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Valuation

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Oct 24, 2008

Contents

• Introduction – Where Value Comes From • Discounting Basics • Overview of Alternative Valuation Methods • Valuation Using Multiples • Valuation Using Projected Earnings • Case Studies

Valuation

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Oct 24, 2008

**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

Valuation

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Oct 24, 2008

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 Valuation 4 Oct 24.Valuation Overview Valuation is a huge topic. 2008 .

2008 . company knowledge and judgment Knowledge about risks and economic outlook to assess risks and value drivers in the forecasts • Valuation should not be intimidating Valuation 5 Oct 24.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.

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.

Valuation

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Oct 24, 2008

**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

Valuation

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Oct 24, 2008

**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

Valuation

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Oct 24, 2008

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 Valuation 9 Oct 24. 2008 .Valuation and Cash Flow • Ultimately.

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 Equity Value Valuation Reference: Private Valuation. Valuation Mistakes 10 Oct 24. 2008 .

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

The Value Matrix . 2008 Give the money to investors Growth - .Stock Categorisation Growth + Pow r H se e ou Pe n l u e a ie r or fu u p re nia nd r ch ve t re rosp ct e s • • • Stretched balance sheet Restructuring Maylook expensive Throwing good money after bad What is the economic reason for getting here and how long can the performance be maintained • • • • • High industry grow th “ Franchise”value Pricing pow er Clear Investm strategy ent Howsustainable? Ca it l Kille pa rs • • • Look cheap but for good reason Cyclical or perm anent Industry or com pany specific factors Try to get out of the business Valuation ROIC/WACC + ++ve Ca Cow sh s • • • • Lowindustry grow th Cash generative and rich Risk/opportunity of diversification Lowrating w strong yield support ith 12 Oct 24.

then can move to terminal value calculation Examine the ROIC in models to determine if detailed assumptions are leading to implausible results Migration table Valuation 13 Oct 24.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. 2008 .

Reasonable Estimates of Growth The medium term outlook The long run •Assessment of industry outlook and company position • ROIC fades towards the cost of capital • Growth fades towards GDP • Long run assumptions: • ROIC = Cost of capital • Real growth = 0% The short term Based on best estimate of likely outcome Reference: Level and persistence of growth rates Much of valuation involves implicitly or explicitly making growth estimates – High P/E comes from high growth Valuation 14 Oct 24. 2008 .

10.5 0 Lowest Second Lowest Median Second Highest Highest Growth Rate Category Valuation 15 Oct 24.4 20 Actual Growth in Income I/B/E/S Growth 15 Optimism in the lowest growth category is still present.0 6.1 12.Growth Issues • Growth issues include Growth is difficult to sustain Law of large numbers means that it is more difficult to maintain growth after a company becomes large Investment analysts overestimate growth Examine sustainable growth formulas from dividend payout and from depreciation rates IBES Growth and Actual Growth from Chan Article 25 Acutal Growth over 5 Years and I/B/E/S Median Growth 22.2 15.3 10 8.0 6. 2008 .0 5 2.5 6.5 9.

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

Alternative Valuation Methods Valuation 17 Oct 24. 2008 .

2008 .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 • The different techniques should give consistent valuation answers See the appraisal folder in the financial library Valuation 18 Oct 24.

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

the value should be the same as the value with alternative approaches • In risk neutral valuation.Risk Neutral Valuation • Theory – If one can establish value with one financial strategy. • 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 . an arbitrage strategy allows one to use the risk free rate in valuing hedged cash flows.

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

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

the discount rates and how much of the company you will own when you exit. 2008 . Oct 24. if you have given away half of your company away.Valuation Diagram – Venture Capital • Valuation in venture capital focuses on the value when you will get out. then the amount you would pay for the share must account for how much you will give 23 away. Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value Discount Rates Enterprise Value Net Debt Equity Value Valuation Evaluate how much of the equity value that you own •In the extreme. and the cash flow is the same before and after your give away.

g. P/E ratio of 15 – terminal value is 20 x 15 • Use high discount rate to account for optimistic projections. 2008 . e.5% • You make an investment and receive shares (your current percent). You know the investment and must establish the number of shares Valuation 24 Oct 24. 5 million investment / 17. e. e.g. 50% discount rate – [20 x 15]/[1+50%]^7 = 17. strategic advice and high risk.g.g. apply a multiple to determine the value of the company.5 million = 28. projection of earnings in year 7 is 20 million.5 million • Establish percentage of ownership you will have in the future value through dividing investment by total value e. • At the positive cash flow period.Venture Capital Method • Determine a time period when the company will receive positive cash flow and earnings.

the value is less.3)/17. 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.Venture Capital Method Continued • In the venture capital method. an adjustment must be made for dilution and the percent of the company retained.000 = 343. 2008 . the value per share must be increased by 30% to maintain the value.5/700.000+VC shares) x 1.000 = 25 per share If an additional 30% of shares is floated. Share value without dilution = 17.373 Valuation 25 Oct 24.g. See the Cost of Capital folder for and example e. If there is dilution in ownership.5-500.3) VC Shares: (25 x 1.5/((500. Value per share = 17. • Therefore.

you may think about creating the company yourself. you would receive cash flows. If you are valuing a company. 2008 . 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. one can replace the assets of a company without investing in the company. By replacing the assets and entering the business. You can reconcile the replacement cost with the discounted cash flow approach Valuation 26 Oct 24.Replacement Cost • First a couple of points regarding replacement cost theory In theory.

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.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. • The ratio of market value to replacement cost is a theoretical ratio that measures the value of management contribution Valuation 27 Oct 24. 2008 . the management may be more productive than others in managing costs or be able to realize higher prices through differentiation of products.

then Q > 1. If the ROIC > industry average. Earn industry average ROIC. 2008 . If the ROIC < industry average.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. then Q < 1 Valuation 28 Oct 24.

