Beruflich Dokumente
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Valuation
October 13
Contents
Introduction Fundamentals of Where Value Comes From
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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 those cash flows, whether it be the cash flow from assets, debt or equity Measurement value forecasting and risk assessment -- is a very complex and difficult problem. Intrinsic value is an estimate and not observable
Reference: Chapter 4
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Consider Investment Alternatives A and B, where A has a higher project IRR than B. Assume A has a return of 11% and B has a return of 9%.
Mathematical Models
Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk.
Project A or Project B would be selected through assessing the return on the projects relative to the weighted average cost of capital for each project. If the WACC for A is 10% and for B is 9.5% then A is selected. One must computed beta for each investment. Compute the distributions in cash flow of project A and project B to equity holders. If the standard deviation is lower for project B, then assess the risk relative to the return.
Compute the achieved rate of return from the ability to raise debt and then assess the return earned on equity. If the return on equity is greater for B then A, select project A.
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Value Differences from Cost of Capital and Terminal Growth Base Low High Beta 1.00 1.50 0.75 Rm 5.00% 7.00% 4.00% Growth 2.00% 0.00% 3.50% Rf 4.50% 4.50% 4.50% Ke Explicit Period Enterprise Value Pct Difference 9.50% 7.00 57,556 15.00% 7.00 29,615 -48.5% 7.50% 7.00 102,606 78.3%
Differences in Beta, Rm and Terminal Growth have an Immense Effect on the Value of the Investment
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Case 1: 15% Volatility; 40% Mean Reversion; 4.5 Long-run Marginal Cost
Case 2: 25% Volatility; 10% Mean Reversion; 4.0 Long-run Marginal Cost
The probability of earning below the risk free rate is about 55%
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Overall Project IRR Leverage Term Interest Rate Cost Repayment Method Equity IRR Average DSCR
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Project A
Amount vs EBITDA 8,500 5,000 17,490 30,990 2.66 1.56 5.47 9.68 Pct 27.4% 16.1% 56.4% 100.0% IRR 7.3% 10.0% 14.9%
Project B
Sources and Uses Map Senior Debt Mezzenaine Debt Equity Total
Entry Multiple EV/EBITDA Transaction Price Exit Multiple EV/EBIDA Project IRR WACC Economic Return
Project A has a higher rate of return relative to its cost of capital, but Project B has a higher equity return
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Enterprise Value Net Debt Equity Value www.edbodmer.com edbodmer@aol.com Reference: Private Valuation; Valuation Mistakes
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Equity Cash Flow, Debt Cash Flow, Free Cash Flow and Cost of Equity, Cost of Debt and WACC
Equity Cash Flow and Value of Equity : Dividends less Equity Issued
Value of Equity PV of Cash Flows at Cost of Equity
+
Debt Cash Flow and Market Value of Debt : Net Interest plus Net Debt Payments
+
Value of Debt PV of Cash Flows at Incremental Cost of Debt
=
Value of Enterprise PV of Cash Flows At WACC
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Valuation Overview
Despite that fact that all we have to do is forecast cash flow and then determine the risk associated with those cash flows, valuation is a huge topic. Some Key issues in valuation analysis include: Cost of Capital in DCF or Discounted Earnings for Measuring Risk Selection of Market Multiple and Adjustment that implicitly accounts for growth in cash flow and risk Determination of Growth Rates in Earnings and Cash Flow Projections How to Compute Terminal Value when Cash Flow Lasts for an Indefinite Period
October 13 16
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Knowledge about risks and economic outlook to assess risks and value drivers in the forecasts
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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
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Much of valuation involves implicitly or explicitly making growth estimates High P/E comes from high growth
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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.
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
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Fade Period
The fade period is the length of time it takes for the long-term growth rate to be reached after from the growth in the last year of the forecast. For example, the last year growth is 10% The terminal growth is 3%
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Growth When Companies are Earning More than their Cost of Capital
It is a lot more difficult to maintain growth when you are earning 40% return on investment than when you are earning 10% in the terminal period
A study by Chan, Karceski, and Lakonishok titled, The Level and Persistence of Growth Rates, published in 2003. According to this study, analyst growth forecasts are overly optimistic and add little predictive power.
Competition tends to compress margins and growth opportunities, and sub-par performance spurs corrective actions. With the passage of time, a firms performance tends to converge to the industry norm. 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. Competition exerts downward pressure on product prices and product innovations and changes in tastes tend to erode competitive advantage. The typical firm will see the return spread (ROIC-WACC) shrink over time.
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Growth Issues
Growth issues include
22.4
20
15
15.1
9.5
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It is in the formula: Cash Flow (ROIC x Inv)/(k-g) which is the basis for multiples
All of the other ratios gross margins, effective tax rates, inventory turnover etc. are just details.
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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
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If there is growth in a model, you should use the add one year of growth to the last period in making the calculation
To use mid-year of specific discounting use the IRR or XIRR or sumproduct
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When evaluating NOPLAT rather than earnings, a similar concept can be used for sustainable growth.
Growth = (Capital Expenditures/Depreciation 1) x Depreciation Rate
Unrealistic to assume growth in units above the growth in the economy on an ongoing basis.
