Valuation

How much are those cash flows

worth?
 Standard Techniques
Book Value
Earnings Multiple
Liquidation Value
Discounted Cash-Flow
Graham,J.andH.Campbell,2001,TheTheoryandPracticeofCorporateFinance:EvidencefromtheField,Jour
nalofFinancialEconomics,60(2-3),187-243.
 Book Value
Firm (Enterprise) Value = Book
Value of Assets
Still one of the most widely used and accepted methods
due to certification by accountants, while also being
perhaps the most flawed.
Based on historic numbers, ignores the future.
Based on accounting numbers that are potentially flawed
and subject to manipulation
Ignores intangibles like customer loyalty.
Ignores risk
The price paid for an asset may have no relation to its
value in operation or if it had to be sold or replaced
(especially as time passes).
 General Motors
Balance Sheet

PERIOD ENDING 31-Dec-03 31-Dec-02 31-Dec-01

Total Current Assets 86,261,000 57,118,000 47,186,000
Long Term Investments 198,778,000 189,859,000 183,661,000
Property Plant and Equipment 72,594,000 36,152,000 39,724,000
Goodwill 3,790,000 6,992,000 10,006,000
Intangible Assets 970,000 7,619,000 6,921,000
Accumulated Amortization - - -
Other Assets 58,924,000 41,372,000 14,177,000

Deferred Long Term Asset

Charges 27,190,000 32,759,000 22,294,000

Total Assets 448,507,000 371,871,000 323,969,000

 Common Stock (Equity) Book
Value
Easy to Calculate
Case 1: Only common stock outstanding
Book value equals owners equity.
Case 2: Common and preferred shares
outstanding
Book value equals owners equity minus book
value of the preferred.
 GM Continued
No Preferred Stock
Balance Sheet

PERIOD ENDING 31-Dec-03 31-Dec-02 31-Dec-01

Stockholders' Equity

Misc. Stocks Options Warrants - - -

Redeemable Preferred Stock - - -

Preferred Stock - - -

Common Stock 937,000 1,032,000 1,020,000

Retained Earnings 13,421,000 10,198,000 9,463,000

Treasury Stock - - -

Capital Surplus 15,185,000 21,583,000 21,519,000

Other Stockholder Equity -4,275,000 -25,999,000 -12,295,000

Total Stockholder Equity 25,268,000 6,814,000 19,707,000

 Pitney Bowes Inc (PBI)
Has Preferred Stock
Stockholders' Equity

Misc. Stocks Options Warrants - - -

Redeemable Preferred Stock - - -

Preferred Stock 1,334 1,456 1,627

Common Stock 323,338 323,338 323,338

Retained Earnings 4,057,654 3,848,562 3,658,481

Treasury Stock -3,313,027 -3,198,414 -2,943,690

Capital Surplus - - 6,979

Other Stockholder Equity 18,063 -121,615 -155,380

Total Stockholder Equity 1,087,362 853,327 891,355

 Comparable Companies
Earnings Multiples
Most common method for valuing assets:
absent market values.
Simple but with many potential pitfalls.

Market Value of Company

V / EBIT
Earnings Before Interest and Taxes
Debt + Equity
.
Earnings Before Interest and Taxes
 From V/EBIT to Market Value
V
Market Value of Asset = Comp EBIT.
EBIT
Obtain Comp(V/EBIT) by using the value-
to-earnings ratio of a comparable traded
company (or the average from a group of
comparable companies).