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

Valuation 30 Oct 24. • In each of these cases. the asset can be shut down when it is not economic and re-started when it becomes economic. This again limits the downside cash flows. When developing a project. one can delay the investment until it becomes clear that the decision is economic.Continued • Problems with DCF because of flexibility in managing assets: In operating an asset. there is a possibility to abandon the project that can limit the downside as more becomes known about the economics of the project. 2008 .Real Options and DCF Problems . management flexibility provides protection in the downside which means that DCF model produces biased results. In deciding when to construct an investment. This allows the asset to retain the upside but not incur negative cash flows.

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 24.9% -.Fundamental Valuation • What was behind the bull market of 1980-1999 EPS rose from 15 to 56 Nominal growth of 6. 2008 Valuation .

2008 .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 Valuation 32 Oct 24.

Discounting Basics Valuation 33 Oct 24. 2008 .

+ 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 • Discounting in the NPV formula assumes END of period • 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) Case exercise to illustrate the effect of discounting (credit spread) on the value of a bond Valuation 34 Oct 24. 2008 ..Debt (Bond) Valuation Bt = It +1 + It +2 + It +3 + ..

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

+ E(Dt +n) + . 2008 .. (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 Valuation 36 Oct 24..Equity – Dividend Discount Valuation and Gordon’s Model Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ...

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

.Free Cash Flow Model Vt = E(FCFt +1) (1+k)1 + E(FCFt +2) + E(FCFt +3) + .Equity Valuation .... 2008 . (1+k)2 (1+k)3 + E(FCFt +n) (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 Valuation 38 Oct 24.

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. 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 Valuation 39 Oct 24. • If there is growth in a model. 2008 .

2008 .Valuation and Sustainable Growth • Value depends on the growth in cash flow. a similar concept can be used for sustainable growth. Valuation 40 Oct 24. 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. Growth = (Capital Expenditures/Depreciation – 1) x Depreciation Rate • Unrealistic to assume growth in units above the growth in the economy on an ongoing basis.

Valuation Using Multiples 41 Oct 24. 2008 Valuation .

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

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.Summary • Useful sanity check for valuation from other methods • Use multiples to avoid subjective forecasts • Among other things. 2008 Valuation .Multiples .

2008 .Mechanics of Multiples • Find market multiple from comparable companies Rarely are there truly comparable companies Understand economics that drive multiples (growth rate.0 • • • 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. cost of capital and return) • P/E Ratio (forward versus trailing) Value/Share = P/E x Projected EPS P/E trailing and forward multiples In the long-term P/E ratios tend to revert to a mean of 15. EV/EBITDA uses free cash flow Valuation 44 Oct 24.

2008 .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 Valuation 45 Oct 24.

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 Valuation 46 Oct 24.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. 2008 .

g. P/E Ratio) Adjustments for liquidity and control premium Valuation 47 Oct 24.g. 2008 . next year’s earnings) What do ratios really mean (e.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.

2008 .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 Valuation 48 Oct 24.

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

25 17.46 11.000x 10.47 2002 Est EPS 28.490x 1.152x $337.97 20.000 High Low Mean Median Total Assets 0.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 3.288x 11. Summary of 21 comparable banking companies with similar assets.131x 17.545.162x 0.12 22.85 16.093x 0.932.172.85 25.' Source: SNL Securities.688x 1.350x 13.000.44 10.25 18.333x 9.415 1. capital and profitability characteristics.037x 12.719x $35.359x 0.841 1.14 22. 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 24.737 11.64 40.883. assuming 8 percent equity as 'normal.255x $5.03 2003 Est EPS 14.000 112.085x $3.195x $5.33 LTM EPS 85. 2002 (Pricing as of 3/25/2002).28 13.31 15.181x 13.737 1. 2008 Valuation .48 18.89 22.07 *Normalized book value.545.611x 11.155x 1.856x 8.48 21.05 18.12 Tangible Book Value* 2.14 16.961 29.182 100.724 48.

0x to 9. 2008 .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 Exelon's 2009 EBITDA assumption. Note that the median is presented before the mean Valuation 51 Oct 24.

8 20 238.4 20.4 Oct 24.6 20.4 20.3 20.1 52 28 238.3 19.7 244.7 20.9 31.2 30. 2008 Price/Tangible Book 251.2 31.8 290.5 7 238.7 319.8 Price/LTM Earnings Median Mean 22.0 Price/Deposits Valuation Median Mean 32.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 Price/Book Median Mean Median Mean 1 238.1 32.1 249.2 309.1 .0 304.2 307.9 30.6 299.9 29.4 301.3 30.5 241.4 16 256.3 20.3 20.7 240.6 299.4 32.

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. and a host of other factors. earnings. but also play a crucial role in determining the risk involved.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. Valuation 53 Oct 24. marketability. Discounts and premiums affect not only the value of the company. control issues. 2008 . contingent liability.

then a non-marketability discount would be subtracted from the value. 2008 . the dividend yield. expected growth in value and holding period. 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. and firm specific issues such as imminent or pending initial public offering (IPO) of stock to be freely traded on a public market.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. • • • Valuation 54 Oct 24. all else equal. The size of the discount varies base on: relative liquidity (such as the size of the shareholder base).

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.

• Minority interest value …represents the value of a minority interest “as if freely tradable” in a public market. 2008 . Minority interest discount …represents the reduction in value from an absence of control of the enterprise. A controlling interest is assumed to have control power over the minority interests. Valuation 56 Oct 24.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.