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P0 = D1/(k-g)
Example
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Capital Junkies
Power House
ROIC/WACC + ++ve
Capital Killers
Once you have a good thing, you should grow
Cash Cows
Growth -
This implies that there are three variables return, growth and cost of capital that are central to valuation analysis
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Growth +
Power House Perennial under achiever or future prospects Stretched balance sheet Restructuring May look expensive
Throwing good money after bad What is the economic reason for getting here and how long can the performance be maintained
High industry growth Franchise value Pricing power Clear Investment strategy How sustainable?
Capital Killers Look cheap but for good reason Cyclical or permanent Industry or company specific factors Cash Cows
Try to get out of the business www.edbodmer.com
ROIC/WACC + ++ve
Low industry growth Cash generative and rich Risk/opportunity of diversification Low rating with strong yield support
Give the money to investors
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Growth -
Microsoft From: 03-January-90 to: 15-December-99 Stock Price and Dividends IRR 33.4%
25.00
3-Jan-90 15-Dec-99
40.00
21-Sep-06
35.00
20.00
30.00
15.00
25.00 EPS Index Stock Index 20.00
10.00
15.00
10.00
5.00
5.00
8/24/1990 2/24/1991 8/24/1991 2/24/1992 8/24/1992 2/24/1993 8/24/1993 2/24/1994 8/24/1994 2/24/1995 8/24/1995 2/24/1996 8/24/1996 2/24/1997 8/24/1997 2/24/1998 8/24/1998 2/24/1999 8/24/1999 2/24/2000 8/24/2000 2/24/2001 8/24/2001 2/24/2002 8/24/2002 2/24/2003 8/24/2003 2/24/2004 8/24/2004 2/24/2005 8/24/2005 2/24/2006 8/24/2006
1/3/1990 5/3/1990 9/3/1990 1/3/1991 5/3/1991 9/3/1991 1/3/1992 5/3/1992 9/3/1992 1/3/1993 5/3/1993 9/3/1993 1/3/1994 5/3/1994 9/3/1994 1/3/1995 5/3/1995 9/3/1995 1/3/1996 5/3/1996 9/3/1996 1/3/1997 5/3/1997 9/3/1997 1/3/1998 5/3/1998 9/3/1998 1/3/1999 5/3/1999 9/3/1999
Earnings are a good indicator of value; but not always as shown by the recent increases which resulted from share buybacksedbodmer@aol.com www.edbodmer.com
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Microsoft From: 03-January-90 to: 15-December-99 Stock Price and Dividends IRR 33.4%
0.40
20.00
3-Jan-90
30.00
0.35
18.00
0.40
0.35
16.00
0.30 25.00 0.25 20.00
12.00
0.20 Stock Index Revenue 10.00 Index ROE
Index
Index
ROE
0.20
8.00
0.15
5.00
0.05
2.00
0.05
1 170 339 508 677 846 1015 1184 1353 1522 1691 1860 2029 2198 2367 2536 2705 2874 3043 3212 3381 3550 3719 3888
1 106 211 316 421 526 631 736 841 946 1051 1156 1261 1366 1471 1576 1681 1786 1891 1996 2101 2206 2311 2416
Strong Returns plus growth resulted in increased price; when return fell, the price fell www.edbodmer.com edbodmer@aol.com October 13 34
ROE
GM From: 11-January-93 to: 08-September-06 Stock Price and Dividends IRR 0.0%
5.00
11-Jan-93 8-Sep-06
GM From: 11-January-93 to: 08-September-06 Stock Price and Dividends IRR 0.0%
3.00 0.40
11-Jan-93
4.00
2.50
3.00
0.30
0.20
2.00
2.00 0.10
EPS Index Stock Index
1/11/1993 7/11/1993 1/11/1994 7/11/1994 1/11/1995 7/11/1995 1/11/1996 7/11/1996 1/11/1997 7/11/1997 1/11/1998 7/11/1998 1/11/1999 7/11/1999 1/11/2000 7/11/2000 1/11/2001 7/11/2001 1/11/2002 7/11/2002 1/11/2003 7/11/2003 1/11/2004 7/11/2004 1/11/2005 7/11/2005 1/11/2006 7/11/2006
(1.00)
(2.00)
0.50
(0.20)
(3.00)
1/11/1993 7/11/1993 1/11/1994 7/11/1994 1/11/1995 7/11/1995 1/11/1996 7/11/1996 1/11/1997 7/11/1997 1/11/1998 7/11/1998 1/11/1999 7/11/1999 1/11/2000 7/11/2000 1/11/2001 7/11/2001 1/11/2002 7/11/2002 1/11/2003 7/11/2003 1/11/2004 7/11/2004 1/11/2005 7/11/2005 1/11/2006
(0.30)
7/11/2006
(4.00)
GM had low growth and low returns and the stock price did not increase. www.edbodmer.com edbodmer@aol.com October 13 35
ROE
1.00
Index
ROIC Issues
Issues with ROIC include
Examine the ROIC in models to determine if detailed assumptions are leading to implausible results Migration table
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Practical Growth Rate Issues: Growth Rate Estimation vs. ROE and Retention Rate
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). Those who use analysts 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.
