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Valuation Analysis

Judson W. Russell, Ph.D., CFA

University of North Carolina-Charlotte

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Agenda

Equity Valuation Fundamentals: Intrinsic Value

Enterprise Valuation Fundamentals: Free Cash Flow

Equity Valuation Fundamentals: Relative Value

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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 stock’s price equals the net present value of its dividends.

• Relative Value Approach: A stock’s value is determined by comparing similar stock values.

• Acquisition Value Approach: Calculate a company’s 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

Enterprise Value =Equity Market Cap.

Net Debt

Preferred Stock

Minority Interest

Equity Market Cap.

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Introduction

COMPARABLE (or “similar”) in terms of:

Operations Financial Aspects

Industry Size

Products Leverage

Markets Margins & Profitability

Distribution channels Growth prospects

Customers Shareholder base

Seasonality Market conditions (acquisitions)

Cyclicality Consideration paid (acquisitions)

Circumstances surrounding thetransaction

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Equity Valuation Process

The Graham and Dodd Approach to Security Selection

1. Study the available facts2. Prepare an organized report3. Project earnings and related data4. Draw valuation conclusions based on established principles

and sound logic5. Make a decision

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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 Companies 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

R E C E S S I O N :C o n s u m e r s t a p l e s ( f o o d ,d r u g s , c o s m e t i c s , t o b a c c o ) ,u t i l i t i e s , s o f t w a r e , a n db i o t e c h n o l o g y f i r m s

R E C O V E R Y : E a r l y s t a g eC o n s u m e r C y c l i c a l s ( a u t o s ,a p p a r e l , m e d i a , r e t a i l e r s ) ,C o n s u m e r C r e d i t ( s a v i n g s a n dl o a n s ) , a n d T r a n s p o r t a t i o n( a i r l i n e s , t r u c k i n g , r a i l r o a d s )

E X P A N S I O N : L a t e S t a g eB a s i c M a t e r i a l s ( c h e m i c a l s ,p l a s t i c s , p a p e r , w o o d ,m e t a l s ) , C a p i t a l G o o d s( e q u i p m e n t a n d m a c h i n e r ym a n u f a c t u r e r s )

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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 - E

Time

Rate of Sales

Growth

B

A

DC E

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Porter’s Five Forces

INDUSTRYCOMPETITORS

POTENTIALENTRANTS

SUBSTITUTES

SUPPLIERS BUYERS

Valuation Approach – Intrinsic Value

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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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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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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 + … + D/(1+ke)]

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


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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 investor’s 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 stock’s 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 = $20.81


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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 let’s assume that the holding period is infinite and the firm’s 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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We can employ the same technique for firm’s 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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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 firm’s 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 Flow Analysis

Using the DCF technique, BAC constructed a valuation for the Company by adding the presentvalue of the Company's projected after-tax cash flows to the present value of the Company'sterminal value.

Dollars in Millions

Projected FYE 12/31

2006 2007 2008 2009 2010Sales 500.0 469.8 499.6 531.1 565.3-Cash COGS and SG&A 400.0 375.8 399.7 424.9 452.2

589,680,386$ EBITDA 100.0 94.0 99.9 106.2 113.1

-Tax Basis Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9Operating Income 85.9 77.8 82.1 86.6 91.2

1 -Taxes 34.4 31.1 32.8 34.6 36.5 40.00%Net Operating Profit After Taxes 51.5 46.7 49.3 52.0 54.7

+Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9-Capex for P,P&E 17.2 17.3 17.3 17.3 17.3-Working Capital Changes 2.2 2.1 3.5 3.4 3.8Operating Cash Flow 46.2 43.5 46.3 50.9 55.5

Cost of Capital 12.0% 12.0% 12.0% 12.0% 12.0%Present Value of Cash Flows 41.3 34.6 32.9 32.3 31.5

1.0$ 2.0$ 3.0$ 4.0$ 5.0$ Exit Multiple

Exit Multiple Valuation Method 589.7 5.5x 6.5x 7.5xCumulative Present Value of Cash Flows 172.7 11.0% 546.2 613.3 680.4 Present Value of Exit Price 417.0 WACC 12.0% 525.5 589.7 653.8 Enterprise Value 589.7 13.0% 505.8 567.2 628.6

Exit Multiple: 6.5x Exit Var. 1.0xWACC: 12.0% WACC Var. 1.0%

Notes:(1) A 40% tax rate was assumed Large Cap Co.? Y

505847.76 680423.4

DCF analysis implies the Company's Enterprise Value is:

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…∞

FCF1 FCF2 FCF3 FCF4 FCF5

How do we account for the remaining cash flows of the firm?

