Equity Instruments & Markets B40.

3331

Valuation Project
Date due: December 13, 2004

Summary Recommendations
Company
Pixar Citigroup Sycamore R io Tinto Swatch (bearer) Swatch (reg.) $ 83.98 FCFF2 $ 78.11 $ 45.91 DDM3 $ 59.90 $ 3.88 FCFFGen $ 3.62 $ 40.08 FCFF2 $ 39.08 SFr. 163.00 FCFE2 SFr. 177.90 SFr. 33.20 FCFE2 SFr. 35.60

Price DCF Valuation R elative Valuation Model Used Value Multiple Used Value
PEG PBV VBV PE VS VS

$ 91.35 $ 75.92 $ 11.06 $ 45.20 SFr. 102.10 SFr. 20.40

Option Valuation
N/ A N/ A N/ A N/ A N/ A N/ A

$204,600 $12,169,000,000 -$207,061,474 $1,316,000,000 $63,800,000 $63,800,000

EVA in last year

R ecommendation
Hold Buy Sell Buy Buy Buy

Group Members: Stefan Fischer (suf200) Espen Stokke (es1446) Ronny Fluegge (rf829) David Gowans (djg291) Adam Qaiser (aaq207)

Background Information
The Swatch Group is a Swiss company that, together with its subsidiaries, is engaged in the manufacture of watches, movements and components and other products. The company offers watches in all price and market categories. It manufactures mechanical and quartz movements and a range of components, including ruby, sapphire and other components. In addition, the company produces and markets jewelry under the DYB brand name, as well as manufactures microchips, quartz resonators and other electronic systems, and operates boutiques and shops.

1. Discounted Cash Flow Valuation

NOTE:

ANY VALUES STATED ARE ALWAYS IN MILLION CHF (Swiss francs), UNLESS IT IS A PER SHARE VALUE

Model Rationale

2-stage FCFE Model DividendsFCFE, relative stable D/E ratio, currently high g Market value of D/E relatively stable during last five years around 6% with long term goal of management to increase it to 7% (interview in Swiss newspaper article) Currently high growth in emerging markets (especially Asia)

FCFE

Taking 12-month trailing data to calculate normalized FCFE

Income Statement 2003 2004H 3'873.0 2'111.0 739.0 n/a 3'134.0 n/a 1'262.0 n/a 216.0 110.0 1'062.0 n/a 3'279.0 1'763.0 594.0 348.0 1.0 0.0 593.0 348.0 96.0 48.0 497.0 300.0 5.0 3.0 492.0 297.0 2003H 1'906.0 n/a n/a n/a 105.0 n/a 1'682.0 224.0 0.0 224.0 38.0 186.0 2.0 184.0 Trailing 12-month data 4'078.0 n/a n/a n/a 221.0 n/a 3'360.0 718.0 1.0 717.0 106.0 611.0 6.0 605.0

Total Revenue Cost of Revenue Gross Profit Selling/General/Admin. Expenses Depreciation/Amortization Other Operating Expenses Total Operating Expense Operating Income Interest Expense Income Before Tax Income Tax Income After Tax Minority Interest Net Income

Growth

Assuming Debt/Equity ratio of 7% translating into 6.5% Debt ratio (DR) Capex of 113% of Depreciation

Assuming a further high growth period over next 10 years Payout ratio has been an average of 14% over last three years; steadily increasing assuming further increase to 20% Average ROE over last three years 14.4% - quite stable (1-Payout ratio) x ROE = Retention ratio x ROE = growth rate Assuming stable growth after 10 years assuming market growth, therefore using risk free rate Further assuming no change in FCF, but sharp increase in payout ratio

Beta

Swatch is officially in Retail-Jewelry Sector however Swatch also produces electronics, therefore taking 50% of each unlevered average sector beta from Europe Marginal tax rate depends on cantons (state) in Switzerland average in West Switzerland (headquarters of Swatch) accumulates to 16% Debt/Equity ratio of 7%

Risk Premium

Sales all around the world Taking geographic sales data as a proxy for country risk premium Adjusting weights for future shifts in sales expecting more sales in Asia

Valuation

Valuing shares as of today Calculating value as of beginning 2005 and then discounting another month

Shares

Swatch has bearer and registered shares outstanding Calculating percentage using book issuance values

Conclusion

I find both Swatch stocks as being undervalued and would recommend to buy shares

2. Value relative to the comparables

Comparables Swatch is in Retail Jewelry and Electronics sector I tried to find as many companies with similar product lines as swatch excluding companies from the Retail Jewelry sector and adding from Electronics sector

Multiple

EV / Sales Comparables have all very different financial leverage some using no debt at all

Simple

Comparables are all retailers Multiple lets adjust for brand name

Average EV / Sales = 1.2 Swatch Group has multiple = 2.3 Looking at those facts Swatch seems to be far overvalued. However, this multiple those not account for any margin differences due to strong brand names. Swatchs product (including the brand name Swatch itself) have a high name recognition among customers and most products are well-known for their quality. Therefore, it will be very easy for Swatch to charge a premium for their name. Most of the comparables do not possess such an asset. Further, Swatch does not bear the full risk of being a luxury retailer. Swatch is less exposed to this cyclical market and therefore receives a higher Enterprise Value compared to some of the comparables.

