Val Project 3

7/31/2019 Val Project 3

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Equity Instruments & MarketsB40.3331

Valuation Project Date due: December 13, 2004

Summary Recommendations

Com an Price CF Valuation Relative Valuation O tion EVA in Recommendation Model Use Value ulti le Use Value Valuation last ear

Pixar 83.98$ FCFF2 78.11$ PEG 91.35$ N/A $204,600 HoldCitigroup 45.91$ DDM3 59.90$ PBV 75.92$ N/A $12,169,000,000 BuySycamore 3.88$ FCFFGen 3.62$ VBV 11.06$ N/A -$207,061,474 SellRio Tinto 40.08$ FCFF2 39.08$ PE 45.20$ N/A $1,316,000,000 Buy

Swatch (bearer) SFr. 163.00 FCFE2 SFr. 177.90 VS SFr. 102.10 N/A $63,800,000 BuySwatch (reg.) SFr. 33.20 FCFE2 SFr. 35.60 VS SFr. 20.40 N/A $63,800,000 Buy

Group Members:

Stefan Fischer (suf200)Espen Stokke (es1446)Ronny Fluegge (rf829)

David Gowans (djg291)Adam Qaiser (aaq207)


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Background Information

The Swatch Group is a Swiss company that, together with its subsidiaries, is engaged in the

manufacture of watches, movements and components and other products. The company offers

watches in all price and market categories. It manufactures mechanical and quartz movements

and a range of components, including ruby, sapphire and other components. In addition, the

company produces and markets jewelry under the DYB brand name, as well as manufactures

microchips, quartz resonators and other electronic systems, and operates boutiques and shops.

1. Discounted Cash Flow Valuation

NOTE: ANY VALUES STATED ARE ALWAYS IN MILLION CHF (Swiss francs),

UNLESS IT IS A PER SHARE VALUE


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Model 2-stage FCFE Model

Rationale Dividends FCFE, relative stable D/E ratio, currently high g

- Market value of D/E relatively stable during last five years around 6% with

long term goal of management to increase it to 7% (interview in Swiss

newspaper article)

- Currently high growth in emerging markets (especially Asia)

FCFE Taking 12-month trailing data to calculate normalized FCFE

2003 2004H 2003H Trailing 12-month dataTotal Revenue 3'873.0 2'111.0 1'906.0 4'078.0Cost of Revenue 739.0 n/a n/a n/a

Gross Profit 3'134.0 n/a n/a n/aSelling/General/Admin. Expenses 1'262.0 n/a n/a n/aDepreciation/Amortization 216.0 110.0 105.0 221.0Other Operating Expenses 1'062.0 n/a n/a n/a

Total Operating Expense 3'279.0 1'763.0 1'682.0 3'360.0Operating Income 594.0 348.0 224.0 718.0Interest Expense 1.0 0.0 0.0 1.0

Income Before Tax 593.0 348.0 224.0 717.0Income Tax 96.0 48.0 38.0 106.0

Income After Tax 497.0 300.0 186.0 611.0Minority Interest 5.0 3.0 2.0 6.0

Net Income 492.0 297.0 184.0 605.0

Income Statement

- Assuming Debt/Equity ratio of 7% translating into 6.5% Debt ratio (DR)

- Capex of 113% of Depreciation

Growth Assuming a further high growth period over next 10 years

- Payout ratio has been an average of 14% over last three years; steadily

increasing assuming further increase to 20%

- Average ROE over last three years 14.4% - quite stable

- (1-Payout ratio) x ROE = Retention ratio x ROE = growth rate

- Assuming stable growth after 10 years assuming market growth, therefore

using risk free rate

- Further assuming no change in FCF, but sharp increase in payout ratio

Beta Swatch is officially in Retail-Jewelry Sector

- however Swatch also produces electronics, therefore taking 50% of each

unlevered average sector beta from Europe

- Marginal tax rate depends on cantons (state) in Switzerland average in

West Switzerland (headquarters of Swatch) accumulates to 16%

- Debt/Equity ratio of 7%


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Risk Premium Sales all around the world

- Taking geographic sales data as a proxy for country risk premium

- Adjusting weights for future shifts in sales expecting more sales in Asia

Valuation Valuing shares as of today

- Calculating value as of beginning 2005 and then discounting another

month

Shares Swatch has bearer and registered shares outstanding

- Calculating percentage using book issuance values

Conclusion I find both Swatch stocks as being undervalued and would recommend

to buy shares

2. Value relative to the comparables

Comparables Swatch is in Retail Jewelry and Electronics sector

- I tried to find as many companies with similar product lines as swatch

excluding companies from the Retail Jewelry sector and adding from

Electronics sector

Multiple EV / Sales

- Comparables have all very different financial leverage some using no

debt at all


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- Comparables are all retailers

- Multiple lets adjust for brand name

Simple Average EV / Sales = 1.2

Swatch Group has multiple = 2.3

Looking at those facts Swatch seems to be far overvalued. However, this

multiple those not account for any margin differences due to strong brand

names. Swatchs product (including the brand name Swatch itself) have a high

name recognition among customers and most products are well-known for

their quality. Therefore, it will be very easy for Swatch to charge a premium for

their name. Most of the comparables do not possess such an asset. Further,

Swatch does not bear the full risk of being a luxury retailer. Swatch is less

exposed to this cyclical market and therefore receives a higher Enterprise

Value compared to some of the comparables.