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Valuation
38 October 13
Valuation Ranges
Do not claim to derive a single number unrealistic to derive one number Forecasting uncertainty Cost of capital uncertainty Bigger ranges for growth companies and for emerging economies
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Relative Valuation
Multiples, Comparative Transactions
Absolute Valuation
DCF, APV, Risk Neutral Valuation, Option Pricing
We Differentiate by
Direct Valuation
DCF, Multiples etc.
Indirect Valuation
Equity IRR from LBO Multiples, Accretion/Dilution in EPS from integrated merger analysis, IRR and debt capacity in project finance
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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
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Leveraged buyout
Entry and exit multiples, debt capacity and EBITDA Growth. See how much you can pay an finance and obtain an equity rate or return consistent general benchmarks such as 20%.
Project Finance
Given contracts and assumptions about cash flows over the life of the asset and debt capacity, see how much investment can be made to generate and equity rate of return.
Merger Integration
Given assumptions about financing and accounting in a mergers, see how much you can afford to pay and still achieve accretion in earnings per share.
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Costs Known
No Future Capital Expenditures
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Investment (Negative)
IPO Terminal Value (Positive)
Terminal Value = Value at IPO x Share of Company Owned
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Cash Flow
Cash Flow
Cash Flow
Cash Flow
Continuing Value
Discount Rates Enterprise Value Net Debt Equity Value www.edbodmer.com edbodmer@aol.com Evaluate how much of the equity value that you own
In the extreme, if you have given away half of your company away, and the cash flow is the same before and after your give away, then the amount you would pay for the share must account for how much you will give October away. 13 49
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Therefore, an adjustment must be made for dilution and the percent of the company retained. See the Cost of Capital folder for and example
e.g. Share value without dilution = 17.5/700,000 = 25 per share If an additional 30% of shares is floated, the value per share must be increased by 30% to maintain the value.
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Replacement Cost
First a couple of points regarding replacement cost theory
In theory, one can replace the assets of a company without investing in the company. If you are valuing a company, you may think about creating the company yourself.
If you replaced a company and really measured the replacement cost, the value of the company may be more than replacement cost because the company manages the assets better than you could. By replacing the assets and entering the business, you would receive cash flows. You can reconcile the replacement cost with the discounted cash flow approach
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Begin with balance sheet categories, account for the age of the plant
Add: cost of hiring and training management If the company is generating more cash flow than that would be produced from replacement cost, the management may be more productive than others in managing costs or be able to realize higher prices through differentiation of products. The ratio of market value to replacement cost is a theoretical ratio that measures the value of management contribution
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In operating an asset, the asset can be shut down when it is not economic and re-started when it becomes economic. This allows the asset to retain the upside but not incur negative cash flows.
When developing a project, there is a possibility to abandon the project that can limit the downside as more becomes known about the economics of the project. In deciding when to construct an investment, one can delay the investment until it becomes clear that the decision is economic. This again limits the downside cash flows. In each of these cases, management flexibility provides protection in the downside which means that DCF model produces biased results.
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Simulation Exercise
To demonstrate how options affect valuation, consider a simple simulation exercise Enter the following inputs Volatility is the standard deviation of the percent change in a variable over time.
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Fundamental Valuation
What was behind the bull market of 1980-1999
Long-term interest rates fell lower cost of capital increases the P/E ratio
Real Market Value by ROIC versus growth
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Discounting Basics
Valuation
61 October 13
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
Case exercise to illustrate the effect of discounting (credit spread) on the value of a bond
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Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ... + E(Dt +n) + ... (1+k)1 (1+k)2 (1+k)3 (1+k)n
Vt is the value of an equity security at time t Dt +n is the dividend in period t+n k is the equity cost of capital difficult to find (CAPM) E() refers to expected dividends If dividends had no growth the value is D/k
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...
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
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Setting-Up the Model to Reflect Period Discounting with Terminal Value and Transaction Dates
The example shown accounts for mid-year discounting and terminal value at the end of the period. The discount rate assumes annual discounting using the formula: The terminal value must use the last mid year value multiplied by (1+g)^1.5
Terminal value is after the last period cash flow and must use mid year period x (1+g)^1.5
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Valuation
68 October 13
Advantages
Valuation depends on opinions of others and not the underlying drivers of value.
Too simple: Does not account for prospective changes in cash flow
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Industry Specific
Value/Oil Reserve Value/Subscriber Value/Square Foot
Issues
Where to find the multiple data and comparable companies
What income or cash flow base to use Discounts for lack of marketability
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Mechanics of Multiples
Find market multiple from comparable companies Rarely are there truly comparable companies Understand economics that drive multiples (growth rate, cost of capital and return) P/E Ratio (forward versus trailing)
Value/Share = P/E x Projected EPS
In the long-term P/E ratios tend to revert to a mean of 15.0
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; EV/EBITDA uses free cash flow
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Theory of growth and multiples depends on long-term growth more than short-term growth. Also depends greatly on the cost of capital.
