Equity Valuation
Contents - overview
• 0. About valuation: introduction ―McKinsey Valuation Best Practice‖ • 1. Valuation Frameworks – the ―technology side‖ • 2. Analyzing historical performance • 3. Projecting future performance • 4. Continuining Value • 5. WACC • 6. Relative Valuation • 7. Examination
— 50% written exam — 50% valuation case
1
Andy Löflund
Goal of the module
1. Understand link between stock market valuation and fundamentals
2. Acquire and develop practical valuation skills - “best practice” 3. Understanding sources of corporate value 4. Skills&Knowledge to pass CIIA EV in final exam
2
Andy Löflund
CIIA EV Syllabus
1. Equity Markets and Structures
BKM: Ch 2-3, SAB: Ch. 2-3 mostly Covered in Module 1: Mats Hansson + market regulation
2. Understanding the Industry Life Cycle BKM Ch 16 (17 new) 5 pages only 3. Analysing the Industry Sector and its Constituent Companies Mostly very basic macro definitions (Jan Antell Module covers), BKM ch 16 (17 new) 19 pages only 3.1. The Industry Sector 3.2. Characteristics of the Industry 3.3. Macro Factor 3.4. Forecasting For Companies in the Sector 3.5. Balance Sheet Factors 3.6. Corporate Strategy 3.7. Valuations
3
Andy Löflund
CIIA EV Syllabus cont.
4. Understanding the Company BKM Ch 16 (17 new) 17 pages 4.1. Historical performance 4.2. Segmental Information 4.3. Inventory, debtors and crediitors 4.4. Depreciation and amortization 4.5. Completing the forecasts
5. Valuation Models of Common Stock BKM Ch 17 (18 new), BM esp. ch 17 Leverage and WACC (Corporate Finance too), SAB ch. 12, 16-18 5.1. DDM 5.2. FCFF 5.3. EVA; MVA, CRROI, Abnormal earnings model 5.4. Measures of relative value
4
Andy Löflund
CGW: Valuation (4th ed.)
Much deeper, practioner oriented book Both for Corporate Developers and Equity/Industry Analysts Industry standard best seeling guide to Valuation “Best valuation book”
Ch. 3 Fundamental Principles of Value Creation (Ch 4) Ch. 5 Frameworks for Valuation Ch. 6 Thinking About Return on Invested Caital and Growth Ch. 7 Analyzing Historical Performance Ch. 8 Forecasting Performance Ch. 9 Estimating Continuing Value Ch. 10 Estimating Cost of Capital Ch. 11. Calculating and Interpreting Results Ch. 12 Using Multiples for Valuation
5
Andy Löflund
Written exam 50%
1-2 essay questions
• Copeland-Goedhart-Wessels: Valuation: Ch, 3, 5-12 • Lecture notes
1-2 valuation problems
• Relative valuation • DCF • FCF • Cost of capital
6
Andy Löflund
Valuation Case 50%
Task: Assess fundamental value of company X by applying CGW Valuation Framework
Teams w/ 3-4 persons
Deadline:
7
Andy Löflund
Econ101: Supply and demand
Prices / values increase when demand exceeds supply Prices / values fall when supply exceeds demand OK. But why does this happen? 1. Unique onetime-transaction = severe contraints in demand and supply forces 2. New information has arrived that changes the expected benefits of ownership of an asset
8
Andy Löflund
“Benefits of owning”?
Critical decision point is current transaction price vs expected benefits from ownership!
BUY (hold) if benefits from ownership exceed potential purchase price = good, value-increasing investment decision
SELL (short) if prevailing price exceeds benefits from owning the asset = good, value creating financing decision (= Short selling = “stock lending”; essentially take a loan indexed to value
of a stock” => profit from price drops = “negative interest on loan”) 9
Andy Löflund
Value creation
= Necessary condition for profitable growth
1. Scarce resources are used as efficiently as possible 2. Beating industry/market peers 3. Maintaining competitive edge 4. Attract more capital 5. Create basis for higher compensation levels for (talented) agents => better pay
(Side note: Industrialism and Global warming problem: we haven’t yet been able to correctly price all input resources [fresh air, rain forests…]) True long run value creation must be based on true pricing of all inputs.
10
Andy Löflund
“Benefits of owning”?
OK. But what are the “benefits from owning an asset”? 1. Cash flow rights
1. Dividends (including their growth potential)
2. Control rights
1. Set corporate policy / active management 2. Get access to corporate resources
3. Favorable risk premium If you can fund an investment cheaper than others, certain cash flow stream will be worth more to you than others => risks are being mispriced in the market
11
Andy Löflund
Listed vs private investments
a) Market listed stock = consensus expectations revealed in market price continuously
Very few constraints on demand and supply Almost non-existant information monopolies Need to move very quickly on information
=> Efficient market hypothesis Utility of analysis = low
(others have already done it)
b) Private investments = no visibility
Possibly huge constraints on demand and supply forces Monopolies on ideas / resources Likely very inefficient market Utility of analysis = potentially very high
12
Andy Löflund
Valuation defined
= “personal process of attempting to increase one’s understanding of where, why and how benefits from ownership happen”
That process will be time-consuming, hard work. How motivated am I? Benefits vs costs = extra value created thanks to analysis minus costs of conducting the analysis
13
Andy Löflund
Arguments against valuation
1. “No one can forecast” 2. “This time is different”
3. “Investors are not rational”
4. “Numbers can always be tweaked to serve a purpose” 5. “Life can’t be reduced to some formula exercise”
14
Andy Löflund
Arguments for valuation
All of economics = “allocation of scarce resoures”
• Undervalued activities => expand! (buy) • Overvalued activities => shrink (sell)
• E.g. decide what to do in…
1. Corporate restructurings 2. M&A deals 3. LBO:s 4. Capital structure optimizing 5. Value Based Management 6. IPO pricing 7. Capital budgeting 8. Corporate development 9. Real estate appraisals 10. Active money management
15
Andy Löflund
Alternative behavioral decision models
Basis for resource allocation decisions - how can you do it? 1.
2.