Regression EV/Sales explained with After-tax Margin and Debt-ratio

EV/Sales (Regression) still lower than actual multiple translating into a share

price of Sfr. 20.40 / 102.10. This can be interpreted that Swatch might beovervalued compared to the sector. However, it shows that partly a higher

after-tax margin keeps the multiple higher than for the comparables what

probably is attributed to the strong brand name. Further, the risk for the

different companies have not been fully included in the regression, because

financial risk is only a part risk and does not reflect operating risks.

3. Value relative to the market

Swiss Market Swiss Market has many special characteristics (e.g. low interest rates)

- I decided to run a market regression with the 60 largest market cap stocks

in the Swiss market (SWX respectively Virt-X)

- Bloomberg tickers: Regression:

EV/Sales = 0.25 + 0.47(After-tax Margin) + 10.52 (DR) Regression Last price(0.22) (0.76) (1.59) Reg. share 20.4 33.20

R2 = 0.75 Bear. share 102.1 163.00

EV/Sales (Regression) 1.64EV/Sales (Actual) 2.30


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Regression shows that Swatch is undervalued compared to the overall Swiss

market.

4. Value Enhancement Strategies / EVA

EVA Calculation was done for the same comparable firms as the relative valuation was done.

Spread Cost of Debt Riskfree Rate Beta RP Cost of Equity DR WACC ROI CI EVA EVA-Spread0.85% 6% 4.8% 0.37 6.4% 7.2% 22.8% 7% 6.3% 77.5 -0.4 -0.56%0.35% 5% 4.8% 2.17 6.4% 18.8% 0.5% 19% 63.0% 623.9 276.3 44.29%0.50% 5% 4.8% 1.19 6.4% 12.5% 3.9% 12% 15.8% 60.9 2.2 3.67%0.35% 9% 8.4% 0.67 6.4% 12.7% 2.3% 13% 4.1% 1591.4 -136.0 -8.55%0.35% 5% 4.8% 0.88 6.4% 10.5% 8.0% 10% 15.3% 156074.0 8170.7 5.24%0.35% 9% 8.4% 0.67 6.4% 12.7% 7.6% 12% 7.1% 705.0 -37.3 -5.29%4.00% 12% 8.4% 0.75 6.4% 13.2% 37.2% 13% 4.4% 2111.4 -180.5 -8.55%0.35% 5% 4.8% 0.58 6.4% 8.6% 5.5% 8% 0.0% 9859.0 -827.7 -8.40%0.70% 6% 4.8% 0.49 6.4% 8.0% 18.0% 8% 13.7% 90.2 5.6 6.15%0.35% 9% 8.4% 0.66 6.4% 12.7% 5.2% 12% 12.6% 529.1 0.6 0.11%0.35% 5% 4.8% 0.93 6.4% 10.8% 0.0% 11% 7.7% 24265.0 -754.4 -3.11%0.35% 5% 4.8% 0.58 6.4% 8.5% 0.0% 9% 1.2% 18591.0 -1365.2 -7.34%0.85% 6% 4.8% 0.88 6.4% 10.5% 58.6% 8% 8.4% 140218.0 955.1 0.68%0.35% 5% 4.8% 1.36 6.4% 13.6% 10.1% 13% 17.8% 3310.0 168.2 5.08%0.35% 9% 8.4% 0.73 6.4% 13.1% 18.6% 12% 22.6% 73.2 7.5 10.30%0.35% 5% 4.8% 1.36 6.4% 13.6% 5.9% 13% 15.0% 3310.0 63.8 1.93%1.00% 9% 8.4% 0.00 6.4% 8.4% 0.0% 8% 15.9% 148.0 11.1 7.53%8.00% 16% 8.4% 1.17 6.4% 15.9% 47.8% 16% 6.7% 5272.1 -495.9 -9.41%

Avg 7.31% 6.21% 0.86 0.06 11.7% 14.0% 11.3% 13.2% 20383.87 325.76 1.88%Median 5.60% 4.82% 0.74 6.4% 12.6% 6.7% 12.2% 10.5% 1851.41 1.42 0.40%

Calculations Following assumptions and calculations were made (marked stock=Swatch):

- in order to be able to compare Swatch values where not taken from DCFvaluation since no adjustments have made for the other comparables

either

- the cost of debt was calculated by using synthetical rating for coverage

ratios and using the risk-free rate appropriate to the company

EV/Sales = 0.25 + 22.472 (After-tax Margin) + 5.449 (DR) + 0.019 (RR)(0.634) (2.613) (1.405) (0.093)