Use EBIT from the firm or asset you are

valuing.
 Advantages of V/EBIT
Easy.
Makes intuitive sense.
If your comparables are really comparable
then it should work.
 Problems with V/EBIT
Earnings used to calculate V/EBIT are
accounting figures.
To the degree the earnings are subject to
manipulation so is EBIT.
Earnings are subject to short-term fluctuations.
Looking for long run earnings.
Might need to adjust earnings for extraordinary items.
Be careful! Some firms have extraordinary items every
year.
V/EBIT assumes all companies will generate the
same growth.
 Other Widely Used Multiples
Price-to-Earnings
Price-to-Sales
Popular for firms with negative earnings.
Market-to-Book value
Also popular for firms with negative earnings.
Asset Value-to-EBIT
Asset Value-to-Revenues
Also popular for firms with negative earnings.
 Price-Earnings Ratios
Very, very popular for equity valuation!
One major pitfall when making
comparisons across companies DEBT!
The higher a firms D/E(quity) ratio the higher
the P/E(earnings) ratio.
Note:
In D/E the E stands for Equity.
In P/E the E stands for Earnings.
Standard terminology, you just have to know which
one is which.
 P/E and Debt Example
A firm has an equity value of 10, earnings of $1,
and no debt.
P/E = 10.
Assume the tax rate is TC. The firm now issues
enough debt so that it pays $1/(1-TC) in interest.
Earnings (which are calculated after interest and
tax payments) now equal 0.
New Earnings = 1 1/(1-TC) + TC/(1-TC) = 0
So long as the price of the stock does not go to
zero (which it will not if there is any expected
growth in the firm) the P/E will equal .
General rule: More D Higher P/E.
 Liquidation Value
Useful if you are really thinking of
liquidating the firm.
Ignores any value from future operations.
Do not use if the firm will continue as a going
concern.
Useful if you want to know if the firm is worth
more dead or alive.
 Discounted Cash Flow Valuation
1. Forecast free cash flows up to some terminal date.
2. Estimate the cost of capital (a.k.a. discount rate).
3. Estimate terminal value (a.k.a. continuing value) which
equals the value after the terminal date.
4. Discount to the present.
5. Add value of excess cash (proxy for marketable
securities) and other non-operating assets.
6. Deduct debt and preferred stock to get the market
value of the common shares.
 Example
New Haven Tea company expected to
produce free cash flows of 200 next year
(year 1).
Expect 10% cash flow growth per year up
until year 7. Thereafter expected growth
of 2% per year.
The discount rate is 8%.
 Solution
First seven years is a growing annuity with
an initial value of 200 and a growth rate of
10%.
Year 1 2 3 4 5 6 7
FCF 200 200x1.1 242 266.2 292.8 322.1 354.3
= 220

Terminal value is a perpetuity starting in

year 8 with an initial value of 354.3x1.1 =
389.74 and a growth rate of 2%.
 Solving for the PV
7 200 1.1 t 1
200 1.1 7

PV .
t 1 1.08 t
1.08 .08 .02
7

Value of the free cash flows 7 200 1.1 t 1

.
t
up to the terminal date t 1 1.08

389.74
Terminal value .
1.08 .06
7
 Three Main Questions
What are the free cash flows?
How to estimate the terminal value?
How do you calculate the cost of capital?
 Free Cash Flow I
Arturo likes to calculate FCF via:

Operating Profit (=EBIT)

- Taxes on EBIT
+ Increase in deferred taxes

= Net Operating Profit Less Adjusted Taxes (=NOPLAT)

+ Depreciation
+ Increase in Working Capital Requirements
+ Capital Expenditures

= Free Cash Flow

 Free Cash Flow II
An alternative route (popular on the street) is:
EBIT
+ Depreciation and Amortization

= EBITDA
EBITDA From the Cash Flow Statement:
Capital Expenditures + Sale of
+ Net Capital Expenditures Assets = Net Capital
+ Change in Working Capital Expenditures

- Cash Taxes Paid

- Cash Interest Paid

= Free Cash Flow

 A Note On NOPLAT
NOPLAT is supposed to represent the free cash
flow to the firm before capital investment.
My preference is to calculate NOPLAT as FCF
+ Cash Interest Paid + Net Capital Expenditures.
Just remember if you use my version it is not
really NOPLAT. A better term would be
FCFBCINCE, but that acronym is pretty hard to
pronounce!
In the notes that follow where you see the
acronym NOPLAT feel free to substitute
FCFBCINCE.
 Working Capital I
(Investment Needed to Operate the Company)
Arturo likes to use:

Operating Cash
+ Accounts Receivable
+ Inventories
- Accounts Payable
- Net Accruals

= Working Capital Reserves

 Working Capital II
For changes in working capital Catherine Nolan (a
bond analyst and my wife) likes to use:

