Valuation How much are those cash flows worth? Standard Techniques • Book Value • Earnings Multiple • Liquidation Value • Discounted Cash-Flow Graham,J.andH.Campbell,2001,“TheTheoryandPracticeofCorporateFinance:EvidencefromtheField,”Jour nalofFinancialEconomics,60(2-3),187-243. Book Value Firm (Enterprise) Value = Book Value of Assets • Still one of the most widely used and accepted methods due to certification by accountants, while also being perhaps the most flawed. • Based on historic numbers, ignores the future. • Based on accounting numbers that are potentially flawed and subject to manipulation • Ignores intangibles like customer loyalty. • Ignores risk • The price paid for an asset may have no relation to its value in operation or if it had to be sold or replaced (especially as time passes). General Motors Balance Sheet PERIOD ENDING 31-Dec-03 31-Dec-02 31-Dec-01 Total Current Assets 86,261,000 57,118,000 47,186,000 Long Term Investments 198,778,000 189,859,000 183,661,000 Property Plant and Equipment 72,594,000 36,152,000 39,724,000 Goodwill 3,790,000 6,992,000 10,006,000 Intangible Assets 970,000 7,619,000 6,921,000 Accumulated Amortization - - - Other Assets 58,924,000 41,372,000 14,177,000 Deferred Long Term Asset Charges 27,190,000 32,759,000 22,294,000 Total Assets 448,507,000 371,871,000 323,969,000 Common Stock (Equity) Book Value Easy to Calculate • Case 1: Only common stock outstanding – Book value equals owner’s equity. • Case 2: Common and preferred shares outstanding – Book value equals owner’s equity minus book value of the preferred. GM Continued No Preferred Stock Balance Sheet PERIOD ENDING 31-Dec-03 31-Dec-02 31-Dec-01 Stockholders' Equity Misc. Stocks Options Warrants - - - Redeemable Preferred Stock - - - Preferred Stock - - - Common Stock 937,000 1,032,000 1,020,000 Retained Earnings 13,421,000 10,198,000 9,463,000 Treasury Stock - - - Capital Surplus 15,185,000 21,583,000 21,519,000 Other Stockholder Equity -4,275,000 -25,999,000 -12,295,000 Total Stockholder Equity 25,268,000 6,814,000 19,707,000 Pitney Bowes Inc (PBI) Has Preferred Stock Stockholders' Equity Misc. Stocks Options Warrants - - - Redeemable Preferred Stock - - - Preferred Stock 1,334 1,456 1,627 Common Stock 323,338 323,338 323,338 Retained Earnings 4,057,654 3,848,562 3,658,481 Treasury Stock -3,313,027 -3,198,414 -2,943,690 Capital Surplus - - 6,979 Other Stockholder Equity 18,063 -121,615 -155,380 Total Stockholder Equity 1,087,362 853,327 891,355 Comparable Companies Earnings Multiples • Most common method for valuing assets: absent market values. • Simple but with many potential pitfalls. Market Value of Company V / EBIT Earnings Before Interest and Taxes Debt + Equity . Earnings Before Interest and Taxes From V/EBIT to Market Value V Market Value of Asset = Comp EBIT. EBIT • Obtain Comp(V/EBIT) by using the value- to-earnings ratio of a “comparable” traded company (or the average from a group of comparable companies). • Use EBIT from the firm or asset you are valuing. Advantages of V/EBIT • Easy. • Makes intuitive sense. • If your comparables are really comparable then it should work. Problems with V/EBIT • Earnings used to calculate V/EBIT are accounting figures. – To the degree the earnings are subject to manipulation so is EBIT. • Earnings are subject to short-term fluctuations. – Looking for “long run” earnings. – Might need to adjust earnings for extraordinary items. • Be careful! Some firms have “extraordinary” items every year. • V/EBIT assumes all companies will generate the same growth. Other Widely Used Multiples • Price-to-Earnings • Price-to-Sales – Popular for firms with negative earnings. • Market-to-Book value – Also popular for firms with negative earnings. • Asset Value-to-EBIT • Asset Value-to-Revenues – Also popular