EQUITY RESEARCH &

INVESTMENT BANKING

VALUATION

Misconceptions about Valuation

Myth 1: A valuation is an objective search for “true” value Truth 1.1: All valuations are biased. The only questions are how

much and in which direction. Truth 1.2: The direction and magnitude of the bias in your valuation

is directly proportional to who pays you and how much you are paid. Myth 2.: A good valuation provides a precise estimate of value

Truth 2.1: There are no precise valuations Truth 2.2: The payoff to valuation is greatest when valuation is least

precise. Myth 3: . The more quantitative a model, the better the

valuation Truth 3.1: One’s understanding of a valuation model is inversely

proportional to the number of inputs required for the model. Truth 3.2: Simpler valuation models do much better than complex

ones.

Basis for all valuation approaches

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon a perception that markets are inefficient and make

mistakes in assessing value an assumption about how and when these inefficiencies

will get corrected In an efficient market, the market price is the

best estimate of value. The purpose of any valuation model is then the justification of this value.

Business Valuation Techniques

Discounted cash flow (DCF) approaches Dividend discount model Free cash flows to equity model (direct approach) Free cash flows to the firm model (indirect approach)

Relative valuation approaches P/E (capitalization of earnings) Enterprise Value/EBITDA Other: P/CF, P/BV, P/S Control transaction based models (e.g. value based on

acquisition premia of “similar” transactions) Contingent claim valuation approaches

Using option valuation techniques to value corporate finance projects and assets (“real options”)

Approaches to Valuation

Valuation Models

Asset BasedValuation

Discounted CashflowModels

Relative Valuation Contingent Claim Models

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capitalapproach

APVapproach

Excess ReturnModels

Stable

Two-stage

Three-stageor n-stage

Current

Normalized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option toliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Firm

DISCOUNTED CASH FLOW

Discounted Cash Flow Valuation

What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset.

Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk.

Information Needed: To use discounted cash flow valuation, you need to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get

present value Market Inefficiency: Markets are assumed to make mistakes in

pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

Discounted Cash Flow Valuation

What cash flow to discount? Investors in stock receive dividends, or periodic cash

distributions from the firm, and capital gains on re-sale of stock in future

If investor buys and holds stock forever, all they receive are dividends

In dividend discount model (DDM), analysts forecast future dividends for a company and discount at the required equity return

Problem with dividends: they are “managed” and not too many companies pay them

Valuation: First Principles

Total value of the firm

= debt capital provided + equity capital provided

+ NPV of all future projects project for the firm

= uninvested capital +

present value of cash flows from all future

projects for the firm

Note: This recognizes that not all capital may be used to invest in projects

The Valuation Process

Identify cash flows available to all stakeholders

Compute present value of cash flows Discount the cash flows at the firm’s weighted average cost of

capital (WACC)

The present value of future cash flows is referred to as: Value of the firm’s invested capital, or Value of “operating assets” or “Total Enterprise Value” (TEV)

The Valuation Process, continued

Value of all the firm’s assets (or value of “the firm”)

= Vfirm = TEV + the value of uninvested capital

Uninvested capital includes: assets not required (“redundant assets”) “excess” cash (not needed for day-to-day operations)

Value of the firm’s equity = Vequity = Vfirm - Vdebt

where Vdebt is value of fixed obligations (primarily debt)

Total Enterprise Value (TEV)

For most firms, the most significant item of uninvested capital is cash

Vfirm = Vequity + Vdebt = TEV + excess cash

TEV = Vequity + Vdebt - excess cash

TEV = Vequity + Net debt

where Net debt = Vdebt – excess cash

Generic DCF Valuation Model

Cash flowsFirm: Pre-debt cash flowEquity: After debt cash flows

Expected GrowthFirm: Growth in Operating EarningsEquity: Growth in Net Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value

CFn.........

Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Growth

Discounted Cashflow Valuation

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset.

Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset.

Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

Value = CF

t

(1+ r)tt =1

t = n

Equity Valuation versus Firm Valuation

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

Equity valuation: Value just the equity claim in the business

Firm Valuation: Value the entire business

Equity Valuation

Assets Liabilities

Assets in Place Debt

Equity

Discount rate reflects only the cost of raising equity financingGrowth Assets

Figure 5.5: Equity Valuation

Cash flows considered are cashflows from assets, after debt payments and after making reinvestments needed for future growth

Present value is value of just the equity claims on the firm

Firm Valuation

Assets Liabilities

Assets in Place Debt

Equity

Discount rate reflects the cost of raising both debt and equity financing, in proportion to their use

Growth Assets

Figure 5.6: Firm Valuation

Cash flows considered are cashflows from assets, prior to any debt paymentsbut after firm has reinvested to create growth assets

Present value is value of the entire firm, and reflects the value of all claims on the firm.

Measuring Cash Flows

Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim

FCFF = EBIT (1 - tax rate)

+ Depreciation and amortization (non cash items)

- Capital Expenditures - Increase in Working Capital

What is working capital?Non-cash current assets - non-interest bearing current liabilities (e.g. A/P & accrued liab.)

Ultimately:

n

tt

t

WACC

FCFFValue

1 )1(

Two Stage FCFF Valuation

The number of periods necessary to forecast is usually

Impossible to forecast cash flow indefinitely into the future with accuracy

Typical solution: break future into “stages” Stage 1 : firm experiences high growth

Sources of extraordinary growth: product segmentation low cost producer

Period of extraordinary growth: based on competitive analysis / industry analysis

Stage 2: firm experiences stable growth

DISCOUNT RATE (COST OF DEBT, COST OF

EQUITY, CAPM)

Cost of Capital (WACC)

After tax cost of capital is the weighted average of required returns on different types of liabilities used to finance the assets under consideration. Formally:

kc = (D/V ) * kd * (1-t) + (E/V ) * ke

kd = cost of debt D=value of debt

ke = cost of equity E=value of equity

kc = overall cost of capital V=D+E

t = firm’s marginal tax rate

Capital Structure

Use market rather than book values of debt and equity if available

“Target” capital structure: Estimate the firm’s current capital structure Review the capital structure of comparable firms Review management’s plans for future financing

What if capital structure is expected to change over time?

Cost of Debt (kd)

Match with term of projects (generally long-term) Focus on “permanent” debt (can include short

term) Use same rate for all types of debt (short and

long-term) Use current as opposed to past yields

Take government yields and add a risk “premium” Historic spread for issuer (long-term best but use short

term spread if no better data) Spread given bond rating, if available 1-3%, if no other information

Cost of Equity (ke): the CAPM

Relevant measure of risk: Contribution a stock makes to the risk of a well

diversified portfolio (the “market” portfolio) Formally, this contribution is given by an asset’s “beta”

The CAPM relates the cost of equity for an individual stock to that asset’s beta (b). Formally:

ke = rf + b RP

The CAPM: Inputs

b - beta Beta for an asset of similar risk to the market portfolio

= 1. Typical range of betas: 0.5 - 2.0 If you cannot measure for firm, use beta of comparable

firm(s). Be consistent with capital structure assumptions (may need to unlever / relever)

rf - risk free rate

Current yield on long-term government bonds

RP - expected market risk premium Historic average of difference between the return on

the market (e.g. Sensex) and long-term government bonds

4-6% if no better data available

Special Cases in DCF Valuation

Capital raising (e.g. IPO) Do cash flow projections account for capital raised?

If so, value of existing equity equals total equity value less amount raised in the IPO

Share price for equity offering = value of existing equity / number of existing shares

If lower price, wealth transfers from original share owners

Private firms “Liquidity discount” ~40%

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RELATIVE VALUATION :

EQUITY VALUE MULTIPLES

29

Relative vs. Fundamental Valuation

The DCF (WACC, FTE, APV) model of valuation is a fundamental method.

Value of firm (equity) is the PV of future cash flows. Ignores the current level of the stock market (industry). Appropriate for comparing investments across different

asset classes (stocks vs. bond vs. real estate, etc). In the long run, fundamental is the correct way of value

any asset.

30

Relative vs. Fundamental Valuation

Relative valuation is based on P/E ratios and a host of other “multiples”.