R2 = 0.62

EV/Sales (Regress ion) 3.22EV/Sales (Actual) 2.30

Regression Last price

Reg. share 40.1 33.2Bear. share 200.5 163.0

ABBN VX Equity EMSN VX Equity MC SW Equity SGKN SW Equity

ADEN VX Equity GALN SW Equity NAAN SW Equity SGSN VX Equity

AT/N SW Equity GEBN SW Equity NESN VX Equity SIGN SW Equity

ATLN SW Equity GIVN VX Equity NOBE SW Equity SIK SW Equity

BAER VX Equity HEPN SW Equity NOVN VX Equity SLHN VX Equity

BALN VX Equity HOLN VX Equity PARG SW Equity STMN SW Equity

BARN SW Equity KNIN SW Equity PHBN SW Equity SUN VX Equity

BCVN SW Equity KUD VX Equity PSPN SW Equity SYNN VX Equity

BEKN SW Equity KUNN SW Equity RIEN SW Equity SYST SW Equity

BKWN SW Equity LISN SW Equity ROG VX Equity UBSN VX Equity

CHRN SW Equity LLB SW Equity RUKN VX Equity UHR VX Equity

CIBN VX Equity LOGN SW Equity SCHN SW Equity UNAX VX Equity

CLN VX Equity LONN VX Equity SCI SW Equity VATN SW Equity

CSGN VX Equity LUKN SW Equity SCMN VX Equity VONN SW Equity

EGL SW Equity MASN SW Equity SEO VX Equity ZURN VX Equity


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- the cost of equity was calculated assuming all businesses have same risk

premium since most operate world wide (therefore using risk premium

from DCF valuation of Swatch) and using provided Beta

- DR=Debt ratio, shows how different those companies are leveraged

Conclusion In absolute terms Swatch has been below the average, but above the median.

Relative comparision of the EVA-spread shows that Swatch has been very

well performing comparing to comparables (ignoring the outliner which has a

huge ROI for some reason).

Enhancements Swatch should surely use more leverage financing since it is still very

conservative with its debt ratio. Debt seems to be very cheap, provides tax

shelters, and the beta will in reality not go up as fast to compensate additional

risk. Therefore, WACC will come down and the EVA-spread can be increased.

5. Final Recommendation

The DCF valuation and the regression with the Swiss market came to the conclusion that Swatch

is undervalued while the valuation relative to comparables has shown that Swatch is overvalued.

How can that be?

In my opinion, this seems to be very logical. The business of Swatch is cyclical. The last

recession is still not entirely over. Companies that sell luxury goods are therefore in general

undervalued, because not all investors are convinced that the economy will pick up again. Swatch

is in comparison with its peer less undervalued. However, looking at the overall market or at thefundamental value (DCF) of Swatch, it is clearly undervalued. With the economy swinging back

and its growth rate, Swatch is worth more.

The stock is a BUY.


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Sycamore Networks Valuation Company Sycamore Networks, Inc.Symbol SCMR

Sector Telecommunications EquipmentType negative earnings companyDCF Valuation ModelFCFF, projections based on revenueRelative Valuation Value to Book CapitalSpecial features Firm has no debt but $1bn in cash/ equivalents from the IPO

in boom times, therefore there is no risk of distress

DCF Valuation

Sycamore Networks manufactures switches for telecom carriers and is a young company,founded during the Hi-Tech boom at the end of the 90s.The valuation model is based on revenue growth projections at a compounded rate of 15% for the next 10 years, which is around the expected growth of thetelecommunications equipment sector. The firms revenues grew by 16% last year after suffering from large losses due to the earlier market crash. The management has takenheavy restructuring measures, cutting costs through lay offs and abandoning unprofitable

product lines, leaving the firm very focused with a mature and competitive product line.Together with the rebounding market that translates into better operating margins and

potential for initially better Sales/Capital ratios (please refer to the summary sheet inAppendix I). Within the sector analysts rank Sycamore Networks at number 7 and itseems optimistic but reasonable to expect it to grow with the industry.

Sycamore has no debt and operating leases are not substantial, hence WACC equals theCost of Equity with 16.34%. The Risk Premium is a weighted average according to therevenues in different countries.

The calculated share price of $3.62 from the DCF valuation is close to the actual current price of $3.88. Sycamore appears slightly overvalued but one could argue that thedifference is within the range of acceptable variation. More importantly, the market andthe results of the DCF valuation agree that Sycamores value is dominated by its cash andmarketable securities assets. The pure cash assets divided by number of shares yield a

price of $3.54. The reason for this is that if the current market projections for telecommunications equipment are realistic then Sycamore cannot create much valueitself relative to the amount of capital it holds. Hence it is not expected to produce a goodReturn on Capital any time soon. A great upside potential for the telecommunicationmarket is not expected by us and the downside risk is that Sycamore keeps on burningcash which it could maintain for a long time. Based on that conclusion and the calculationresults the recommendation tends to sell.