for firms with negative earnings. Price-Earnings Ratios • Very, very popular for equity valuation! • One major pitfall when making comparisons across companies – DEBT! – The higher a firm’s D/E(quity) ratio the higher the P/E(earnings) ratio. – Note: • In D/E the “E” stands for Equity. • In P/E the “E” stands for Earnings. • Standard terminology, you just have to know which one is which. P/E and Debt Example • A firm has an equity value of 10, earnings of $1, and no debt. – P/E = 10. • Assume the tax rate is TC. The firm now issues enough debt so that it pays $1/(1-TC) in interest. Earnings (which are calculated after interest and tax payments) now equal 0. – New Earnings = 1 – 1/(1-TC) + TC/(1-TC) = 0 • So long as the price of the stock does not go to zero (which it will not if there is any expected growth in the firm) the P/E will equal ∞. • General rule: More D → Higher P/E. Liquidation Value • Useful if you are really thinking of liquidating the firm. – Ignores any value from future operations. – Do not use if the firm will continue as a going concern. – Useful if you want to know if the firm is worth more dead or alive. Discounted Cash Flow Valuation 1. Forecast free cash flows up to some terminal date. 2. Estimate the cost of capital (a.k.a. discount rate). 3. Estimate terminal value (a.k.a. continuing value) which equals the value after the terminal date. 4. Discount to the present. 5. Add value of excess cash (proxy for marketable securities) and other non-operating assets. 6. Deduct debt and preferred stock to get the market value of the common shares. Example • New Haven Tea company expected to produce free cash flows of 200 next year (year 1). • Expect 10% cash flow growth per year up until year 7. Thereafter expected growth of 2% per year. • The discount rate is 8%. Solution • First seven years is a growing annuity with an initial value of 200 and a growth rate of 10%. Year 1 2 3 4 5 6 7 FCF 200 200x1.1 242 266.2 292.8 322.1 354.3 = 220 • Terminal value is a perpetuity starting in year 8 with an initial value of 354.3x1.1 = 389.74 and a growth rate of 2%. Solving for the PV 7 200 1.1 t 1 200 1.1 7 PV . t 1 1.08 t 1.08 .08 .02 7 Value of the free cash flows 7 200 1.1 t 1 . t up to the terminal date t 1 1.08 389.74 Terminal value . 1.08 .06 7 Three Main Questions • What are the free cash flows? • How to estimate the terminal value? • How do you calculate the cost of capital? Free Cash Flow I Arturo likes to calculate FCF via: Operating Profit (=EBIT) - Taxes on EBIT + Increase in deferred taxes = Net Operating Profit Less Adjusted Taxes (=NOPLAT) + Depreciation + Increase in Working Capital Requirements + Capital Expenditures = Free Cash Flow Free Cash Flow II An alternative route (popular on the street) is: EBIT + Depreciation and Amortization = EBITDA EBITDA From the Cash Flow Statement: Capital Expenditures + Sale of + Net Capital Expenditures Assets = Net Capital + Change in Working Capital Expenditures - Cash Taxes Paid - Cash Interest Paid = Free Cash Flow A Note On NOPLAT • NOPLAT is supposed to represent the free cash flow to the firm before capital investment. • My preference is to calculate “NOPLAT” as FCF + Cash Interest Paid + Net Capital Expenditures. • Just remember if you use my version it is not really “NOPLAT.” A better term would be FCFBCINCE, but that acronym is pretty hard to pronounce! • In the notes that follow where you see the acronym NOPLAT feel free to substitute FCFBCINCE. Working Capital I (Investment Needed to Operate the Company) Arturo likes to use: Operating Cash + Accounts Receivable + Inventories - Accounts Payable - Net Accruals = Working Capital Reserves Working Capital II For changes in working capital Catherine Nolan (a bond analyst and my wife) likes to use: Changes in Accounts