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					        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 
                        rg
 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.

				
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