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Relative Valuation

Multiple: Value to Book CapitalSector: Telecommunications Equipment

Number of comparable firms: 127 (source: compfirm.xls)

Sycamore has negative earnings, even a negative EBITDA. Therefore, many multiples donot apply. Moreover, the whole sector is in trouble with most other firms losing money aswell, yielding regressions with questionable explanatory power. The multiple that gavethe best results is Value to Book Value of Capital. However, Sycamore appearsundervalued by the factor of 4 (with an actual V/BV ratio of 1.05), which is unrealistic.The regression results are shown in Appendix II, showing a qualitative contradiction witha ROC that has a negative impact (other multiples and regressions were even worse).Interestingly, if one biases the sample by restricting it to the 45 positive earnings firmsonly, Sycamore should trade at 65% of its book value (Appendix II A). Given theanalysts forecast of -8% revenues for the next five years that actually seems more

realistic. But again revenues have a negative impact in the regression with iscontradictory and does not yield a meaningful result if expected revenues are increased.

The market regression (US) giving a V/BV ratio of 3 still translates into a share price of $11.06 as opposed to the current $3.88. A subjective valuation compared to the sector average of 6.9 also does not provide any justifiable basis for some story. Therecommendation is therefore to ignore relative valuation results.

EVA calculation

The numbers used in the calculation are in million US$:

Return On CapitalAfter Tax Op Income

EBIT(1-t) -59.2827Depreciation 9.618

-49.6647

Book Value of Capital 962.989

ROC -5.16%

Cost of Capital 16.34%

EVA -207.061

Telecom Equipment SectorROC - WACC 4.88%

comparative EVA 46.994


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The EVA for Sycamore in the most recent year is a negative $200 million compared witha positive EVA of $47 million that it should have produced with a sector average for Return on Capital and Cost of Capital. These results are consistent with Sycamoresnegative earnings.

Summary

Sycamore has a lot of Capital but the market does not present enough opportunities toinvest it. Due to the current negative earnings Sycamore is reluctant to give cash back toshareholders and even thinks about using it for acquisitions. However, it is unclear whether a reasonable opportunity might come up. Since there is no debt Sycamore willdefinitely survive the negative earnings period but we do not expect it to produce a goodReturn on Capital in the future.

It was not appropriate to carry out an option valuation on this firm since the firm has no

debt and therefore does not have a default option to put the assets of the firm to debt-holders.

Based on the DCF valuation the recommendation remains sell .


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Appendix I Sycamore DCF Valuation

Inputs

I. Income Statement commentsCurrent EBIT (44.91)$

Interest income from cash and marketable securities 15.89$Current Capital Spending 71.34$Current Depreciation and Amortization 9.62$Current Revenues 44.55$II. Balance Sheet This period Last period Current Non-cash Working Capital (16.04)$ (20.55)$Book Value of Debt -$ 0Book Value of Equity 955.44$ 993Cash & Marketable Securities 635.03$non operating assets 327.96$ 327,961III. Tax Information

NOL carried forward -$ according to company estimationMarginal tax rate 35.00%

Risk PremiumInputs for Discount Rate revenue weight in year Risk free rate 4.10% 10yr bond yield on 10/12/2004 2002 2003 2004 aveUnlevered Beta corrected for cash 2.28 United States 13% 9% 41% 2Risk Premium 5.37% England 47% 44% 21% 3Cost of Equity 16.34% France 22% 13% 1

Japan 20% 15% 13% 1Expectations for the future all other countries 20% 10% 12% 1

Compounded Annual Growth Rate in Revenues for next 10 years: 15.00% weighted averagnon-cash working capital as a percent of revenues in future periods 3.00%sales to capital ratio 1.50

Stable Growth Inputs

Expected Growth Rate in perpetutity = 4%Speed of convergenceExpected Operating Margin = 21.28% 1 rapid restructuring takes placeExpected Debt to Capital(MV) Ratio for the firm = 0.00%Expected Beta = 1.10 Expected Cost of Debt = 7.00%Return on Capital for the firm = 14.20% based on Return on Equity (Industry average)

Per Share InputsNumber of Shares outstanding = 272.123Current Stock Price = 3.60$Does your firm have equity options outstanding? YesIf yes, enter the number of options outstanding = 30.846472

and the average exercise price of the options outstanding = 6.95and the average maturity of the options outstanding = 3.2and the standard deviation in the firm's stock price = 95%


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Valuation Summary

PV of FCFF during high growth phase = (27)$PV of Terminal Value = 83$Value of Operating Assets of the firm = 56$Value of Cash & Non-operating assets= 962.99$Value of Equity = 1,019$- Value of Equity Options = 33$Value of Equity in Common Stock = 985$ Treasury Stock ApproachValue of Equity per share = 3.62$ 4.07$

Revenues $53 $64 $77 $92 $111 $129 $144 $158 $171 $181 $189EBIT -$30 -$11 $2 $11 $18 $24 $29 $33 $36 $38 $40EBIT(1-t) -$30 -$11 $2 $11 $18 $19 $19 $21 $23 $25 $26- Reinvestment $6 $7 $9 $10 $12 $12 $10 $10 $8 $7 $7FCFF -$36 -$18 -$7 $0 $6 $8 $9 $12 $15 $18 $19