Do not invest in understanding => 100% (gut) feeling based choices
Do not invest in understanding, but watch closely what others are doing and follow them (herding) because they are likely to be onto something
want and hope markets to be inefficient so there is always time for followers also to benefit from fashion waves
3.
Invest in understanding, build own opinion about value, go against the crowd if supported by analysis
4.
If possible adopt a passive investment style without investment in understanding enjoying market returns (no more no less)
1. No do, if you’re the CEO / corporate guy (corporate job) 2. No do, if you run an active fund (wealth management job) 3. No do, if you work with M&A:s or related deals (investment bank job)
16
Andy Löflund
Misconceptions about valuation
“Valuation...” Myth 1: is an objective search for “true” value
• Fact 1.1: All valuations are biased. The only questions are how much and in which direction • Fact 1.2: The direction and magnitude of the bias depends on salary level and boss (motivation)
Myth 2.: provides a precise estimate of value
• Fact 2.1: There are no precise valuations (+/-15% error ―normal‖) • Fact 2.2: The payoff to valuation is greatest when valuation is least precise
Myth 3: . is better the more quantitative a valuation model is
• Fact 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model • Fact 3.2: Simpler valuation models do much better than complex ones
17
Andy Löflund
Valuation
Purpose: Profit from informed investments!
1. Detect under- (over)valuation
2. Buy undervalued / sell overvalued 3. Eliminate market risk by finding similar (perfectly correlated) asset => take opposite position
18
Andy Löflund
Valuation goals
Example: You believe Hokia is underpriced at €25 (fair value 25.5) and Notorola overpriced at €13.5 (fair value 13.23). Suppose Hokia and Notorola betas are 1.4 against a broad market index. What should you do, given that, within two weeks,
a) fair prices will be established for sure.
b) actual prices are affected by market conditions which could go up or down by 4%.
c) mispricing still prevails unchanged.
d) It turns out analysis was misguided and actual fair values were Hokia: 24.55 Notorola: 13.77.
19
Andy Löflund
Example:
Answers:
a)
b) c) d)
20
Andy Löflund
1. Valuation means...
...always taking a stand on:
1. Company future Earnings/Cash Flow potential
• ―profitable growth‖ • how profitable? • for how long?
2. Required investments to sustain growth
• Working capital needs • CapEx/Acquisition needs
3. The riskiness of the company’s stock
• in relation to other investment alternatives
21
Andy Löflund
1. Valuation process (McKinsey)
1. Framework for valuation technique (ch. 5) 2. Strategy, Profitability, Industry development => ROI & Growth? (ch. 6) 3. Analyzing historical performance (ch. 7) 4. Forecasting future performance (ch. 8) 5. Continuing value (ch. 9) 6. WACC (ch. 10) 7. Interpreting results (ch. 11)
+ Using Multiples for Valuation (ch. 12)
22
Andy Löflund
1. Typical valuation process (McKinsey)
1. Choice of internally consistent realistic valuation model 2. Forecast of model inputs
1. 2. 3. 4. 5. ROIC:s Invested Capital Investment needs Growth rates Cost of capital (discount rate)
Usually based upon historical analysis of company numbers + benchmarking to industry peers
3. Adjusting historical inputs to strategic position of the company in its industry
4. Eye for details
1. Dealing with capital structure and financial leverage 2. Dealing with the long horizon of equity Etc. 23
Andy Löflund
1. Valuation - summary
Cash Flow
FCFFt
Enterprise Value
Cost of Capital
WACC
NOPLAT t
./.
Net Investmentst
kE
kD
Target D/V
ROI forec. period T
ROI postforec. period
NWCt
+
CapExt
rf
+
CVT bE
+
Default premium
*
Equity risk premium
24
Andy Löflund
1. Re-cap of valuation technologies (Ch. 5)
A. Discounted cash flow methods (=“as it looks today” value)
• 1. Direct equity valuation
— 1.1. Dividend discount model (DDM) — 1.2. Free Cash Flow to Equity model (FCFE) — 2.1. Free Cash Flow to Firm model (FCFF)
• 2. Firm/‖enterprise‖ valuation
B. Relative valuation
– 2.1.1. WACC – 2.1.2. APV – 2.1.3. (Economic Profit and Capital Cash Flow models)
C. Option based approaches (= value of active management)
• Binomial, ―tree‖ models • more or less analytical formulas (Black-Scholes) • (Adjusted) Book value - ―substance value‖
— provides lower bound for value only] 25
• Valuation ratios (benchmarked against ―industry peers‖)
[D. Other valuation methods (old school)
Andy Löflund
1.1. Generic valuation model
• Generic valuation equation = ―Present Value‖
ECFt T E CFt EVT V0 t 1 k t 1 1 k t t 1
• where
• k = risk-adjusted discount rate or ―required rate of return‖
— defined consistently with the cash flow being discounted! frequently assumed constant through time (=we neglect term structure effects!)
• E[CF] = expected cash flow of investment
• V stands for ―Value‖
— E[VT] = ―terminal‖, ―horizon‖ or ―continuing‖ value which slices up the valuation into a ―forecast period‖ 1-T and a ―horizon period‖ T+1 to inf.
26
Andy Löflund
1.1. Frameworks for DCF-based valuation
Model Measure Discount factor Assessment Enterprise DCF Free Cash Flow Works best for projects, business units, and Weighted average companies that manage their capital structure to a cost of capital target level Weighted average cost of capital Explicitly highlights when a company creates value Unlevered cost of equity Highlights changing capital structure more easily than WACC-based models Compresses free cash flow and the interest tax shield in one number, making it difficult to compare performance among companies and over time Difficult to implement correctly because capital structure is embedded within cash flow. Best used when valuing financial institutions.
