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Connor Haley 02.09.

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The Art of Valuation
 Goals of this presentation  Keep you interested– Valuation is FUN  Explain the weaknesses inherent in any DCF  Introduce a three-layered approach to valuation

DCF Valuation
 What is it?
 Shortcomings  Inaccurate information (distant cash flows) is added to accurate information (near-term cash flows), which produces inaccurate information  Leads to false sense of security

Example
 Consider the Terminal Value in a DCF
 Comprises the majority of the value in most valuations  If we are wrong by 1% in either direction, range of TV

is greater than 3-1!

Term. Cost of Capital 8% 7%

Term. Growth Rate Multiple 4% 5% 1/(8%-4%) = 25 1/(7%-5%)= 50

9%

3%

1/(9%-3%) = 16.6

A Better System
1) Asset Value- How much are the company’s assets on

the books worth TODAY 2) Earnings Power Value- How much is the current earnings power worth (assuming zero growth) 3) DCF– How much (if anything) is growth worth?

Asset Value
 Any valuation start with a decision about the

competitive position of the firm  Is industry..
 Economically viable?

Value at “Reproduction Costs” Value at Liquidation Value (Scrap)

 In Terminal Decline?

 Even with this approach, we separate good and bad

information (as we move down BS)

Earnings Power Value

Estimates the current earnings power—if it were to continue indefinitely into the future with zero growth.

 Adjusted earnings include  Rectifying accounting misrepresentations (one-time charges”  Resolving discrepancies between depreciation and amortization and actual amount of investment by the company  Take into account the current position in the business cycle  EPV has the advantage of being based entirely on currently

available information and is uncontaminated by more uncertain conjectures about the future

Earnings Power Value Formula=
EBIT – Taxes = NOPAT (net operating profit after tax) + Depreciation and amortization - Maintenance capital expenditures (only maintenance, not total capex) = Adjusted Operating Cash Flow

(Adjusted OCF/ Cost of capital) + Net Cash = Earnings Power Value / Shares outstanding
= EPV/share

DCF– Value the Growth
 Most difficult to estimate, must be confident in

competitive advantages
 Realize not all growth is valuable—for companies w/o

competitive advantages, growth can actually DESTROY value  By employing three-stage valuation, an investor has a far better idea of what he/she is betting on than an investor just starting with DCF

 Reverse DCF can often be more useful in evaluating

the sanity of the current market price

Example: Skechers (SKX)
 Shoe company founded in 1992, competes with Adidas,

Nike, New Balance  Over $1 B sales since 2005  “Shape-Ups” Boosted earnings 40% in 2010
 Company too aggressive with growth plans (fad)  Forced to liquidate inventory at huge write-downs  Will likely have to pay large fine ($60 mm) for false

advertising claims to FTC  Stock price fallen from high of $23 to low of $11 to current price of $14

1: Asset Value
 Current Stock Price= ~$14
 $18 TBV/share (28% upside)  Excludes value of int. assets  Need to further adjust for further inventory write-downs ($35 mm), $60 mm FTC liability  Adjusted TBV= ~$16 (14% upside)  NCAV: $9.25- 9.72/share (~30% downside)  Most conservative estimate of Asset Value

Earnings Power Value
 Two Scenarios modeled for run-rate
 2007 operating results as a proxy for what the company

could look like without the Shape-up revenue  2005 operating results, which are 30% lower than 2007

2- Earnings Power Value
2005 Results EBIT Taxes NOPAT Maintenance Capex D&A Adj. Cash Flow EPV Net Cash Total EPV EPV/Share $77.2 mm $30.88 $46.32 $18.50 $32 $60 $600 $63.7 $663.7 $13.26 (5% overvalued) 2007 Results $112.9 mm $45.16 $67.74 $18.50 $32 $81 $810 $63.7 $873.7 $17.47 (24% undervalued)

Value of Growth
 Assumes 2007 starting point for FCF ($70.2 mm)
 Average 5% growth next ten years, 2% TG  11% Discount Rate, constant margins

 IV/Share = $21, (50% undervalued)

Valuation Summary
 Asset Value:  Low: $9.25  High: $16  EPV  Low: $13.26 (5% DS)  High: $17.47 (24% US)  DCF  Base: $21  EPV > Asset Value =

company has competitive adv. in marketplace  My competitive analysis suggests SKX is likely to maintain market position (but not necc. Increase)  Stock likely worth between EPV values

Summary
 Relying on DCF alone is dangerous  It lumps together estimates based on good information with those based on very uncertain assumptions producing poor information  It relies on making accurate estimates of events that are far in the future  The 3-Stage Valuation model I have proposed emphasizes

current information and a knowledge about fundament competitive conditions  It depends on specific knowledge about particular industries and assets, and it places less faith in projections of rosy futures unless substantiated by current hard date  This is the discipline of value investing in the Graham and Dodd Tradition