Valuation Analysis

Judson W. Russell, Ph.D., CFA University of North Carolina-Charlotte

Agenda

Equity Valuation Fundamentals: Intrinsic Value Enterprise Valuation Fundamentals: Free Cash Flow Equity Valuation Fundamentals: Relative Value

Introduction

Valuation is both art and science Art through reasonable, defensible: Assumptions Judgment and interpretation of data Science through application of analytical formulae Valuation is based on future performance

Introduction

Two main valuation questions:

1)What is a company worth by valuation metrics?

2) What can or will a potential buyer pay?

Introduction

Three main valuation methodologies

Intrinsic Value Approach: A stocks price equals the net present value of its dividends. Relative Value Approach: A stocks value is determined by comparing similar stock values. Acquisition Value Approach: Calculate a companys stock price by determining its worth to a third party acquirer.

Golden Rule: Footnote your assumptions

Introduction

EQUITY VALUE:

Value of shareholders interest After interest expense, preferred dividends and minority interest expense Multiples of net income, book value, EPS Other common terms: Market Value, Market Capitalization, Offer Value (in an acquisition context)

Introduction

ENTERPRISE VALUE: Includes all forms of capital Market value of equity, debt, preferred stock, minority interest Before interest expense, preferred dividends and minority interest expense Multiples of sales, EBITDA, EBIT or any other applicable metric (per subscriber, per bed, etc.) Other common terms: Aggregate Value, Firm Value, Total Capitalization, Adjusted Market Value, Transaction Value

Introduction

Equity Market Cap. Enterprise Value

Equity Market Cap. Net Debt

Preferred Stock
Minority Interest

Introduction

COMPARABLE (or similar) in terms of:

Operations
Industry Products Markets Distribution channels Customers Seasonality Cyclicality

Financial Aspects
Size Leverage Margins & Profitability Growth prospects Shareholder base Market conditions (acquisitions) Consideration paid (acquisitions) Circumstances surrounding the transaction
9

Equity Valuation Process

The Graham and Dodd Approach to Security Selection Study the available facts Prepare an organized report Project earnings and related data Draw valuation conclusions based on established principles and sound logic Make a decision

1. 2. 3. 4.

5.

10

Valuation Process

The top-down approach starts with an analysis of alternative economies and security markets. The initial objective is to decide how to allocate investment funds among countries and within countries to bonds, stocks, and cash. The second phase is the analysis of alternative industries. The objective at this stage is to determine which industries will prosper based on your analysis of the economy. The final, third, phase focuses on security selection. The objective is to determine which companies within the selected industries will prosper and which stocks are undervalued.

Analysis of Alternative Economies and Security Markets

Analysis of Alternative Industries

Analysis of Individual Companies and Stocks

11

Valuation Process Example

The top-down analysis for a U.S. homebuilder: Economy GDP will increase 3% Capital Markets Interest rates will remain low Industry Housing starts to stay strong Homebuilding Company Homebuilder to gain market share. Sales will increase by 15% versus the industry average of 10%. Steady profit margins signify a 15% earnings increase.

12

Economic Cycles

RECESSION: Consumer staples (food, drugs, cosmetics, tobacco), utilities, software, and biotechnology firms

RECOVERY: Early stage Consumer Cyclicals (autos, apparel, media, retailers), Consumer Credit (savings and loans), and Transportation (airlines, trucking, railroads)

EXPANSION: Late Stage Basic Materials (chemicals, plastics, paper, wood, metals), Capital Goods (equipment and machinery manufacturers)

13

Industry Analysis

Forecast Sales An insightful analysis when predicting industry sales is to view the industry over time and divide its development into stages. Pioneering development - A Rapid accelerating growth - B Mature growth - C Stabilization and market maturity - D Deceleration of growth and decline - E
Rate of Sales Growth B A D C E

Time

14

Porters Five Forces

POTENTIAL ENTRANTS

SUPPLIERS

INDUSTRY COMPETITORS

BUYERS

SUBSTITUTES

15

Valuation Approach Intrinsic Value

Valuation Approaches Intrinsic Value

The value of an asset is the present value of its expected returns. The process of valuation requires estimates of (1) the stream of expected returns and (2) the required rate of return on the investment. The value of a preferred stock (perpetuity) is simply the stated annual dividend divided by the required rate of return on preferred stock (kp). A preferred stock with an $8 per year dividend and required return of 9% is valued as: V = $8 / 0.09 = $88.89

17

Valuation Approaches Intrinsic Value

The valuation of common stock is more difficult than bonds or preferred stock because an investor is uncertain about the size of the returns, the time pattern of returns, and the required rate of return (ke). However, the value of common stock is still the present value of its future cash flows. The only cash flows an equity investor ever gets are dividends (cash or liquidating). A model to value common stock is the dividend discount model (DDM).