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Logical comparisons
Sample should have similar WACC and growth rates and therefore be in the same industry and have the same kind of risks. Note difference in size and difference in company profile.
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The red bars from the DCF valuation are compared to market date
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Which multiple best reflects value for the various companies note the EV/EBITDA is most stable
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EV/EBITDA by Industry
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Banks/Insurance
Market/Book may be best Not many intangible assets, so book value is meaningful Book value is the value of loans which is adjusted with loan loss provisions Cost of capital and financing is very important because of the cost of deposits
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Multiples - Summary
Useful sanity check for valuation from other methods
CF x (1+g)/(k-g)
Compute the implied EV/EBITDA from the data
Also compute the implied P/E and the implied EV/EBITDA when computing the DCF
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P = D1/(k-g) g = ROE * (1-DPO) or DPO = 1 - g/ROE P/E = D/E/(k-g) Substituting for D/E = DPO P/E = (1-g/r)/(k-g)
k = (1-g/r)/(P/E) + g
Example: if r = k than the formula boils down to 1/(k) If the g = 0, the formula is P/E = 1/k
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1990
1995
2000
2006
15.2
16.5
28.6
16.0
Dividend Yields
S&P 500 Prime Rate 10-Year Treasury 3.9% 9.9% 10.6% 3.7% 10.0% 8.6% 2.3% 8.8% 6.6% 1.2% 9.2% 6.0% 1.76% 8.3% 4.7%
LIBOR
N/A
7.5%
5.4%
5.9%
5.3%
Low P/E when longterm interest rates where high www.edbodmer.com edbodmer@aol.com October 13 86
1/PE = 6.6%
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Demonstrates that the multiple in the merger is consistent with other transactions
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# of Deals Price/Book
Median Mean Median Mean
1 238.5
Price/Tangible Book
251.8
Price/LTM Earnings
Median Mean
22.0
Price/Deposits
Median Mean
32.1
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Adjustments to Multiples
Process Find multiples from similar public companies Adjust multiples for
Liquidity Size Control premium Developing country discount
Apply adjusted multiples to book value, earnings, and EBITDA There is often more money in dispute in determining the discounts and premiums in a business valuation than in arriving at the pre-discount valuation itself. Discounts and premiums affect not only the value of the company, but also play a crucial role in determining the risk involved, control issues, marketability, contingent liability, and a host of other factors.
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A controlling interest is assumed to have control power over the minority interests.
Minority interest value represents the value of a minority interest as if freely tradable in a public market.
Minority interest discount represents the reduction in value from an absence of control of the enterprise.
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Multiples
2000
2001
2002
2003
2004
2005
2006
Public
Private
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Source: Mergerstat (U.S. Only) Disclaimer: Data is continually updated and is subject to change
12.8 11.4 8.8 11.6 11.1 11.1 9.3 6.9 8.4 7.0 9.4 8.6 11.3 8.8 7.8 11.8 9.9 9.4 11.8 11.4 11.3
Multiples
8.3
1999
2000
2001
2002
2003
2004
2005
2006
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Source: Mergerstat (U.S. Only) Disclaimer: Data is continually updated and is subject to change
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P/E = (1-g/r)/(k-g) g -- long term growth rate in earnings and cash flow r -- rate of return earned on new investment k -- discount rate
(k-g) = (1-g/r)/(P/E)
k = (1-g/r)/(P/E) + g
Example: if r = k than the formula boils down to 1/(k) If the g = 0, the formula is P/E = 1/k P = E/(k-g) x (1-g/r)
If, for some reason, g = r, then the Gordon model could be applied to compute k.
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October 13
99
http://googlefinance.com/
http://marketwatch.com/ http://bloomberg.com/ http://pages.stern.nyu.edu/~adam odar/
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October 13
10 0
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October 13
10 1
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10 2
P/E Ratio
If you use the P/E ratio for valuation, the ratio implies that only this year or last years earnings matter Cash matters to investors in the end, not earnings (different lifetime of earnings) When earnings reflect cash flow, P/E is reasonable for valuation
High P/E causes treadmill and does not necessary imply that companies are performing well
Earnings can be managed and manipulated
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10 3
Use of P/E Ratio Formula to Compute the Required Return on Equity Capital
It will become apparent later that one cannot get away from estimating the cost of equity capital and the CAPM technique is inadequate from a theoretical and a practical standpoint. The following example illustrates how the formula can be used in practice: k = (1-g/r)/(P/E) + g
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10 4
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
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10 5
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10 6
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10 7
No Taxes
No Leverage No Depreciation No Growth Rate ROIC = 10%
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10 8
Comparative Multiples
With the simple assumptions, each of the multiples is the same as shown below
Exercise: Data table with alternative parameters to investigate P/E and EV/EBITA
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10 9
Comparative Multiples
Once taxes, leverage and depreciation are added, the multiples diverge as shown on the table below:
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October 13
11 0
Valuation
111 October 13
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 of the business and allows sensitivity and scenario analysis Fundamental not biased by optimism or pessimism in the market
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Morgan Stanley performed a discounted cash flow analysis, which is designed to imply a value of a company by calculating the present value of estimated future cash flows of the company.