Regression

EV/Sales explained with After-tax Margin and Debt-ratio

EV/Sales = 0.25 + 0.47(After-tax Margin) + 10.52 (DR) (0.22) (0.76) (1.59) R2 = 0.75 EV/Sales (Regression) EV/Sales (Actual) 1.64 2.30 Regression Last price 20.4 33.20 102.1 163.00

Reg. share Bear. share

EV/Sales (Regression) still lower than actual multiple translating into a share price of Sfr. 20.40 / 102.10. This can be interpreted that Swatch might be overvalued compared to the sector. However, it shows that partly a higher after-tax margin keeps the multiple higher than for the comparables what probably is attributed to the strong brand name. Further, the risk for the different companies have not been fully included in the regression, because financial risk is only a part risk and does not reflect operating risks.

3. Value relative to the market

Swiss Market Swiss Market has many special characteristics (e.g. low interest rates) I decided to run a market regression with the 60 largest market cap stocks in the Swiss market (SWX respectively Virt-X) Bloomberg tickers: Regression:

ABBN VX Equity ADEN VX Equity AT/N SW Equity ATLN SW Equity BAER VX Equity BALN VX Equity BARN SW Equity BCVN SW Equity BEKN SW Equity BKWN SW Equity CHRN SW Equity CIBN VX Equity CLN VX Equity CSGN VX Equity EGL SW Equity

EMSN VX Equity GALN SW Equity GEBN SW Equity GIVN VX Equity HEPN SW Equity HOLN VX Equity KNIN SW Equity KUD VX Equity KUNN SW Equity LISN SW Equity LLB SW Equity LOGN SW Equity LONN VX Equity LUKN SW Equity MASN SW Equity

MC SW Equity NAAN SW Equity NESN VX Equity NOBE SW Equity NOVN VX Equity PARG SW Equity PHBN SW Equity PSPN SW Equity RIEN SW Equity ROG VX Equity RUKN VX Equity SCHN SW Equity SCI SW Equity SCMN VX Equity SEO VX Equity

SGKN SW Equity SGSN VX Equity SIGN SW Equity SIK SW Equity SLHN VX Equity STMN SW Equity SUN VX Equity SYNN VX Equity SYST SW Equity UBSN VX Equity UHR VX Equity UNAX VX Equity VATN SW Equity VONN SW Equity ZURN VX Equity

EV/Sales = 0.25 + 22.472 (After-tax Margin) + 5.449 (DR) + 0.019 (RR) (0.634) (2.613) (1.405) (0.093) R2 = 0.62 EV/Sales (Regression) EV/Sales (Actual) 3.22 2.30 Regression Last price 40.1 33.2 200.5 163.0

Reg. share Bear. share

Regression shows that Swatch is undervalued compared to the overall Swiss market.

4. Value Enhancement Strategies / EVA

EVA Calculation was done for the same comparable firms as the relative valuation was done.
Spread Cost of Debt 0.85% 6% 0.35% 5% 0.50% 5% 0.35% 9% 0.35% 5% 0.35% 9% 4.00% 12% 0.35% 5% 0.70% 6% 0.35% 9% 0.35% 5% 0.35% 5% 0.85% 6% 0.35% 5% 0.35% 9% 0.35% 5% 1.00% 9% 8.00% 16% Avg Median 7.31% 5.60% Riskfree Rate 4.8% 4.8% 4.8% 8.4% 4.8% 8.4% 8.4% 4.8% 4.8% 8.4% 4.8% 4.8% 4.8% 4.8% 8.4% 4.8% 8.4% 8.4% 6.21% 4.82% Beta 0.37 2.17 1.19 0.67 0.88 0.67 0.75 0.58 0.49 0.66 0.93 0.58 0.88 1.36 0.73 1.36 0.00 1.17 0.86 0.74 RP Cost of Equity 6.4% 7.2% 6.4% 18.8% 6.4% 12.5% 6.4% 12.7% 6.4% 10.5% 6.4% 12.7% 6.4% 13.2% 6.4% 8.6% 6.4% 8.0% 6.4% 12.7% 6.4% 10.8% 6.4% 8.5% 6.4% 10.5% 6.4% 13.6% 6.4% 13.1% 6.4% 13.6% 6.4% 8.4% 6.4% 15.9% 0.06 6.4% DR WACC 22.8% 7% 0.5% 19% 3.9% 12% 2.3% 13% 8.0% 10% 7.6% 12% 37.2% 13% 5.5% 8% 18.0% 8% 5.2% 12% 0.0% 11% 0.0% 9% 58.6% 8% 10.1% 13% 18.6% 12% 5.9% 13% 0.0% 8% 47.8% 16% 11.3% 12.2% ROI 6.3% 63.0% 15.8% 4.1% 15.3% 7.1% 4.4% 0.0% 13.7% 12.6% 7.7% 1.2% 8.4% 17.8% 22.6% 15.0% 15.9% 6.7% 13.2% 10.5% CI 77.5 623.9 60.9 1591.4 156074.0 705.0 2111.4 9859.0 90.2 529.1 24265.0 18591.0 140218.0 3310.0 73.2 3310.0 148.0 5272.1 20383.87 1851.41 EVA EVA-Spread -0.4 -0.56% 276.3 44.29% 2.2 3.67% -136.0 -8.55% 8170.7 5.24% -37.3 -5.29% -180.5 -8.55% -827.7 -8.40% 5.6 6.15% 0.6 0.11% -754.4 -3.11% -1365.2 -7.34% 955.1 0.68% 168.2 5.08% 7.5 10.30% 63.8 1.93% 11.1 7.53% -495.9 -9.41% 325.76 1.42 1.88% 0.40%