18

Valuation Approaches Intrinsic Value

The DDM assumes that the value of a share of common stock is the present value of all future dividends as;
V = [D1/(1+ke)1 + D2/(1+ke)2 + + D/(1+ke)]

Since estimating D is impossible, other methods have evolved based upon a terminal stock value, or a constant rate of growth.

19

Valuation Approaches Intrinsic Value

Assume an investor wants to buy a stock, hold it for one year, and then sell it. We must evaluate the dividend cash flows as well as the terminal value in one year. These cash flows are then discounted at the investors required rate of return. A company earned $2.50 a share last year and paid a $1 dividend (40% dividend payout). The firm has a consistent record regarding payout and we expect it to earn $2.75 per share during the coming year. We expect the stock to trade at $22 at the end of the coming year. Further, the risk-free rate is 5%, the market return is 10%, and the stocks beta is 1.2. ke = rf + b(E(rm) rf ) = 5 + 1.2 (10-5) = 11%, D1 = E1(dividend payout) = $2.75(.4) = $1.10 V = [D1/(1+ke)1 + Stock Value1/(1+ke)1] V = [$1.10/(1+.11)1 + $22/(1+.11)1] V = 0.99 + 19.82 = $20.81
20

Valuation Approaches Intrinsic Value

When valuing a firm with an infinite holding period we assume that dividends, at some point, exhibit a constant rate of growth. Assume that a firm is in a state of constant growth, we can value the infinite stream of cash flows using the following abbreviated formula: V = D1/(ke - g)

For instance, in our previous example lets assume that the holding period is infinite and the firms dividends are growing at 6% per year perpetually. The dividend in one year was $1.10 and the required rate of return was 11%.

V = $1.10/(.11- .06) = $22.00

21

Valuation Approaches Intrinsic Value

We can employ the same technique for firms that have varying rates of growth by assuming that the growth rate becomes constant, at some point. For instance, suppose we have a firm experiencing rapid growth due to its position in the product cycle. At some point the growth rate has to slow or the firm will become the market! We can accommodate this scenario with a multistage model by discounting the rapid growth phase dividends individually and then determining the terminal value using the constant growth methodology. V = [D1/(1+ke)1 + D2/(1+ke)2 + + (Dn+1/(ke-g)) /(1+ke)n]

22

Valuation Approaches Intrinsic Value

Suppose that ABC Company has a current dividend of $1.00 per share with growth expectations of 20% for each of the next two years. After that point, the firm expects dividends to grow at 4% each year indefinitely. Given a cost of equity of 11%, calculate the value of the firms shares. V = [D1/(1+ke)1 + D2/(1+ke)2 + V2/(1+ke)2] where V2= D3/(ke g) V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2] V = $1.08 + $1.17 + $17.39 = $19.64

23

Valuation Approach Intrinsic Value

DISCOUNTED CASH FLOW ANALYSIS

Intrinsic value of the company Unlevered free cash flows Independent of capital structure Free cash flows generated by the assets that are available to all capital holders Present value of: (1) free cash flows and (2) projected terminal value Terminal value is used to estimate value beyond the forecast period Exit Multiple Method (assumes the sale of the business) Perpetuity Growth Rate Method (3) Discount rate = Weighted average cost of capital (WACC) WACC = ka = wdkd(1-t) + weke

24

Discounted Cash Flow Analysis

Using the DCF technique, BAC constructed a valuation for the Company by adding the present value of the Company's projected after-tax cash flows to the present value of the Company's terminal value. DCF analysis implies the Company's Enterprise Value is: $ 589,680,386
Dollars in Millions

