position would be prestigious and with the extra income we would be able to
purchase more consumer durables. As all of you know, interviews are a long and painful process.
The interviews lasted two days and at the end of the last day the professor was interviewing with
the chief executive who would ultimately be making the hiring decision. At the very end of the
interview, the executive asked him, “what is 7 times 3?” The finance professor confidently
responded, “22.”
• When he got home from New York his family, for once, was eagerly awaiting his return… with lists
of consumer durables in their hands. “How did it go?” they asked. “Good,” he said, “except in the
last interview they asked me 7x3 and I said 22.” “Ohh! Dad!!!” they cried, “it’s 21!” They threw out
their lists of consumer durables, knowing he would never get the job.
• Much to his surprise he got a call 2 weeks later saying he’d gotten the position and the firm was
having a reception in his honor. At the reception he found the executive and went up to him. “Do
you remember our interview?” the professor asked. “Yes,” said the executive. “And do you
remember when you asked me 7x3 and I said 22.” “Yes,” replied the executive, “I wrote down
your answer.” “Well the correct answer is 21,” said the professor, “why did I get the job?” “Well,”
said the executive, “of all the finance professors we interviewed… you were the closest.”
• The moral of the story is, if I can do this, you can do this: pricing bonds and non-American options
using monte carlo simulation to replicate the results achieved explicitly using decision trees.
163 Oct 24, 2008

Valuation
Finance Professors
• A medical doctor, an engineer, and a finance professor are at a cocktail

party.
The medical doctor pompously asserts that the medical profession is
the oldest profession. He cites a passage from the Bible, in Genesis
where god creates man and woman. “Surely,” he says, “this was the
first medical act.”
The engineer jumps in and says, “I remember a passage prior to
that, which says, out of the chaos and confusion, God created the
earth. Surely, this was the first act of engineering and predates the
first medical act.”
“Aha!” says the finance professor, “who created the confusion?!”
• Condolences regarding the confusing nature of risk management under

non-uniformly shifting yield curve conditions followed.
164 Oct 24, 2008

Valuation

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Valuation

1 Oct 24, 2008

• Introduction – Where Value Comes From

• Overview of Alternative Valuation Methods

• Valuation Using Multiples

• Valuation Using Projected Earnings

2 Oct 24, 2008

Every major decision a company makes is in one way or another

• Valuation analysis involves assessing

 Risks in valuing assets, debt and equity

• Measurement value – forecasting and risk assessment -- is a

• Intrinsic value is an estimate and not observable

3 Oct 24, 2008

Valuation is a huge topic. Some Key issues in valuation analysis.

Selection of Market Multiple and Adjustment

Growth Rates in Earnings and Cash Flow Projections

Terminal Value Method and Calculation

 Use several vantage points

 Do not assume false precision

4 Oct 24, 2008

Valuation model with project earnings or cash flows

Industry Comparative Data to establish Multiples and Cost of

• Industry, company knowledge and judgment

Knowledge about risks and economic outlook to assess risks

• Valuation should not be intimidating

5 Oct 24, 2008

• A Company’s value depends on:

Return on Invested Capital

Weighted Average Cost of Capital

• All of the other ratios – gross margins, effective tax rates,

6 Oct 24, 2008

In financial terms, value

7 Oct 24, 2008

• What you think future cash flows will be

• How risky are those cash flows

Reference: Folder on Yield

8 Oct 24, 2008

• Ultimately, value comes from cash flow in any model:

 They still have implicit cost of capital and growth that

• Growth rate in cash flow is a key issue in any of the models

9 Oct 24, 2008

• Valuation using discounted cash flows requires forecasted cash

Discount Rate is WACC

Net Debt Reference: Private

10 Oct 24, 2008

Growth + Economic profit is

Capital Junkies Power House

This implies that

11 Oct 24, 2008

• Issues with ROIC include

Will the ROIC move to WACC because of competitive pressures

What is the expected change in ROIC

Examine the ROIC in models to determine if detailed assumptions are

13 Oct 24, 2008

Based on best •Assessment of industry • Long run

Much of valuation involves implicitly or explicitly

14 Oct 24, 2008

• Growth issues include

Growth is difficult to sustain

Law of large numbers

company becomes large 22.4

Acutal Growth over 5 Years and I/B/E/S Median

overestimate growth 15 Optimism in the lowest growth