11.7% 14.0% 12.6% 6.7%

Calculations

Following assumptions and calculations were made (marked stock=Swatch): in order to be able to compare Swatch values where not taken from DCF valuation since no adjustments have made for the other comparables either the cost of debt was calculated by using synthetical rating for coverage ratios and using the risk-free rate appropriate to the company

the cost of equity was calculated assuming all businesses have same risk premium since most operate world wide (therefore using risk premium from DCF valuation of Swatch) and using provided Beta

Conclusion

DR=Debt ratio, shows how different those companies are leveraged

In absolute terms Swatch has been below the average, but above the median. Relative comparision of the EVA-spread shows that Swatch has been very well performing comparing to comparables (ignoring the outliner which has a huge ROI for some reason).

Enhancements

Swatch should surely use more leverage financing since it is still very conservative with its debt ratio. Debt seems to be very cheap, provides tax shelters, and the beta will in reality not go up as fast to compensate additional risk. Therefore, WACC will come down and the EVA-spread can be increased.

5. Final Recommendation
The DCF valuation and the regression with the Swiss market came to the conclusion that Swatch is undervalued while the valuation relative to comparables has shown that Swatch is overvalued. How can that be? In my opinion, this seems to be very logical. The business of Swatch is cyclical. The last recession is still not entirely over. Companies that sell luxury goods are therefore in general undervalued, because not all investors are convinced that the economy will pick up again. Swatch is in comparison with its peer less undervalued. However, looking at the overall market or at the fundamental value (DCF) of Swatch, it is clearly undervalued. With the economy swinging back and its growth rate, Swatch is worth more. The stock is a BUY.

Sycamore Networks Valuation

Company Sycamore Networks, Inc. Symbol SCMR Sector Telecommunications Equipment Type negative earnings company DCF Valuation ModelFCFF, projections based on revenue Relative Valuation Value to Book Capital Special features Firm has no debt but $1bn in cash/ equivalents from the IPO in boom times, therefore there is no risk of distress

DCF Valuation
Sycamore Networks manufactures switches for telecom carriers and is a young company, founded during the Hi-Tech boom at the end of the 90s. The valuation model is based on revenue growth projections at a compounded rate of 15% for the next 10 years, which is around the expected growth of the telecommunications equipment sector. The firms revenues grew by 16% last year after suffering from large losses due to the earlier market crash. The management has taken heavy restructuring measures, cutting costs through lay offs and abandoning unprofitable product lines, leaving the firm very focused with a mature and competitive product line. Together with the rebounding market that translates into better operating margins and potential for initially better Sales/Capital ratios (please refer to the summary sheet in Appendix I). Within the sector analysts rank Sycamore Networks at number 7 and it seems optimistic but reasonable to expect it to grow with the industry. Sycamore has no debt and operating leases are not substantial, hence WACC equals the Cost of Equity with 16.34%. The Risk Premium is a weighted average according to the revenues in different countries. The calculated share price of $3.62 from the DCF valuation is close to the actual current price of $3.88. Sycamore appears slightly overvalued but one could argue that the difference is within the range of acceptable variation. More importantly, the market and the results of the DCF valuation agree that Sycamores value is dominated by its cash and marketable securities assets. The pure cash assets divided by number of shares yield a price of $3.54. The reason for this is that if the current market projections for telecommunications equipment are realistic then Sycamore cannot create much value itself relative to the amount of capital it holds. Hence it is not expected to produce a good Return on Capital any time soon. A great upside potential for the telecommunication market is not expected by us and the downside risk is that Sycamore keeps on burning cash which it could maintain for a long time. Based on that conclusion and the calculation results the recommendation tends to sell.

Relative Valuation
Multiple: Sector: Number of comparable firms: Value to Book Capital Telecommunications Equipment 127 (source: compfirm.xls)

Sycamore has negative earnings, even a negative EBITDA. Therefore, many multiples do not apply. Moreover, the whole sector is in trouble with most other firms losing money as well, yielding regressions with questionable explanatory power. The multiple that gave the best results is Value to Book Value of Capital. However, Sycamore appears undervalued by the factor of 4 (with an actual V/BV ratio of 1.05), which is unrealistic. The regression results are shown in Appendix II, showing a qualitative contradiction with a ROC that has a negative impact (other multiples and regressions were even worse). Interestingly, if one biases the sample by restricting it to the 45 positive earnings firms only, Sycamore should trade at 65% of its book value (Appendix II A). Given the analysts forecast of -8% revenues for the next five years that actually seems more realistic. But again revenues have a negative impact in the regression with is contradictory and does not yield a meaningful result if expected revenues are increased. The market regression (US) giving a V/BV ratio of 3 still translates into a share price of $11.06 as opposed to the current $3.88. A subjective valuation compared to the sector average of 6.9 also does not provide any justifiable basis for some story. The recommendation is therefore to ignore relative valuation results.