Terminal Value Approach

Constant Growth Method

Free Cash Flow Analysis

FCFn

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Terminal Value Calculation

A. The Exit Multiple Method

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The Present Value of the Terminal ValueDiscounted Cash Flow Analysis

1 2010 EBITDA (Terminal Value) $113.10

2 x Exit multiple 6.5x

3= Pretax Sales Proceeds (future value) $735.15

4/ discount factor (back 5 years at 12%) 0.5674

5 Present value of terminal value $417.14

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Terminal Value as % of Enterprise Value

Provides a reality check of the DCF value

• Higher the %, more of the Enterprise Value is being realized with the assumed sale of the business at the end of the forecast period

• Confidence level in the 70-85% range, depending on the company and situation


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How much of the Enterprise Value for the Company is being generated by the Terminal Value?

• What is your comfort level with this percentage?


Present Value of Exit Multiple = $417Enterprise Value = $589.7 Percentage = $417/$589.7 = 70.7%

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Terminal Value Calculation

B. The Perpetuity Growth Method

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Now we’ll look at the perpetuity growth technique to capture the terminal value of Company.

The terminal value captures all future cash flows of the firm assuming a constant growth factor.

The operating cash flow of the firm in 2010 is $55.5. Assuming a growth rate of 4% the operating cash flow in 2011 would be $57.72.

We have a discount factor of 12% and a growth factor of 4% with a cash flow of $57.72.

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Perpetuity Growth Formula

Terminal Value = FCFN+1

(ka - g)where:

FCFN+1 = steady-state free cash flow in period N+1g = nominal perpetual growth rate

ka = discount rate

Terminal Value = $55.5(1.04)=$57.72= $721.5 .12-.04 0.08

Present Value of Perpetuity Growth Terminal Value = $721.5/(1.12^5) = $409.40


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Relative Value Analysis

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How do we use relative value?

The hardest part of relative value is finding comparable firms.

Once you have a decent list of comparables you need to determine which scaling variable to?

Next, you want to compare your target firm’s multiple to the average of the comparable set.

Finally, make sure that you account for differences, e.g. leverage, market position, patents, etc.

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Comparing PE Ratios across a Sector

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Comparing PE Ratios across a Sector

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Investors prefer to estimate the value of common stock using an earnings multiplier model.

P0 = D1/(ke - g)

Divide both sides by next year’s projected earnings:

P0/E1 = (D1/E1)(1/(ke - g))

The P/E ratio (forward) is determined by:

• The expected dividend payout ratio (D1/E1)

• The required rate of return on the stock (ke)

• The expected growth rate of dividends (g)

Relative Value

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Assume that a firm has an expected dividend payout of 40%, a required rate of return of 11%, and a growth rate of dividends of 6%. Next year’s earnings (E1) are expected to be $2.75.

P0/E1 = (.40)(1/(.11-.06)) = 8.0x

The value of the stock today is based on the P/E1 and estimate of E1.

P0 = P0/E1 x E1 = 8.0 x $2.75 = $22.00

Relative Value

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The best known measure of relative value for common stock is the P/E ratio or the earnings multiplier.

Analysts have also turned their attention to other measures of relative value:

• Price/book value (P/BV) : market value of the company divided by its book value. This metric is used a great deal with financial stocks since many of their assets are carried at values very close to market value. This metric can be used for firms with negative earnings or cash flows. Several studies have indicated that P/BV is a good indicator of future performance.

• Price/cash flow (P/CF) : market value of the company divided by its cash flow.

• Price/sales (P/S) : market value of the company divided by its sales.

Relative Value

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Expected Growth Rate

When a firm retains earnings and acquires assets, if it earns some positive rate of return on these additional assets, the total earnings of the firm will increase.

The rate of earnings growth depends on the proportion of earnings retained and the rate of return it earns on the new assets acquired.