Such analysis indicated that Mobil has been trading in the recent past at an 8% to 15% discount to Exxon. a price to earnings multiple increase of 1 for Exxon Mobil would result in an enhancement of value to shareholders of approximately $10 billion. Morgan's analysis indicated that if Mobil were to be valued at price to earnings multiples comparable to those of Exxon. • Finally.P.P. • 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. organizations which compile brokers' earnings estimates on public companies. and First Call.P. According to J. there would be an enhancement of value to its shareholders of approximately $11 billion. Valuation 57 Oct 24. 2008 . • J. Morgan's analysis.P/E Analysis – Use of P/E Ratio in Valuation • J. 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. Morgan performed an analysis comparing Exxon's price to earnings multiples with Mobil's price to earnings multiples for the past five years.

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

2008 .Company Profile in website Valuation 59 Oct 24.

Therefore. I describe some background related to the ratio and some theory with regards to the P/E ratio. 2008 Valuation .Price Earnings Ratio • The price earnings ratio is obviously very important in stock evaluation. 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.

depreciation and other accounting factors that can affect value.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. 2008 . Valuation 61 Oct 24.

not earnings (different lifetime of earnings) • When earnings reflect cash flow. 2008 . the ratio implies that only this year or last years earnings matter • Cash matters to investors in the end. 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 Valuation 62 Oct 24.P/E Ratio • If you use the P/E ratio for valuation.

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

2008 .00% 10 0 Past 3 Year Growth 1991 1992 19931994 1995 1996 1997 1998 1999 20002001 2002 2003 10.2 1 EPS 0.00% ROE 25% 30 20 PE Ratio 30. Microsoft EPS and ROE 1.8 0. The PE is explained by ROE falling and growth falling as implied in the PE formula.00% 50.4 1.00% Oct 24.2 0 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 Microsoft P/E and Growth 45% 40% 35% 30% 20% 15% 10% 5% 0% 60 50 P/E Ratio 60.6 0.00% 0. ROE Etc • Microsoft’s P/E has fallen even though EPS has Grown.00% Valuation 64 Growth Rate 40 40.00% 20.Microsoft P/E .4 0.

2008 .Illustration of Drivers with Trucking Companies What should drive the difference in P/E Ratios. Could this analysis be applied to a private company Valuation 65 Oct 24.

2008 .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 Valuation 66 Oct 24.

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. 2008 . • The following example illustrates how the formula can be used in practice: k = (1-g/r)/(P/E) + g • Valuation 67 Oct 24.

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 Valuation 68 Oct 24. 2008 .

Capital Expenditures relative to cash flow Valuation 69 Oct 24. Taxes.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. 2008 .

2008 .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 Valuation 70 Oct 24.

2008 .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% Valuation 71 Oct 24.Relationship Between Multiples .

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

Comparative Multiples • Once taxes. 2008 . leverage and depreciation are added. the multiples diverge as shown on the table below: Valuation 73 Oct 24.

• When comparing companies. 2008 . • In applying multiples for comparable transactions. if synergy values are added.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. there is double counting • If industry has cycles. the operating leverage and financial risks should be similar and there should be an understanding of why P/E ratios are different. must be careful in application Valuation 74 Oct 24.

In practice. 2008 .Market and sector PE ratios – The danger of averages • This chart illustrates issues associate with computing averages. Valuation 75 Oct 24. the number of comparable firms is small and choosing the median is advisable.

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

**Advantages and Disadvantages of DCF
**

• Disadvantages Assumptions: Requires WACC assumptions and residual value assumptions. There are major problems with WACC estimation. Forecasting Problems: Complex forecasting models can easily be manipulated Growth: The residual value depends on growth rates which can easily distort value Real Options: Discussed above

• Advantages Theoretically Valid – value comes from free cash flow and assessing risk of the free cash flow. Operating and Financial Values – explicitly separates value from operating the company with value of financial obligations and value from cash Sensitivity – forces an understanding of key drivers and allows sensitivity and scenario analysis

Valuation

77

Oct 24, 2008

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

Valuation

78

Oct 24, 2008

**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

Valuation

79

Oct 24, 2008

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 Valuation 80 Oct 24. 2008 .

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.

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

Double Counting of Assets and Obligations • Work through simple examples to make sure that the cash flow and the adjustments to valuation are consistent. 2008 . 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 Valuation 83 Oct 24. • Work through simple examples • Examples minority interest Income from minorities is included in free cash flow.

selling expenses. tax rate. • Further out Individual line items more difficult Focus on key drivers Operating margin.DCF Valuation – Length of Forecast • Short-run Forecast all financial statement items Gross-margin. 2008 Valuation . Etc. capital efficiency • Continuing Value When ROIC and growth stabalise 84 Oct 24.

00 54. income from other investments must not be in free cash flow Note how investments are added and debt is deducted in arriving at equity value Valuation 85 Oct 24.736.02 Treatment of other investments depend on definition of free cash flow.00 4.464. Here.416.00 30.282.02 24.DCF Example to Compute Equity Value from Free Cash Flow – Net Debt is Bank and Minority Interest minus Cash and Listed Investments $ Explicit forecasts Terminal valuation Appraised Enterprise Value (AEV) Plus: Listed investments Plus: Other investments Plus: Cash Total Appraised Value Less: Bank & other debt Less: Minorities Equity value 8.824.924.43 17.316.00 78.811. 2008 .02 3.00 20.356.59 26.

2008 .Continuing Value Valuation 86 Oct 24.

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. where prices reflect long-run marginal production cost. 2008 .Estimating Continuing Value • Continuing value is important aspect of valuation • In actual valuations compiled by McKinsey. or in the case of commodities. when the market is saturated Valuation 87 Oct 24. or in the case of high growth companies.

• A few methods of computing residual value include: Perpetuity EBITDA Multiple P/E Ratio Market to Book Ratio Replacement Cost NOPLAT • Present value of residual amount to add to present value of cash flow to establish enterprise value 88 Oct 24.Continuing Value to Add to Free Cash Flow • Terminal or continuing value is analogous to dividends and capital gains. residual value is capital gain. the net capital expenditures are reduced to zero in stable growth. even as the firm is assumed to grow at some rate forever. Valuation . Here. high growth firms with high net capital expenditures are assumed to keep reinvesting at current rates. Second. even as growth drops off. Free cash flow is dividends. the valuations tend to be too high. Not surprisingly. 2008 First. these firms are not valued very highly in these models.