Extremely popular with the press, CNBC, Stock brokers Used to value one stock against another. Can not compare value across different asset classes

(stocks vs. bond vs. real estate, etc). Can not answer the question is the “stock market over

valued?” Can answer the question, “I want to buy a tech stock,

which one should I buy?” Can answer the question, “Which one of these overpriced

IPO’s is the best buy?”

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Relative Valuation

Prices can be standardized using a common variable such as earnings, cashflows, book value, or revenues.

- Earnings Multiples Price/Earning ratio (PE) and variants Value/EBIT Value/EBDITA Value/Cashflow Enterprise value/EBDITA

- Book Multiples Price/Book Value (of equity) PBV

- Revenues Price/Sales per Share (PS) Enterprise Value/Sales per Share (EVS)

- Industry Specific Variables (Price/kwh, Price per ton of steel, Price per click, Price per labor hour)

Price Earnings Ratio

PE = Market Price per Share / Earnings per Share There are a number of variants on the basic PE ratio in use.

They are based upon how the price and the earnings are defined.

Price: is usually the current price

is sometimes the average price for the year EPS: earnings per share in most recent financial

year

earnings per share in trailing 12 months (Trailing PE)

forecasted earnings per share next year (Forward PE)

forecasted earnings per share in future year

33

PE Ratio: Fundamentals

To understand the fundamental start with the basic equity discounted cash flow model.

With the dividend discounted model

Dividing both sides by EPS

gr

DivP

e 1

0

gr

gratio Payout

EPS

P

e

)1(

0

0

34

PE Ratio: Fundamentals

Holding all else equal higher growth firms will have a higher PE ratio than

lower growth firms. higher risk firms will have a lower PE ratio than low risk

firms. Firms with lower reinvestment needs will have a higher

PE ratio than firms with higher reinvestment needs.

Of course, other things are difficult to hold equal since high growth firms, tend to have high risk and high reinvestment rates.

35

Graph PE ratio0

50

100

150

VW

_P

E

1975q1 1980q1 1985q1 1990q1 1995q1 2000q1 2005q1stata_qtr

36

Is low (high) PE cheap (expensive)?

A market strategist argues that stocks are over priced because the PE ratio today is too high relative to the average PE ratio across time. Do you agree?

Yes No

If you do not agree, what factor might explain the high PE ratio today?

37

A Question

You are reading an equity research report on Informix, and the analyst claims that the stock is undervalued because its PE ratio is 9.71 while the average of the sector PE ratio is 35.51. Would you agree?

Yes No Why or why not?

38

P/BV Ratio

The measure of market value of equity to book value of equity.

BVequity

equityMV

B

P

39

P/BV Ratio: Stable Growth Firm Going back to dividend discount model,

Defining the return on equity (ROE)=EPS0/BV0 and realizing that div1=EPS0*payout ratio, the value of equity can be written as

If the return is based on expected earnings (next period)

gr

DivP

e 1

0

gr

gratiopayoutROEBVP

e

)1( 0

0

gr

gratio payoutROEPVB

BV

P

e

)1(

0

0

gr

ratio payoutROEPVB

BV

P

e

0

0

40

Price Sales Ratio

The ratio of market value of equity to the sales

Though the third most popular ration it has a fundamental problem. - the ratio is internally inconsistent.

Revenue Total

equityMV

S

P

41

Price Sales Ratio

Using the dividend discount model, we have

Dividing both sides by sales per share and remembering that

We get

gr

gratio payoutmargin ProfitPS

sales

P

e

)1(

0

0

gr

DivP

e 1

0

shareper Sales

shareper Earnings margin Profit

42

Price Sales Ratio and Profit Margin

The key determinant of price-sales ratio is profit margin.

A decline in profit margin has a twofold effect First, the reduction in profit margin reduces the price-

sales ratio directly Second, the lower profit margin can lead to lower

growth and indirectly reduce price-sales ratio.

Expected growth rate = retention rate * ROE retention ratio *(Net profit/sales)*( sales/book value of

equity)

retention ratio * (profit margin) * (sales/ BV of equity)

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Inconsistency in Price/Sales Ratio

Price is the value of equity While sales accrue to the entire firm. Enterprise to sales, however, is consistent.