Morgan Stanley calculated ranges of implied equity values per share for Wyeth, based on discounted cash flow analyses utilizing Wall Street analyst estimates compiled by Thomson First Call and Wyeth management projections for the calendar years 2009 through 2013. In arriving at the estimated equity values per share of Wyeths common stock, Morgan Stanley calculated a terminal value by applying a range of perpetual free cash flow growth rates ranging from (0.5)% to 0.5%.
Such rate range was derived, based on Morgan Stanleys judgment, after considering a number of factors, including growth of the overall economy, projected earnings expectations for comparable pharmaceutical companies and Wyeths upcoming patent expiration profile. Morgan Stanley observed that this range implied P/E multiples for Wyeth that were consistent with the P/E multiples of the comparable companies studied by Morgan Stanley and identified above under Comparable Companies Analysis. The unlevered free cash flows and the terminal value were then discounted to present values using a range of weighted average cost of capital from 7.0% to 9.0%.
Morgan Stanley selected this range using the capital asset pricing model. The weighted average cost of capital is a measure of the average expected return on all of a given companys equity securities and debt based on their proportions in such companys capital structure.
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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
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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
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11 7
DCF Discussion
DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and susceptible to error. DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Example: Sun Microsystems, which recently traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-term growth rate of 13.0%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a one percent fall in interest rates boosts the value to about $7.70.
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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
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Further out Individual line items more difficult Focus on key drivers
Operating margin, tax rate, capital efficiency
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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 8,924.43 17,811.59 26,736.02 3,416.00 4,356.00 20,316.00 54,824.02 24,282.00 78.00 30,464.02
Treatment of other investments depend on definition of free cash flow. Here, 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
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Example of DCF
Lehman Brothers and Evercore calculated per share equity values by: first determining a range of enterprise values of BellSouth by
adding the present values of the after-tax unlevered free cash flows and
terminal values for each EBITDA terminal multiple and discount rate scenario
then subtracting from the enterprise values the net debt (which is total debt minus cash) and dividing those amounts by the number of fully diluted shares of BellSouth.
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October 13
12 3
JPMorgan conducted a discounted cash flow analysis to determine a range of estimated equity values per diluted share for Exelon common stock.
JPMorgan calculated the present value of the Exelon cash flow streams from 2005 through 2009, assuming it continued to operate as a stand-alone entity, based on financial projections for 2005 through 2007 and extensions of those projections from 2008 through 2009 in each case provided by Exelon's management.
JPMorgan also calculated an implied range of terminal values for Exelon at the end of 2009 by applying a range of multiples of 8.0x to 9.0x to Exelon's 2009 EBITDA assumption. The cash flow streams and the range of terminal values were then discounted to present values using a range of discount rates from 5.25% to 5.75%, which was based on Exelon's estimated weighted average cost of capital, to determine a discounted cash flow value range. The value of Exelon's common stock was derived from the discounted cash flow value range by subtracting Exelon's debt and adding Exelon's cash and cash equivalents outstanding as of December 31, 2004.
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The WACC used included country premium that produced a WACC of 22%
The assets of the bank are not loans, but are government securities
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The key is to understand how these items affect the value in theory and be able to work through examples
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12 9
Deferred Tax
There are two ways to consider deferred tax:
Option 1:
Ignore deferred tax in the calculation of free cash flow and either add or subtract deferred tax assets or liabilities
Option 2:
Model deferred tax as part of free cash flows and explicitly model the net operating loss
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October 13
13 0
Deferred Tax
Simulation (see Deferred Tax Example.xls) on CD, shows
If stable growth in capital expenditures, growth in deferred tax is the same as growth in overall capital expenditures
Should subtract deferred tax changes from cash flow and not make other adjustments to value
If use EBITDA EBIT x Tax without considering deferred tax, will understate value by the PV of deferred tax
Deferred tax as a percent of capital stays constant and does not vary much for different growth rates
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October 13
13 1
The future dilution should be a reduction in the equity value of the company
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October 13
13 2
Option Example
We apply the intrinsic value method of accounting for employee stock-based compensation and expense it ratably over the vesting period. We recognize compensation cost for awards on the grant-date fair value of those awards.
Weighted Average Remaining Life (Years) 2.1 9.9 9.9 1.4 9.5 9.7 8.2 8.3 8.2 8.2 1.3 7.8 Number Exercisable 116,300 28,500 54,000 25,995 81,000 160,005 6,000 471,800
Exercise Prices $ $ $ $ $ $ $ $ $ $ $ 4.5 6.6 6.65 7.5 7.6 7.8 9.7 11.6 12.5 17 18.1
Number Outstanding 116,300 7,000 1,000 28,500 4,000 200 360,000 173,300 556,740 1,088,760 6,000 2,341,800
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October 13
13 3
Minority Interest
Minority interest should be deducted in computing the value of common equity The issue is whether the minority interest should be subtracted at market value or at book value If the minority interest is significant, the market value should be used rather than the book value.
Example:
Minority interest is 49% of the value of the company The market value of the company is three times the book value The minority interest should also be three times the book value
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October 13
13 4
If the contracts are included in the cash flows, the value of the derivatives is in the free cash flow and no adjustment should be made.