Receivable + Changes in Inventories + Changes in Accounts Payable = Changes Working Capital Reserves Why the Difference? • Catherine Nolan’s argument. – Operating cash is what you want to back out, so including it is basically double counting. • In fact it is often double counting. If a firm spends money on administrative costs and pays with a check, the SG&A account goes up and the cash account goes down. – Net Accruals can include a number of non-cash items and can be easily manipulated. You are better of ignoring them. – Working capital is the difference between what you owe people (accounts payable) and what you are hoping to get paid for (accounts receivable and inventories). Forecasting Free Cash Flows 1. Forecast Sales A. Project size of the target market. B. Project market share. 2. Examine historical relationships between sales and other components of free cash flow. A. Be careful here! Are you sure the firm will continue along its current trajectory? Forecasting Free Cash Flows (continued) 3. Check reasonableness of forecasts. A. What do the forecasts assume about the ability of the company to generate “abnormal” (economic) profits? B. Gross domestic product grows at a real rate of 3.41% in a typical year (1929-2003). That means in the long run no firm can grow faster than this. i. Are your long run estimates consistent with this? ii. What do your estimates say about the firm’s long run relative market share? iii. What do your estimates say about the long run size of the industry relative to the rest of the economy or related industries? For example, if you assume BookUsHotels.com will eventually produce $X in sales you must also assume that the hotel industry will as well. Forecasting Free Cash Flows (continued) 4. Discount Rates A. Be consistent in dealing with free cash flows and discount rates. B. Discount rates should reflect market and not firm specific risk. i. Common mistake is to increase the discount rate in response to firm specific risk. ii. Example: A pharmaceutical firm has a 25% chance of making a breakthrough. This does not influence the discount rate. It does influence the expected future cash flows. In this case PV = .25(PV w/ breakthrough) + .75(0). Reasonable Forecasts Some Guidelines • What are the assumptions about the company’s ability to create economic profits? • Key drivers for economic growth are the Return on Investment Capital (ROIC) and the growth rate (g). Calculating ROIC and g NOPLAT ROIC . Invested Capital Invested Capital = Long Term Assets + Working Capital Requirements g ROIC Investment Rate where: Net Investment Investment Rate . NOPLAT The accuracy of your valuation will depend upon the degree to which you accurately forecast ROIC and g. Valuation and Growth a Few Examples • All of the following firms are perpetual growth firms. • They use a constant investment rate (a.k.a. “plowback”) rule. • They have a constant ROIC (a.k.a. “return on equity”). Example 1 – Base Line No Growth Firm Investment Rate 0.00% ROIC 20.00% Growth Rate 0.00% Discount Rate 10.00% Year 0 1 2 3 4 5 NOPLAT 100 100 100 100 100 100 Net Investment 0 0 0 0 0 0 Free Cash Flow 100 100 100 100 100 100 PV(Free Cash Flow) = 100 + 100/.1 = 1100 Example 2 – Value Creating Firm Investment Rate 25.00% ROIC 25.00% Growth Rate 6.25% Discount Rate 10.00% Year 0 1 2 3 4 5 NOPLAT 100 106.25 112.89 119.95 127.44 135.41 Net Investment 25 26.56 28.22 29.99 31.86 33.85 Free Cash Flow 75 79.69 84.67 89.96 95.58 101.56 PV(Free Cash Flow) = 75 + 79.69/(.1-.0625) = 2200 Example 3 –Growing But No Value Added Firm Investment Rate 25.00% ROIC 10.00% Growth Rate 2.50% Discount Rate 10.00% Year 0 1 2 3 4 5 NOPLAT 100 102.5 105.06 107.69 110.38 113.14 Net Investment 25 25.63 26.27 26.92 27.6 28.29 Free Cash Flow 75 76.88 78.8 80.77 82.79 84.86 PV(Free