Projected FYE 12/31 Sales -Cash COGS and SG&A EBITDA -Tax Basis Depreciation & Amortization Operating Income 1 -Taxes Net Operating Profit After Taxes +Depreciation & Amortization -Capex for P,P&E -Working Capital Changes Operating Cash Flow Cost of Capital Present Value of Cash Flows 2006 500.0 400.0 100.0 14.1 85.9 34.4 51.5 14.1 17.2 2.2 46.2 12.0% 41.3 $ 1.0 $ 2007 469.8 375.8 94.0 16.2 77.8 31.1 46.7 16.2 17.3 2.1 43.5 12.0% 34.6 2.0 $ 2008 499.6 399.7 99.9 17.8 82.1 32.8 49.3 17.8 17.3 3.5 46.3 12.0% 32.9 3.0 $ 2009 531.1 424.9 106.2 19.6 86.6 34.6 52.0 19.6 17.3 3.4 50.9 12.0% 32.3 4.0 $ 2010 565.3 452.2 113.1 21.9 91.2 36.5 54.7 21.9 17.3 3.8 55.5 12.0% 31.5 5.0 589.7 11.0% 12.0% 13.0% 6.5x 12.0% 5.5x 546.2 525.5 505.8 Exit Multiple 6.5x 613.3 589.7 567.2 Exit Var. WACC Var. Large Cap Co.? 505847.76 7.5x 680.4 653.8 628.6 1.0x 1.0% Y 680423.4 40.00%

Exit Multiple Valuation Method Cumulative Present Value of Cash Flows Present Value of Exit Price Enterprise Value

172.7 417.0 589.7

WACC

Exit Multiple: WACC: Notes: (1) A 40% tax rate was assumed

25

Free Cash Flow Analysis

FCF1 FCF2 FCF3 FCF4 FCF5 FCFn How do we account for the remaining cash flows of the firm?

Terminal Value Approach Constant Growth Method

26

Terminal Value Calculation

A. The Exit Multiple Method

27

The Present Value of the Terminal Value

Discounted Cash Flow Analysis

1 2 3 4 5

2010 EBITDA (Terminal Value) x Exit multiple = Pretax Sales Proceeds (future value)

$113.10 6.5x $735.15 0.5674 $417.14

/ discount factor (back 5 years at 12%)

Present value of terminal value

28

Terminal Value as % of Enterprise Value

Discounted Cash Flow Analysis

Provides a reality check of the DCF value

Higher the %, more of the Enterprise Value is being realized with the assumed sale of the business at the end of the forecast period Confidence level in the 70-85% range, depending on the company and situation

29

Terminal Value as % of Enterprise Value

Discounted Cash Flow Analysis

How much of the Enterprise Value for the Company is being generated by the Terminal Value? What is your comfort level with this percentage?

Present Value of Exit Multiple = $417 Enterprise Value = $589.7

Percentage = $417/$589.7 = 70.7%

30

Terminal Value Calculation

B. The Perpetuity Growth Method

31

Discounted Cash Flow Analysis

Now well look at the perpetuity growth technique to capture the terminal value of Company. The terminal value captures all future cash flows of the firm assuming a constant growth factor. The operating cash flow of the firm in 2010 is $55.5. Assuming a growth rate of 4% the operating cash flow in 2011 would be $57.72. We have a discount factor of 12% and a growth factor of 4% with a cash flow of $57.72.

32

Perpetuity Growth Formula

Discounted Cash Flow Analysis
Terminal Value = FCFN+1 (ka - g)

where: FCFN+1 = steady-state free cash flow in period N+1 g = nominal perpetual growth rate ka = discount rate
Terminal Value = $55.5(1.04) =$57.72= $721.5 .12-.04 0.08 Present Value of Perpetuity Growth Terminal Value = $721.5/(1.12^5) = $409.40
33

Relative Value Analysis

34

How do we use relative value?

The hardest part of relative value is finding comparable firms. Once you have a decent list of comparables you need to determine which scaling variable to? Next, you want to compare your target firms multiple to the average of the comparable set. Finally, make sure that you account for differences, e.g. leverage, market position, patents, etc.

35

Comparing PE Ratios across a Sector

36

Comparing PE Ratios across a Sector

37

Relative Value

Investors prefer to estimate the value of common stock using an earnings multiplier model. P0 = D1/(ke - g)

Divide both sides by next years projected earnings:

P0/E1 = (D1/E1)(1/(ke - g))

The P/E ratio (forward) is determined by: The expected dividend payout ratio (D1/E1) The required rate of return on the stock (ke) The expected growth rate of dividends (g)

38

Relative Value

Assume that a firm has an expected dividend payout of 40%, a required rate of return of 11%, and a growth rate of dividends of 6%. Next years earnings (E1) are expected to be $2.75. P0/E1 = (.40)(1/(.11-.06)) = 8.0x

The value of the stock today is based on the P/E1 and estimate of E1. P0 = P0/E1 x E1 = 8.0 x $2.75 = $22.00
39

Relative Value

The best known measure of relative value for common stock is the P/E ratio or the earnings multiplier. Analysts have also turned their attention to other measures of relative value: Price/book value (P/BV) : market value of the company divided by its book value. This metric is used a great deal with financial stocks since many of their assets are carried at values very close to market value. This metric can be used for firms with negative earnings or cash flows. Several studies have indicated that P/BV is a good indicator of future performance. Price/cash flow (P/CF) : market value of the company divided by its cash flow. Price/sales (P/S) : market value of the company divided by its sales.