It also assumes that either there are no new share issues. 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. 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. 2008 Valuation . 89 Oct 24. or if new share issues occur.Sustainable Growth and Plowback Rate • In the P/E ratio.

• 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. Valuation 90 Oct 24.0x to 9. • The cash flow streams and the range of terminal values were then discounted to present values using a range of discount rates from 5. • JPMorgan calculated the present value of the Exelon cash flow streams from 2005 through 2009.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. 2004. 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. to determine a discounted cash flow value range. assuming it continued to operate as a stand-alone entity. • JPMorgan also calculated an implied range of terminal values for Exelon at the end of 2009 by applying a range of multiples of 8. which was based on Exelon's estimated weighted average cost of capital.0x to Exelon's 2009 EBITDA assumption. 2008 .25% to 5.75%.

From this analysis.72x to 8.43% to 6. The cash flow streams and terminal values were discounted to present values using a range of discount rates of 5. Lehman Brothers calculated terminal values by applying a range of terminal multiples to assumed 2009 EBITDA of 7.Example of Discounted Cash Flow Analysis • For the Exelon discounted cash flow analysis. This range was based on the firm value to 2004 estimated EBITDA multiple range derived in the comparable companies analysis. The price to earnings multiple range used was 14.43%. Lehman Brothers calculated a range of implied equity values per share of Exelon common stock. 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. Valuation 91 Oct 24.72x.0%.5% to 6.0x to 15. 2008 .0x and the weighted average cost of capital was 5. • PSE&G: For PSEG's regulated utility subsidiary.

depreciation. 2008 . among other things. taxes. Valuation 92 Oct 24.80x. • The estimated un-levered after-tax free cash flows and estimated terminal values were then discounted to present value using discount rates of 9. by terminal EBITDAX multiples of 6.0 percent. • That analysis indicated an implied exchange ratio reference range of 0. commonly referred to as EBITDAX.5x in the case of both Texaco and Chevron. The analysis was based on estimates of the managements of Texaco and Chevron adjusted.0 percent to 10.Discounted Cash Flow Analysis – Real World Example • Credit Suisse First Boston estimated the present value of the stand-alone. after-tax free cash flows that Texaco could produce over calendar years 2001 through 2004 and that Chevron could produce over the same period. amortization and exploration expense. Unlevered.5x to 7. • Ranges of estimated terminal values were calculated by multiplying estimated calendar year 2004 earnings before interest.56x to 0. to reflect. differing assumptions about future oil and gas prices. as reviewed by or discussed with Texaco management.

The use of similar multiples in terminal value is highly inappropriate. 2008 .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. Valuation 93 Oct 24. 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.

2008 . 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 Valuation 94 Oct 24.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.

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. Cash Flow for Valuation – CF x (1+g) 2. not mid year 95 Oct 24. PV of the Value -. 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. Value at Last Day of Forecast – CF x (1+g)/(WACC –g) 3.discount rate must be at last day of forecast. the discount factor should be the final year period Without growth. 2008 Valuation .

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.g) • Once the Perpetuity Value is established for in the last year. Adjustments can be made to assume that flows occur in the middle of the year. 2008 . the discounting of the residual is different from discounting of the individual cash flows Valuation 96 Oct 24. In this case.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 .

Valuation 97 Oct 24. P/E – companies without lumpy investments Telcom Manufacturing • Replacement Cost – when replacement cost can be established Oil. Gas and Mining Airlines 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.Practical Issues and Continuing Value • Book Value – when book value means something from an economic standpoint •It seems foolish to Banks Utility Companies • EV/EBITDA. 2008 . the P/E multiple in the terminal value should be lower. If there is stable growth.

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 Valuation 98 Oct 24. how to handle existing options.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. 2008 .

Example of Residual Value Analysis Exercise on ROIC in Financial Ratio Folder Valuation 99 Oct 24. 2008 .

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

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 Valuation 101 Oct 24. 2008 .

Price Earnings and Gordon Model Gordon Dividend Discount Model. 2008 . 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 Valuation 102 Oct 24.

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 Valuation 103 Oct 24. 2008 .

2008 .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 Valuation 104 Oct 24.

0% 16.0% Valuation 105 Oct 24.0 1.0% 4.00 2.0% 10.50 1.0% 22.786 3.50 Market to Book 2.50 y = 13.102x + 0.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 4.0% 2.0% 18.2595 R2 = 0.00 0.0% ROE 12.50 0.00 Exelon 3.0% 8. 2008 .0% 6.0% 14.0% 20.00 Return on equity associated with a market to book ratio of 1.

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

2008 .Reference: Selected Valuation Issues Valuation 107 Oct 24.

Choosing between firm (DCF) and equity valuation (PE x EPS forecasts) boils down to the pragmatic issue of ease. Valuation 108 Oct 24.Valuation Issues • 1. 2008 . • 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. 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.

0% 10.0% 10.1/(WACC-g) Valuation 109 Oct 24.FCF 100.00 6.000 0% 0% 8% P/E Ratio EV/EBITDA Market to Book 10% 0% 10% WACC Results Enterprise Value .00 10.00 100.NOPLAT Enterprise Value .00 10.00 Return on Invested Capital Return on Equity ROIC Multiple .000.000.00 10.0% 10.Firm Valuation versus Equity Valuation Multiples – Depreciation Rate Assumptions Return and Cost of Capital Required Equity Return Growth Rate Return on Invested Capital Leverage Leverage (Book Value) Interest Rate Other Deprecitation Rate Cap Exp/Depreciation Investment Tax Rate 5% 100% 100.7 1.[(1-(g/ROIC))/(WACC-g)] FCF Multiple . 2008 .