Economic profit Adjusted Present Value
Economic profit
Free Cash Flow
Unlevered cost of Capital Cash Flow Capital Cash Flow equity Cash flow to Equity Cash Flow Equity Levered cost of equity
27
Andy Löflund
1.1. Value of a multibusiness company (all present values, $ mill.)
UNIT A UNIT B UNIT C Sum of BU:s ./. Corporate Center Excess Cash Enterprise Value ./. Value of debt Equity value
28
135 50 272,5 457,5 -70 40 427,5 -200 227,5
Andy Löflund
1.1. Discounted cash flow models
DDM
E DIV t T E DIV t E PT P0 t 1 k E t t 1 1 k E t 1
FCFE
EFCFEt T EFCFEt E VTE V t 1 kE t 1 1 kE t t 1
E 0
T EFCFF EFCFF E VTF t t V0F 1 WACCt t 1 1 WACCt t 1
where E[VTE ] = Expected “horizon” or continuing value of equity” kE is the required rate of return on (typically levered) equity
FCFF
where E[VTF ] = Expected “horizon” or continuing value of firm” WACC = weighted average cost of capital: kE *(E/V) + kD*(1-tC)*(D/V)
29
Andy Löflund
1.1. Valuation and KVD:s
• While correct, generic formulas are not user friendly given the large number of difficult forecasts required...
• Therefore, we frequently simplify valuations by specifying cash flows in terms of ―Key Value Drivers‖ (KVD)
— Most important KVD:s are — 1. Cash flow growth (g) — 2. Quality of investment (ROI or equivalent) — 3. Quantitity of investment
– e.g. retention or ―plowback‖ ratio – investments into net working capital and fixed assets
— 4. Required rate of return — (5. Starting level of key cash flow or invested capital item)
30
Andy Löflund
1.1. Simplifying valuations
• Typical simplifications (apart from assuming a constant discount rate over time):
— 1. No cash flow growth (=mature industry w/ full capacity utilization)
– no growth=> no investments either => cash flow steady ―forever‖ – However: cash replacement investments needed to support longterm production capability of assets
— 2. Constant cash flow growth (―Gordon‖ model)
– cash flow grows at g percent per period, forever – growth must be supported by investment » there are limits to productivity enhancements! – given the additional assumption that ROI of new investment remains constant over time, the retention or plowback ratio b, i.e. periodic investments as a percentage of cash flow is a constant!
g = b*ROI
(in DDM of FCFE use ROE instead!)
31
Andy Löflund
1.1. Simplifying valuations
• Typical simplifications (apart from assuming a constant discount rate over time): (cont.)...
— 3. Industry competition wipes out economic profit after T periods, no profitable growth thereafter
– industry converges towards ―perfect competition‖ (ROIC=WACC) – strategic edge evaporates over time – sensible and prudent given that for no firm can perpetual g > nominal GDP -- which often happens in practice with #2!
— 4. Industry competition reduces economic profits by period T, but some profitable growth opportunities persist
– some companies have excelled over very long periods so #3. may in some cases be downward biased
32
Andy Löflund
1.1. Q&D valuation formulas
• Handy formulas include (see appendix for more detail):
— Formulas given for ―equity valuation‖ so E = cash earnings, use after-tax EBIT in place of E in firm valuations! — (Formulas will be given in final exam.)
Symbols: E = cash earnings (DDM, FCFE) or EBIT(1-TaxRate) k= required rate of return on equity or WACC b= plowback (retention) rate of earnings or EBIT(1-TaxRate) ROE = return on equity or after-tax return on investment ROI*=ROI*(1-TaxRate) g = growth rate of earnings or EBIT(1-TaxRate)
1.
• 1. No growth
E1 P0 k
Note: E=DIV as no investments!
2.
• 2. Constant perpetual cash flow growth
P0
E1 1 b E0 1 g 1 b kg kg
or “EP” formulation
P0
E1 g ROE k E1 k ROE k (k g )
33
Andy Löflund
1.1. Re-cap of valuation theory
• Handy formulas ... cont.
3.
• 3. Growth T periods+no growth thereafter
E0 (1 bs ) (1 g s ) (1 g s )T E0 (1 g s )T 1 P0 1 k gs (1 k )T k (1 k )T
or “EP” formulation
T E1 g ROE k (1 g ) P0 E1 T 1 k ROE k (k g ) (1 k )
or approximately
P0
ROE k E1 g E1 T k ROE k (1 k )
T s s 0
4. Supernormal growth T periods+ normal “constant” growth thereafter
4. P E (1 b ) (1 g ) 1 (1 g ) E (1 g )
0 s s 0
k gs
(1 k )
T
1 bc k gc (1 k )T
T 1
or “EP” formulation g ROEs k (1 g s )T gc ROEc k (1 g s )T E P0 1 E1 s ROE k (k g ) 1 (1 k )T E1 ROE k (k g ) (1 k )T k s s c c
or approximately
P0 g ROEs k T k g s gc ROEc k T k g s E1 E1 s ROE k (k g ) (1 k ) E1 ROE k (k g ) 1 (1 k ) k s s c c
34
Andy Löflund
1.3. Simple valuation example – NOG Corp.
Example: “NOG Corp.”
• 100 % equity financed no growth company • Produces a constant EBIT of 10 MEUR
— depr. assumed = cash replacement investment Year
• 10 mill. shares outstanding • Corporate Tax rate 26% • Past stock returns have been... =================>
• Riskfree rate is currently 4%
• The expected market risk premium is 6%
35
Market return NOG return 1996 -8 % -35 % 1997 -58 % -13 % 1998 34 % 68 % 1999 29 % 28 % 2000 10 % -46 % 2001 -17 % -63 % Avg return -2 % -10 % Volatility 34 % 50 % Corr(rm,NOG) 0,56 b(NOG) 0,81 (NOG) -0,09
Andy Löflund
1.3. NOG “fair” price?
Example: “NOG Corp.”
• What is current ―fair‖ share price of NOG?
• V = PV(FCF,k)? • V = PV(DIV,k)? • => we need cash flow forecast FCF and discount rate k! • FCF = EBIT minus taxes = DIV (as no debt! repl.inv.=depr.!) FCF= 10*(1-0.26) = 7.4 MEUR • k = required rate of return on NOG unlevered equity?...
— Simplest model is CAPM, so we need NOG equity beta estimate... suppose NOG unlevered beta estimate is 0.81
36
Andy Löflund
1.3. Estimating NOG cost of equity
Example: “NOG Corp.”
• Using CAPM to define risk adjusted discount rate k = 4% + 0.81 * 6% = 8.86% p.a.