Specifically, the growth rate (g) of equity earnings without external financing is equal to the percentage of net earnings retained (retention rate, b) times the rate of return on equity capital (ROE).

g = (retention rate)(return on equity)g = (b)(ROE)

This growth rate is called the internal or sustainable growth rate. The firm can increase its rate of growth by 1) retaining a larger portion of its

earnings for reinvestment in the firm or 2) increasing its ROE (recall, ROE = profit margin x total asset turnover x financial leverage).

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Pulling it all together

Firm XYZ is trading at $18 currently. Last year’s earnings were $2.00 per share. The firm’s ROE is 10% and you expect it to stay that way for the foreseeable future. The firm has a stable dividend payout policy of 40%. The current nominal risk-free rate is 7%, the expected market return is 12% and XYZ’s beta is 1.2. Value XYZ and indicate what you should do based on your estimate.

1. Determine required rate of return: ke = 7% + 1.2(12%-7%) = 13%2. Determine growth rate: g = (.60)(10%) = 6%3. Determine last year’s dividend: $2.00(.40) = $0.80.

4. Determine next year’s dividend: D1 = D0(1+g) = $0.80(1.06) = $0.85

5. Calculate the value projection: V = D1/(ke - g) = $0.85/(.13-.06) = $12.146. Compare the stock value to its current market price: $12.14 vs. $18.007. Sell recommendation.

2. Overview of Conrail Inc.

Valuation Analysis

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• Conrail, through its wholly-owned subsidiary Consolidated Rail Corporation, provides freight transportation services within the northeast and midwest United States. Conrail interchanges freight with other United States and Canadian railroads for transport to destinations within and outside Conrail's service region. Conrail operates no significant line of business other than the freight railroad business and does not provide common carrier passenger or commuter train service.

• Consolidated Rail Corporation is a Pennsylvania corporation incorporated on February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization Act of 1973, the rail properties of many of the railroads in the northeast and midwest region of the United States which had gone bankrupt during the early 1970's, the largest of which was the Penn Central Transportation Company ("Penn Central"). The US government sold its 85% stake to the public in 1987.

Conrail Inc.Company Description

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CSX and Norfolk Southern

Conrail is the ideal extension for both into the Northeast

“Northeast corridor” is a must for a transcontinental railroad

Strategic positioning with 2 major Western rails

Analysis of Potential Acquirers

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Financial Overview of Conrail

Date: October 14, 1996 (pre-CSX merger announcement)CRR Financial Information

as of 6/30/96Dollar amounts and shares in millions

Multiple based on10/14/96 price of

$71.00

LTM Revenues $3,712 2.19x

LTM EBITDA $993 8.2x

LTM EBIT $705 11.5x

Diluted Shares Outstanding (a) (b) 81.718

Market Capitalization of Equity $5,802

ESOP Preferred Stock $281

Total Debt (at book values) $2,078

Cash and equivalents $28

Enterprise Value $8,133(a) 81.067 million common shares outstanding and 1.556 million options with an average strike of $41.28.

Option proceeds assumed to repurchase shares at current share price under the treasury stock method.(b) Excludes ESOP junior preferred stock convertible into 9.75 million common shares.

The Conrail Case Study

3. Comparable Public Company Analysis

“Analysis of Selected Publicly Traded Companies”“Public Comparables”

“Trading Comparables”“Comp Co’s”

“Common Stock Comparisons”

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Comparable Public Company Analysis

Previous analyses of other bankers• Industry specialists

• M&A

Proxy Statement - “Peer group index” 10-K / IPO Prospectus - “Competition section” Research (respect the Chinese Wall) S&P Tearsheets, Value Line, Bloomberg SIC code screen from FactSet Company’s views

Determining the Appropriate Universe

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1) Most recent 10-K and/or annual report

2) 10-Q from latest quarter

3) News announcements (before required filing)

4) Research reports and EPS estimates

Use SEC-filed documents whenever possible

Comparable Public Company AnalysisPublic Information Checklist

What comparables should be used to value

Conrail?

Valuation Analysis

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Summary of the Railroad Industry

1995 Financial Information

Name (ticker) Total Rev Rail Rev - $ Rail Rev - % Non-Rail (%-Rev) Comments

Burlington NorthernSanta Fe (BNI)

$8,170 $8,170 100% BNI operates in 35 states, mostly in thewestern US. In September, 1995 BNI tookcontrol of Santa Fe Pacific, making it thesecond largest railroad in the US.