40

Expected Growth Rate

When a firm retains earnings and acquires assets, if it earns some positive rate of return on these additional assets, the total earnings of the firm will increase. The rate of earnings growth depends on the proportion of earnings retained and the rate of return it earns on the new assets acquired. Specifically, the growth rate (g) of equity earnings without external financing is equal to the percentage of net earnings retained (retention rate, b) times the rate of return on equity capital (ROE).
g = (retention rate)(return on equity) g = (b)(ROE)

This growth rate is called the internal or sustainable growth rate. The firm can increase its rate of growth by 1) retaining a larger portion of its earnings for reinvestment in the firm or 2) increasing its ROE (recall, ROE = profit margin x total asset turnover x financial leverage).

41

Pulling it all together

Firm XYZ is trading at $18 currently. Last years earnings were $2.00 per share. The firms ROE is 10% and you expect it to stay that way for the foreseeable future. The firm has a stable dividend payout policy of 40%. The current nominal risk-free rate is 7%, the expected market return is 12% and XYZs beta is 1.2. Value XYZ and indicate what you should do based on your estimate. Determine required rate of return: ke = 7% + 1.2(12%-7%) = 13% Determine growth rate: g = (.60)(10%) = 6% Determine last years dividend: $2.00(.40) = $0.80. Determine next years dividend: D1 = D0(1+g) = $0.80(1.06) = $0.85 Calculate the value projection: V = D1/(ke - g) = $0.85/(.13-.06) = $12.14 Compare the stock value to its current market price: $12.14 vs. $18.00 Sell recommendation.

1. 2. 3. 4. 5. 6. 7.

42

Valuation Analysis

2. Overview of Conrail Inc.

Conrail Inc.
Company Description
Conrail, through its wholly-owned subsidiary Consolidated Rail Corporation, provides freight transportation services within the northeast and midwest United States. Conrail interchanges freight with other United States and Canadian railroads for transport to destinations within and outside Conrail's service region. Conrail operates no significant line of business other than the freight railroad business and does not provide common carrier passenger or commuter train service.

Consolidated Rail Corporation is a Pennsylvania corporation incorporated on February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization Act of 1973, the rail properties of many of the railroads in the northeast and midwest region of the United States which had gone bankrupt during the early 1970's, the largest of which was the Penn Central Transportation Company ("Penn Central"). The US government sold its 85% stake to the public in 1987.

44

CSX and Norfolk Southern

Analysis of Potential Acquirers

Conrail is the ideal extension for both into the Northeast Northeast corridor is a must for a transcontinental railroad Strategic positioning with 2 major Western rails

45

Financial Overview of Conrail

The Conrail Case Study

Date: October 14, 1996 (pre-CSX merger announcement)

CRR Financial Information as of 6/30/96 Dollar amounts and shares in millions LTM Revenues LTM EBITDA LTM EBIT Diluted Shares Outstanding (a) (b) Market Capitalization of Equity ESOP Preferred Stock Total Debt (at book values) Cash and equivalents Enterprise Value $3,712 $993 $705 81.718 $5,802 $281 $2,078 $28 $8,133 Multiple based on 10/14/96 price of $71.00 2.19x 8.2x 11.5x

(a) 81.067 million common shares outstanding and 1.556 million options with an average strike of $41.28. Option proceeds assumed to repurchase shares at current share price under the treasury stock method. (b) Excludes ESOP junior preferred stock convertible into 9.75 million common shares.

46

3. Comparable Public Company Analysis

Analysis of Selected Publicly Traded Companies Public Comparables Trading Comparables Comp Cos Common Stock Comparisons

Comparable Public Company Analysis

Determining the Appropriate Universe

Previous analyses of other bankers

Industry specialists M&A

Proxy Statement - Peer group index 10-K / IPO Prospectus - Competition section Research (respect the Chinese Wall) S&P Tearsheets, Value Line, Bloomberg SIC code screen from FactSet 48

Comparable Public Company Analysis

Public Information Checklist

1) Most recent 10-K and/or annual report 2) 10-Q from latest quarter 3) News announcements (before required filing) 4) Research reports and EPS estimates

Use SEC-filed documents whenever 49 possible

Valuation Analysis

What comparables should be used to value Conrail?