E[ri]
Market risk premium
10% E[rNOG] 8.86%
E[rm] rf
4%
0
0.81 1
b
37
Andy Löflund
1.3. And the fair share value is...
Example: NOG...
Then:
FCF 7.4 V0 83.521MEUR k 0.0886
83.521 P0 8.35 10
€ per share
38
Andy Löflund
1.3. If NOG had growth prospects...
Example: NOG... If the future expected free cash flows were, e.g., ... t Year E[FCF] HV PV(FCF+HV) Cumulative with no growth 1 2003 6,9 0,0 6,3 6,3 after 2016... Then
• V = 123 MEUR
2 2004 3 2005 4 2006 5 2007 6 2008 7 2009 8 2010 9 2011 10 2012 11 2013 12 2014 13 2015 14 20166,8 7,2 10,3 9,4 8,8 7,5 8,9 9,5 11,2 12,2 13,3 14,5 14,5 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 163,7 5,7 5,6 7,3 6,1 5,3 4,1 4,5 4,4 4,8 4,8 4,8 59,1 12,1 17,7 25,0 31,1 36,4 40,6 45,1 49,5 54,3 59,1 63,9 123,0
and
• P = 12.3 €/sh. • (Can you spot an unrealistic assumption in the valuation?)
39
Andy Löflund
1.3. NOG as levered equity?
Example: NOG... What if NOG was levered instead with 40 MEUR perpetual 4% debt? We have at least three valuation model choices: 1. Firm level APV 2. Firm level WACC calculation 3. Direct equity valuation Let us go back to no growth scenario, for simplicity!
40
Andy Löflund
1.3. APV valuation
Example: NOG...
Method #1. Firm level APV:
Add PV(financing side effects) to unlevered firm value, deduct debt to arrive at equity value! PV(fin. side FX) = PV(interest tax shields) = PV(tC*kD*D) = 0.26 * 0.04 * 40 / 0.04 = 10.4 MEUR. Value = Unlevered firm value + PV(int.tax sh.) = Value = 83.521 + 19.4 = 93.921 ./. Debt 40 MEUR ==> Value of total Equity is 93.921 - 40 = 53.921 MEUR.
41
Andy Löflund
1.3. WACC valuation
Example: NOG...
Method #2. Firm level WACC valuation: WACC = kE * (E/V) + kD*(1-tc)*(D/V)
Need target D/V, assume D/V=0.4259 (40/93.921) Need kE, cost of levered equity: assume int.rate tax shields are risk free, then... kE = kU + (kU-kD)*(1- tc)*D/E = kE = 0.0886+(0.0886-0.04)*0.74*(0.4259/0.5741) = 0.11528, i.e. 11.528% Thus, WACC=11.528%*(0.5741) + 4%*0.74*(0.4259) = 7.8789% Value of enterprise/firm = 7.4 / 0.078789 ~ 93.921 MEUR. ./. Debt 40 MEUR ==> Value of total Equity is thus 93.921 ./. 40 = 53.921 MEUR.
42
Andy Löflund
1.3. FCFE valuation
Example: NOG...
Method #3. Direct equity valuation (“FCFE”=“DDM” here) Define FCFE = (EBIT-IntExpenses)*(1-TaxRate) <=> FCFE = (10 - 40*0.04)*(1-0.26) = 6.216 MEUR.
Discount with cost of levered equity kE=11.528%...
Value of equity = 6.216 / 0.11528 = 53.921 MEUR.
43
Andy Löflund
1.3. NOG summary
Three methods, one result….!
APV Cash Flow 7.4 WACC 7.4 FCFE 6.216
Discount rate
8.86%
7.88%
11.53%
Value of firm
93.921
93.921
93.921
44
Andy Löflund
1.3. Key points in example
1. Match cost of capital with CF to be discounted!
• Equity cash flow = levered cost of equity • Debt cash flow => cost of debt • Firm cash flow => WACC if levered, cost of unlevered equity if unlevered firm or APV valuation
2. Valuation in nominal terms!
3. Leverage increases kE! 4. Normally growth through investments complicate the analysis
• • • • required investment to sustain growth? growth horizon? quality of growth? capital structure implications of growth?
— target D/V ratio? constant / changing?
45
Andy Löflund
2. Relative valuation (ch. 12)
Suppose EPS and corresponding P/E ratios of two no-growth firms A and B in the same industry are:
A 1 € / share 12 12 € per share B 1.2 € per share 8 6.67 € per share 9.6 € per share
EPS P/E Price per share
• We interpret ―same industry‖ here as meaning cash flows of the two firms are perfectly correlated due to similar business logic and capital structure.
What do the two P/E ratios 12 and 8 tell us about the “valuation” of A and B...?
46
Andy Löflund
2. Relative valuation (Ch. 12)
Consider investment strategy:
• Buy 10000 B shares, short sell 12000 A shares: cost of strategy =-10000*9.6 + 12000*12 = -96000 + 144000 = +48000€ (receive money!) • Annual Dividends received from B: 10000*1.2 = 12000 €/share. • Annual Dividends owed from shorting A:-12000*1=-12000 €/share. • Annual cash flow difference from position is zero!!!
We receive money up front against no future liability => arbitrage opportunity, likely to be short-lived as arbitrageurs / speculators / hedge funds etc. rush to exploit it.
47
Andy Löflund
2. Relative valuation (Ch. 12)
==> buying pressure increases PB, and selling pressure lowers PA, causing P/E ratios to converge! If P/E of A and B would be equal, for example 10, implying PA=10 and PB = 12, then there would be no arbitrage opportunity...
Buy 10000 B shares, short sell 12000 A shares: cost of strategy = -10000*12 + 12000*10 = -12000 + 12000 = 0€.
• Annual Dividends received from B: 10000*1.2 = 12000 €/share. • Annual Dividends owed from short position in A: -12000*1 =-12000 €/share.
• Annual cash flow difference is zero. • (Running it backwards, buy A & short B, produces similar outcome.)
48
Andy Löflund
2. Relative valuation
Example is a “Modigliani-Miller” “Law of One Price” justification for usage of valuation ratios, measures of relative value <==>
“Similar things”, in terms of expected return and risk, should cost as much.
