CLASS #4: DCF VALUATION PART 2
May 4, 2008
Agenda
Homework (ACN) Academics vs. Industry Strengths and Weaknesses of the DCF valuation model Valuing different businesses using the DCF Industry implications Beyond the DCF
Accenture
Academics vs. Industry
Wall Street and public companies like “EBITDA” Academics: EBITDA is not cash. It is an accounting number that is a good proxy of cash. APV vs. WACC APV breaks down the valuation of a company into different parts
Part1: Operating cashflows
Discounted using unlevered return of equity rel Terminal value is calculated by the Gordon perpetuity growth model Discounted using the rate of debt Probability of the company not able to meet financial obligations
Part2: Tax shield
Part 3: Cost of financial distress
Part 4: Cost of financing (fees!)
Merits of the DCF
Strengths:
Captures the time value of money and opportunity cost Scientific Widely used Based on cashflow Almost always results in overvaluation. Why? Can we ever predict the future? “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Warren Buffett
Weaknesses:
Based on many assumptions Which assumptions are the most critical? 5 years vs. 10 years estimation
Other Considerations
The same asset is worth a different value to a different person
Value is in the eyes of the beholder
Synergies The whole is greater than the sum of its parts Wrigley is more “useful” to MARS than to Exxon Mobil Therefore, we might have to value a company differently based on who is buying it Synergies: Value(AB) > Value(A) + Value(B)
How do we cater for synergies in our DCF?
Where is the value of brand equity in the DCF model? E.g. Coke, Microsoft, Marlboro Goodwill
Other Considerations (cont.)
With so many valuation methods available to us
trading and transaction comps: P/E, P/EBITDA, EV/EBITDA DCF: APV, WACC, etc Which one gives the “most correct” valuation? Which one does the market believe the most?
Mr. Market is a valuator
Supply and demand
Valuing Different Companies Using the DCF 1
Dot Coms
Is
the DCF model a good model for valuing dot com companies? Can we use the comps valuation methods?
P/E (share price divided by earnings per share)
E.g. Value of company = Net Income * P/E (comps)
Multiples
of Revenue
E.g. Value of company = Revenue * Revenue X (comps)
Clicks Number
of new subscribers (e.g. Facebook)
Valuing Different Companies Using the DCF 2
Microsoft (MSFT) and Philip Morris (MO, PM)
What
do these two companies have in common that is critical to their valuations?
Litigation
risks ($$$)
How
do you provide for this in your DCF model?
Private Companies
10-K! Selected key numbers are often available Is the DCF a good model for valuing private companies?
No
Industry Implications
Everyone in the industry knows how to do a DCF Every bank, every analyst uses , uses similar assumptions, studies the same theories in school, but bankers and analysts come up with extremely different values and recommendations (Buy/Sell/Hold) for the same company Interesting trends The industry always comes back to two questions:
What percentage of a banker/analyst’s performance is due to luck vs. skills Is past performance a good indicator of future performance?
So is it all just a crapshoot?
Experience leads to better valuation Valuation is an art, not a science
The key is to develop your own framework and style
Understanding of the business is the key Wall Street often gets it wrong?
Conflicting agendas and interests AOL Time Warner
Mkt Value (before): AOL 163bn, Time Warner 83bn Mkt Value (after): Around 350bn 2002: Record $100bn in non-recurring charges, almost all from writedown of the goodwill from the merger
Luck?
Peter Lynch (MBA, Wharton) managed the Fidelity Magellan Fund from 1977 to 1990, during which time the fund's assets grew from $20 million to $14 billion. More importantly, Lynch reportedly beat the S&P 500 Index benchmark in 11 of those 13 years, achieving an annual average return of 29%1. If you had invested $10,000
$10,000 * (1+29%)13 = $273,947
The power of compounding and long-term investing
1Source:
http://www.investopedia.com/university/greatest/peterlynch.asp
Luckier?
This person Has beaten the S&P 500 36 out of the past 42 years Has a compounded annual gain of 21.1% Decides what to invest by reading a lot of 10-Ks and performing analysis on them If you had invested $1,000 in 1965 with him, your investment was worth $984,440 in 2007
Good Read
Interested in:
Investment banking
Monkey Business: Swinging Through the Wall Street Jungle by John Rolfe and Peter Troob The Accidental Investment Banker: Inside the Decade That Transformed Wall Street by Jonathan A. Knee Liar's Poker: Rising Through the Wreckage on Wall Street by Michael Lewis Valuation for Mergers, Buyouts, and Restructuring by Enrique R. Arzac http://www.berkshirehathaway.com/letters/letters.html
Trading
Textbook
General
Questions?
William Koo (wkoo2008@kellogg.northwestern.edu)