0% 10.000 30% 0% 8% P/E Ratio EV/EBITDA Market to Book 10% 0% 10% WACC Results Enterprise Value .000.NOPLAT Enterprise Value .00 Return on Invested Capital Return on Equity ROIC Multiple .00 5.000.00 100.00 10.00 10.0% 10. 2008 .Equity vs Firm Valuation – Income Taxes and Depreciation Assumptions Return and Cost of Capital Required Equity Return Growth Rate Return on Invested Capital Leverage Leverage (Book Value) Interest Rate Other Deprecitation Rate Cap Exp/Depreciation Investment Tax Rate 5% 100% 100.2 1.0% 10.FCF 100.1/(WACC-g) Valuation 110 Oct 24.00 10.[(1-(g/ROIC))/(WACC-g)] FCF Multiple .

1/(WACC-g) Valuation 111 Oct 24.6 1.0% 14.4% 10.82 12.74 7.NOPLAT Enterprise Value .000 30% 50% 8% P/E Ratio EV/EBITDA Market to Book 10% 0% 10% WACC Results Enterprise Value . 2008 .82 Return on Invested Capital Return on Equity ROIC Multiple .[(1-(g/ROIC))/(WACC-g)] FCF Multiple .56 12.FCF 128.589. Depreciation and Taxes Assumptions Return and Cost of Capital Required Equity Return Growth Rate Return on Invested Capital Leverage Leverage (Book Value) Interest Rate Other Deprecitation Rate Cap Exp/Depreciation Investment Tax Rate 5% 100% 100.Equity vs Firm Valuation – Leverage.86 6.205.13 143.8% 10.

Free cash flow is affected to a large extent by capital expenditures which can cause problems. especially when leverage is changing significantly over time (for example. it is often easier to estimate equity than the DCF. Valuation 112 Oct 24. in project finance and in leveraged buyouts where equity IRR is used). 2008 . • Equity value measures a real cash flow to owners.Firm versus Equity Valuation • From the perspective of convenience. rather than an abstraction (free cash flows to the firm exist only on paper).

the firm's reinvestment policy and its rate of return. try using fundamentals. For expected growth in earnings = Retention Ratio * ROE. 2008 . • Think about the two factors that determine growth .Measurement of Expected Growth Rate • While there are many who use historical (past) growth as a measure of expected growth. where reinvestment rate is Cap Exp/Depreciation Valuation 113 Oct 24. or choose to trust analysts (with their projections). where Retention Ratio is 1 – Dividend Payout For expected growth in EBIT = Reinvestment Rate * ROC.

0% 6.43 15.00% 0.96 1.38 18.00% FALSE TRUE Investment Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income .Value/Net Income PEG: PE/Growth 5 15.00% FALSE TRUE 5.00% FALSE TRUE 3 15.0% 0.00% 0.67 15.07 15.Payout) 7.00% Valuation 114 Oct 24.18 9.0% 0.78 2.67 15.61 1.42 1.67 15.85 6.00% 10 FALSE TRUE 6.10 6.03 5.50 13.00% 0.67 15.66 10.At 100% Payout – Growth Equals ROE Price to Earnings Computation Long-Term Growth Rate Long-Term Return Return on Equity Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 0.57 11.98 1.67 1 15.0% 0.84 6.22 2.03 7.00% FALSE TRUE 7 15.00% 0.95 6.00% 15.00% 0.95 3.38 18.84 2.0% 15.78 6.67 15.0% 0.0% 0.06 1.98 6.87 2 15.36 10.67 15. 2008 .00% 0.00% 0.00% 0.00% 0.73 20.85 1.88 1.39 8 15.06 6.67 15.00% FALSE TRUE 6 15.56 11.0% 0.00% FALSE TRUE 4 15.00% 0.80 0.00% FALSE TRUE 9 15.03 15.76 9.88 6.80 13.42 6.0% 0.28 - Cash Flow to Equity and Valuation Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch Growth over Forecast Horizon Growth Period Future Earn Current 10 3.14 24.67 15.67 15.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio .33 20.0% 0.22 6.

39 8.12 0.64 9.85 6.79 6.00% FALSE TRUE 9 15.57 0.0% 0.67 0.00% 0.51 1.59 8.12 15.00% 50.28 12.67 0.57 0.83 1.69 15.34 9.67 0.92 1.59 6.00% 50.00% 50.85 1.97 0.00% FALSE TRUE 7 15.67 0.74 10.48 0.26 13.0% 0.19 0.79 11.67 1 15.36 1.22 1.69 6.59 0.67 0.70 0.51 7.51 15.64 6.67 0.28 0.At 50% Payout – Growth is ½ of the ROE Price to Earnings Computation Long-Term Growth Rate Stable Growth Rate Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 0.00% 50.87 0.36 1.51 6.0% 0.13 1.28 0.85 6.83 0.38 0.66 0.98 6.50 0.00% 50.55 7.0% 0.00% 7.5% 15.00% FALSE TRUE 10 15.79 15. 2008 .03 0.67 0.43 0.25 3.51 0.0% 6.59 15.00% 50.00% FALSE TRUE 4 15.03 6.0% 0.92 0.22 0.15 1.0% 0.13 0.85 15.00% FALSE TRUE 6 15.37 0.36 0.33 0.00% 50.00% 50.00% 50.73 Cash Flow to Equity and Valuation Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch Growth over Forecast Horizon Growth Period Future Earn Current 10 1.67 14.15 0.85 12.67 0.45 2 15.74 15.Value/Net Income PEG: PE/Growth 5 15.00% 50.92 6.69 9.00% TRUE TRUE Investment Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income .67 0.00% FALSE TRUE 3 15.83 0.30 11.98 14.00% FALSE TRUE 6.42 7.85 1.36 0.64 15.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio .50% Valuation 115 Oct 24.10 0.0% 0.74 6.0% 0.97 1.92 13.89 8 15.36 9.57 1.10 15.Payout) 7.03 7.0% 0.00% 10 FALSE TRUE 6.55 6.92 15.55 15.76 0.67 0.32 10.