Conversely, if market is efficient (+ limits to arbitrage small) and P/E ratios are persistently different, then the two firms are somehow different • note: besides differing growth prospects and risk, low correlation between cash flows of firms even in same industry may occur because of low quality of reported accounting information
49
Andy Löflund
2. Relative valuation
Even with limits to arbitrage (e.g. expensive shorting or low liquidity), and some degree of dissimilarity between the two firms, valuation differences offer a tempting risk arbitrage opportunity:
• Those who have A strive to sell it quickly when the price is still high • B looks like a ―cheap buy‖, especially compared to the ―roughly similar quality A‖ • Demand and supply move to narrow relative valuation gap
50
Andy Löflund
2. Relative valuation
If a stock has a low multiple compared to an industry comparison group, it could be due to False comparison group (apples vs oranges) Error in multiple computation Temporary items distort multiple Differences in risk (e.g. leverage) Differences in growth outlook Other differences such as liquidity of stock, quality of governance, … 7. Market pricing error (buying opportunity) 1. 2. 3. 4. 5. 6.
51
Andy Löflund
2. Four best practices (CGW)
1. Choose comparables with similar prospects for ROIC and Growth 2. Use multiples based on forward-looking estimates 3. Use enterprise value (EV) multiples based on EBITA to mitigate problems with capital structure and one-time gains and losses 4. Adjust the EV multiple for nonoperating items, such as excess cash, operating leases, employee stock options, amnd pension expenses (same as w/ ROIC and FCFF adjusting)
52
Andy Löflund
2. What is relative valuation?
In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation then,
• we need to identify comparable assets and obtain market values for these assets • convert these market values into standardized values, since the absolute prices cannot be compared. This process of standardizing creates price multiples. • compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or over valued
53
Andy Löflund
2. Standardizing Value
Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues.
• Earnings Multiples
— — — — Price/Earnings Ratio (PE) and variants (PEG and Relative PE) Value/EBIT Value/EBITDA Value/Cash Flow
• Book Value Multiples
— Price/Book Value(of Equity) (PBV) — Value/ Book Value of Assets — Value/Replacement Cost (Tobin’s Q)
• Revenues
— Price/Sales per Share (PS) — Value/Sales
• Industry Specific Variable (Price/kwh, Price per ton of steel ....)
54
Andy Löflund
2.1. Price Earnings Ratio: Definition
PE = Market Price per Share / Earnings per Share
There are a number of variants on the basic PE ratio in use.
They are based upon how the price and the earnings are defined.
Price:
is usually the current price is sometimes the average price for the year
EPS:
earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year
55
Andy Löflund
2.1. PE from fundamentals
For perpetual growth model (Gordon): divide thru w/ E1 to get “theoretical” forward PE:
P0 E1 g ROE k E1 k ROE k (k g )
/E1
<=>
P 1 g ROE k E1 k ROE k (k g )
For 2-stage model T period growth + no growth...then:
P0 ROE k E1 g E1 T k k (1 k ) ROE ROE k P 1 g T E1 k ROE k (1 k )
56
/E1
<=>
Andy Löflund
2.1. PE with 2-stage model
P0 g ROEs k T k g s gc ROEc k T k g s E1 E1 s ROE k (k g ) (1 k ) E1 ROE k (k g ) 1 (1 k ) k s s c c
P/E
You need double digit g, ROE and T together with below 10% k to generate PE ratios above 20!
T 5 10 15 20 P/E
5% 16,5 18,6 20,8 23,0
ROEs= k 7% gs 10 % 18,6 23,0 27,3 31,6 ROEs= k 7% gs 10 % 36,5 43,1 49,6 56,2
20 % gc=
15 % 20,8 27,3 33,8 40,3
5% 11,8 13,0 14,3 15,6
0,0 % k 9,5 % gs 10 % 13,0 15,6 18,1 20,6 5,5 % k 9,5 % gs 10 % 13,8 16,3 18,9 21,4
ROIc=
0% k 13 % gs 10 % 8,9 10,1 11,3 12,5 k 13 % gs 10 % 7,4 8,8 10,2 11,7
15 % 14,3 18,1 21,9 25,7 ROIc=
5% 8,3 8,9 9,5 10,1 10 %
15 % 9,5 11,3 13,1 14,8
If required rate of return of equity would be 13% (high beta stock), PE:s have a very hard time exceeding 15!
20 % gc=
T 5 10 15 20
5% 30,7 31,4 32,1 32,8
15 % 42,4 54,8 67,1 79,5
5% 12,4 13,5 14,6 15,7
15 % 15,2 19,2 23,2 27,1
5% 7,2 8,4 9,6 10,8
15 % 7,6 9,3 10,9 12,5
57
Andy Löflund
2.2. PEG ratio
PE ratio divided by estimated earnings growth rate *100 PEG=1 is neutral valuation In actual fact, risk and payout (1-plowback) continue to affect PEG-ratio: Division by g does not neutralize the effect of growth due to non-linearities
58
Andy Löflund
2.3. Relative PE
= Ratio of firm PE to overall market P/E
should use same earnings base in calculation
Normalization by market enables better comparisons of valuations over time - Not (as) dependent on market interest rate level
Increases when firm growth rate above market growth rate Decreases when firm’s riskiness w.r.t. market increases (high beta stocks)
59
Andy Löflund
2.4. Value/Earnings and Value/Cashflow Ratios
While price earnings ratios look at the market value of equity relative to earnings to equity investors
Value/earnings ratios look at the market value of the firm relative to operating earnings. Value to cash flow ratios modify the earnings number to make it a cash flow number.