To value a firm using EV/S Compute the average EV/S for comparable firms EV of subject firm = average EV/S time subject’s firm

projected sales Market value = EV – market debt value + cash

gr

Cash-debt MVequity MV

sales

EV

e

0

0

44

Example: Valuing a firm using P/E ratios In an industry we identify 4 stocks which are similar to the

stock we want to evaluate.

The average PE = (14+18+24+21)/4=19.25 Our firm has EPS of $2.10 P/2.25=19.25 P=19.25*2.25=$40.425 Note – do not include the stock to be valued in the average Also do not include firm with negative P/E ratios

Stock A PE=14

Stock B PE=18

Stock C PE=24

Stock D PE=21

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Alternatives to FCFF : EBDITA and EBIT

Most analysts find FCFF to complex or messy to use in multiples. They use modified versions.

After tax operating income: EBIT (1-t) Pre tax operating income or EBIT EBDITA, which is earnings before interest, tax,

depreciation and amortization.

EBDITA

MVdebtequityMV

EBDITA

Value

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Value/EBDITA multiple

The no-cash version

When cash and marketable securities are netted out of the value, none of the income from the cash or securities should be reflected in the denominator.

The no-cash version is often called “Enterprise Value”.

EBDITA

cashMVdebtequityMV

EBDITA

Value

47

Enterprise Value

EV = market value of equity + market value of debt – cash and marketable securities

Many companies who have just conducted an IPOs have huge amount of cash – a “war chest”

EV excludes this cash from value of the firm Cash +MV of non-cash assets = MV debt + MV equity

MV of non-cash assets = MV debt + MV equity - Cash

For example: XYZ (did IPO in 2009)Its 2009 cash was $31.1 million, Total assets = $40.1 million,

Debt=0 EV=$9 million.

For young firms it is common to use EV instead of Value.

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Reasons for increased use of Value/EBDITA

The multiple can be computed even for firms that are reporting net losses, since EBDITA are usually positive.

More appropriate than the PE ratio for high growth firms.

Allows for comparison across firms with different financial leverage.

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Choosing between the Multiples

There are dozen of multiples There are three choices

Use a simple average of the valuations obtained using a number of different multiples

Use a weighted average of the valuations obtained using a number of different multiples (one ratio may be more important than another)

Choose one of the multiples and base your valuation based on that multiple (usually the best way as you provide some insights why that multiple is important )

What to control for...

Multiple Variables that determine it…PE Ratio Expected Growth, Risk, Payout Ratio

PBV Ratio Return on Equity, Expected Growth, Risk, Payout

PS Ratio Net Margin, Expected Growth, Risk, Payout Ratio

EVV/EBITDA Expected Growth, Reinvestment rate, Cost of capital

EV/ Sales Operating Margin, Expected Growth, Risk, Reinvestment

Relative Value and Fundamentals

Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio (1+g)/(r-g)

PEG=Payout ratio (1+g)/g(r-g)

PBV=ROE (Payout ratio) (1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF1/(WACC -g)

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

COST BASED METHODS

Cost based methods

Book value - Historical cost valuation All assets are taken at historical book value Value of goodwill is added to this above figure to arrive

at the valuation

Replacement value Cost of replacing existing business is taken as the value

of the business

Liquidation value Value if company is not a going concern Based on net assets or piecemeal value of net assets

Book value method

Current cost valuation All assets are taken at current value and summed to arrive at

value This includes tangible assets, intangible assets, investments,

stock, receivables

VALUE = ASSETS – LIABILITIES

Current cost valuation: Difficulties

Technology valuation – whether off or on balance sheet Tangible assets – valuation of fixed assets in use may not be a

straightforward or easy exercise Could be subject to measurement error

55

Book value method

Current cost valuation: More difficulties The company is not a simple sum of stand alone elements in the

balance sheet Organization capital is difficult to capture in a number – this

includes Employees Customer relationships Industry standing and network capital

Valuation of goodwill Based on capital employed and expected profits vs. actual

profits Based on number of years of super profits expected May be discounted at suitable rate