Canadian National(CNI)

C$4,100 C$4,100 100% Canadian National was owned by thegovernment until late 1995 when it wasprivatized. As a result of this transaction,as well as previous governmentalownership, its financial statements arerather messy—eg., there are significantNOLS, and the capital structure is strange.Although no longer owned by the Canadiangovernment, CNI, as all Canadianrailroads, operates under governmentregulation. CNI has some lines thatoverlap with Conrail in the northeasternUS.

Canadian Pacific (CP) C$7,946 C$3,757 47% CP Ships (12%)Energy (34%)Real estate (12%)

Obviously another Canadian railroad. Notethe rail and non-rail revenue percentagesexclude inter-company eliminations.

Conrail (CRR) $3,686 $3,686 100% Do you include the company you are tryingto value in the list of comparablecompanies?

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CSX (CSX) $10,504 $4,819 46% Shipping (38%)Intermodal (9%)Barge (5%)Real estate (2%)

Although only 46% of CSX’s revenues arefrom rail operations, the shipping,intermodal, and barge lines are alltransportation businesses. Notwithstandingthe fact that rail is only 46% of CSX’srevenues, rail contributes 77% of operatingincome.

Florida East Coast(FLA)

$201 $149 74% Real estate (14%)

Mtr carrier (12%)

FLA’s rail operations run the length ofFlorida, along the Atlantic coast. FLA hasa unique ownership structure. It is owned54% by St. Joe Paper Company, which isin turn 69% owned by the DuPont family.The DuPonts’ chief interest in FLA is itsextensive land holdings.

Illinois Central (IC) $644 $644 100% IC is a “single track” line that runs up anddown the Mississippi River. Unlike theother large US railways, IC principallyhauls agriculture commodities, rather thanfreight.

Kansas City Southern(KSU)

$775 $502 65% Asset mgt (31%)

Other (4%)

The rail operations run through MO, AR,TX, LA, MS, AL. The Asset Managementsegment is comprised of two prominentinvestment operations: the Janus andBerger funds.


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Norfolk Southern(NSC)

$4,668 $4,012 86% NAVL (14%) Its rail operations are principally in the SEand MW. North American Van Lines(NAVL) is its other major segment. Railaccounts for 94% of consolidated operatingincome.

Union Pacific (UNP)

Wisconsin Central(WCLX)

$11,100

$263

$9,874

$263

90%

100%

Trucking (9%)

Logistics (1%)

The country’s largest railroad operatingthroughout the western US. Recentlyacquired Southern Pacific.

An extremely profitable railroad operatingin the upper Midwest. Also has equity,investments in rail operations in NewZealand and the UK.

Required Analytical Adjustments

Valuation Analysis

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One-Time Non-Recurring Items

“Normalizing” the income statement for one-time items• Adjust for non-recurring items (gains and losses)

What was Conrail’s normalized 1995 income statement?• What adjustment needs to be made to operating income?

• What adjustment needs to be made to net income?

• What adjustment needs to be made to taxes?

Subjectivity of the Analysis

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Conrail’s 1995 Income Statement

CONRAIL INC. CONSOLIDATED STATEMENTS OF INCOME[CAPTION] Years ended December 31, ----------------------------($ In Millions Except Per Share Data) 1995 1994 1993 ------ ------ ------[S] [C] [C] [C]Revenues $3,686 $3,733 $3,453 ------ ------ ------Operating expenses Way and structures 485 499 492 Equipment 766 815 703 Transportation 1,324 1,379 1,283 General and administrative 370 350 384 Asset disposition charge (Note 2) 285 Early retirement program (Note 9) 84 ------ ------ ------ Total operating expenses 3,230 3,127 2,862 ------ ------ ------Income from operations 456 606 591Interest expense (194) (192) (185)Loss on disposition of subsidiary (Note 10) (80)Other income, net (Note 11) 130 118 114 ------ ------ ------Income before income taxes and the cumulative effect of changes in accounting principles 392 532 440Income taxes (Note 6) 128 208 206 ------ ------ ------Income before the cumulative effect of changes in accounting principles 264 324 234Cumulative effect of changes in accounting principles (Notes 1, 6 and 7) (74) ------ ------ ------Net income $ 264 $ 324 $ 160 ====== ====== ======