EVA calculation
The numbers used in the calculation are in million US$:
Return On Capital After Tax Op Income
EBIT(1-t) Depreciation

-59.2827 9.618 -49.6647 962.989 -5.16% 16.34% -207.061

Book Value of Capital ROC Cost of Capital EVA

Telecom Equipment Sector ROC - WACC comparative EVA

4.88% 46.994

The EVA for Sycamore in the most recent year is a negative $200 million compared with a positive EVA of $47 million that it should have produced with a sector average for Return on Capital and Cost of Capital. These results are consistent with Sycamores negative earnings.

Summary
Sycamore has a lot of Capital but the market does not present enough opportunities to invest it. Due to the current negative earnings Sycamore is reluctant to give cash back to shareholders and even thinks about using it for acquisitions. However, it is unclear whether a reasonable opportunity might come up. Since there is no debt Sycamore will definitely survive the negative earnings period but we do not expect it to produce a good Return on Capital in the future. It was not appropriate to carry out an option valuation on this firm since the firm has no debt and therefore does not have a default option to put the assets of the firm to debtholders. Based on the DCF valuation the recommendation remains sell.

Appendix I Sycamore DCF Valuation

Inputs
I. Income Statement comments

Current EBIT Interest income from cash and marketable securities Current Capital Spending Current Depreciation and Amortization Current Revenues
II. Balance Sheet

Current Non-cash Working Capital Book Value of Debt Book Value of Equity Cash & Marketable Securities non operating assets
III. Tax Information

$ (44.91) $ 15.89 $ 71.34 $ 9.62 $ 44.55 This period Last period $ (16.04) $ (20.55) $ 0 $ 955.44 993 $ 635.03 $ 327.96 327,961 $ 35.00% according to company estimation Risk Premium

NOL carried forward Marginal tax rate

Inputs for Discount Rate

Risk free rate Unlevered Beta corrected for cash Risk Premium Cost of Equity
Expectations for the future

4.10% 2.28 5.37% 16.34%

10yr bond yield on 10/12/2004

revenue weight in year 2002 2003

United States
England France Japan all other countries 15.00% 3.00% 1.50

13% 47% 20% 20%

9% 44% 22% 15% 10%

2004 41% 21% 13% 13% 12%

average 21.00% 37.33% 11.67% 16.00% 14.00%

Compounded Annual Growth Rate in Revenues for next 10 years: non-cash working capital as a percent of revenues in future periods sales to capital ratio
Stable Growth Inputs

weighted average Risk Premium

Expected Growth Rate in perpetutity = Expected Operating Margin = Expected Debt to Capital(MV) Ratio for the firm = Expected Beta = Expected Cost of Debt = Return on Capital for the firm =
Per Share Inputs

4% Speed of convergence 21.28% 1 rapid restructuring takes place 0.00% 1.10 7.00% 14.20% based on Return on Equity (Industry average)

Number of Shares outstanding = Current Stock Price = Does your firm have equity options outstanding? If yes, enter the number of options outstanding = and the average exercise price of the options outstanding = and the average maturity of the options outstanding = and the standard deviation in the firm's stock price =

272.123 3.60 Yes 30.846472 6.95 3.2 95%

Valuation Summary
Sycamore Networks The Valuation PV of FCFF during high growth phase = PV of Terminal Value = Value of Operating Assets of the firm = Value of Cash & Non-operating assets= Value of Equity = - Value of Equity Options = Value of Equity in Common Stock = Value of Equity per share = $ $ $ $ $ $ $ $ (27) 83 56 962.99 1,019 33 985 3.62

Treasury Stock Approach $ 4.07

Summary Output
Revenues EBIT EBIT(1-t) - Reinvestment FCFF $53 -$30 -$30 $6 -$36 $64 -$11 -$11 $7 -$18 $77 $2 $2 $9 -$7 $92 $11 $11 $10 $0 $111 $18 $18 $12 $6 $129 $24 $19 $12 $8 $144 $29 $19 $10 $9 $158 $33 $21 $10 $12 $171 $36 $23 $8 $15 $181 $38 $25 $7 $18 $189 $40 $26 $7 $19

Detailed Calculations

Base
Revenue Growth Rate Revenues Operating Margin EBIT Taxes EBIT(1-t) + Depreciation - Capital Expenditures - Chg WC FCFF NOL Terminal Value $44.547

-133.08%
-$59.283 $0.000 -$59.283 $9.618 $71.341 $4.505 -$125.511 $0.000

1 20.00% $53.456 -55.90% -$29.881 $0.000 -$29.881 $11.542 $17.214 $0.267 -$35.821 $29.881