Summary of the Railroad Industry

1995 Financial Information Name (ticker) Burlington Northern Santa Fe (BNI) Total Rev $8,170 Rail Rev - $ $8,170 Rail Rev - % 100% Non-Rail (%-Rev) Comments BNI operates in 35 states, mostly in the western US. In September, 1995 BNI took control of Santa Fe Pacific, making it the second largest railroad in the US. Canadian National was owned by the government until late 1995 when it was privatized. As a result of this transaction, as well as previous governmental ownership, its financial statements are rather messyeg., there are significant NOLS, and the capital structure is strange. Although no longer owned by the Canadian government, CNI, as all Canadian railroads, operates under government regulation. CNI has some lines that overlap with Conrail in the northeastern US. CP Ships (12%) Energy (34%) Real estate (12%) Obviously another Canadian railroad. Note the rail and non-rail revenue percentages exclude inter-company eliminations. Do you include the company you are trying to value in the list of comparable companies?

Canadian National (CNI)

C$4,100

C$4,100

100%

Canadian Pacific (CP)

C$7,946

C$3,757

47%

Conrail (CRR)

$3,686

$3,686

100%

51

Summary of the Railroad Industry

1995 Financial Information Name (ticker) CSX (CSX) Total Rev $10,504 Rail Rev - $ $4,819 Rail Rev - % 46% Non-Rail (%-Rev) Shipping (38%) Intermodal (9%) Barge (5%) Real estate (2%) Comments Although only 46% of CSXs revenues are from rail operations, the shipping, intermodal, and barge lines are all transportation businesses. Notwithstanding the fact that rail is only 46% of CSXs revenues, rail contributes 77% of operating income. FLAs rail operations run the length of Florida, along the Atlantic coast. FLA has a unique ownership structure. It is owned 54% by St. Joe Paper Company, which is in turn 69% owned by the DuPont family. The DuPonts chief interest in FLA is its extensive land holdings. IC is a single track line that runs up and down the Mississippi River. Unlike the other large US railways, IC principally hauls agriculture commodities, rather than freight. Asset mgt (31%) Other (4%) The rail operations run through MO, AR, TX, LA, MS, AL. The Asset Management segment is comprised of two prominent investment operations: the Janus and Berger funds.

Florida East Coast (FLA)

$201

$149

74%

Real estate (14%) Mtr carrier (12%)

Illinois Central (IC)

$644

$644

100%

Kansas City Southern (KSU)

$775

$502

65%

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Summary of the Railroad Industry

1995 Financial Information Name (ticker) Norfolk Southern (NSC) Total Rev $4,668 Rail Rev - $ $4,012 Rail Rev - % 86% Non-Rail (%-Rev) NAVL (14%) Comments Its rail operations are principally in the SE and MW. North American Van Lines (NAVL) is its other major segment. Rail accounts for 94% of consolidated operating income. The countrys largest railroad operating throughout the western US. Recently acquired Southern Pacific. An extremely profitable railroad operating in the upper Midwest. Also has equity, investments in rail operations in New Zealand and the UK.

Union Pacific (UNP)

$11,100

$9,874

90%

Trucking (9%) Logistics (1%)

Wisconsin Central (WCLX)

$263

$263

100%

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Valuation Analysis

Required Analytical Adjustments

One-Time Non-Recurring Items

Subjectivity of the Analysis

Normalizing the income statement for one-time items

Adjust for non-recurring items (gains and losses)

What was Conrails normalized 1995 income statement?

What adjustment needs to be made to operating income? What adjustment needs to be made to net income? What adjustment needs to be made to taxes?

55

Conrails 1995 Income Statement

CONRAIL INC. CONSOLIDATED STATEMENTS OF INCOME [CAPTION] ($ In Millions Except Per Share Data) [S] Revenues Operating expenses Way and structures Equipment Transportation General and administrative Asset disposition charge (Note 2) Early retirement program (Note 9) Total operating expenses Income from operations Interest expense Loss on disposition of subsidiary (Note 10) Other income, net (Note 11) Income before income taxes and the cumulative effect of changes in accounting principles Income taxes (Note 6) Income before the cumulative effect of changes in accounting principles Cumulative effect of changes in accounting principles (Notes 1, 6 and 7) Net income Years ended December 31, ---------------------------1995 1994 1993 ---------------[C] [C] [C] $3,686 $3,733 $3,453 ---------------485 766 1,324 370 285 -----3,230 -----456 (194) 130 -----392 128 -----264 -----$ 264 ====== 499 815 1,379 350 84 -----3,127 -----606 (192) 118 -----532 208 -----324 -----$ 324 ====== 492 703 1,283 384 -----2,862 -----591 (185) (80) 114 -----440 206 -----234 (74) -----$ 160 ======