Base 1 2 3 4 5 6 7 8 9 10 Terminal Yea

Revenue Growth Rate 20.00% 20.00% 20.00% 20.00% 20.00% 16.00% 12.00% 10.00% 8.00% 6.00%Revenues $44.547 $53.456 $64.148 $76.977 $92.373 $110.847 $128.583 $144.013 $158.414 $171.087 $181.352Operating Margin -133.08% -55.90% -17.31% 1.99% 11.64% 16.46% 18.87% 20.08% 20.68% 20.98% 21.13%EBIT -$59.283 -$29.881 -$11.102 $1.530 $10.748 $18.245 $24.265 $28.913 $32.760 $35.897 $38.324 $40.1Taxes $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $4.831 $10.120 $11.466 $12.564 $13.413 $14.06EBIT(1-t) -$59.283 -$29.881 -$11.102 $1.530 $10.748 $18.245 $19.434 $18.794 $21.294 $23.333 $24.910 $26.1+ Depreciation $9.618 $11.542 $13.850 $16.066 $17.994 $19.793 $21.377 $22.659 $23.588 $24.555 $25.562 $26.61- Capital Expenditures $71.341 $17.214 $20.657 $24.234 $27.796 $31.555 $32.668 $32.483 $32.757 $32.624 $32.098 $33.74- Chg WC $4.505 $0.267 $0.321 $0.385 $0.462 $0.554 $0.532 $0.463 $0.432 $0.380 $0.308 $0.2FCFF -$125.511 -$35.821 -$18.230 -$7.023 $0.484 $5.928 $7.610 $8.507 $11.693 $14.884 $18.067 $18.7NOL $0.000 $29.881 $40.983 $39.453 $28.705 $10.461 $0.000 $0.000 $0.000 $0.000 $0.000 $0.0Terminal Value

Tax Rate 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 19.91% 35.00% 35.00% 35.00% 35.00%Debt Ratio 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Beta 2.28 2.28 2.28 2.28 2.28 2.28 2.04 1.81 1.57 1.34 1.10 Cost of Equity 16.34% 16.34% 16.34% 16.34% 16.34% 16.34% 15.08% 13.81% 12.54% 11.27% 10.00%Cost of Capital 16.34% 16.34% 16.34% 16.34% 16.34% 16.34% 15.08% 13.81% 12.54% 11.27% 10.00%


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Appendix II Sycamore Regression

Results of multiple regression for Value/BV of Capital

Summary measuresMultiple R 0.5694R-Square 0.3242Adj R-Square 0.1975StErr of Est 6.1879

ANOVA TableSource df SS MS F p-valueExplained 3 293.8922 97.9641 2.5585 0.0915Unexplained 16 612.6365 38.2898

Regression coefficientsCoeff ic ient Std Err t -value p-value Lower l imit Upper l imi t

Constant 5.8474 2.4783 2.3594 0.0313 0.5936 11.1012ROC -7.2771 3.0945 -2.3516 0.0318 -13.8372 -0.7171Expected Growth in Revenues: next 5 years 26.0711 16.2601 1 .6034 0 .1284 -8.3989 60.5410Market Debt to Capital -16.4406 12.8402 -1.2804 0.2187 -43.6606 10.7793

Sycamore Value/BV of Capital ROC Expected Growth in Revenues: next 5 years Market Debt to Capital 1.05 -4.53% -8.00% 0.00%

expected V/BV from sectorregression 4.09

expected V/BV from marketregression: 3.04

average V/BV in sector 6.89

Appendix II A: Sample of positive earnings firms

Results of multiple regression for Value/BV of Capital

Summary measuresMultiple R 0.8453R-Square 0.7145Adj R-Square 0.6366StErr of Est 3.3789

ANOVA TableSource df SS MS F p-valueExplained 3 314.2392 104.7464 9.1747 0.0025Unexplained 11 125.5850 11.4168

Regression coefficientsCoeff ic ient Std Err t -value p-value Lower l imit Upper l imi t

Constant 1.3709 1.6581 0.8268 0.4259 -2.2785 5.0203ROC 28.4040 6.3706 4.4586 0.0010 14.3823 42.4256

Expected Growth in Revenues: next 5 years -7.0592 12.6620 -0.5575 0 .5883 -34.9281 20.8097Market Debt to Capital 4.3825 11.8829 0.3688 0.7193 -21.7717 30.5366

SCMR expected V/BV = 0.65


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PIXAR VALUATION

Background

Pixar was formed in 1986 and is a leading digital animation studio. The Companys objective isto create, develop and produce computer-animated feature films with heartwarming stories andmemorable characters that appeal to audiences of all ages. To date, the company has createdand produced six full-length animated feature films: Toy Story, A Bug's Life, Toy Story 2,Monsters, Inc., Finding Nemo, and The Incredibles, which were marketed and distributed by TheWalt Disney Company. The first five films are among the top eleven grossing animated films of alltime, with combined worldwide box office receipts of more than $2.5 billion. The company isexpected to continue growing during the next couple of years.

Valuation Methodology.

Pixar will be valued in US dollars using a 2-stage Free Cash Flow to Firm (FCFF) model. The calculation will be performed using nominal values and rates.

Risk Free RateThe current yield on the 10 year US Treasury bond is 3.98%. This is the risk free rate used incalculating the cost of equity.

Risk Premium

Pixar operates in the US, and the geometric average of risk premium in the US from 1928 to 2003is 4.82%.