2 20.00% $64.148 -17.31% -$11.102 $0.000 -$11.102 $13.850 $20.657 $0.321 -$18.230 $40.983

3 20.00% $76.977 1.99% $1.530 $0.000 $1.530 $16.066 $24.234 $0.385 -$7.023 $39.453

4 20.00% $92.373 11.64% $10.748 $0.000 $10.748 $17.994 $27.796 $0.462 $0.484 $28.705

5 20.00% $110.847 16.46% $18.245 $0.000 $18.245 $19.793 $31.555 $0.554 $5.928 $10.461

6 16.00% $128.583 18.87% $24.265 $4.831 $19.434 $21.377 $32.668 $0.532 $7.610 $0.000

7 12.00% $144.013 20.08% $28.913 $10.120 $18.794 $22.659 $32.483 $0.463 $8.507 $0.000

8 10.00% $158.414 20.68% $32.760 $11.466 $21.294 $23.588 $32.757 $0.432 $11.693 $0.000

9
8.00% $171.087 20.98% $35.897 $12.564 $23.333 $24.555 $32.624 $0.380 $14.884 $0.000

10 Terminal Year 6.00% 4.10% $188.788 $181.352 21.13% 21.28% $38.324 $40.180 $13.413 $14.063 $24.910 $26.117 $25.562 $26.610 $32.098 $33.744 $0.308 $0.223 $18.067 $18.760 $0.000 $0.000 $317.736

Cost of Capital Calculations Tax Rate 0.00% Debt Ratio 0.00% Beta 2.28 Cost of Equity 16.34% Cost of Capital 16.34%

0.00% 0.00% 2.28 16.34% 16.34%

0.00% 0.00% 2.28 16.34% 16.34%

0.00% 0.00% 2.28 16.34% 16.34%

0.00% 0.00% 2.28 16.34% 16.34%

0.00% 0.00% 2.28 16.34% 16.34%

19.91% 0.00% 2.04 15.08% 15.08%

35.00% 0.00% 1.81 13.81% 13.81%

35.00% 0.00% 1.57 12.54% 12.54%

35.00% 0.00% 1.34 11.27% 11.27%

35.00% 0.00% 1.10 10.00% 10.00%

35.00% 0.00% 1.10 10.00% 10.00%

Appendix II Sycamore Regression

Results of multiple regression for Value/BV of Capital Summary measures Multiple R R-Square Adj R-Square StErr of Est ANOVA Table Source Explained Unexplained Regression coefficients Constant ROC Expected Growth in Revenues: next 5 years Market Debt to Capital Coefficient 5.8474 -7.2771 26.0711 -16.4406 Std Err 2.4783 3.0945 16.2601 12.8402 t-value 2.3594 -2.3516 1.6034 -1.2804 p-value 0.0313 0.0318 0.1284 0.2187 Lower limit 0.5936 -13.8372 -8.3989 -43.6606 Upper limit 11.1012 -0.7171 60.5410 10.7793

0.5694 0.3242 0.1975 6.1879

df 3 16

SS 293.8922 612.6365

MS 97.9641 38.2898

F 2.5585

p-value 0.0915

Sycamore expected V/BV from sector regression expected V/BV from market regression: average V/BV in sector

Value/BV of Capital

ROC

Expected Growth in Revenues: next 5 years

Market Debt to Capital

1.05 4.09

-4.53%

-8.00%

0.00%

3.04 6.89

Appendix II A: Sample of positive earnings firms

Results of multiple regression for Value/BV of Capital Summary measures Multiple R R-Square Adj R-Square StErr of Est ANOVA Table Source Explained Unexplained Regression coefficients Constant ROC Expected Growth in Revenues: next 5 years Market Debt to Capital Coefficient 1.3709 28.4040 -7.0592 4.3825 Std Err 1.6581 6.3706 12.6620 11.8829 t-value 0.8268 4.4586 -0.5575 0.3688 p-value 0.4259 0.0010 0.5883 0.7193 Lower limit -2.2785 14.3823 -34.9281 -21.7717 Upper limit 5.0203 42.4256 20.8097 30.5366

0.8453 0.7145 0.6366 3.3789

df 3 11

SS 314.2392 125.5850

MS 104.7464 11.4168

F 9.1747

p-value 0.0025

SCMR expected V/BV = 0.65

PIXAR VALUATION
Background
Pixar was formed in 1986 and is a leading digital animation studio. The Companys objective is to create, develop and produce computer-animated feature films with heartwarming stories and memorable characters that appeal to audiences of all ages. To date, the company has created and produced six full-length animated feature films: Toy Story, A Bug's Life, Toy Story 2, Monsters, Inc., Finding Nemo, and The Incredibles, which were marketed and distributed by The Walt Disney Company. The first five films are among the top eleven grossing animated films of all time, with combined worldwide box office receipts of more than $2.5 billion. The company is expected to continue growing during the next couple of years. Valuation Methodology. Pixar will be valued in US dollars using a 2-stage Free Cash Flow to Firm (FCFF) model. The calculation will be performed using nominal values and rates.