Changes in Accounts Receivable

+ Changes in Inventories
+ Changes in Accounts Payable

= Changes Working Capital Reserves

 Why the Difference?
Catherine Nolans argument.
Operating cash is what you want to back out, so
including it is basically double counting.
In fact it is often double counting. If a firm spends money on
administrative costs and pays with a check, the SG&A
account goes up and the cash account goes down.
Net Accruals can include a number of non-cash items
and can be easily manipulated. You are better of
ignoring them.
Working capital is the difference between what you
owe people (accounts payable) and what you are
hoping to get paid for (accounts receivable and
inventories).
 Forecasting Free Cash Flows
1. Forecast Sales
A. Project size of the target market.
B. Project market share.
2. Examine historical relationships between
sales and other components of free cash
flow.
A. Be careful here! Are you sure the firm will
continue along its current trajectory?
 Forecasting Free Cash Flows
(continued)
3. Check reasonableness of forecasts.
A. What do the forecasts assume about the ability of
the company to generate abnormal (economic)
profits?
B. Gross domestic product grows at a real rate of
3.41% in a typical year (1929-2003). That means in
the long run no firm can grow faster than this.
i. Are your long run estimates consistent with this?
ii. What do your estimates say about the firms long run
relative market share?
iii. What do your estimates say about the long run size of the
industry relative to the rest of the economy or related
industries? For example, if you assume
BookUsHotels.com will eventually produce $X in sales you
must also assume that the hotel industry will as well.
 Forecasting Free Cash Flows
(continued)
4. Discount Rates
A. Be consistent in dealing with free cash flows and
discount rates.
B. Discount rates should reflect market and not firm
specific risk.
i. Common mistake is to increase the discount rate in
response to firm specific risk.
ii. Example: A pharmaceutical firm has a 25% chance of
making a breakthrough. This does not influence the
discount rate. It does influence the expected future cash
flows. In this case PV = .25(PV w/ breakthrough) + .75(0).
 Reasonable Forecasts Some
Guidelines
What are the assumptions about the
companys ability to create economic
profits?
Key drivers for economic growth are the
Return on Investment Capital (ROIC) and
the growth rate (g).
 Calculating ROIC and g
NOPLAT
ROIC .
Invested Capital
Invested Capital = Long Term Assets + Working Capital
Requirements

g ROIC Investment Rate

where:
Net Investment
Investment Rate .
NOPLAT
The accuracy of your valuation will depend upon the degree to
which you accurately forecast ROIC and g.
 Valuation and Growth a Few
Examples
All of the following firms are perpetual
growth firms.
They use a constant investment rate
(a.k.a. plowback) rule.
They have a constant ROIC (a.k.a. return
on equity).
 Example 1 Base Line No Growth Firm

Investment Rate 0.00%

ROIC 20.00%
Growth Rate 0.00%
Discount Rate 10.00%
Year 0 1 2 3 4 5

NOPLAT 100 100 100 100 100 100

Net Investment 0 0 0 0 0 0

Free Cash Flow 100 100 100 100 100 100

PV(Free Cash Flow) = 100 + 100/.1 = 1100
 Example 2 Value Creating Firm

Investment Rate 25.00%

ROIC 25.00%
Growth Rate 6.25%
Discount Rate 10.00%
Year 0 1 2 3 4 5

NOPLAT 100 106.25 112.89 119.95 127.44 135.41

Net Investment 25 26.56 28.22 29.99 31.86 33.85

Free Cash Flow 75 79.69 84.67 89.96 95.58 101.56

PV(Free Cash Flow) = 75 + 79.69/(.1-.0625) = 2200
 Example 3 Growing But No Value
Added Firm
Investment Rate 25.00%