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Note 2: Asset Disposition Charge

2. Asset Disposition Charge ------------------------ Included in 1995 operating expenses is an asset dispositioncharge of $285 million, which reduced net income by $176 million.The asset disposition charge resulted from a review of the Company'sroute system and other operating assets to determine those that nolonger effectively and economically support current and expectedoperations. The Company identified and has committed to sell 1,800miles of rail lines that are expected to provide proceedssubstantially less than net book value. In addition, other assets,principally yards and side tracks, identified for disposition havebeen written down to estimated net realizable value.

Normalizing Conrail’s Income Statement for 1995

Reported Adjustment Normalized

Operating Income – Pretax Adjustment $456 000000000 000000000

Taxes – Incremental Tax Adjustment 128 000000000 000000000

Net Income – After-tax Adjustment 264 000000000 000000000

4. Comparable Acquisition Analysis

“Analysis of Selected Acquisitions”“Acquisition Comparables”

“Acq Comps”“Deal Comps”

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Comparable Acquisition Analysis

Previous analyses of other bankers Screen for comparable M&A transactions

• Securities Data Corp. (SDC)

• Compile “list” from SIC code screen

Other possibilities:• Industry newsletters, journals

• M&A journals and almanacs

• News services

• Research reports

Determining the Appropriate Universe

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Financial information• SEC filed documents if possible

SDC M&A summary• Summary description of the transaction, key dates,

premiums paid

News run Merger documents (if applicable)

• Form 8-K, Proxy/S-4 for pro forma financial info

Research & EPS estimates (if applicable)

Comparable Acquisition AnalysisInformation Checklist

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Looking for comparability regarding:• transaction size

• Nature of acquirer:• Strategic buyer

• financial buyer

• Recent timeframe

Comparable Acquisition Analysis

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Comparable Acquisition AnalysisComparable Acquisition Analysis - Multiples Summary

(Dollars in Millions)

Effective TransactionDate Target Acquiror Enterprise Value Sales EBITDA

Jun-96 CCP Holdings, Inc. Illinois Central Corp. $157 2.06x 5.3x

Sep-96 Southern Pacific Union Pacific Corp. $5,500 1.74x 7.7x

May-95 Chicago & North West. Union Pacific Corp. $2,611 2.25x 8.3x

Sep-95 Santa Fe Pacific Burlington Northern $5,106 1.90x 8.5x

Cancelled Kansas City Southern Illinois Central Corp. $1,625 3.25x 9.0x

(1) Adjusted average omits the high and low values.

Enterprise Value as a Multiple of:

Comparable Industry Transactions Comments: CCP was a small railroad owned by three individuals.

Comments: This is a large, recent transaction.

Comments: Union Pacific had owned 32% of CNW, and completed the purchase of the remaining 68%. The statistics in the chart reflect the transaction as if the entire 100% were purchased.

Comments: Another large, recent transaction.

Comments: The transaction from mid-1994 was cancelled since the parties could not agree on how to value the asset management businesses.

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Comparable Acquisition AnalysisComparable Acquisition Analysis - Multiples Summary

(Dollars in Millions)

Effective TransactionDate Target Acquiror Enterprise Value Sales EBITDA

Sep-92 Midsouth Corp. Kansas City Southern $347 3.39x 8.8x

Apr-90 Soo Line Corp. Canadian Pacific Ltd. $528 0.98x 7.4x

Oct-89 CNW Corp. CNW Acquisition Corp. $1,651 1.65x 7.1x

Jul-89 Illinois Central Rail. The Prospect Group $672 1.22x 5.8x

Enterprise Value as a Multiple of:

Comparable Industry Transactions Comments: The target operates rail lines in La, Miss, Ala.

Comments: The target operates principally in the upper Midwest---Minn and Wisc.

Comments: A very successful acquisition by the Blackstone group, a major financial buyer in the US.

Comments: Another very successful LBO, this time by another prominent financial buyer, the Prospect group.

(1) Adjusted average omits the high and low values.

5. Discounted Cash Flow Analysis

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In this section we will project free cash flow for Conrail and determine the enterprise value by discounting these cash flows at the appropriate discount rate.

