# Introduction to valuation Fundamental Analysis

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```					         VALUATION PROCESS

 Introduction to valuation
 Estimating firm value with DCF model

 Value drivers in a DCF model

 Links between DCF model and the
market

April, 27 2006   Fideuram Investimenti SGR   1
Introduction to valuation
Valuation process

between
VALUE and PRICE
of an asset

April, 27 2006            Fideuram Investimenti SGR   2
Introduction to valuation

Valuation is useful                           Valuation models are
because markets are                              QUANTITATIVE so
inefficient                              valuation is OBJECTIVE

FALSE                                      FALSE
Valuation allows us to                            Valuation models
use the market                              depend on the bias we
efficiency theory with                           put in the valuation
skepticism                                      process
April, 27 2006            Fideuram Investimenti SGR                3
Introduction to valuation
Valuation provides a                       What matters is the
TIMELESS and PRECISE                        PRODUCT of valuation
estimate of value                          NOT the PROCESS

FALSE                                FALSE
Valuation models                        Valuation process help us
imply making                          selecting right inputs and
assumptions on the                          understanding value
future.                                      drivers
April, 27 2006            Fideuram Investimenti SGR                4
Introduction to valuation
and valuation process:

The relationship         This relationship              Deviations from
between value                   is                     this relationship
and underlying                                             MUST BE
STABLE OVER
financial factors                                         CORRECTED
TIME
CAN BE
In a reasonable
MEASURED
timeframe
April, 27 2006             Fideuram Investimenti SGR                  5
Estimating firm value with DCF
Two different options:

DCF valuation                                        Relative valuation

Relates the value                                     Relates the value of
of an asset to the                                    an asset looking at
NPV of expected                                         the pricing of
future cash flow                                     comparable assets

April, 27 2006          Fideuram Investimenti SGR                           6
Estimating firm value with DCF
DCF models: equity or firm valuation?

Equity Value                                             Firm Value

∑t=1- n           =    CFe
t
∑t=1- n       =      CFf
t

(1+ke)t                                          (1+wacc)
t

With                                                         With
Ke= Cost of Equity                                           WACC= Weighed Average Cost
of Capital
n= life of the asset
n= life of the asset
CFe= Cash flow to Equity
(ie. dividend)                                               CFf= Cash flow to Firm (prior
payments to debt-holder or
April, 27 2006                 Fideuram Investimenti SGR   equity-holder)             7
Estimating firm value with DCF
Value drivers in a DCF model:

•Sales growth

•Profitability: EBITDA & EBIT margins

•Cash flow generation: CAPEX
spending
•Closing the DCF: WACC and
Terminal Value
April, 27 2006         Fideuram Investimenti SGR   8
Value drivers in a DCF model
Estimating Sales Growth:

Compare growth
estimates with
historical data   Make assumptions
on market growth
and market share
expectations

Compare growth
estimates with
analyst estimates
April, 27 2006     Fideuram Investimenti SGR                   9
Value drivers in a DCF model
Estimating Profitability:
EBITDA Margin

Compare            Compare                       Compare
estimates          estimates                    estimates
with historical         with                     with analysts
data           competitors                  assumptions

April, 27 2006      Fideuram Investimenti SGR              10
Value drivers in a DCF model
Estimating cash flow: Capex spending
Capex Spending consist of

Net CAPEX                          Non Cash Working Capital

CAPEX - Depreciation                                 investments in

“real” drain from                       inventories             Accounts
cash flow                                                 receivables/
payables
April, 27 2006          Fideuram Investimenti SGR                     11
Value drivers in a DCF model
Closing DCF: estimating WACC

Cost of Equity                       +                   Cost of Debt

Ke= Rf+(Rp        x   Beta)      Credit profile LT Debt LT credit
free)

April, 27 2006               Fideuram Investimenti SGR                  12
Value drivers in a DCF model
Closing DCF: estimating Terminal Value
Liquidation                                Stable growth
value                                     approach