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Note 2: Asset Disposition Charge

2. Asset Disposition Charge -----------------------Included in 1995 operating expenses is an asset disposition charge of $285 million, which reduced net income by $176 million. The asset disposition charge resulted from a review of the Company's route system and other operating assets to determine those that no longer effectively and economically support current and expected operations. The Company identified and has committed to sell 1,800 miles of rail lines that are expected to provide proceeds substantially less than net book value. In addition, other assets, principally yards and side tracks, identified for disposition have been written down to estimated net realizable value.

Normalizing Conrails Income Statement for 1995

Reported Operating Income Pretax Adjustment Taxes Incremental Tax Adjustment Net Income After-tax Adjustment $456 128 264 Adjustment 000000000 000000000 000000000 Normalized 000000000 000000000 000000000

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4. Comparable Acquisition Analysis

Analysis of Selected Acquisitions Acquisition Comparables Acq Comps Deal Comps

Comparable Acquisition Analysis

Determining the Appropriate Universe

Previous analyses of other bankers Screen for comparable M&A transactions

Securities Data Corp. (SDC) Compile list from SIC code screen

Other possibilities:

Industry newsletters, journals M&A journals and almanacs News services Research reports
59

Comparable Acquisition Analysis

Information Checklist

Financial information

SEC filed documents if possible Summary description of the transaction, key dates,
premiums paid

SDC M&A summary

News run Merger documents (if applicable) Research & EPS estimates (if applicable)

Form 8-K, Proxy/S-4 for pro forma financial info

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Comparable Acquisition Analysis

Looking for comparability regarding:

transaction size Nature of acquirer: Recent timeframe

Strategic buyer financial buyer

61

Comparable Acquisition Analysis

Comparable Acquisition Analysis - Multiples Summary (Dollars in Millions) Effective Date Comparable Industry Transactions Transaction Enterprise Value Enterprise Value as a Multiple of: Sales EBITDA

Target

Acquiror

Jun-96

CCP Holdings, Inc.

Illinois Central Corp.

$157

2.06x

5.3x

Comments: CCP was a small railroad owned by three individuals. Sep-96 Southern Pacific Union Pacific Corp. $5,500 1.74x 7.7x

Comments: This is a large, recent transaction.

May-95 Chicago & North West. Union Pacific Corp. $2,611 2.25x 8.3x The statistics in

Comments: Union Pacific had owned 32% of CNW, and completed the purchase of the remaining 68%. the chart reflect the transaction as if the entire 100% were purchased. Sep-95 Santa Fe Pacific Burlington Northern $5,106 1.90x

8.5x

Comments: Another large, recent transaction.

Cancelled

Kansas City Southern

Illinois Central Corp.

$1,625

3.25x

9.0x

Comments: The transaction from mid-1994 was cancelled since the parties could not agree on how to value the asset management businesses.

(1) Adjusted average omits the high and low values.

62

Comparable Acquisition Analysis

Comparable Acquisition Analysis - Multiples Summary (Dollars in Millions) Effective Date Comparable Industry Transactions Transaction Enterprise Value Enterprise Value as a Multiple of: Sales EBITDA

Target

Acquiror

Sep-92

Midsouth Corp.

Kansas City Southern

$347

3.39x

8.8x

Comments: The target operates rail lines in La, Miss, Ala. Apr-90 Soo Line Corp. Canadian Pacific Ltd. $528 0.98x 7.4x

Comments: The target operates principally in the upper Midwest---Minn and Wisc.

Oct-89

CNW Corp.

CNW Acquisition Corp.

$1,651

1.65x

7.1x

Comments: A very successful acquisition by the Blackstone group, a major financial buyer in the US.

Jul-89

Illinois Central Rail.

The Prospect Group

$672

1.22x

5.8x

Comments: Another very successful LBO, this time by another prominent financial buyer, the Prospect group.

(1) Adjusted average omits the high and low values.