If the contracts are not included in cash flows, the value should be added or subtracted from the enterprise value If the derivatives are related to locking in interest rates, the value of the derivatives is analogous to valuing debt at market value and it should be include in the DCF
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October 13
13 5
If the cost of debt is higher because of a higher probability of default, the equity holders are receiving this value because they own a call option. If two companies have the same cash flow and one has more leverage, the enterprise value should not be reduced. Thus, in theory, the cost of equity should be lower. The APV where all-equity cost of capital is computed solves this problem.
Practice Do not use the high cost of debt in the WACC and do not adjust the cost of equity
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October 13
13 7
Legal Claims
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October 13
13 8
No issue with defined contribution since contribution covers future obligations and there is no future obligation that is not covered
Defined benefit plan can lead to requirements to fund that are not included in investment reserves Difference between investment reserves and pension requirements is unfunded liability or asset Unfunded liability is like debt it will have to be replaced by getting cash through issuing debt or equity
If a company runs a defined-benefit pension plan for its employees, it must fund the plan each year. If the company funds its plan faster then expenses dictate, the company can recognise a portion of the excess assets on the balance sheet.
If the liability is included in operating expenses, then no adjustment may be necessary
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October 13
13 9
Accrue expense as deposit into fund and accumulate pension fund sufficient to pay all obligations
Deposits to pension fund equal the accrued expense Pension liability for future payments equals pension fund
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14 0
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October 13
14 1
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14 2
Terminal Value
Valuation
143 October 13
Gordons
CFt x (1+g)/
(WACC-g)
History
Terminal Value
Infinity Step 1: PV to year t End of period t, so Gordons method must use t+1 cash flows
Valuation Date
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14 4
In actual valuations compiled by McKinsey, the terminal value is 56% to 125% of valuation
High terminal values are reasonable if cash flow in early years is offset by outflows for capital spending that should generate higher cash flows in later years The terminal value should reflect cash flow and earnings that is at the middle of the business cycle, or in the case of commodities, where prices reflect long-run marginal production cost, or in the case of high growth companies, when the market is saturated
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14 5
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
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14 6
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14 7
EBITDA
Working Capital
Growing the Final Year Ignores the Implicit Return on Investment in the EBITDA and the Compute the Theoretical EV/EBITDA Driven by Grow Final Year Cash Flow at Low Relationship Between Cap Exp Growth and ROIC, Capital Expenditures/Depreciation, Tax Growth Rate EBITDA Growth Rate and Depreciation Rate If Revenue and Expense Growth Rates are Changing, the Growth Rate in Working Capital will not be Correct by Simply Applying the Model and Additional Period After the Last Terminal Growth to the Final Year Working Explicit Year, Where the Revenues and Grow at Final Year Capital Expenses Grow at the Terminal Growth There is a Theoretical Relationship between Compute the Equilibrium Capital Expenditures Capital Expenditures and Depreciation that to Depreciation by Making a Simple Model that Depends on Growth and Depreciation Rates; Extends for Many Periods. This Model is a this Growth Rate Does Not Equal 100% Unless Function of the Plant Life and the Growth in there is No Growth Capital Expenditures Compute Equilibrium Deferred Taxes as Function of Tax and Book Depreciation Rates and Income Tax Rate using a Similar Method Deferred Taxes Reach and Equilibirum Level as Above, with a Long-term Model that that Should be Consistent with Cap Exp Growth Reaches Equilibrium
Capital Expenditures
Either Use the Final Year Capital Expenditures or Set Capital Expenditures Equal to Depreciation
Taxes
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14 8
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15 0
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15 1
Goldman Sachs derived illustrative implied equity values for Constellations implied 40% share of the combined company ranging from $6,822 million to $25,326 million and illustrative implied equity values ranging from $37.76 to $140.16 per share of the common stock of the combined company. Applying the mid-point discount rate of 6.75% and the mid-point perpetuity growth rate of 3.25%, Goldman Sachs derived an illustrative implied equity value for Constellations implied 40% share of the combined company of $12,139 million and an illustrative implied equity value of $67.18 per share of the common stock of the combined company.
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15 2
Lehman Brothers and Evercore estimated a range of terminal values in 2015 based on AT&T management estimates, in 2010 based on consensus research estimates, and in 2008 based on BellSouth management estimates calculated based on selected free cash flow perpetuity growth rates of 1.0% to 2.0% for AT&T management estimates and 1.5% to 2.5% for BellSouth management estimates and consensus research estimates. For BellSouths Wireline segment, Citigroup and Goldman Sachs calculated a range of estimated terminal values by multiplying the BellSouth Wireline segments calendar year 2008 EBITDA by selected multiples ranging from 4.75x to 5.25x. For BellSouths 40% interest in Cingular, BellSouths Wireless business segment, Citigroup and Goldman Sachs calculated a range of estimated terminal values by multiplying Cingulars calendar year 2008 estimated EBITDA by selected multiples ranging from 5.75x to 6.25x.
