Discounted Cash Flows (DCF) Pros Widely accepted Provides a
generally reliable and sophisticated approach to valuation by
accounting for: Profitability Growth Capital investment/intensity
Capital structure Risk and opportunity cost Cons Generally not easy
to calculate Grounded by assumptions Gives only an absolute
valuation, which in isolation is not telling Loaded with
assumptions
Slide 4
Discounted Cash Flows (DCF) A DCF model has three parts:
Explicit forecast period Cash flows are after-tax incremental cash
flows Continuing value or terminal period Perpetuity FCF, NOPLAT,
NOPAT Constant growth Multiples Discount rate Discount rates can be
determined a number of different ways (e.g., CAPM, Gordon growth
model, APT, etc), but the expected free cash flows are discounted
at the rate that reflects the risk of the cash flows.
Slide 5
How to Display a DCF- Based Model Assumptions Example: Here we
develop a base case model from Wall Street Research and CSFB
projections
Slide 6
6 Discounted Cash Flow Valuation ($ in millions) (1) 2004E not
included in calculating NPV of cash flows.
Slide 7
General Thoughts on Relative Valuations Most Valuations on Wall
Street Use Multiples Multiples reflect current market perceptions
Relative Valuations require fewer explicit assumptions and are
easier to use Relative valuations often find a more receptive
audience (easier to understand as there are less assumptions)
Slide 8
Price/Sales Pros Easy to calculate Maybe the only available
multiple Cons Ignores profitability Does not account for margins
(Fed Ex vs. UPS) or taxes (PFE vs. BMY) Completely ignores capital
structure Debt not included in the value of the firm Interest costs
and tax shield are ignored Ignores future growth opportunities
Ignores capital intensity and investment While simple Price/Sales
has numerous pitfalls users must be aware of.
Slide 9
Price/Earnings (P/E) Pros Most commonly used and accepted
multiple with sell side research Easy to calculate (simply need to
ensure you match time periods, trailing, current, future) Takes
into account profitability Cons Cannot use if companies do not have
accounting earnings Are GAAP earnings a good measure of cash flow?
Adjustments for normalized earnings? Ignores Economic Profitability
A company could be buying earnings (AutoZone example, see next
page) Completely ignores capital structure Debt not included in the
value of the firm Interest costs and tax shield are ignored Ignores
future growth opportunities Ignores capital intensity and
investment Although widely accepted, P/E has serious
drawbacks.
Slide 10
Are Autozones Investors Only Concerned With Earnings? Through
the 90s Autozones EPS grew at a 25% CAGR.
Slide 11
Enterprise Value/EBITDA (EV/EBITDA) Pros Second most commonly
used and accepted multiple on Wall Street Easy to calculate (but
need to ensure you match time periods, trailing, current, future)
Takes into account profitability EBITDA generally a good proxy for
cash Takes into account capital structure Includes debt in the
value of the firm (should use net debt) Includes Interest as part
of cash flow Cons Ignores Economic Profitability Ignores capital
intensity and investment The EBITDA multiple is a cleaner multiple,
however it still misses the hurdle rate and investment required
into the business.
Slide 12
Value/Book or EV/Book Important here is that Value/Book defines
how much the market is paying for past investments. Pros Used by
Wall Street to gauge capital intensity and investment return Easy
to calculate Takes into account capital structure Includes debt in
the value of the firm Includes Interest as part of cash flow Cons
Ignores both accounting and economic profitability Any additional
problems with these metrics? (Matching/timing of values) Value/Book
accounts for the investments made into a business and its future
value creation potential. Profitability however is now
ignored.
Slide 13
Implementing a Multiples Approach One more thing.. Define the
multiple There are different definitions for the same multiple
(current, trailing, forward) It is integral to look at the entire
distribution of the multiple Understand the differences between the
mean, median and standard deviation Understand why the outlier are
outliers (question relevance of the multiple and the companies
inclusion in the peer group) Understand the fundamentals of the
multiple What are the strengths and weaknesses of the multiple
Slide 14
Choosing a Peer Group for Relative Valuation Methods Why are
you trying to determine value? Defining why you are performing a
valuation has a direct effect on choosing a firms peers.
Slide 15
Display Example: A Valuation Perspective From our analysis what
can you tell me about our company? P/E 2004E
Market/Book-Current
Slide 16
Display Example: Relative Valuation- Utility Holding Companies
mismatched time periods P/E 2003 (1) EV/EBITDA 2004 (2) Market/Book
(1) Source: First Call (2) Source: Wall Street Research Errors to
note here PE is 2003, EV/EBITDA is 2004 and Market to book is not
label. Remember you MUST match time periods.
Slide 17
PXs trading multiples are consistent with the markets
expectations for future performance. P/E - 2004E EV / 2004E EBITDA
Market/Book Current Display Example: Relative Valuation - Correct
Time Periods Note:Value-to-Cost defined as a real market-to-book
ratio. A Value-to-Cost ratio >1.0x implies that the market is
expecting future profitable growth from the Company. Current
value-to-cost ratio for the S&P 500 = 1.85x. V/C for S&P
500 Source:I/B/E/S Estimate. 2003 P/E