**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

Valuation

117

Oct 24, 2008

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

Price to Earnings Computation

Long-Term Growth Rate Long-term Return Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 7.50% 15.0% 10.0% 20.00 1 15.00% 50.00% 10 FALSE TRUE 6.85 6.85 1.03 0.51 7.36 0.51 20.00 0.51 10.00% 0.91 0.47 2 15.00% 50.00% FALSE TRUE 3 15.00% 50.00% FALSE TRUE 4 15.00% 50.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio - Value/Net Income PEG: PE/Growth 5 15.00% 50.00% FALSE TRUE 6 15.00% 50.00% FALSE TRUE 7 15.00% 50.00% FALSE TRUE 20.55 1.03 20.00 2.67 8 15.00% 50.00% FALSE TRUE 9 15.00% 50.00% FALSE TRUE 10 15.00% 50.00% TRUE TRUE

Investment

Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income - Payout) 7.36 1.10 0.55 7.92 0.55 20.00 0.55 10.0% 0.83 0.46 7.92 1.19 0.59 8.51 0.59 20.00 0.59 10.0% 0.75 0.45 8.51 1.28 0.64 9.15 0.64 20.00 0.64 10.0% 0.68 0.44 9.15 1.37 0.69 9.83 0.69 20.00 0.69 10.0% 0.62 0.43 9.83 1.48 0.74 10.57 0.74 20.00 0.74 10.0% 0.56 0.42 10.57 1.59 0.79 11.36 0.79 20.00 0.79 10.0% 0.51 0.41 11.36 1.70 0.85 12.22 0.85 20.00 0.85 10.0% 0.47 0.40 12.22 1.83 0.92 13.13 0.92 20.00 0.92 10.0% 0.42 0.39 13.13 1.97 0.98 14.12 0.98 20.00 42.35 43.34 10.0% 0.39 16.71

**Cash Flow to Equity and Valuation
**

Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch

Growth over Forecast Horizon Growth Period Future Earn Current 10 1.97 1.03 7.50%

Valuation

118

Oct 24, 2008

70 0.00% 15.36 1.85 12.39 13.47 2 15.0% 0.74 11.00% FALSE TRUE 13.44 9.62 0.00% 50.75 0.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio .83 0.00% FALSE TRUE 9 15.74 10.0% 0.83 1.42 10.48 0.59 0.00% 50.55 1.79 10.43 24.20 25.64 11.00% 50.00% FALSE TRUE 10 15.12 0.46 7.Long-Term Growth is 3% instead of 7.43 0.03 0.0% 0.47 0.79 11.19 Price to Earnings Computation Long-Term Stable Growth Rate Long-term Return Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 3.00% FALSE TRUE 6 15.40 12.00% 10 FALSE TRUE 6.00% FALSE TRUE 4 15.85 6.97 0.19 0.43 0.51 0.00% 50.69 11.85 1.92 13.83 0.13 1.68 0.92 11.37 0.55 10.57 0.74 10.39 9.0% 10.51 1.0% 0.13 0.85 11.00% FALSE TRUE 3 15.92 0.83 0.43 0.00% 0.51 7.15 0.76 8 15.22 0.28 0.0% 0.22 1.19 1.91 0.Payout) 7.43 0.0% 0.Value/Net Income PEG: PE/Growth 5 15.92 10.71 Cash Flow to Equity and Valuation Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch Growth over Forecast Horizon Growth Period Future Earn Current 10 1.56 0.36 0.15 1. 2008 .19 10.00% FALSE TRUE 7 15.00% 50.43 0.00% TRUE TRUE Investment Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income .69 10.79 11.43 1 15.59 10.59 11.P/E Ratio Falls to 13.42 0.59 8.43 9.51 0.55 7.36 1.64 9.98 11.00% 50.10 0.00% 50.03 7.51 10.85 10.41 11.98 14.0% 0.43 0.69 9.55 11.45 8.50% Valuation 119 Oct 24.97 1.5% .43 0.43 0.00% 50.00% 50.64 10.51 11.36 0.03 13.57 1.92 1.0% 11.43 0.0% 0.0% 0.00% 50.

2008 . and that the cost of capital will not change over time. the terminal value becomes: • Terminal Value in year n = Cash Flow in year n+1 / (r . If we make this assumption. with DCF.Estimation of Terminal Value • Terminal value refers to the value of the firm (or equity) at the end of the high growth period. by assuming a stable growth rate that the firm can sustain forever. Valuation 120 Oct 24. Estimate terminal value.g) • This approach requires the assumption that growth is constant forever.

• In theory.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.real growth in the economy and the expected inflation rate. can grow faster than the economy which it operates it . Valuation 121 Oct 24. 2008 . 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 .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.

• 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.Exit multiple in DCF valuation • In some discounted cash flow valuations. the terminal value is estimated using a multiple. In an equity valuation model. the exit multiple is often of EBIT or EBITDA. • Problems arise if the PE assumes a higher growth than is sustainable after the holding period. 2008 . the exit multiple may be the PE ratio. Valuation 122 Oct 24. In firm valuation models. usually of earnings.

and that you create a hybrid. These exit multiples use the biggest single assumption made in these valuation models. even if the fundamentals do not justify them. which is neither DCF nor relative valuation. • 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. If there is stable growth. Valuation 123 Oct 24. exit multiples may introduce relative valuation into discounted cash flow valuation. 2008 . the P/E multiple in the terminal value should be lower.Exit multiples and DCF valuation • On the contrary.