The form of value to cash flow ratios that has the closest parallels in DCF valuation is the value to Free Cash Flow to the Firm, which is defined as: Value/FCFF =
(Market Value of Equity + Market Value of Debt) EBIT (1-tc) - (Cap Ex - Deprecn) - Chg in WC
60
Andy Löflund
2.5. Enterprise value / FCFF
E0 (1 bs ) (1 g s ) (1 g s )T E0 (1 g s )T 1 1 bc P0 1 T k gc (1 k )T k gs (1 k )
convert to ―firm valuation‖ notation
FCF0 (1 g s ) (1 g s )T FCF0 (1 g s )T 1 V0 1 T WACC g s (1 WACC) WACC gc (1 WACC)T V0 (1 g s ) FCF0 WACC g s (1 g s )T (1 g s )T 1 1 T T (1 WACC) WACC gc (1 WACC)
/ FCF0
Multiple is increasing in FCF (EBIT) growth and decreasing in cost of capital WACC!
61
Andy Löflund
2.6. Alternatives to FCFF - EBIT and EBITDA
Many find FCFF too messy to use in multiples (partly because capital expenditures and working capital have to be estimated). They use modified versions of the multiple with the following alternative denominator:
• after-tax operating income or EBIT(1-tC) • pre-tax operating income or EBIT
• net operating income (NOI), a slightly modified version of operating income, where any non-operating expenses and income is removed from the EBIT
• EBITDA, which is earnings before interest, taxes, depreciation and amortization.
62
Andy Löflund
2.6. Pros of Value/EBITDA
1. EBIT > 0 even when earnings negative.
2. Some long-term high growth firms may have misleading (too low) current earnings due to heavy investment needs
3. Comparing firms with differing leverage is OK.
(EBIT level, WACC might differ though)
63
Andy Löflund
2.7. Price-Book Value Ratio: Definition
The price/book value ratio is the ratio of the market value of equity to the book value of equity, i.e., the measure of shareholders’ equity in the balance sheet. Price/Book Value =
2-stage growth + no growth <=>
P0
Market Value of Equity Book Value of Equity
ROE k E1 g E1 T k ROE k (1 k )
/ BV0
ROE k P0 ROE g ROE T BV0 k ROE k (1 k )
Note: E1 = BV0*ROE
<=>
ROE k P0 ROE g T BV0 k k (1 k )
64
Andy Löflund
2.7. P/B to ROE
Like PEG, ROE could be normalized against differing ROE levels by division to give a “Value Ratio“ Value Ratio = (P/B) / ROE
65
Andy Löflund
2.8. Price Sales Ratio: Definition
The price/sales ratio is the ratio of the market value of equity to the sales. Price/ Sales=
Market Value of Equity Total Revenues Could also normalize it against profit margins: Normalized Price/Sales = (Price/Sales) / Profit Margin%
66
Andy Löflund
2.9. Choosing the right multiple
1. EV/EBIT and EV/EBITDA and P/B have the best accuracy 2. P/S and P/E worse 3. Always use foreward earnings / EBIT etc.
67
Andy Löflund
2.9. Choosing Between the Multiples
Many multiples exist...which one to use?
In addition, relative valuation can be relative to a sector (or comparable firms) or to the entire market
Since there can be only one final estimate of value, there are three choices at this stage:
• Take a simple average of all multiple implied values? • Take a weighted average of all multiple implied values? • Choose ―best‖ multiple and imply value from it?
68
Andy Löflund
2.9. Picking one Multiple
Usually best method (and easiest)compared to averaging business... The multiple that is used can be chosen in one of three ways:
• Cynics: Pick the multiple that serves your purpose! • Use the multiple that actually has been shown to be related to actual market values. How do we know? Research team needed. • Use the multiple that seems to make the most sense for that sector, given how value is measured and created.
69
Andy Löflund
2.9. Guidelines
Some common sense guidelines for multiple choice:
Sector Cyclical Manufacturing High Tech, High Growth Multiple Used PE, Relative PE PEG Rationale Often with normalized earnings Big differences in growth across firms Assume future margins will be good Firms in sector have losses in early years and reported earnings can vary depending on depreciation method Generally no cap ex investments from equity earnings Book value often marked to market If leverage is similar across firms If leverage is different
High Growth/No Earnings PS, VS Heavy Infrastructure VEBITDA
REITa Financial Services Retailing
P/CF PBV PS VS
70
Andy Löflund
3. Valuation framework (Ch. 6-)
Copeland-Koller-Murrin: Valuation...
“Best practice” Widely accepted, sound principles Steps are: 1. Analyze historical performance 2. Estimate cost of capital 3. Forecast performance 4. Estimate continuing value 5. Evaluate scenarios
71
Andy Löflund
3. Step #1. Analyzing Historical Performance
Assess historical KVD:s and FCF
- Strive to pick an entire historical economic cycle - beware of cyclically low/high recent cash flow! - normalization often advisable
72
Andy Löflund
3. Step #1. Analyzing Historical Performance
Integrate Income and Balance sheets to cash flows and further to key ratios
• • • • • • • • • • Reorganize accounting statements for valuation purpose Invested capital NOPLAT (roughly after-tax EBIT) historical ROIC historical Economic Profit historical FCFF historical growth historical investment rates (into NWC and CapEx) credit health liquidity position other stuff
— goodwill, operating leases, reserves
— breakdown in tree ROIC = Operating margin * Capital Turnover
Benchmark to peers or market
73
— caution to differing international accounting conventions
Andy Löflund
3. Realistic ROI and growth levels
Example: Stockmann ROI
Stockmann Sijoitetun Pääoman Tuotto-% 3Y MOVA 16 14 12 10 8 6 4 2 0 1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
74
Andy Löflund
3. Realistic ROI and growth levels
Example: Stockmann Sales Growth
Stockmann Sales Growth 3Y MOVA 0,25
0,2
0,15
0,1
0,05
0 1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
75
Andy Löflund
4. WACC or APV?
WACC-method works best when... 1. Target long-term capital structure can be assumed constant 2. Capital structure is simple, few embedded liability options APV-method works best when... 1. Target D/V is not constant through time 2. Complicated option-features present
• e.g. significant executive options (warrants) • significant mezzanine financing: convertible debt etc. • Valuation steps with APV:
— 1. Compute 100% equity financed (i.e. unlevered) enterprise value — 2. Add PV of financial side fx like subsidized financing, debt capacity
— 3. Add excess marketable securities — 4. Subtract senior claim values: senior bonds, junior bonds, mezzanine, executive warrants...to get value of equity
76
Andy Löflund
4.1. Estimating cost of capital
Cost of capital reflects, among other things at least... “investors willingness to entrust their money with the (managers of) the firm for a reasonable price given the expected outlook on company cash flow”
Cost of capital increasing in factors reducing “willingness” (“mistrust”):
1. 2. 3. 4.
