Introduction to ValuationPresented by Alina Costica

October 26, 2007

Introduction to ValuationAgenda

Valuation OverviewWhat is Valuation?

Why Value a Company?

How Can You Value a Company?

Key Concept ReviewThree Financial Statements

Time Value of Money

DCF Overview Cost of Capital

Forecasting Cash Flows

Bringing It All Together

Valuation Overview

Valuation OverviewValuation is Highly Subjective

Valuation is both Art and Science

Perspective: Buyer

Seller

Make reasonable decisions based on:Limited information

Time constraints

Valuation Overview Why Value a Company?

" One hundred thousand lemmings cannot be wrong"Graffiti

Valuation Overview Why Value a Company?

IPO - Initial Public Offerings

SEO – Seasoned Equity Offerings

Debt Offerings

M&A – Mergers & AcqusitionsBuy and sell advice

Divestitures and restructurings

LBO – Leveraged Buy-Out

Defense analysis - vulnerable to hostile takeover?

Fairness opinions – is the price paid/received “Fair”?

Research

Investing

Valuation OverviewHow Can You Value a Company?

Valuation Public Comparables

Discounted Cash Flow

Acquisition Comparables

Merger Consequences

Leveraged Buyout

Other Techniques

Key Concept Review

Key Concept ReviewFinancial Statements

Balance Sheet

Assets– Cash

– Accounts Receivable

– Inventories

– PP&E

Liabilities & OE– Accounts Payable

– Notes Payable

– Long-Term Debt

Income StatementRevenues

- COGS

Gross Profit

- SG&A

Operating Income (EBIT)

- Interest

- Taxes

Net Income

Cash Flow StatementCash Flow from Operations

Cash Flow from Investing

Cash Flow from Financing

Key Concept ReviewNormalizing Financial Statements

Adjust for one-time itemsNot expected to be part of the normal cost of doing business in the future

Extraordinary items: “unusual in nature and infrequent in occurrence”

Common examples of non-recurring items: Restructuring charge

Gain/loss on sale of divisions

Legal settlements

Where to find non-recurring items: Separate line item on income statements

MD&A and footnote

Key Concept ReviewTime Value of Money

A dollar today is worth more than a dollar tomorrow

Formula:

PV = Present Value

FV = Future Value

r = Discount rate

n = Number of years you are discounting back

nrFVPV

)1( +=

DCF Overview

DCF OverviewWhat is a DCF?

“Intrinsic value” of the companyTheoretical vs. relative value

Flexible analysis

Changes in projections impact value– Growth rates

– Operating margins

Challenges: Forecasting

Subjective (assumptions)

Sensitive to changes

DCF results should be presented as a range of estimated values, not as a single estimate !

DCF OverviewWhat is a DCF?

DCF = Discounted Cash Flow

= Present value of all future cash flows

n= Life of the asset

CF = Future cash flow

r = Discount rate = WACC

g = Growth rate in perpetuity

∑=

= −+

++

=nt

tt

t

grgCF

rCFValue

1 )()1(

)1(

DCF OverviewWhat do I need to do a DCF?

Estimate discount rate: cost of capital

Forecast Free Cash Flows (FCFs)

Calculate the Present Values of FCFs

Estimate the Terminal Value

Derive an implied valuation range

Cost of CapitalWACC

Discount rate used to calculate PV of future cash flows

WACC = Weighted Average Cost of Capital

Formula:

We = Weight of Equity = E/(D+E)

E = Market Cap = Shares Outstanding * Share Price

Wd = Weight of Debt = D/(D+E)

Ke = Cost of Equity

Kd = Cost of Debt

t = taxes

)1( tKWKWWACCddee

−×+×=

Cost of CapitalCost of Equity

Formula:

Ke = Cost of Equity

Rf = Risk Free Rate

– Treasury bonds

β = Beta

– 5 year monthly regression of stock returns against S&P returns

Rp = Historical Equity Market Risk Premium

– Measures risk of an average investment

– 4-5.5%

– Learn more at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

pferrK ×+= β

Cost of CapitalCost of Debt

Formula:

Ke = Cost of Debt

Rf = Risk Free Rate

Spread

– Depends on company’s risk of default debt ratings

– Learn more at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

spreaddefaultrKfd+=

Cost of CapitalCalculating WACC

Exercise: Share Price: $20

Shares Outstanding: 5mm

Rf: 5%

β: 1.00

Rp: 5.00%

Market Value of Debt: 100mm

Spread: 3%

Effective Tax Rate: 50%

Cost of CapitalCalculating WACC

Answer: Market Cap = Shares Outstanding * Share Price = 20*5 = $100mm

We = 100/(100+100) = 50%

Wd = 100/(100+100) = 50%

Ke = Rf+β * Rp = 5% +1*5% = 10%

Kd = Rf + spread = 5% + 3% = 8%

WACC = We * Ke + Wd * Kd (1-t)

= 50% * 10% + 50% * 8% (1-.5)

= 5% + 2% = 7%

Forecasting Free Cash Flow

Calculate

FCFF = Ebit(1-t)

+ D&A

- CapEx

– Change in NWC

Forecast revenue

Calculate marginsAs % of Sales

– COGS

– SG&A

– EBIT

Create cases : Downside/Base/Upside

Forecasting Terminal Year

Rule of thumb:

Revenue growth rate cannot exceed growth of economy

Beta trends towards 1

CapEx = Depreciation

What % market share are you forecasting?

DCF OverviewBringing it all together

n= Life of the asset

CF = Future cash flow

r = Discount rate = WACC

g = Growth rate in perpetuity

∑=

= −+

++

=nt

tt

t

grgCF

rCFValue

1 )()1(

)1(

Additional Resources

Essential Public Information

10-K and/or annual report from latest fiscal year

10-Q from latest year

News announcementsSources: press release, Bloomberg, Reuters

Earnings announcement before filing with SEC

Research reportsRecent research reports from reputable Wall Street firms

Share price, and dividend

Essential Public InformationSources

Company Website

SEC Filings EDGAR

Research ReportsVirtual Business Library InvestextSternLinks

The Bible of Valuation: www.damodaran.com