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5. Discounted Cash Flow Analysis

Discounted Cash Flow Analysis

In this section we will project free cash flow for Conrail and determine the enterprise value by discounting these cash flows at the appropriate discount rate. We will also explore the following:

valuation using a terminal exit multiple valuation using a perpetuity growth formula valuation incorporating the effects of synergies

65

Discounted Cash Flow Analysis

As the title implies we will need to determine Conrails cash flows. Typically, we will want to look at the past three years of financials to form a basis for our projections. The projection period is usually five years and then either:

an assumed sale of the firm takes place to capture the value of all future cash flows (exit multiple approach), or we value all future cash flows assuming that growth will remain constant at a level approximately equal to the economys GDP growth level (perpetuity growth approach).

66

Discounted Cash Flow Analysis

Since we are interested in the firm value, we will look at unlevered after-tax cash flows to the firm. This allows us to view the firm value to all stakeholders, i.e. debt, preferred, and common. The basic approach is to:

project sales determine EBITDA subtract the tax deductible depreciation and amortization amounts subtract taxes adjust for non-cash expenses, capital expenditures, and working capital needs.

67

Discounted Cash Flow Analysis

Lets start with a historical look at Conrails cash flows:
Sales
S ales Grow th

Conrail Historical Operating Cash Flow FYE 12/31 1994 1995 1996 3733.0 3686.0 3797.0
8.1% -1.3% 3.0%

CAGR 1994-1996 0.9%

-Cash COGS an d SG&A EBITDA

E B IT DA Margin

2766.2 966.8
25.9%

2650.2 1035.8
28.1%

2726.2 1070.8
28.2%

5.2%

-Tax Basis Depr eciation & Am or tization 276.2 Oper atin g In com e 690.6
Op eratin g In come Margin 18.5%

294.9 740.9
20.1%

307.6 763.2
20.1%

5.1%

-Taxes N et Oper atin g P r ofit After Taxes +Depr eciation & Am or tization -Capex for P ,P &E -Wor k in g Capital Ch an ges Oper atin g Cash F low

265.9 424.7 276.2 410.6 15.5 274.7

285.2 455.6 294.9 405.5 42.9 302.2

293.8 469.4 307.6 417.7 26.4 332.9

5.1%

10.1%

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Discounted Cash Flow Analysis - BASE CASE

The discounted cash flow ("DCF") analysis is based on Conrail's historical performance and Wall Street research expectations. * Sales are projected to reach $4,401 million by FY 2001 through organic growth. Sales figures for 1997-2001 assumed 3% growth per year. * Rail Operating Ratio falls from 79.9% in 1996E to 77.9% in 1997 and by an additional 1% per year for 1998-2001, hitting 73.9% in 2001. This operating improvement is based on Conrail's stated goal of achieving an operating ratio of 75%. * All working capital needs are projected to support the annual growth. * Capital expenditures are estimated to be 11.5% of revenues in 1997 and 11% for 1998-2001, in line with historical levels. Depreciation is a reasonable estimate from the capital expenditures and existing PP&E base. * The following table compares Conrail's historical operating results to the projections: Historical 1995 (1.3%) 79.9% 28.1% 20.1% Projected 1999 3.0% 75.9% 32.3% 24.1%

Revenue Growth Rail Operating Ratio (1) EBITDA Margin Operating Inc. Margin

1994 8.1% 81.5% 25.9% 18.5%

1996E 3.0% 79.9% 28.2% 20.1%

1997 3.0% 77.9% 30.2% 22.1%

1998 3.0% 76.9% 31.3% 23.1%

2000 3.0% 74.9% 33.3% 25.1%

2001 3.0% 73.9% 34.3% 26.1%

(1) Rail Operating Ratio = Rail Operating Expenses (including depreciation) divided by Rail Revenues

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Discounted Cash Flow Analysis

Additional assumptions:

Taxes are assumed to be 38.5% of operating income. Working capital will be:

-$34.0 million -$22.1 million -$23.1 million -$24.3 million -$25.6 million

1997 1998 1999 2000 2001

Cost of capital is 11% for Conrail based on the stability of the firms cash flows. We will use an exit multiple of 8x EBITDA in 2001 to value the sale of Conrail. This multiple compares to an average 8.3x EV/LTM EBITDA multiple using Comparable Acquisition Analysis.

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Terminal Value

A. The Exit Multiple Method

The Present Value of the Terminal Value

Discounted Cash Flow Analysis

Note: Does not match the $7,177.2 on the previous page due to rounding.