Risk Free Rate

The current yield on the 10 year US Treasury bond is 3.98%. This is the risk free rate used in calculating the cost of equity.

Risk Premium
Pixar operates in the US, and the geometric average of risk premium in the US from 1928 to 2003 is 4.82%.

Market and Book Value of Equity and Debt

Equity The book value of equity was given in the Pixar financial statements as $1 119 million. The market value of equity December 10 2004 was $4 779 million (56.901 million shares outstanding; stock price: $83.98). Debt
Interest expenses Average maturity for the debt Pre-tax cost of debt Present value of annuity Book value of debt Present value of the book value of the debt Estimated market value of conventional debt Debt value of opearting leases Market value of outstanding debt 2,647 5 4.33% 11,676 61,133 49,457 61,133 1,325 62,458

The estimated market values of debt and equity gives Pixar a debt/equity ratio of 1.31% ($4779/$62.458). Compared to the industry average of 20.86%, Pixar is moderately levered.

Beta Calculation
The beta of Pixar was estimated by analyzing betas of comparable firms. Pixars operations in the computer software industry were treated separately from the main operations in the entertainment industry. First, unlevered betas corrected for cash were calculated. Second, estimated enterprise values were used at weights in order to find Pixars total unlevered beta. The unlevered beta is estimated to be 1.107.
Levered and unlevered betas by industry Entertainment Computer softw are Average Market D/E Unlevered Cash/Firm Corrected Beta Ratio Tax Rate Beta Value for cash 1.27 26.37% 17.16% 1.04 3.80% 1.08 1.83 3.58% 9.95% 1.77 13.09% 2.04 Enterprise Firm Value Unlevered Value Porportion Beta 892,716 26,530 919,246 97.1% 2.9% 100% 1.08 2.04 1.107

Pixar com petes in tw o industries Entertainment Computer softw are Pixar

Revenues EV / Sales 316,566 7,537 2.82 3.52

Using the market values of debt and equity, Pixars levered beta is 1.117:
Unlevered beta Marginal tax rate Equity, market value Debt, market value Levered beta 1.107 35% 4,853,204 62,458 1.117

Cost of Equity
Pixars cost of equity is simply calculated using the risk free rate of 3.98%, the risk premium of 4.82% and the bottom-up levered beta of 1.117. Using the CAPM formula the Cost of Equity for Pixar is 9.28%.

Cost of Debt
Given Pixars conservative leverage, the company default spread is almost insignificant. Also, there is no country default risk.
EBT Interest expenses EBIT Operating lease expense Interest expense Interest coverage ratio Riskfree rate Country default spread Company default spread (2004) Pre-tax cost of debt 269,915 2,647 272,562 846 2,647 78.27 3.98% 0% 0.35% 4.33%

Firm Valuation Two-Stage Free Cash Flow to Firm Model

In order to value the firm, I have chosen to use a two-stage Free Cash Flow to Firm model (FCFF). I believe that Pixar will maintain its position as the leading digital animation studio for the next five years, before other companies start to catch up. Facing tougher competition in a more saturated market, it is likely that Pixar will mature during the five years that follows the highgrowth period, and ultimately converge towards the industry averages regarding leverage and growth. The industry will also move towards the market (beta = 1). Input in the DCF-model:
Length of High Grow th Period Beta used for stock Riskfree rate Risk Premium Cost of Equity Cost of Debt Tax Rate After-tax Cost of debt Equity/(Debt+Equity ) Debt/(Debt+Equity) Cost of Capital 5 1.12 3.98% 4.82% 9.36% 4.33% 36.86% 2.73% Stable 1.00 3.98% 4.82% 8.80% 4.33% 35.00% 2.81% 79.14% 20.86% 7.55%

Free Cash Flow to the Firm In order to calculate the FCFF, adjustments regarding leases and R&D expenses have to be made. Please see the appendix for detailed calculations.
Leases Average year life for assets 3 Reported operating lease expenses this year 846 Depreciation operating lease 442 Adjustments in operating income from operating leases 404 R&D Reported R&D expense this year Amortization R&D Adjustments in operating income from R&D

8,963 7,933 1,030

These adjustments change Pixars operating income as follows:

Operating income Adjustments, operating leases Adjustments, R&D Adjusted operating income Tax rate on income After-tax operating income Ignored tax effect of R&D Expenditures EBIT * (1-tax rate) 259,547 404 1,030 260,981 36.9% 164,780 380 165,160

Growth, Return on Capital, and Reinvestment After an impressing growth in operating earnings of 136% and 84.3% during the past two years, Pixar is expected to continue growing fast, however at a downward sloping pace. To capture this

downward slope, the growth for the next five years is estimated by taking the natural log of (growtht / growtht-1). After the five-year long high-growth period, the growth is linearly scaled down towards the steady state rate of 3.98% (=risk free rate).
EBIT * (1-tax rate) Grow th LN( ! Growth) 2002 37,894 2003 89,610 136.5% 0.482 2004 165,160 84.3% 0.482 2005 52.1% 0.482 2006 32.2% 0.482 2007 19.9% 0.482 2008 12.3% 0.482 2009 7.6%