ROIC 10.00%

Growth Rate 2.50%

Discount Rate 10.00%

Year 0 1 2 3 4 5

NOPLAT 100 102.5 105.06 107.69 110.38 113.14

Net Investment 25 25.63 26.27 26.92 27.6 28.29

Free Cash Flow 75 76.88 78.8 80.77 82.79 84.86

PV(Free Cash Flow) = 75 + 76.88/(.1-.025) = 1100

 ROIC vs. Discount Rate
What it Implies
ROIC > Discount Rate
Normal. Firm earns an above average return on
some investments. Should stop investing when the
marginal investment has a return equal to the
discount rate.
ROIC = Discount Rate
Likely the firm is over investing! Its investments with
returns below the interest rate are offsetting those
above. Other possibility, all investments by the firm
earn exactly the rate of interest. Yea, sure.
ROIC < Discount Rate
Value destruction. Buy out management and stop the
firm before it invests again!
 Example 4 No Growth, Value
Destroying Firm
Investment Rate 25.00%

ROIC 0.00%
Growth Rate 0.00%
Discount Rate 10.00%
Year 0 1 2 3 4 5

NOPLAT 100 100 100 100 100 100

Net Investment 25 25 25 25 25 25

Free Cash Flow 75 75 75 75 75 75

PV(Free Cash Flow) = 75+75/.1 = 825
 Example 5 Growing, Value
Destroying Firm
Investment Rate 25.00%

ROIC 5.00%
Growth Rate 1.25%
Discount Rate 10.00%
Year 0 1 2 3 4 5

NOPLAT 100 101.25 102.52 103.80 105.09 106.41

Net Investment 25 25.31 25.63 25.95 26.27 26.60

Free Cash Flow 75 75.94 76.89 77.85 78.82 79.81

PV(Free Cash Flow) = 75+75.94/(.1-.0125) = 942.86
 Ways of Estimating Earnings
Growth
Look at the past.
The historical growth in earnings per share is a typical
starting point.
Look at what others are projecting.
Other analysts may be using information you do not
have. It is often useful to know what their estimates
are.
Look at fundamentals.
How much are they investing?
What is the return on their investment?
 Estimating the Firms Terminal
(Continuing) Value
Free cash flows (FCF) grow at a constant
rate after the forecast horizon.
Used far more often than any other method.
Just remember, in the long run NO firm can
grow faster than GDP!

FCFT 1
TV
rg
r = discount rate, g = growth rate, T = end of the
forecast horizon
 Terminal Value Estimation
Constant Growth Continued
Be careful when you use this formula, as your CAPEX in
the FCF calculation should match the growth rate you
choose.
This is once again related to the ratio Sales/Fixed Assets.
One can show that the previous formula can be written in the
following way:
g
NOPLATT 1 1
TVT ROIC ,
r g
ROIC = long-term return on newly invested capital.
This formula may be easier to use than the previous
formula since you do not have to estimate CAPEX.
Instead it is estimated for you from g and ROIC.
 Estimating TVs
Convergence Approach
Assumes that competitive forces will
ensure that after the forecast horizon,
returns on the firms new investments will
equal the discount rate (r).
ROIC = r and so,

NOPLATT 1
TVT
r
 Estimating TV
Accounting Values
Terminal value = Book Value of Invested
Capital
Backward looking.
Easy to use.
 Pitney Bowes Inc (PBI)
Balance Sheet

Assets

Total Current Assets 2,513,175 2,552,625 2,556,608

Long Term Investments 3,189,283 3,246,083 3,236,258

Property Plant and Equipment 1,070,232 1,046,935 1,008,270

Goodwill 956,284 827,241 635,873

Intangible Assets 203,606 - -

Accumulated Amortization - - -

Other Assets 958,808 1,059,430 881,462

Deferred Long Term Asset Charges - - -

Total Assets 8,891,388 8,732,314 8,318,471

 Calculating Terminal Asset Value
from Projected Book Value
PBI grew at about 5% in 2002 and 2% in
2003.
Average growth rate of 3.5% is not
unreasonable.
In 2003 total assets (book value) equaled
8,891,388.
Suppose want TV as of 2010 (seven years
later) = 8,891,388x1.0357 = 11,312,329.
 Economic Value Added
(EVA)
EVA = Invested Capital x (ROIC r)
What is this?
1. A popular buzz word!
2. The value the firm created via its
investments. Remember, firms should
invest so long as the marginal return on
equity (ROIC) exceeds the interest rate.
This means a typical firm should have a
positive EVA.