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Valuation Analysis

Judson W. Russell, Ph.D., CFA University of North Carolina-Charlotte

1

Agenda

Equity Valuation Fundamentals: Intrinsic Value Enterprise Valuation Fundamentals: Free Cash Flow Equity Valuation Fundamentals: Relative Value

2

Introduction

Valuation is both art and science Art through reasonable, defensible: Assumptions Judgment and interpretation of data Science through application of analytical formulae Valuation is based on future performance

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Introduction

Two main valuation questions:

1)What is a company worth by valuation metrics?2) What can or will a potential buyer pay?

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Introduction

Three main valuation methodologies

Intrinsic Value Approach: A stocks price equals the net present value of its dividends. Relative Value Approach: A stocks value is determined by comparing similar stock values. Acquisition Value Approach: Calculate a companys stock price by determining its worth to a third party acquirer.

Golden Rule: Footnote your assumptions

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Introduction

EQUITY VALUE:

Value of shareholders interest After interest expense, preferred dividends and minority interest expense Multiples of net income, book value, EPS Other common terms: Market Value, Market Capitalization, Offer Value (in an acquisition context)

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Introduction

ENTERPRISE VALUE: Includes all forms of capital Market value of equity, debt, preferred stock, minority interest Before interest expense, preferred dividends and minority interest expense Multiples of sales, EBITDA, EBIT or any other applicable metric (per subscriber, per bed, etc.) Other common terms: Aggregate Value, Firm Value, Total Capitalization, Adjusted Market Value, Transaction Value

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Introduction

Equity Market Cap. Enterprise Value

=

Equity Market Cap. Net Debt Preferred Stock Minority Interest

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Introduction

COMPARABLE (or similar) in terms of:

OperationsIndustry roducts arkets istribution channels ustomers easonality yclicality

Financial Aspectsize Leverage argins & ro itability Growth prospects hareholder base arket conditions (acquisitions) onsideration paid (acquisitions) ircumstances surrounding the transaction9

Equity Valuation ProcessThe Graham and Dodd Approach to Security Selection Study the available facts Prepare an organized report Project earnings and related data Draw valuation conclusions based on established principles and sound logic Make a decision

1. 2. 3. 4.

5.

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Valuation Process

The top-down approach starts with an analysis of alternative economies and security markets. The initial objective is to decide how to allocate investment funds among countries and within countries to bonds, stocks, and cash. The second phase is the analysis of alternative industries. The objective at this stage is to determine which industries will prosper based on your analysis of the economy. The final, third, phase focuses on security selection. The objective is to determine which companies within the selected industries will prosper and which stocks are undervalued.

Analysis of Alternative Economies and Security Markets

Analysis of Alternative Industries

Analysis of Individual Com anies and Stocks

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Valuation Process Example

The top-down analysis for a U.S. homebuilder: Economy GDP will increase 3% Capital Markets Interest rates will remain low Industry Housing starts to stay strong Homebuilding Company Homebuilder to gain market share. Sales will increase by 15% versus the industry average of 10%. Steady profit margins signify a 15% earnings increase.

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Economic Cycles

RECESSI N: Consumer staples (food, drugs, cosmetics, tobacco), utilities, soft are, and biotechnology firms

REC VERY: Early stage Consumer Cyclicals (autos, apparel, media, retailers), Consumer Credit (savings and loans), and Transportation (airlines, trucking, railroads)

EXPANSI N: Late Stage Basic Materials (chemicals, plastics, paper, ood, metals), Capital oods (equipment and machinery manufacturers)

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Industry Analysis

Forecast Sales An insightful analysis when predicting industry sales is to view the industry over time and divide its development into stages. Pioneering development - A Rapid accelerating growth - B Mature growth - C Stabilization and market maturity - D Deceleration of growth and decline - ERate of Sales ro th B A Time D C E

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Porters Five ForcesPOTENTIAL ENTRANTS

SUPPLIERS

INDUSTRY COMPETITORS

BUYERS

SUBSTITUTES

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Valuation Approach Intrinsic Value

Valuation Approaches Intrinsic Value

The value of an asset is the present value of its expected returns. The process of valuation requires estimates of (1) the stream of expected returns and (2) the required rate of return on the investment. The value of a preferred stock (perpetuity) is simply the stated annual dividend divided by the required rate of return on preferred stock (kp). A preferred stock with an $8 per year dividend and required return of 9% is valued as: V = $8 / 0.09 = $88.89

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Valuation Approaches Intrinsic Value

The valuation of common stock is more difficult than bonds or preferred stock because an investor is uncertain about the size of the returns, the time pattern of returns, and the required rate of return (ke). However, the value of common stock is still the present value of its future cash flows. The only cash flows an equity investor ever gets are dividends (cash or liquidating). A model to value common stock is the dividend discount model (DDM).