Going Concern versus Liquidation Valuation

Assets Liabilities

Investments alreadymade

Debt

Equity

Borrowed money

Owner’s fundsInvestments yet tobe made

Assets in PlaceExisting InvestmentsGenerate cashflows today

Growth AssetsExpected Value that will be created by future investments

Figure 1.1: A Simple View of a Firm

When valuing a going concern, we value both assets in place and growth assets

In liquidation valuation, we value only investments already made

Merger Methods

Comparable transactions: Identify recent transactions that are “similar”

Ratio-based valuation Look at ratios to price paid in transaction to various target

financials (earnings, EBITDA, sales, etc.) Ratio should be similar in this transaction

Premium paid analysis Look at premiums in recent merger transactions (price paid

to recent stock price) Premium should be similar in this transaction

COMPANY ANALYSIS:

QUALITATIVE ISSUES

Company Analysis: Qualitative Issues

Sales Revenue (growth) Profitability (trend) Product line (turnover, age)

Output rate of new products Product innovation strategies R&D budgets

Pricing Strategy Patents and technology

Company Analysis: Qualitative Issues

Organizational performance Effective application of company resources Efficient accomplishment of company goals

Management functions Planning - setting goals/resources Organizing - assigning tasks/resources Leading - motivating achievement Controlling - monitoring performance

Company Analysis: Qualitative Issues

Evaluating Management Quality Age and experience of management Strategic planning

Understanding of the global environment Adaptability to external changes

Marketing strategy Track record of the competitive position Sustainable growth Public image

Finance Strategy - adequate and appropriate Employee/union relations Effectiveness of board of directors

Company Analysis: Quantitative Issues

Operating efficiency Productivity Production function

Importance of Q.A. Understanding a company’s risks

Financial, operating, and business risks Financial Ratio Analysis

Past financial ratios With industry, competitors, and

Regression analysis Forecast Revenues, Expenses, Net Income Forecast Assets, Liabilities, External Capital

Requirements

An Adage

“Financial statements are like fine perfume;

To be sniffed but not swallowed.”

APPENDIX

Approaches to Valuation

Valuation Models

Asset BasedValuation

Discounted CashflowModels

Relative Valuation Contingent Claim Models

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capitalapproach

APVapproach

Excess ReturnModels

Stable

Two-stage

Three-stageor n-stage

Current

Normalized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option toliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Firm

Choosing the right Discounted Cashflow Model

Can you estimate cash flows?

Yes No

Use dividend discount model

Is leverage stable or likely to change over time?

Stable leverage

Unstable leverage

Are the current earnings positive & normal?

Yes

Use current earnings as base

No

Is the cause temporary?

Yes No

Replace current earnings with normalized earnings

Is the firm likely to survive?

Yes No

Adjust margins over time to nurse firm to financial health

Does the firm have a lot of debt?

YesNo

Value Equity as an option to liquidate

Estimate liquidation value

What rate is the firm growingat currently?

< Growth rate of economy

Stable growthmodel

> Growth rate of economy

Are the firm’s competitive advantges time limited?

Yes No

2-stage model

3-stage orn-stagemodel

FCFE FCFF

Which approach should you use? Depends upon the asset being valued..

Mature businessesSeparable & marketable assets

Growth businessesLinked and non-marketable assets

Liquidation &Replacement costvaluation

Other valuation models

Asset Marketability and Valuation Approaches

Cashflows currently orexpected in near future

Assets that will never generate cashflows

Discounted cashflow or relative valuation models

Relative valuation models

Cash Flows and Valuation Approaches

Cashflows if a contingencyoccurs

Option pricing models

Unique asset or businessLarge number of similar assets that are priced

Discounted cashflow or option pricing models

Relative valuation models

Uniqueness of Asset and Valuation Approaches

And the analyst doing the valuation….

Very short time horizonLong Time Horizon

Liquidation value Discounted Cashflow value

Investor Time Horizon and Valuation Approaches

Option pricing models

Relative valuation

Markets are correct on average but make mistakes on individual assets

Discounted Cashflow value

Views on market and Valuation Approaches

Option pricing models

Relative valuation

Markets make mistakes but correct them over time

Asset markets and financialmarkets may diverge

Liquidation value