Pixars return on capital is at a relatively high 26.61% (data from Value Line), and I have assumed that Pixar is able to retain its current ROC for the next five years. However, as the company will gradually come under pressure from competitors, the ROC will slide down towards the stablestate cost of capital of 7.55%. This is higher than the industry average of 6.70%, but Im assuming that Pixar doesnt invest in negative NPV projects that will reduce the ROC below the cost of capital. Given the growth and the ROC, the next years reinvestment rate is 195.7%. To achieve high growth in the high-growth period, Pixar must reinvest more than its operating income, and is therefore forced to issue new debt. However, as the growth declines, there is less need for reinvestment, and the operating income will cover the reinvestment needs. Weighted Average Cost of Capital The weighted average cost of capital is calculated using the WACC-formula (rd * (1-t) * D/ (D+E) + re * E/ (D+E)). Because Pixar has to issue new debt to sustain the high growth, the leverage and thus the WACC will change continuously. I have assumed that Pixar eventually will move towards the industry average capital structure with an equity ratio of ca. 79%. This is a relatively conservative leverage, and I have therefore supposed that Pixar maintains its current credit rating and that the cost of debt remains stable. Valuing Options and Value of Equity per share Pixars outstanding options were valued using the Black-Scholes option pricing model. The inputs below were taken from the latest quarterly report, filed November 12, 2004.
Stock Price Strike Price Adjusted S Expiration (in years) Number of options outstanding Number of shares outstanding T-Bond rate Standard deviation in stock prices Variance Annualized dividend yield Div. Adj. interest rate d1 N (d1) d2 N (d2) Value per option Value of all options outstanding 83.98 27.12 82.95 5.00 2,771 56,901 3.98% 39.00% 0.1521 0.00% 3.98% 1.946151 0.974182 1.074084 0.858607 61.72 171,030

The value of all options outstanding will be subtracted from the equity, reducing the equity claims on the firm and thus the share price. Estimating the Market Value of Equity per Share The DCF-valuation below indicates that Pixar is slightly overvalued.
Length of High Grow th Period Beta us ed f or s toc k Ris kf ree rate Ris k Premium Cos t of Equity Cos t of Debt Tax Rate A f ter-tax Cos t of debt Equity /(Debt+Equity ) Debt/(Debt+Equity ) Cos t of Capital Grow th Rate Return on Capital Reinv es tment Rate Current Ex pec ted Growth Rate Return on Capital Reinves tment Rate EBIT * (1 - tax rate) Reinv es tment Free Cas h Flow to Firm Equity Debt Equity/(Equity+Debt) Cos t of Capital Cumulated Cos t of Capital Present V alue Perc entage of value of operating as s ets Pres ent V alue of FCFF in high grow th phas e Pres ent V alue of Terminal V alue of Firm V alue of operating as s ets of the f irm V alue of Cas h, Marketable Sec urities & Non-operating as s ets V alue of Firm Market V alue of outs tanding debt Market V alue of Equity V alue of Equity in Options V alue of Equity in Common Stoc k Market V alue of Equity /s hare Pric e per s hare in the market Recom m endation 4,778,546 62,458 98.7% 9.28% 26.61% 165,160 52.06% 5 1.12 3.98% 4.82% 9.36% 4.33% 36.86% 2.73% Stable 1.00 3.98% 4.82% 8.80% 4.33% 35.00% 2.81% 79.14% 20.86% 7.55% 3.98% 7.55% 52.71% 1 52.1% 26.6% 195.7% 251,147 491,381 -240,234 2 32.2% 26.6% 120.8% 331,900 401,056 -69,155 3 19.9% 26.6% 74.6% 397,828 296,971 100,856 4 12.3% 26.6% 46.1% 446,645 205,972 240,673 5 7.6% 26.6% 28.5% 480,486 136,811 343,675 6 6.9% 22.8% 30.1% 513,434 154,435 358,999 7 6.1% 19.0% 32.3% 544,949 176,175 368,774 8 5.4% 15.2% 35.7% 574,478 205,140 369,338 9 4.7% 11.4% 41.4% 601,474 248,752 352,722 10 Term inal 3.98% 7.55% 52.71% 625,413 3.98% 7.55% 52.71% 650,304

329,637 342,757 295,776 8,611,976 4,075,795 1,074,599 79.14% 7.55%

4,778,546 4,778,546 4,778,546 4,778,546 4,778,546 4,637,996 4,497,445 4,356,895 4,216,345 4,075,795 302,693 371,848 371,848 371,848 371,848 512,398 652,948 793,499 934,049 1,074,599 94.0% 8.97% 108.97% -220,463 -4.7% 1,103,937 3,546,506 4,650,443 27,545 4,677,988 62,458 4,615,530 171,030 4,444,500 78.11 83.98 SELL! 92.8% 8.88% 118.65% -58,285 -1.3% 92.8% 8.88% 129.19% 78,067 1.7% 92.8% 8.88% 140.67% 171,092 3.7% 92.8% 8.88% 153.17% 224,379 4.8% 90.1% 8.60% 166.35% 215,816 4.6% 87.3% 8.33% 180.20% 204,645 4.4% 84.6% 8.06% 194.73% 189,664 4.1% 81.9% 7.80% 209.93% 168,020 3.6% 79.1% 7.55%

225.78% 242.83% 131,001 3,546,506 2.8% 76.26%

Recommendation: SELL!!