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Valuation Approaches Intrinsic Value

The DDM assumes that the value of a share of common stock is the present value of all future dividends as; V = [D1/(1+ke)1 + D2/(1+ke)2 + + Dg/(1+ke)g]

Since estimating Dg is impossible, other methods have evolved based upon a terminal stock value, or a constant rate of growth.

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Valuation Approaches Intrinsic Value

Assume an investor wants to buy a stock, hold it for one year, and then sell it. We must evaluate the dividend cash flows as well as the terminal value in one year. These cash flows are then discounted at the investors required rate of return. A company earned $2.50 a share last year and paid a $1 dividend (40% dividend payout). The firm has a consistent record regarding payout and we expect it to earn $2.75 per share during the coming year. We expect the stock to trade at $22 at the end of the coming year. Further, the risk-free rate is 5%, the market return is 10%, and the stocks beta is 1.2. ke = rf + b(E(rm) rf ) = 5 + 1.2 (10-5) = 11%, D1 = E1(dividend payout) = $2.75(.4) = $1.10 V = [D1/(1+ke)1 + Stock Value1/(1+ke)1] V = [$1.10/(1+.11)1 + $22/(1+.11)1] V = 0.99 + 19.82 = $20.8120

Valuation Approaches Intrinsic Value

When valuing a firm with an infinite holding period we assume that dividends, at some point, exhibit a constant rate of growth. Assume that a firm is in a state of constant growth, we can value the infinite stream of cash flows using the following abbreviated formula: V = D1/(ke - g)

For instance, in our previous example lets assume that the holding period is infinite and the firms dividends are growing at 6% per year perpetually. The dividend in one year was $1.10 and the required rate of return was 11%. V = $1.10/(.11- .06) = $22.00

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Valuation Approaches Intrinsic Value

We can employ the same technique for firms that have varying rates of growth by assuming that the growth rate becomes constant, at some point. For instance, suppose we have a firm experiencing rapid growth due to its position in the product cycle. At some point the growth rate has to slow or the firm will become the market! We can accommodate this scenario with a multistage model by discounting the rapid growth phase dividends individually and then determining the terminal value using the constant growth methodology. V = [D1/(1+ke)1 + D2/(1+ke)2 + + (Dn+1/(ke-g)) /(1+ke)n]

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Valuation Approaches Intrinsic Value

Suppose that ABC Company has a current dividend of $1.00 per share with growth expectations of 20% for each of the next two years. After that point, the firm expects dividends to grow at 4% each year indefinitely. Given a cost of equity of 11%, calculate the value of the firms shares. V = [D1/(1+ke)1 + D2/(1+ke)2 + V2/(1+ke)2] where V2= D3/(ke g) V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2] V = $1.08 + $1.17 + $17.39 = $19.64

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Valuation Approach Intrinsic Value

DISCOUNTED CASH FLOW ANALYSIS

Intrinsic value of the company Unlevered free cash flows Independent of capital structure Free cash flows generated by the assets that are available to all capital holders Present value of: (1) free cash flows and (2) projected terminal value Terminal value is used to estimate value beyond the forecast period Exit Multiple Method (assumes the sale of the business) Perpetuity Growth Rate Method (3) Discount rate = Weighted average cost of capital (WACC) WACC = ka = wdkd(1-t) + weke

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Discounted Cash FlowAnalysisUsing the DCF technique, BAC constructed a valuation for the Com pany by adding the present value of the Com pany's projected after-tax cash flows to the present value of the Com pany's term value. inal DCF analysis implies the Company's Enterprise Value is: $ 589,680,386Dollars in Millions

ProjectedF 12/31 YE Sales -Cash COGS and SG&A E BITDA -Tax Basis Depreciation & Am ortization Operating Incom e 1 -Taxes Net Operating Profit A