Market and Book Value of Equity and Debt

Equity

The book value of equity was given in the Pixar financial statements as $1 119 million.

The market value of equity December 10 2004 was $4 779 million (56.901 million sharesoutstanding; stock price: $83.98).

Debt

Interest expenses 2,647 Average maturity for the debt 5Pre-tax cost of debt 4.33%

Present value of annuity 11,676

Book value of debt 61,133Present value of the book value of the debt 49,457

Estimated market value of conventional debt 61,133Debt value of opearting leases 1,325Market value of outstanding debt 62,458

The estimated market values of debt and equity gives Pixar a debt/equity ratio of 1.31%($4779/$62.458). Compared to the industry average of 20.86%, Pixar is moderately levered.


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Beta Calculation

The beta of Pixar was estimated by analyzing betas of comparable firms. Pixars operations in thecomputer software industry were treated separately from the main operations in the entertainmentindustry. First, unlevered betas corrected for cash were calculated. Second, estimated enterprisevalues were used at weights in order to find Pixars total unlevered beta. The unlevered beta is

estimated to be 1.107.Levered and unlevere d betas byindustry

AverageBeta

Market D/ERatio Tax Rate

UnleveredBeta

Cash/FirmValue

Correctedfor cash

Entertainment 1.27 26.37% 17.16% 1.04 3.80% 1.08Computer softw are 1.83 3.58% 9.95% 1.77 13.09% 2.04

Pixar compete s in tw o industries Revenues EV / SalesEnterprise

ValueFirm ValuePorportion

UnleveredBeta

Entertainment 316,566 2.82 892,716 97.1% 1.08

Computer softw are 7,537 3.52 26,530 2.9% 2.04Pixar 919,246 100% 1.107

Using the market values of debt and equity, Pixars levered beta is 1.117:

Unlevered beta 1.107Marginal tax rate 35%Equity, market value 4,853,204Debt, market value 62,458Levered beta 1.117

Cost of Equity

Pixars cost of equity is simply calculated using the risk free rate of 3.98%, the risk premium of 4.82% and the bottom-up levered beta of 1.117. Using the CAPM formula the Cost of Equity for Pixar is 9.28%.

Cost of Debt

Given Pixars conservative leverage, the company default spread is almost insignificant. Also,there is no country default risk.

EBT 269,915Interest expenses 2,647EBIT 272,562Operating lease expense 846Interest expense 2,647

Interest coverage ratio 78.27

Riskfree rate 3.98%Country default spread 0%Company default spread (2004) 0.35%Pre-tax cost of debt 4.33%


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Firm Valuation Two-Stage Free Cash Flow to Firm Model

In order to value the firm, I have chosen to use a two-stage Free Cash Flow to Firm model(FCFF). I believe that Pixar will maintain its position as the leading digital animation studio for thenext five years, before other companies start to catch up. Facing tougher competition in a moresaturated market, it is likely that Pixar will mature during the five years that follows the high-

growth period, and ultimately converge towards the industry averages regarding leverage andgrowth. The industry will also move towards the market (beta = 1) .

Input in the DCF-model:

Length of High Grow th Period 5 Stable

Beta used for stock 1.12 1.00Riskfree rate 3.98% 3.98%Risk Premium 4.82% 4.82%Cost of Equity 9.36% 8.80%

Cost of Debt 4.33% 4.33%Tax Rate 36.86% 35.00%

Af ter-tax Cost of debt 2.73% 2.81%

Equity/(Debt+Equity ) 79.14%Debt/(Debt+Equity) 20.86%Cost of Capital 7.55%

Free Cash Flow to the Firm

In order to calculate the FCFF, adjustments regarding leases and R&D expenses have to bemade. Please see the appendix for detailed calculations.

Leases Average year life f or assets 3

Repor ted operating lease expenses this year 846Depreciation operating lease 442

Adjustments in operating income from operating 404

R&DReported R&D expense this year 8,963

Amortization R&D 7,933 Adjustments in operating income from R&D 1,030

These adjustments change Pixars operating income as follows:

Operating income 259,547 Adjustments, operating leases 404 Adjustments, R&D 1,030 Adjusted operating income 260,981Tax rate on income 36.9%

Af ter-tax operating income 164,780Ignored tax effect of R&D Expenditures 380EBIT * (1-tax rate) 165,160

Growth, Return on Capital, and Reinvestment

After an impressing growth in operating earnings of 136% and 84.3% during the past two years,Pixar is expected to continue growing fast, however at a downward sloping pace. To capture this


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downward slope, the growth for the next five years is estimated by taking the natural log of (growth t / growth t-1). After the five-year long high-growth period, the growth is linearly scaled downtowards the steady state rate of 3.98% (=risk free rate).

2002 2003 2004 2005 2006 2007 2008 2009

EBIT * (1-tax rate) 37,894 89,610 165,160Grow th 136.5% 84.3% 52.1% 32.2% 19.9% 12.3% 7.6%LN( ! Growth) 0.482 0.482 0.482 0.482 0.482 0.482

Pixars return on capital is at a relatively high 26.61% (data from Value Line), and I have assumedthat Pixar is able to retain its current ROC for the next five years. However, as the company willgradually come under pressure from competitors, the ROC will slide down towards the stable-state cost of capital of 7.55%. This is higher than the industry average of 6.70%, but Im assumingthat Pixar doesnt invest in negative NPV projects that will reduce the ROC below the cost of capital.