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

Price to Earnings Computation

Long-Term Stable Growth Rate Long-term Return Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 3.00% 20.0% 10.0% 12.14 1 15.00% 30.00% 10 FALSE TRUE 6.85 6.85 1.03 0.31 7.57 0.31 12.14 0.31 10.00% 0.91 0.28 2 15.00% 30.00% FALSE TRUE 3 15.00% 30.00% FALSE TRUE 4 15.00% 30.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio - Value/Net Income PEG: PE/Growth 5 15.00% 30.00% FALSE TRUE 6 15.00% 30.00% FALSE TRUE 7 15.00% 30.00% FALSE TRUE 15.92 1.03 15.49 1.48 8 15.00% 30.00% FALSE TRUE 9 15.00% 30.00% FALSE TRUE 10 15.00% 30.00% TRUE TRUE

Investment

Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income - Payout) 7.57 1.14 0.34 8.36 0.34 12.14 0.34 10.0% 0.83 0.28 8.36 1.25 0.38 9.24 0.38 12.14 0.38 10.0% 0.75 0.28 9.24 1.39 0.42 10.21 0.42 12.14 0.42 10.0% 0.68 0.28 10.21 1.53 0.46 11.29 0.46 12.14 0.46 10.0% 0.62 0.29 11.29 1.69 0.51 12.47 0.51 12.14 0.51 10.0% 0.56 0.29 12.47 1.87 0.56 13.78 0.56 12.14 0.56 10.0% 0.51 0.29 13.78 2.07 0.62 15.23 0.62 12.14 0.62 10.0% 0.47 0.29 15.23 2.28 0.69 16.82 0.69 12.14 0.69 10.0% 0.42 0.29 16.82 2.52 0.76 18.59 0.76 12.14 33.86 34.62 10.0% 0.39 13.35

**Cash Flow to Equity and Valuation
**

Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch

Growth over Forecast Horizon Growth Period Future Earn Current 10 2.52 1.03 10.50%

Valuation

124

Oct 24, 2008

Length of Time Until Stable Growth – 20 Years is 19

**Price to Earnings Computation
**

Long-Term Stable Growth Rate Long-term Return Equity Cost of Capital P/E Formula: (1-g/r)/(k-g) Year Return on Equity Dividend Payout Holding Period Switch for Terminal Period Switch for Cash Flow Period 3.00% 20.0% 10.0% 12.14 1 15.00% 30.00% 20 FALSE TRUE 6.85 6.85 1.03 0.31 7.57 0.31 12.14 0.31 10.00% 0.91 0.28 2 15.00% 30.00% FALSE TRUE 3 15.00% 30.00% FALSE TRUE 4 15.00% 30.00% FALSE TRUE Total Value (Sum of Annual Value) Initial Earnings PE Ratio - Value/Net Income PEG: PE/Growth 5 15.00% 30.00% FALSE TRUE 6 15.00% 30.00% FALSE TRUE 7 15.00% 30.00% FALSE TRUE 19.51 1.03 18.99 1.81 8 15.00% 30.00% FALSE TRUE 9 15.00% 30.00% FALSE TRUE 10 15.00% 30.00% FALSE TRUE

Investment

Beginning Investment Beginning Equity (Last Period Ending) Add: Earnings (ROE x Beginning Equity) Less: Dividends (NI x Payout Ratio) Ending Equity (Beg + Income - Payout) 7.57 1.14 0.34 8.36 0.34 12.14 0.34 10.0% 0.83 0.28 8.36 1.25 0.38 9.24 0.38 12.14 0.38 10.0% 0.75 0.28 9.24 1.39 0.42 10.21 0.42 12.14 0.42 10.0% 0.68 0.28 10.21 1.53 0.46 11.29 0.46 12.14 0.46 10.0% 0.62 0.29 11.29 1.69 0.51 12.47 0.51 12.14 0.51 10.0% 0.56 0.29 12.47 1.87 0.56 13.78 0.56 12.14 0.56 10.0% 0.51 0.29 13.78 2.07 0.62 15.23 0.62 12.14 0.62 10.0% 0.47 0.29 15.23 2.28 0.69 16.82 0.69 12.14 0.69 10.0% 0.42 0.29 16.82 2.52 0.76 18.59 0.76 12.14 0.76 10.0% 0.39 0.29

**Cash Flow to Equity and Valuation
**

Cash flow from Dividends from Above Terminal Multiple of Earnings from Above Terminal Cash Flow (Earnings x Mult x (1+g)) Total Cash Flow (Terminal + Dividends) Required Return on Equity Discount Factor [1/(required return + 1)^yr] Value of Cash Flow [CF x Discount Fac] x Switch

Growth over Forecast Horizon Growth Period Future Earn Current 20 6.85 1.03 10.50%

Valuation

125

Oct 24, 2008

**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.

Valuation

126

Oct 24, 2008

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

Normalized Net Income = Industry-average ROE * Current Book Value of Equity . . 2008 . 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 a one-time charge. the average return on equity or capital for the industry can be used to estimate normalized earnings for the firm. once management has been removed. .Normalized after-tax Operating Income = Industry-average ROC * Current Book Value of Assets Valuation 128 Oct 24. The implicit assumption is that the firm will recover back to industry averages.Valuation of a firm that is Losing Money • .If the earnings of a firm are depressed due to poor quality management.

If the equity earnings are depressed due to high leverage. Valuation 129 Oct 24. factoring in the reduction in leverage over time. 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.Valuation of a firm that is losing money • . the best solution is to value the firm rather than just the equity. a firm with negative operating income today could be assumed to converge on the normalized earnings five years from now. use the average operating or profit margins for the industry in conjunction with revenues to arrive at normalized earnings.If the negative earnings over time have caused the book value to decline significantly over time. Thus. • . 2008 .

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

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

EPS Measures – Establishing a reliable starting point • Reported EPS – EPS reported by the company using generally accepted accounting principles. 2008 . 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 Valuation 132 Oct 24.