High risk Illquidity (foreign listed? size/turnover?) Bad/unclear corporate governance Wierd ownership structure (only domestic owners, single majority owner?)
77
Andy Löflund
4.1. Estimating cost of capital - Risk
(Given no pricing error) If cash flow growth prospects do not explain (e.g.) a high valuation, it must be due to (most) investors being really eager to hold the stock = “low cost of capital”
• = they perceive it as low risk OR • = they truly trust the CG OR • = it is really big liquid (blue chip) OR
• = it is a large global company listed on many stock exchanges
— (wide globally diversified ownership base)
78
Andy Löflund
4.1. Estimating cost of capital - Risk
The major component traditionally assumed to impact cost of capital
Debt financing: Use of bond ratings to gauge risk class and “credit spread”
Equity financing: Level of systematic risk of industry (unlevered equity beta) + financial leverage effect
79
Andy Löflund
4.1. Estimating WACC
1. Use market value weights for all types of capital
2. Specify cost of capital items after-tax to match after tax free cash flow.
3. Use nominal cost of capital (1+real rate)*(1+E[infl.]) to match nominal cash flow modelling 4. Utilize market prices at date of valuation, if possible Debt deducted should equal debt in WACC Check for gross discrepancies between assumed target D/V ratio in WACC and that implied by your valuation!
80
Andy Löflund
4.1. Step #2. Estimating the Cost of Capital
The WACC can be defined in many ways, two most common definitions include (assumes simple D&E only capital structure!):
E D WACC k E k D 1 t C V V
or
assumes debt cash flows are equally risky as debt and therefore discounted with kD! Can always be used! assumes debt cash flows are risky and therefore discounted with kU!
D WACC kU k D t C V
where tc is the corporate tax rate kU = unlevered cost of equity kD = cost of debt kE = cost of (levered) equity
81
Andy Löflund
4.1. Step #2. Estimating the Cost of Capital
Current practice tends to measure risk in equity through the beta, i.e. assume the CAPM holds.
Then beta is the risk measure supposed to reflect, systematic risk, liquidity, CG, ownership structure Beware! Even ignoring #2.-#4, a better APM than CAPM is the Fama-French 3 Factor Model high (low) beta stocks as well as small value (large growth) stocks have higher (lower) than average systematic risk and hence cost of equity
On top of equity risk financial leverage must be taken into account...
82
Andy Löflund
4.1. FF 3FM
83
Andy Löflund
4.1. Step #2. Estimating the Cost of Capital
Relationship between levered and unlevered cost of equity are as follows: (zero growth case, approximation to other cases)
D kE ku ku kD 1 t C E
or
assumes debt cash flows are equally risky as debt and therefore discounted with kD!
D k E ku ku k D E
where tc is the corporate tax rate kU = unlevered cost of equity kD = cost of debt kE = cost of (levered) equity
84
assumes debt cash flows are risky and therefore discounted with ku!
Andy Löflund
4.1. Step #2. Estimating the Cost of Capital
Relationship between levered and unlevered equity betas are as follows: (zero growth case, approximation to other cases)
D b E bU bU b D 1 t C E
or
assumes debt cash flows are equally risky as debt and therefore discounted with kD!
D b E bU bU b D E
where tc is the corporate tax rate b U = unlevered equity beta b D = debt beta b E = levered equity beta
85
assumes debt cash flows are risky and therefore discounted with ku!
Andy Löflund
4.1. Target D/V?
1. Use market value weights for all types of capital
• Market D/E ratio = (Book D/E ratio) * (Book/Market ratio) ! • Only if B/M = 1 then market and book gearing coincide • Usually assumed constant through time, although not mandatory
Think in terms of the long-term target capital structure
• 1. Smoothing over recent transitory capital structure changes • 2. Get around circularity problem • 3. Benchmark to industry, why deviation?
The debt you subtract to get equity should normally be the debt used in the capital structure & WACC
86
Andy Löflund
4.2. Cost of debt
Straight investment grade debt
• Find company bond rating • Use current yield from rating class as a proxy for expected cost of debt
Below investment grade
• Significant default rates bias (promised) yields upward compared to expected yields!
— Need expected default rates and value in default to compte expected yields...
• May need to use BBB-rated debt yields as proxy
Own rating model
• e.g. interest coverage ratio based
87
Andy Löflund
4.3. Cost of hybrids or “mezzanine”
e.g. convertible bonds, capital loans etc.
Split up value into (1) bond part and (2) warrant part (or equivalent option) Estimate costs as cost of debt and equity for the parts separately.
88
Andy Löflund
4.4. Cost of equity
1. CAPM expected “cost” (= return)
E ki rf b i E rm rf
• rf risk free rate • Market Risk Premium E[rm] - rf
• Beta of security / capital type i, bi
2. Implied “IRR” from valuation model
• e.g. solve for kE from P = DIV1/(kE - g) given P and DIV1 and g forecasts!
89
Andy Löflund
4.4. Cost of equity
1. CAPM
• “rf” should be defined with: — no default risk — no re-investment risk (term structure effects=0) — no inflation risk
— in practice, 5 or 10 year government bond yield typically used
– match with ―duration of firm cash flow‖ – not universally accepted, some advocate short maturity TBills – choose rf consistently with MRP!
• New in U.S: ―TIPS‖ (―Treasury-Inflation-ProtectedSecurities‖) replacing Tbills as a riskfree rate!
— Coming in Europe?
90
Andy Löflund
4.4. Cost of equity
1. CAPM
• Expected Market Risk Premium
— These days around 2-4% for developed markets — Think ―Europe‖ or ―World‖ as the market — Use consistent rf definition with above!
— Historical average likely too high
– – – – Good luck Inconsistency with theories Survivorship bias Dimson-Marsh-Staunton European data
91
Andy Löflund
4.4. Cost of equity
1. CAPM
• Beta?