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October 13
15 3
Without growth, the value is the cash flow (cf x 1+g)) divided by the discount growth
The discounting should also reflect the growth rate Formula 1. Cash Flow for Valuation CF x (1+g) 2. Value at Last Day of Forecast CF x (1+g)/(WACC g) 3. PV of the Value -- discount rate must be at last day of forecast, not mid year
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October 13
15 4
Sustainable growth once stable period has been reached is probably less than the growth used in the explicit forecast period. This means that the multiple should be less as well.
The multiples for evaluating a merger transaction may include synergies and other current market items. The use of similar multiples in terminal value is highly inappropriate. Constant growth rates can also cause problems Using FCF x (1+g)/(k-g) requires the assumption that growth is constant forever, and that the cost of capital will not change over time.
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Formula for Sustainable Growth Cap Exp/Investment Depreciation/Investment Cap Exp/Depreciation x Depreciation Depreciation Implied EV/EBITDA can be established
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15 7
To replace assets will have to pay current costs rather than historic costs that were affected by inflation. If the company has grown, the stable cash flows will reflect current state of the company. Address with simple simulations to derive equilibrium level of capital expenditures relative to depreciation
October 13 15 8
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If the last year cash flow occurs at the middle of the year and it is assumed that the company is sold at the end of the last year, then you should use (1+g)^1.5 rather than (1+g) in discounting
If you use XNPV it is equivalent to computing a daily discount rate with the formula (1+r)^(1/365)-1 and then using the number of days in the discounting process
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15 9
Earnings Valuation
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16 1
P =
R = D/P + G
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2.50
Market to Book
2.00
1.50
1.00
0.50
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% ROE 12.0% 14.0% 16.0% 18.0% 20.0% 22.0%
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16 3
Valuation
164 October 13
Valuation Issues 1. How do you choose between firm and equity valuation (DCF valuation versus Earnings Growth)
Done right, firm and equity valuation should yield the same values for the equity with consistent assumptions. Choosing between firm (DCF) and equity valuation (PE x EPS forecasts) boils down to the pragmatic issue of ease. For banks, firm valuation does not work because small differences in WACC can have dramatic effects on valuation while and if the market value of debt differs from the book value, firm value can cause distortions.
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16 5
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16 6
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16 7
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17 0
- Normalized Net Income = Average ROE * Current Book Value of Equity - Normalized after-tax Operating Income = Average ROC * Current Book Value of Assets - Once earnings are normalized, the growth rate used should be consistent with the normalized earnings, and should reflect the real growth potential of the firm rather than the cyclical effects.
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17 1
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17 3
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17 6
EPS adjustments
Item Profits and losses on operations discontinued during the period Profits or losses on disposals of investments acquired for resale but not held in the ordinary course of business Extraordinary items Gains or losses on the disposal of fixed assets Gains or losses on the disposal of subsidiaries/associates or business units Goodwill amortisation Provisions for reorganisation or restructuring
Note: adjustments only made to the extent disclosure allows and materiality equires
economic
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17 7
20,000 Shares in issue 1 January Rights issue on 30 September Last cum div price before the stock goes ex rights 150,000 One for three 6
3 1 4
18 2 20
Cum rights price Theoretical ex rights price Bonus fraction 150,000 50,000 200,000 20,000 / 185,000 x6/5
Time weighted number of shares in issue 1/1 30/9 Rights issue 1/10 31/12 EPS
0.1081
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Weighted Average
190 million
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18 0
Diluted Shares
If you have agreed to give away shares to someone, then your claim to the cash flow of the company is reduced. In the extreme, if you have given away half of your company away, and the cash flow is the same before and after your give away, then the amount you would pay for the share must account for how much you will give away. In this extreme example, you should reduce the value by . This can be accomplished by using diluted shares rather than basic shares.
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18 1
Option dilution
Calculation of the number of shares in the dilution calculation is illustrated below:
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Equivalence factor approach Net Profit Class A Class B Primary Secondary $300,000 Par value $5.00 $0.50 0.1 25.00c 40.00x 2.5 48.00x 1,200,000 (300,000 / 1,2000,000) (10.00 / 0.25) Class A EPS x equivalence factor (10.00 / 0.25) No. 800,000 4,000,000 Total par value $4,000,000 $2,000,000 $6,000,000 Price $10 $1.2
Secondary to primary equivalence factor Equivalent number of primary shares Class A EPS Class A PE Class B EPS Class B PE
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18 3
Multiple Listings
Fungible shares listed on different exchanges EPS calculated on the basis of total shares - Value equity based on shares held by the investor group to whom your research is directed
State owned
H Shares
A Shares
Total
Number ( million) Price - local Price - RMB Equity Value RMB million
300
30 RMB 5 5 2433
486.7
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October 13
18 4
Year
Calculation
Cumulative expense
Expense
$ 250,000
$ 250,000
$ 500,000
$ 250,000
$ 900,000
$ 400,000
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18 5
Financing The greater the gearing of a company the greater the cost of equity and therefore, all other things being equal, the lower the value and the lower the PE
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18 6
Cash flows should be discounted at cost of capital that reflects the interest rates where the country is located
This means that the risk free rate in the country where the subsidiary is located should be used.