Cash Flow) = 75 + 76.88/(.1-.025) = 1100 ROIC vs. Discount Rate What it Implies • ROIC > Discount Rate – Normal. Firm earns an above average return on some investments. Should stop investing when the marginal investment has a return equal to the discount rate. • ROIC = Discount Rate – Likely the firm is over investing! Its investments with returns below the interest rate are offsetting those above. Other possibility, all investments by the firm earn exactly the rate of interest. Yea, sure. • ROIC < Discount Rate – Value destruction. Buy out management and stop the firm before it invests again! Example 4 – No Growth, Value Destroying Firm Investment Rate 25.00% ROIC 0.00% Growth Rate 0.00% Discount Rate 10.00% Year 0 1 2 3 4 5 NOPLAT 100 100 100 100 100 100 Net Investment 25 25 25 25 25 25 Free Cash Flow 75 75 75 75 75 75 PV(Free Cash Flow) = 75+75/.1 = 825 Example 5 – Growing, Value Destroying Firm Investment Rate 25.00% ROIC 5.00% Growth Rate 1.25% Discount Rate 10.00% Year 0 1 2 3 4 5 NOPLAT 100 101.25 102.52 103.80 105.09 106.41 Net Investment 25 25.31 25.63 25.95 26.27 26.60 Free Cash Flow 75 75.94 76.89 77.85 78.82 79.81 PV(Free Cash Flow) = 75+75.94/(.1-.0125) = 942.86 Ways of Estimating Earnings Growth • Look at the past. – The historical growth in earnings per share is a typical starting point. • Look at what others are projecting. – Other analysts may be using information you do not have. It is often useful to know what their estimates are. • Look at fundamentals. – How much are they investing? – What is the return on their investment? Estimating the Firm’s Terminal (Continuing) Value • Free cash flows (FCF) grow at a constant rate after the forecast horizon. – Used far more often than any other method. – Just remember, in the long run NO firm can grow faster than GDP! FCFT 1 TV rg r = discount rate, g = growth rate, T = end of the forecast horizon Terminal Value Estimation Constant Growth – Continued • Be careful when you use this formula, as your CAPEX in the FCF calculation should match the growth rate you choose. – This is once again related to the ratio Sales/Fixed Assets. – One can show that the previous formula can be written in the following way: g NOPLATT 1 1 TVT ROIC , r g ROIC = long-term return on newly invested capital. This formula may be easier to use than the previous formula since you do not have to estimate CAPEX. Instead it is estimated for you from g and ROIC. Estimating TV’s Convergence Approach • Assumes that competitive forces will ensure that after the forecast horizon, returns on the firm’s new investments will equal the discount rate (r). – ROIC = r and so, NOPLATT 1 TVT r Estimating TV Accounting Values • Terminal value = Book Value of Invested Capital – Backward looking. – Easy to use. Pitney Bowes Inc (PBI) Balance Sheet Assets Total Current Assets 2,513,175 2,552,625 2,556,608 Long Term Investments 3,189,283 3,246,083 3,236,258 Property Plant and Equipment 1,070,232 1,046,935 1,008,270 Goodwill 956,284 827,241 635,873 Intangible Assets 203,606 - - Accumulated Amortization - - - Other Assets 958,808 1,059,430 881,462 Deferred Long Term Asset Charges - - - Total Assets 8,891,388 8,732,314 8,318,471 Calculating Terminal Asset Value from Projected Book Value • PBI grew at about 5% in 2002 and 2% in 2003. – Average growth rate of 3.5% is not unreasonable. – In 2003 total assets (book value) equaled 8,891,388. – Suppose want TV as of 2010 (seven years later) = 8,891,388x1.0357 = 11,312,329. Economic Value Added (EVA) EVA = Invested Capital x (ROIC – r) • What is this? 1. A popular buzz word! 2. The value the firm created via its investments. Remember, firms should invest so long as the marginal return on equity (ROIC) exceeds the interest rate. This means a typical firm should have a positive EVA.