EPS adjustments Valuation 133 Oct 24. 2008 .

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

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

Dilution – Factors and treatment • Contingently issuable shares . • 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 Valuation 136 Oct 24.Include shares in the calculation of basic EPS if the contingency has been met. 2008 .

you should reduce the value by ½. then the amount you would pay for the share must account for how much you will give away. • This can be accomplished by using diluted shares rather than basic shares. • In the extreme. if you have given away half of your company away. • In this extreme example. and the cash flow is the same before and after your give away. Valuation 137 Oct 24.Diluted Shares • If you have agreed to give away shares to someone. 2008 . then your claim to the cash flow of the company is reduced.

Option dilution • Calculation of the number of shares in the dilution calculation is illustrated below: Valuation 138 Oct 24. 2008 .

2008 .Multiple share classes Valuation 139 Oct 24.

Multiple Listings • Fungible shares listed on different exchanges – EPS calculated on the basis of total shares .7 HKD 1.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) Price .58 769 30 RMB 5 5 2433 486.RMB Equity Value – RMB million 300 156.local Price . 2008 .7 Valuation 140 Oct 24.50 1.

000 $ 400.000 $ 250. 2008 . No employees leave in year 1 and 2 but 10% leave In year 3. The company estimates that 25% of the employees Will leave over the 3 year period. The options are contingent on the employees working at the Company in 3 years time.000 Valuation 141 Oct 24.000 3 100 x 180 x $50 x 3/3 less $500.000 $ 250.000 $ 500. The estimated fair value is $ 50 per option.000 $ 250.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. Year Calculation Cumulative expense Expense 1 2 100 x (200 x 75%) x $50 x 1/3 100 x (200 x 75%) x $50 x 2/3 less $ 250.000 $ 900.

all other things being equal. 2008 . the lower the value and the lower the PE Valuation 142 Oct 24. 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.Issues in the application of PEs • Accounting Policy differences – Particularly significant for cross border comparisons where companies may follow local.

Once the value is established. different sectors etc. 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. 2008 . • 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. translate the amount to the home country at the spot exchange rate Valuation 143 Oct 24.Valuation of Subsidiary Companies in Different Countries • How would things differ if we are valuing companies from different countries.

different sectors etc. 2008 Valuation . 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.Valuation of Subsidiary Companies in Different Countries • How would things differ if we are valuing companies from different countries.

different sectors etc.Valuation of Subsidiary Companies in Different Countries • How would things differ if we are valuing companies from different countries. as a practical matter. use the expected future spot Ringet/Baht exchange rates Since. the spot exchange rate must reflect the future values. Valuation 145 Oct 24. forward exchange rates are not available beyond 18 months. • 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. compute future spot rates from interest rate parity Interest rate parity means that if you invest in risk free securities of different currencies. 2008 .

• Example of future expected spot exchange rates: Valuation 146 Oct 24. different sectors etc.Valuation of Subsidiary Companies in Different Countries • How would things differ if we are valuing companies from different countries. 2008 .

2008 .Example of Foreign Valuation Valuation 147 Oct 24.

The basic point is to keep things consistent. 2008 . sometimes. then the valuation does not include other investments. may wish to elaborate on that rather than just defining free cash flow in a text book term.Free Cash Flow We often talk about free cash flow. 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 Valuation 148 Oct 24. it is challenging to assess what is "free“ cash flow or not. If you define FCF as EBITDA without other income.

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

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

what is the rule of thumb and how do you determine which year onwards should be terminal year (i. Valuation 151 Oct 24. exchange rate risks etc and how to get them. betas and what is the best method vs the most practical method. How do you determine that. Should we include country risk. 2008 .Terminal Value Terminal value. Also there is no mentioning of cash revolver and how to calculate it.e. and the use of a stable growth rate. 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. how long should your forecasted period be).

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. 2008 . risk is driven by bankers outside of the company rather than the management or advisors to the company. In this case the equity IRR was driven by the level of leverage and the structure of the debt.LBO Valuation • • How can LBO’s be valued by making an assumption on target IRRs for the venture cap / private equity investor. In this case. • • • Valuation 152 Oct 24. Recall the very first simple case that was developed in the class.

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 Valuation 153 Oct 24. 2008 .

2008 .First. Find the File Valuation 154 Oct 24.

2008 .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 Valuation 155 Oct 24.

Data Table with Multiples Valuation 156 Oct 24. 2008 .

P/E Ratio.present value per share of future growth opportunities r -. Growth and Required Return • P/E = (1/r) + PVGO/EPS PVGO -.required rate of return on equity • This formula does not include the component of whether earnings are greater than cost of capital Valuation 157 Oct 24. 2008 .

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 Valuation 158 Oct 24.Industry by Industry P/E Analysis • • • High P/E companies have relatively low ROE. 2008 .

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

2008 .Industry by Industry P/E Ratio – Sorted from Highest to Lowest Valuation 160 Oct 24.

Industry by Industry P/E Ratio – Sorted from Highest to Lowest Valuation 161 Oct 24. 2008 .

Industry by Industry P/E Ratio – Sorted from Highest to Lowest Valuation 162 Oct 24. 2008 .

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

in Genesis where god creates man and woman. The medical doctor pompously asserts that the medical profession is the oldest profession. an engineer. 2008 . “I remember a passage prior to that.” he says. out of the chaos and confusion. Surely. this was the first act of engineering and predates the first medical act. God created the earth.” “Aha!” says the finance professor. “Surely. “this was the first medical act. Valuation 164 Oct 24.Finance Professors • A medical doctor. which says. and a finance professor are at a cocktail party. He cites a passage from the Bible.” The engineer jumps in and says. “who created the confusion?!” • Condolences regarding the confusing nature of risk management under non-uniformly shifting yield curve conditions followed.

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