We will also explore the following:• valuation using a terminal exit multiple

• valuation using a perpetuity growth formula

• valuation incorporating the effects of synergies

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As the title implies we will need to determine Conrail’s cash flows.

Typically, we will want to look at the past three years of financials to form a basis for our projections.

The projection period is usually five years and then either:• an assumed sale of the firm takes place to capture the value of all

future cash flows (exit multiple approach), or

• we value all future cash flows assuming that growth will remain constant at a level approximately equal to the economy’s GDP growth level (perpetuity growth approach).

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Since we are interested in the firm value, we will look at unlevered after-tax cash flows to the firm.

This allows us to view the firm value to all stakeholders, i.e. debt, preferred, and common.

The basic approach is to:• project sales

• determine EBITDA

• subtract the tax deductible depreciation and amortization amounts

• subtract taxes

• adjust for non-cash expenses, capital expenditures, and working capital needs.

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Let’s start with a historical look at Conrail’s cash flows:

Conrail Historical Operating Cash Flow FYE 12/31

1994 1995 1996 CAGR 1994-1996Sales 3733.0 3686.0 3797.0 0.9%Sales Growth 8.1% -1.3% 3.0%

-Cash COGS and SG&A 2766.2 2650.2 2726.2EBITDA 966.8 1035.8 1070.8 5.2%EBITDA Margin 25.9% 28.1% 28.2%

-Tax Basis Depreciation & Amortization276.2 294.9 307.6Operating Income 690.6 740.9 763.2 5.1%Operating Income Margin 18.5% 20.1% 20.1%

-Taxes 265.9 285.2 293.8Net Operating Profit After Taxes 424.7 455.6 469.4 5.1%

+Depreciation & Amortization 276.2 294.9 307.6-Capex for P,P&E 410.6 405.5 417.7-Working Capital Changes 15.5 42.9 26.4Operating Cash Flow 274.7 302.2 332.9 10.1%

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Discounted Cash Flow Analysis - BASE CASEThe discounted cash flow ("DCF") analysis is based on Conrail's historical performance and Wall Street research expectations.

* Sales are projected to reach $4,401 million by FY 2001 through organic growth.Sales figures for 1997-2001 assumed 3% growth per year.

* Rail Operating Ratio falls from 79.9% in 1996E to 77.9% in 1997 and by an additional 1% per year for 1998-2001, hitting73.9% in 2001. This operating improvement is based on Conrail's stated goal of achieving an operating ratio of 75%.

* All working capital needs are projected to support the annual growth.

* Capital expenditures are estimated to be 11.5% of revenues in 1997 and 11% for 1998-2001, in line with historical levels.Depreciation is a reasonable estimate from the capital expenditures and existing PP&E base.

* The following table compares Conrail's historical operating results to the projections:

1994 1995 1996E 1997 1998 1999 2000 2001Revenue Growth 8.1% (1.3%) 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%

Rail Operating Ratio (1) 81.5% 79.9% 79.9% 77.9% 76.9% 75.9% 74.9% 73.9%

EBITDA Margin 25.9% 28.1% 28.2% 30.2% 31.3% 32.3% 33.3% 34.3%

Operating Inc. Margin 18.5% 20.1% 20.1% 22.1% 23.1% 24.1% 25.1% 26.1%

(1) Rail Operating Ratio = Rail Operating Expenses (including depreciation) divided by Rail Revenues

Historical Projected

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Additional assumptions:• Taxes are assumed to be 38.5% of operating income.

• Working capital will be:

• -$34.0 million 1997

• -$22.1 million 1998

• -$23.1 million 1999

• -$24.3 million 2000

• -$25.6 million 2001

• Cost of capital is 11% for Conrail based on the stability of the firm’s cash flows.

• We will use an exit multiple of 8x EBITDA in 2001 to value the sale of Conrail. This multiple compares to an average 8.3x EV/LTM EBITDA multiple using Comparable Acquisition Analysis.

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Terminal Value

A. The Exit Multiple Method

74

The Present Value of the Terminal Value


Note: Does not match the $7,177.2 on the previous page due to rounding.