Given the growth and the ROC, the next years reinvestment rate is 195.7%. To achieve highgrowth in the high-growth period, Pixar must reinvest more than its operating income, and istherefore forced to issue new debt. However, as the growth declines, there is less need for reinvestment, and the operating income will cover the reinvestment needs.

Weighted Average Cost of Capital

The weighted average cost of capital is calculated using the WACC-formula (r d * (1-t) * D/ (D+E) +r e * E/ (D+E)). Because Pixar has to issue new debt to sustain the high growth, the leverage andthus the WACC will change continuously. I have assumed that Pixar eventually will move towardsthe industry average capital structure with an equity ratio of ca. 79%. This is a relativelyconservative leverage, and I have therefore supposed that Pixar maintains its current credit ratingand that the cost of debt remains stable.

Valuing Options and Value of Equity per share

Pixars outstanding options were valued using the Black-Scholes option pricing model. The inputsbelow were taken from the latest quarterly report, filed November 12, 2004.

Stock Price 83.98Strike Price 27.12

Adjusted S 82.95Expiration (in years) 5.00Number of options outstanding 2,771Number of shares outstanding 56,901T-Bond rate 3.98%Standard deviation in stock prices 39.00%Variance 0.1521

Annualized dividend yield 0.00%Div. Adj. interest rate 3.98%

d1 1.946151N (d1) 0.974182

d2 1.074084N (d2) 0.858607

Value per option 61.72Value of all options outstanding 171,030


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The value of all options outstanding will be subtracted from the equity, reducing the equity claimson the firm and thus the share price.

Estimating the Market Value of Equity per Share

The DCF-valuation below indicates that Pixar is slightly overvalued.

Length of High Grow th Period 5 Stable

Beta used for stock 1.12 1.00Riskf ree rate 3.98% 3.98%

Risk Premium 4.82% 4.82%Cost of Equity 9.36% 8.80%

Cost of Debt 4.33% 4.33%

Tax Rate 36.86% 35.00% Af ter-tax Cost of deb t 2.73% 2.81%

Equity/(Debt+Equity ) 79.14%

Debt/(Debt+Equity) 20.86%Cost of Capital 7.55%

Grow th Rate 52.06% 3.98%

Return on Capital 7.55%Reinves tment Rate 52.71%

Current 1 2 3 4 5 6 7 8 9 10 Terminal

Expected Growth Rate 52.1% 32.2% 19.9% 12.3% 7.6% 6.9% 6.1% 5.4% 4.7% 3.98% 3 .98%Return on Capital 26.61% 26.6% 26.6% 26.6% 26.6% 26.6% 22.8% 19.0% 15.2% 11.4% 7.55% 7.55%

Reinves tment Rate 195.7% 120.8% 7 4.6% 46.1% 2 8.5% 30.1% 3 2.3% 35.7% 4 1.4% 52.71% 52.71%EBIT * (1 - tax rate) 165,160 251,147 331,900 397,828 446,645 480,486 513,434 544,949 574,478 601,474 625,413 650,304

Reinves tment 491,381 401,056 296,971 205,972 136,811 154,435 176,175 205,140 248,752 329,637 342,757Free Cash Flow to Firm -240,234 -69,155 100,856 240,673 343,675 358,999 368,774 369,338 352,722 295,776 8,611,976

Equi ty 4 ,778 ,546 4 ,778 ,546 4 ,778,546 4 ,778 ,546 4 ,778,546 4 ,778 ,546 4 ,637,996 4 ,497 ,445 4 ,356,895 4 ,216 ,345 4 ,075,795 4 ,075 ,795 Debt 62,458 302,693 371,848 371,848 371,848 371,848 512,398 652,948 793,499 934,049 1,074,599 1,074,599

Equity/(Equity+Debt) 98.7% 94.0% 92.8% 92.8% 92.8% 92.8% 90.1% 87.3% 84.6% 81.9% 79.1% 79.14%Cost of Capital 9.28% 8.97% 8.88% 8.88% 8.88% 8.88% 8.60% 8.33% 8.06% 7.80% 7.55% 7.55%

C umu la te d C os t o f C ap ita l 1 08 .9 7% 1 1 8.6 5% 12 9.1 9% 1 4 0.6 7% 15 3.1 7% 1 6 6.3 5% 18 0.2 0% 1 9 4.7 3% 20 9.9 3% 2 2 5.7 8% 24 2.8 3%Present V alue -220,463 - 58,285 78,067 171,092 224,379 215,816 204,645 189,664 168,020 131,001 3,546,506

Percentage of value of operating assets -4.7% -1.3% 1.7% 3.7% 4.8% 4.6% 4.4% 4.1% 3.6% 2.8% 7 6.26%

Pres ent Value of FCFF in high grow th phas e 1,103,937Present Value of Terminal Value of Firm 3,546,506

Value of operating assets of the f irm 4,650,443Value of Cash, Marketable Securities & Non-operating assets 27,545

Value of Firm 4,677,988Market V alue of outstanding debt 62,458

Market V alue of Equity 4,615,530Value of Equity in Options 171,030

Value of Equity in Common Stock 4,444,500Market V alue of Equity/share 78.11

Price per share in the market 83.98Recommendation SELL!