Assume the liquidation of                                Estimates the TV
the firm at terminal year                                 as the PV of a
perpetual series
Find a reasonable multiple to
apply at terminal year
(EV/Sales, EV/IC, EV/Ebitda)
April, 27 2006                 Fideuram Investimenti SGR                      13
International Business Machines Corp - DCF Valuation
2005         2006       2007       2008        2009       2010       2011       2012       2013       TV
Sales                    92,826     94,683     97,523    100,449     103,463    106,567    109,764    113,056    116,448 Cagr 02-05          2.7%
Sales Growth              -3.6%       2.0%       3.0%       3.0%        3.0%       3.0%       3.0%       3.0%       3.0%
Consensus                92,827     94,403        -          -                                                             I/B/E/S
Ebitda Margin             17.3%      17.7%      18.0%      18.0%      18.0%      18.0%      18.0%      18.0%       18.0%   Top Analyst
Consensus                 17.3%      17.7%       0.0%
Ebitda                   16,059     16,759     17,554     18,081      18,623     19,182     19,757     20,350     20,961 Cagr 02-05          4.0%
D&A                      (4,548)    (4,450)    (4,584)    (4,721)     (4,863)    (5,009)    (5,159)    (5,314)    (5,473)
D&A % of Sales            -4.9%      -4.7%      -4.7%      -4.7%       -4.7%      -4.7%      -4.7%      -4.7%      -4.7%
Consensus                  4.9%       4.7%
Ebit                     11,510     12,309     12,971     13,360      13,761     14,173     14,599     15,037     15,488 Cagr 02-05          5.1%
Ebit Margin               12.4%      13.0%      13.3%      13.3%       13.3%      13.3%      13.3%      13.3%      13.3%
Tax Rate                  36.0%      36.0%      36.0%      36.0%       36.0%      36.0%      36.0%      36.0%      36.0%
NOPAT                     7,367      7,878      8,301      8,550       8,807      9,071      9,343      9,623      9,912

Capex                    (4,767)    (5,701)    (6,635)     (6,834)    (7,039)    (7,250)    (7,468)    (7,692)    (7,923)
Capex/Sales                 5%         6%          7%          7%        7%          7%        7%          7%        7%
Capex/Sales
CTO                        1.30       1.30       1.30       1.30        1.30       1.30       1.30       1.30       1.30    Capital Turn
Invested Capital         67,132     68,383     70,434     72,547      74,724     76,966     79,275     81,653     84,102 Cagr 02-05          2.6%
Roic                      11.0%      11.5%      11.8%      11.8%       11.8%      11.8%      11.8%      11.8%      11.8%
UFCF                      7,149      6,627      6,250      6,437       6,630      6,829      7,034      7,245    175,667

WACC                       7.2%                                                                                         Terminal Value
Theor. WACC                7.2%                                                                                            EV/IC              2.00
Roic-Wacc              5%
EV/Ebitda             8.0
Target EV              \$136,502                                                                                         EV/Sales             1.44
Target EV/Sales           1.47
Target EV/Ebitda          8.50                                                                                          FCF Perpetuity
Target EV/IC              2.03                                                                                                             177,679
Net Debt per Share
Per Share Value
\$8
\$78
Value                     drivers                                      EV/Ebitda
EV/IC
8.5
2.11
UP/Downside               0.7%                                                                                          Terminal g            3.0%

April, 27 2006                                      Fideuram Investimenti SGR                                                    14
Focus on profitability

ROIC                                         ROE

Ebit (1-tax rate)                                 Net Income
Invested Capital                                  BV of Common
Equity

Efficiency in generating profits                         Profitability for an
from invested capital                               equity investor

April, 27 2006               Fideuram Investimenti SGR                      15
Focus on profitability: decomposing ROE

ROE = Net Profit Margin x Leverage x Asset Turnover

Value Drivers in a DCF                              Market price
model                                            via
P/Book multiple
April, 27 2006        Fideuram Investimenti SGR                     16
Links between DCF and the market
Linking ROE and P/Book starting from a DDM
model (stable growth company)

P0= DPS1                           and                     ROE=   EPS1
Ke - gn                                              BV Equity0
Price/Book = (ROE – gn)
For a complete
calculation see:
(Ke – gn)             A. Damodaran -
Investment
gn= growth rate in dividends (perpetual)         valuation –
WileyFinance
(2002) –
Ke= Cost of Equity                               chapter 19

April, 27 2006                    Fideuram Investimenti SGR                      17
VALUATION PROCESS
CONCLUSION
   Higher the discipline building a valuation process,
better the quality of results
   A DCF model give you a comprehensive picture of
firm value
   Focus the attention on few value drivers (sales
growth, margins and cash flow)

   Analyse profitability to find links between valuation
model and market price
April, 27 2006         Fideuram Investimenti SGR          18

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