Relative Valuation
Pixar is a high-growth company, and I have therefore chosen the PEG-ratio for the relative valuation. Independent variables The sample contains 25 firms, and three independent variables have been used in the regression. Given the relatively small sample, one could argue that the regression shouldnt contain more than two independent variables (maximum one for every 10 stocks in the sample). However, the models explanatory power is increased when including three independent variables. FCFE/Net Income. The FCFE has been calculated as follows: FCFE = (FCFF - EBIT(1-t)) * (1-d) + Net Income LN (Expected growth in earnings per share for the next five years). I have used the natural log to achieve linearity between the PEG and Expected growth in EPS.

Beta. Beta has been chosen as a proxy for cost of equity. Because there are more Value Line betas than Regression betas available, I have used the former to maximize the sample of firms in the regression.

The numbers below show the results from the regression. An R Square of 0.3693 is not great, but acceptable.
Regression Statistics Multiple R 0.6077113 R Square 0.369313 Adjusted R Square 0.2792149 Standard Error 1.8473947 Observations 25 ANOVA df Regression Residual Total 3 21 24 SS 41.968117 71.670212 113.63833 MS 13.989372 3.4128672 F Significance F 4.0990087 0.0194618

Intercept FCFE/Net Income Value Line Beta LN(Grow th in EPS)

CoefficientsStandard Error 3.5246823 3.8291306 0.3127159 1.6152751 -2.8021617 1.7575327 -1.0754337 1.0141077

t Stat 0.9204915 0.1935991 -1.5943725 -1.0604729

P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.3677699 -4.4384307 11.487795 -4.4384307 11.487795 0.8483501 -3.0464326 3.6718644 -3.0464326 3.6718644 0.1257934 -6.457151 0.8528275 -6.457151 0.8528275 0.3009746 -3.184386 1.0335186 -3.184386 1.0335186

Using the updated data on earnings and growth from the DCF-valuation, Pixars predicted PEG is 2.25, compared to 2.08 in the market.
Intercept FCFE/Net Income Levered beta Expected grow th in EPS the next five years LN(Grow th in EPS) Predicted PEG Coefficients 3.5246823 0.3127159 -2.802162 -1.075434 Pixar 1.000 1.117 23.8% -1.44 2.25

This indicates that Pixar is undervalued:

Earnings Expected grow th in EPS the next five years Predicted share price Price per share in the market Recom m endation 170.42 23.8% 91.35 83.98 BUY!

(Expected growth = (The product of the growth rates during the five-year period)^0.2 1). According to the relative valuation, Pixar is slightly undervalued in the market; the stock should sell for $91.35. Recommendation: BUY!!

Value Enhancement
The analysis below shows that Pixar are investing in good projects
Return on capital Cost of capital Spread Book value of capital Economic value added 26.61% 9.28% 17.33% 1,180,484 204,600

Compared to the Entertainment industry, the impression of Pixar as a well-managed firm is fortified:
Entertainment Industry Return on capital Cost of capital Spread 6.70% 8.92% -2.22%

Where Pixars current ROC is 17.33% above its cost of capital, the entertainment industry is on average loosing money on its investments; the ROC is 2.22% below the cost of capital.

Conclusion
The results from the DCF valuation demonstrate that the market overvalues Pixar with ca. $4 per share, or about 7.5%. On the other hand, the relative valuation indicates that Pixar is undervalued by about $7.4 (8.8%). The Value Enhancement analysis suggests that Pixar invests in great projects and creates much more value than the entertainment industry on average. So, which conclusion should be drawn from these ambiguous results? Even though the relative valuation and the EVA-analysis propose a BUY-recommendation, Im not completely convinced. All of Pixars six films have been big blockbusters, but it is unlikely that the future will bring the same impressing amount of home runs. Today, animation films are regarded as something new and exiting. However, I dont think this will be the case in a few years, and Pixars movies will probably face stiffer competition both from other animation films and from normal movies. On the other hand, I dont think the results from the DCF valuation are strong enough to recommend SELL. To sum up, my recommendation is HOLD.

Appendix
Convert operating leases into debt Future minimum lease payments 2004 2005 2006 2007 After 2007 Debt value of leases Conventional debt Debt value of opearting leases Debt outstanding at Pixar PV at 6% 845 288 82 62 47 1,325

882 314 93 74 58

61,133 1,325 62,458

Capitalize R&D expenditures Assumed life of R&D 3 R&D expense 15,095 8,963 8,497 6,339 Amort. Unamortized protion this year 1.00 15,095 0.67 5,975 2,988 0.33 2,832 2,832 0.00 0 2,113 23,903 7,933

Year 2004 2003 2002 2001 Total Tax effect on R&D expensing

380