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Terminal Value as % of Enterprise Value

Discounted Cash Flow Analysis

Provides a reality check of the DCF value

Higher the %, more of the Enterprise Value is being realized with the assumed sale of the business at the end of the forecast period Confidence level in the 70-85% range, depending on the company and situation

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Terminal Value as % of Enterprise Value

Discounted Cash Flow Analysis

How much of the Enterprise Value for the Conrail Base Case is being generated by the Terminal Value? What is your comfort level with this percentage?

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B. The Perpetuity Growth Method

Discounted Cash Flow Analysis

Now well look at the perpetuity growth technique to capture the terminal value of Conrail. We will combine this technique with an analysis of the synergy benefits from a possible Norfolk Southern or CSX acquisition of Conrail.

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Synergies Valuation
Discounted Cash Flow Analysis

Analyze for the synergy value independently

Determine the DCF value with synergies

Realization percentage for additional sensitivities analysis What is the timing of the realization?

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Synergies Valuation
Discounted Cash Flow Analysis

Terminal Value by Perpetuity Growth Method

Use a steady-state FCF Maintenance CapX (Depreciation = CapX) No deferred taxes Estimate steady-state working capital needs

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Perpetuity Growth Formula

Discounted Cash Flow Analysis

Terminal Value

FCFN+1 (r - g)

where: FCFN+1 = steady-state free cash flow in period N+1 g = nominal perpetual growth rate r = discount rate

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Discounted Cash Flow Analysis - SYNERGIES

The Synergies valuation analysis was created to calculate the present value of the expected net sales and operating savings benefits from a possible Norfolk Southern or CSX acquisition of Conrail.

* Incremental revenue synergies from single line service, new coal traffic and highway-to-railway transfers, less of losses from enhanced competition

* Operating cost savings from reduction in general and administrative, transportation, and equipment expenses.
* Additional capital expenditures are assumed for roadway, equipment and terminals, plus cash severance costs. Net investments avoided are assumed in years 2000 and 2001. * Synergies are assumed to grow at 3% per year in perpetuity.

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Discounted Cash Flow Analysis - SYNERGIES

Using the DCF technique, Bank of America constructed a valuation for the estimated syneriges of a possible Norfolk Southern or CSX merger with Conrail.

Assumes 100% Realization

Dollars in Millions

DCF analysis implies that the synergies are worth:

$2,794 million

Projected FYE 12/31 Incremental Sales -Cash Costs to Achieve Incremental Sales Net Incremental Sales +Cost Savings Operating Income Contribution (1) -Taxes Net Operating Profit Contribution After Taxes -Merger Outlays & Costs / Investments Avoided Net Operating Cash Flow (2) Cost of Capital Present Value of Cash Flows $ $ Perpetuity Valuation Method Cumulative Present Value of Cash Flows Present Value of Terminal Value Enterprise Value

1997 227.6 (186.2) 41.4

81.0 122.4 (47.1) 75.3 (551.7) (476.4) 13.0% (421.6) 1.0 $ 1.0 $

1998 544.8 (448.3) 96.6

310.3 406.9 (156.7) 250.2 (439.7) (189.4) 13.0% (148.3) 2.0

1999 881.0 (722.4) 158.6

529.3 687.9 (264.9) 423.1 (262.1) 161.0 13.0% 111.6 3.0

2000 907.5 (744.1) 163.4

545.2 708.6 (272.8) 435.8 34.5 470.3 13.0% 288.4 4.0

2001 934.7 (766.4) 168.3

561.5 729.8 (281.0) 448.8 34.5 483.3 13.0% 262.3 5.0 5.0 2,794.4 12.0% 13.0% 14.0% 3.0% 13.0% Perpetuity Growth Rate 2.5% 3.0% 3.5% $3,070.4 $3,250.0 $3,450.7 2,653.2 2,794.4 2,950.4 2,311.8 2,425.0 2,548.8 Growth Rate Var. WACC Var. Large Cap Co.? 2311840.68 0.5% 1.0% Y 3450738.5 38.50%

2.0 $

3.0 $

4.0 $

$92.4 2,702.0 $2,794.4

WACC

Perpetuity Growth Rate: WACC: Notes:

(1) A 38.5% marginal tax rate was assumed. (2) A higher WACC of 13.0% was utilized give the uncertainty of synergy realization.

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Terminal Value of the Synergies

Discounted Cash Flow Analysis

Note: Does not match the $2,702 on the previous page due to rounding.

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What is the Total DCF for Conrail?

What is the Total DCF Valuation?

Discounted Cash Flow Analysis

Base Case DCF Conrails FCFs + Synergies $8,880 million + = $10,280 million

50% of $1,400 million

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