75


Provides a reality check of the DCF value

• Higher the %, more of the Enterprise Value is being realized with the assumed sale of the business at the end of the forecast period

• Confidence level in the 70-85% range, depending on the company and situation


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How much of the Enterprise Value for the Conrail Base Case is being generated by the Terminal Value?

• What is your comfort level with this percentage?


B. The Perpetuity Growth Method

78


Now we’ll look at the perpetuity growth technique to capture the terminal value of Conrail.

We will combine this technique with an analysis of the synergy benefits from a possible Norfolk Southern or CSX acquisition of Conrail.

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Synergies Valuation

Analyze for the synergy value independently

Determine the “DCF value with synergies”• Realization percentage for additional sensitivities

analysis

• What is the timing of the realization?


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Synergies Valuation

Terminal Value by Perpetuity Growth Method• Use a steady-state FCF

• Maintenance CapX (Depreciation = CapX)

• No deferred taxes

• Estimate steady-state working capital needs


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Perpetuity Growth Formula

Terminal Value = FCFN+1

(r - g)

where:

FCFN+1 = steady-state free cash flow in period N+1g = nominal perpetual growth rater = discount rate


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Discounted Cash Flow Analysis - SYNERGIES

The Synergies valuation analysis was created to calculate the present value of the expected net sales and operating savings benefits from a possible Norfolk Southern or CSX acquisition of Conrail.

*Incremental revenue synergies from single line service, new coal traffic and highway-to-railway transfers, less of losses from enhanced competition

*Operating cost savings from reduction in general and administrative, transportation, and equipment expenses.

*Additional capital expenditures are assumed for roadway, equipment and terminals, plus cash severance costs. Net investments avoided are assumed in years 2000 and 2001.

*Synergies are assumed to grow at 3% per year in perpetuity.

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Discounted Cash Flow Analysis - SYNERGIES

Using the DCF technique, Bank of America constructed a valuation for the estimated syneriges of a possible NorfolkSouthern or CSX merger with Conrail.

Dollars in Millions

Projected FYE 12/31

1997 1998 1999 2000 2001Incremental Sales 227.6 544.8 881.0 907.5 934.7-Cash Costs to Achieve Incremental Sales (186.2) (448.3) (722.4) (744.1) (766.4)

$2,794 million Net Incremental Sales 41.4 96.6 158.6 163.4 168.3

+Cost Savings 81.0 310.3 529.3 545.2 561.5Operating Income Contribution 122.4 406.9 687.9 708.6 729.8

(1) -Taxes (47.1) (156.7) (264.9) (272.8) (281.0) 38.50%Net Operating Profit Contribution After Taxes 75.3 250.2 423.1 435.8 448.8

-Merger Outlays & Costs / Investments Avoided (551.7) (439.7) (262.1) 34.5 34.5Net Operating Cash Flow (476.4) (189.4) 161.0 470.3 483.3

(2) Cost of Capital 13.0% 13.0% 13.0% 13.0% 13.0%Present Value of Cash Flows (421.6) (148.3) 111.6 288.4 262.3

1.0$ 2.0$ 3.0$ 4.0$ 5.0$

1.0$ 2.0$ 3.0$ 4.0$ 5.0$ Perpetuity Growth Rate

Perpetuity Valuation Method 2,794.4 2.5% 3.0% 3.5%Cumulative Present Value of Cash Flows $92.4 12.0% $3,070.4 $3,250.0 $3,450.7Present Value of Terminal Value 2,702.0 WACC 13.0% 2,653.2 2,794.4 2,950.4 Enterprise Value $2,794.4 14.0% 2,311.8 2,425.0 2,548.8

Perpetuity Growth Rate: 3.0% Growth Rate Var. 0.5%WACC: 13.0% WACC Var. 1.0%

Notes:(1) A 38.5% marginal tax rate was assumed. Large Cap Co.? Y

(2) A higher WACC of 13.0% was utilized give the uncertainty of synergy realization. 2311840.68 3450738.5

DCF analysis implies that the synergies are worth:

Assumes 100% Realization

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Terminal Value of the SynergiesDiscounted Cash Flow Analysis

Note: Does not match the $2,702 on the previous page due to rounding.

What is the Total DCF for Conrail?

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What is the Total DCF Valuation?

Base Case DCF

Conrail’s FCFs + 50% of Synergies

$8,880 million + $1,400 million

= $10,280 million