— unlevered vs levered equity betas — preferably, use industry average unlevered equity betas — historical OLS regression
– need to unlever to first get industry betas! – use monthly data/longer estimation period to combat illquidity distortions
92
Andy Löflund
4.4.Historical market premium varies a lot
Forecasts made 5 (10) years ahead using D/P regression
93
Andy Löflund
4.4. Implied market return
1. Pick a 2-stage model for T year horizon 2. Obtain market index dividend forecasts up to T 3. Estimate long-term nominal growth rate of market (nominal long-term GDP growth usually). 4. Back out rm that equates PV(dividends+HV) with current market index level.
94
Andy Löflund
4.5. Alternative approaches
1. Fama-French 3F model already mentioned as being the one (at least) academics mostly believe in although we know it doesn’t explain well momentum, small growth stocks etc.
- implementation issues; estimate three premia and three betas instead of 1+1...
2. Use of past (long-term!) realized average stock return (of peers)? Tend to be very noisy and highly dependent on sample period
95
Andy Löflund
5. Step #3. Forecasting Performance
1. Length and detail of forecasts
2. Analyze industry
• ―business logic‖ • threats from new entry/new technology? • sustainability of margins, ROIC, growth
3. Link between strategy and future KPI:s
• Strategy => KPI forecasts => Inc. and BS forecasts => FCFF forecasts
4. Evaluate alternative scenarios
5. Overall consistency
• growth <=> ROIC <=> Investments vs ―strategic view‖
96
Andy Löflund
5.1. Forecasting cash flows
We should forecast expected cash flows or alternatively do scenario-based valuations Scenario: Optimistic Realistic Pessimistic E[CF] prob. 40% 40% 20% CF +10 +8 -4 +6.4
• Frequent error is to provide upward biased ―budget‖, or ―hoped for‖ forecasts instead of expectation
— e.g., do the forecasts acknowledge there is some probability for a zero CF?
97
Andy Löflund
5.1. Forecasting FCF
1. Forecast KVD:s 2. Build pro forma income statements and balance sheets from KVD:s
• check reasonability of numbers, benchmarking, financing feasible?
3. Derive FCF from step #2.
98
Andy Löflund
5.1. Free Cash Flow To Equity - FCFE
+ EBIT ./. Interest Expense = EBT ./. taxes = Net Income + Depreciation = CF from operations ./. Working capital increase (operative, non-int.bearing) ./. Gross capital expenditures ./. Debt amoritizations + New debt issues = FCFE
99
Andy Löflund
5.1. Free Cash Flow To Firm - FCFF
+ EBITA (EBIT before Interest, Taxes and Goodwill Amortization) ./. taxes (* may have to be “adjusted” for financial items) = “NOPLAT” + Depreciation (all depreciation but goodwill type amortization) = Gross CF ./. Working capital increase (non-interest bearing or “operative”) ./. Gross capital expenditures (net investment + depreciation) = FCFF before goodwill ./. Investments into goodwill (DGoodwill + goodwill amort.) = FCFF after goodwill
100
Andy Löflund
6. Step #4. Estimating Continuing Value
1. Pick simplified long-term growth model
• Industry analysis - the long run outlook?
g NOPLATT 1 1 ROIC I CVT WACC g
or
g NOPLATT 1 ROIC ROICI WACC EP 1 I T CVT WACC WACC WACC g
2. Estimating long run continuing value model parameters
• ROIC, NOPLAT growth rate, investment rate?
101
Andy Löflund
6. Step #4. Estimating Continuing Value
1. Forecast at least 7 years (over a whole business cycle). 2. ROIC is marginal ROIC, for many companies ROIC = WACC .
3. NOPLAT(T+1) should be normalized . 4. FCF - remember to subtract investments required to sustain long-term growth
5. Growth rate - normally long term cons. (volume, or “real”) growth of industry’s product + inflation
• Long-term nominal GDP growth is about +/-6%
102
Andy Löflund
6. Step #4. Estimating Continuing Value
6. Long term growth should never exceed nominal GDP (nominal RF level) growth 7. Constant growth could be assumed zero or negative indicating we model a peak at T and then diminishing size for company in relation to industry/market
8. Frequently riskiness of firm changes as it enters a constant growth phase from “high growth” => lower beta?
103
Andy Löflund
7. Step #5. Interpret the results
1. Calculate PV(FCFF) + PV(continuing value)
2. Subtract debt, hybrid securities, PV(leases) , minority interest, executive options*
• in-the-money executive options can alternatively be treated as ―fully diluted equity‖ => increase number of shares instead of subtracting value of exec. options.
3. Add cash/excess marketable securities 4. Add PV(non-operative) cash flow or assets 5. Weight each scenario with steps #1.-#4 with scenario probabilities to sum up.
104
Andy Löflund
7. Some closing remarks...
1. Develop a habit of drawing time lines graphs (10-30 years ahead) of your projected ROI:s (compare to WACC), g:s
2. 3. 4.
5. 6.
Normalize and average out lumpy investments/NWC needs Positive NWC temporary, prudent to assume zero. Look out for starting level CF, HV assumptions; many valuation errors can be traced back to these
Stick to g=ROI*b consistency Don’t overdo cost of capital estimations (unless you are selling them for a good price ;)
No way these will ever be 100% accurate, so don’t worry about third decimal of your beta
Ask: is this a stock investors like? If yes, is it just the growth outlook, or is it something else? If they don’t like a stock, why? Check ownership structure, low cost of capital firms have dispersed, global ownership, good track record of liquidity and good CG Very high valuation must go together with low cost of capital; if you can’t see it, suspect ovevaluation If overvaluation would actually be present who would/could move to exploit it? Why don’t they?
105
Andy Löflund
7. Valuation - summary
Cash Flow
FCFFt
Enterprise Value
Cost of Capital
WACC
NOPLAT t
./.
Net Investmentst
kE
kD
Target D/V
ROI forec. period T
ROI postforec. period
NWCt
+
CapExt
rf
+
CVT bE
+
Default premium
*
Equity risk premium
106
Andy Löflund