Once the value is established, translate the amount to the home country at the spot exchange rate
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18 7
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18 8
To convert the Baht to Ringgit, use the expected future spot Ringet/Baht exchange rates
Since, as a practical matter, forward exchange rates are not available beyond 18 months, compute future spot rates from interest rate parity Interest rate parity means that if you invest in risk free securities of different currencies, the spot exchange rate must reflect the future values.
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18 9
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October 13
19 0
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19 1
We often talk about free cash flow, sometimes, it is challenging to assess what is "free cash flow or not, may wish to elaborate on that rather than just defining free cash flow in a text book term. The basic point is to keep things consistent. If you define FCF as EBITDA without other income, then the valuation does not include other investments. On the other hand if FCF is defined using Cash B/4 Financing that includes other income, the other investments are included in the valuation
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October 13
19 2
Can the trainer also cover dealing with in-the money options and convertibles? Convertibles can trade as straight debt if it is unlikely that the convertibles will be converted to common shares, or if the conversion option is in the money, it is clear that the convertibles will be switched into common shares. In this case, the ownership share of current shareholders is diluted. If you buy the current shares, you are not really getting the whole company because you will have to give a share of the cash flow to the convertible bondholders.
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19 3
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19 4
Terminal Value
Terminal value, and the use of a stable growth rate. How do you determine that, what is the rule of thumb and how do you determine which year onwards should be terminal year (i.e. how long should your forecasted period be). On how to calculate a WACC, rather than just providing the formula of WACC, it would be useful to give instructions on where to find the market premium data, betas and what is the best method vs the most practical method. Should we include country risk, exchange rate risks etc and how to get them.
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October 13
19 5
LBO Valuation
How can LBOs be valued by making an assumption on target IRRs for the venture cap / private equity investor. Recall the very first simple case that was developed in the class. In this case the equity IRR was driven by the level of leverage and the structure of the debt. Valuation is realistically driven by the equity IRR criteria of developers and not free cash flow or WACC The risk metric boils down to the debt capacity of the LBO and the value of the investment depends on the debt structure. In this case, risk is driven by bankers outside of the company rather than the management or advisors to the company.
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1. 2. 3. 4.
Does the CEO have other board seats? Has the company made takeovers of more than $250 million in the last 3 years? Did the auditor grow up with the company? Do finance writers call the CEO:
- Whiz-kid - Dynamo - Takeover King - Breath of fresh air in the old boardroom
5. 6. 7. 8. 9. 10. 11. 12. 13. Does the company sponsor the highest level of performing arts in the country? Does the Chairman speak at more than 4 seminars a year? Did the share price rocket because of some new technological breakthrough? Has the company recently moved into a luxurious head office? Is the company installing a state-of-the-art computer system? Is the company diversifying into media, resources, high-tech? Has the chief executive been praised by finance writers for innovative financings? Has the chief executive been involved with a previous corporate collapse? Does the Chairman have a private sauna in his office?
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October 13
19 8
Finance Professor
A finance professor received a call from a large financial institution in New York, asking him to interview for a position on their scientific advisory committee. He agreed to go up and interview, knowing that such a position would be prestigious and with the extra income we would be able to purchase more consumer durables. As all of you know, interviews are a long and painful process. The interviews lasted two days and at the end of the last day the professor was interviewing with the chief executive who would ultimately be making the hiring decision. At the very end of the interview, the executive asked him, what is 7 times 3? The finance professor confidently responded, 22. When he got home from New York his family, for once, was eagerly awaiting his return with lists of consumer durables in their hands. How did it go? they asked. Good, he said, except in the last interview they asked me 7x3 and I said 22. Ohh! Dad!!! they cried, its 21! They threw out their lists of consumer durables, knowing he would never get the job. Much to his surprise he got a call 2 weeks later saying hed gotten the position and the firm was having a reception in his honor. At the reception he found the executive and went up to him. Do you remember our interview? the professor asked. Yes, said the executive. And do you remember when you asked me 7x3 and I said 22. Yes, replied the executive, I wrote down your answer. Well the correct answer is 21, said the professor, why did I get the job? Well, said the executive, of all the finance professors we interviewed you were the closest. The moral of the story is, if I can do this, you can do this: pricing bonds and non-American options using monte carlo simulation to replicate the results achieved explicitly using decision trees.
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October 13
19 9
Finance Professors
A medical doctor, an engineer, and a finance professor are at a cocktail party. The medical doctor pompously asserts that the medical profession is the oldest profession. He cites a passage from the Bible, in Genesis where god creates man and woman. Surely, he says, this was the first medical act. The engineer jumps in and says, I remember a passage prior to that, which says, out of the chaos and confusion, God created the earth. Surely, this was the first act of engineering and predates the first medical act.
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October 13
20 0
http://pages.stern.nyu.edu/~adamodar/
www.sec.us.gov -- financial documents www.finance.yahoo.com; www.googlefinance.com; www.valueline.com -- stock prices and financial ratios www.standardandpoors.com; www.moodys.com credit rating and other information www.bondsonline.com credit spreads
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20 1