Recommendation: SELL!!

Relative Valuation

Pixar is a high-growth company, and I have therefore chosen the PEG-ratio for the relativevaluation.

Independent variables

The sample contains 25 firms, and three independent variables have been used in theregression. Given the relatively small sample, one could argue that the regression shouldntcontain more than two independent variables (maximum one for every 10 stocks in the sample).However, the models explanatory power is increased when including three independentvariables.

FCFE/Net Income. The FCFE has been calculated as follows:FCFE = (FCFF - EBIT(1-t)) * (1-d) + Net Income

LN (Expected growth in earnings per share for the next five years). I have used thenatural log to achieve linearity between the PEG and Expected growth in EPS.


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Beta. Beta has been chosen as a proxy for cost of equity. Because there are more ValueLine betas than Regression betas available, I have used the former to maximize thesample of firms in the regression.

The numbers below show the results from the regression. An R Square of 0.3693 is not great, butacceptable.

Regression StatisticsMultiple R 0.6077113R Square 0.369313

Adjusted R Square 0.2792149Standard Error 1.8473947Observations 25

ANOVAdf SS MS F ignificance F

Regres sion 3 41.968117 13.989372 4.0990087 0.0194618Residual 21 71.670212 3.4128672Total 24 113.63833

Coefficients tandard Er ro t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 3.5246823 3.8291306 0.9204915 0.3677699 -4.4384307 11.487795 -4.4384307 11.487795FCFE/Net Income 0.3127159 1.6152751 0.1935991 0.8483501 -3.0464326 3.6718644 -3.0464326 3.6718644Value Line Beta -2.8021617 1.7575327 -1.5943725 0.1257934 -6.457151 0.8528275 -6.457151 0.8528275LN(Growth in EPS) -1.0754337 1.0141077 -1.0604729 0.3009746 -3.184386 1.0335186 -3.184386 1.0335186

Using the updated data on earnings and growth from the DCF-valuation, Pixars predicted PEG is2.25, compared to 2.08 in the market.

Coeff ic ients Pixar Intercept 3.5246823FCFE/Net Income 0.3127159 1.000Levered beta -2.802162 1.117

Expected grow th in EPS the next five years 23.8%LN(Grow th in EPS) -1.075434 -1.44Predicted PEG 2.25

This indicates that Pixar is undervalued:

Earnings 170.42Expected grow th in EPS the next five years 23.8%Predicted share price 91.35Price per share in the market 83.98Recom m endation BUY!

(Expected growth = (The product of the growth rates during the five-year period)^0.2 1).

According to the relative valuation, Pixar is slightly undervalued in the market; the stock shouldsell for $91.35. Recommendation: BUY!!


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Value Enhancement

The analysis below shows that Pixar are investing in good projects

Return on capital 26.61%Cost of capital 9.28%Spread 17.33%Book value of capital 1,180,484Economic value added 204,600

Compared to the Entertainment industry, the impression of Pixar as a well-managed firm isfortified:

Entertainment IndustryReturn on capital 6.70%Cost of capital 8.92%Spread -2.22%

Where Pixars current ROC is 17.33% above its cost of capital, the entertainment industry is onaverage loosing money on its investments; the ROC is 2.22% below the cost of capital.

Conclusion

The results from the DCF valuation demonstrate that the market overvalues Pixar with ca. $4 per share, or about 7.5%. On the other hand, the relative valuation indicates that Pixar is undervaluedby about $7.4 (8.8%). The Value Enhancement analysis suggests that Pixar invests in greatprojects and creates much more value than the entertainment industry on average.

So, which conclusion should be drawn from these ambiguous results? Even though the relativevaluation and the EVA-analysis propose a BUY-recommendation, Im not completely convinced.

All of Pixars six films have been big blockbusters, but it is unlikely that the future will bring thesame impressing amount of home runs. Today, animation films are regarded as something newand exiting. However, I dont think this will be the case in a few years, and Pixars movies willprobably face stiffer competition both from other animation films and from normal movies. Onthe other hand, I dont think the results from the DCF valuation are strong enough to recommendSELL.

To sum up, my recommendation is HOLD.


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Appendix

Future minimum lease payments PV at 6%2004 882 845

2005 314 2882006 93 822007 74 62

Af ter 2007 58 47Debt value of leases 1,325

Conventional debt 61,133Debt value of opearting leases 1,325Debt outstanding at Pixar 62,458

Convert ope rating leases into debt

Ass umed life of R&D 3

Year R&D

expense Amort.this year

2004 15,095 1.00 15,0952003 8,963 0.67 5,975 2,9882002 8,497 0.33 2,832 2,8322001 6,339 0.00 0 2,113Total 23,903 7,933

Tax effect on R&D expensing 380

Capitalize R&D expenditures

Unamortized protion

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