VALUATIONS

1. CHAPTER 6 VALUATIONS

2. Objectives • At the end of the chapter, you should be able to: • Outline the concepts applied in the valuation of assets • Understand the effects of risk and return on valuations • Value debentures • Value preference shares • Use the constant dividend growth model to value ordinary shares • Apply a two stage valuation dividend model to value ordinary shares • Use the Free Cash flow model to value a company and the ordinary equity of a company • Use relative valuation methods such as the price-earnings (P/E) ratio to value ordinary shares • Use the EVA approach to value the ordinary equity of a firm • Understand how valuations affect the role of the financial manager

3. Outline • What are valuations? • Some valuation myths • What is the effect of the risk and return relationship on value? • Valuation of debentures • Debentures in perpetuity and redeemable debentures • Valuation of preference shares • Cumulative and non-cumulative preference shares, redeemable and convertible preference shares • Valuation of ordinary shares • Dividend Growth model – constant growth and two stage valuation model • Free Cash Flow model • Free cash flow to the Firm • Free cash flow to Equity • Relative valuations – P/E ratio (earnings yield) approach • The EVA approach to valuations

4. What are Valuations? • Determination of the value of an asset stated in monetary terms • Value = present value of future cash flows • As the future is uncertain, valuations are subject to uncertainty • An active market for assets creates a value due to the actions of many buyers and sellers

5. Valuations based on quantitative models are always accurate Valuations are objective Valuations are precise Valuations are valid over extended time periods The valuation number is the most important aspect of any valuation Valuation Myths

6. What are the Building Blocks of a Valuation? • The amount of each future cash flow • The timing of such cash flows • The riskiness of future cash flows • The required rate of return

7. How does Risk and Return Affect Value? • Effect of Return on Value • If asset A is returning R1m per year and asset B is returning R1.2m per year, then asset B will have a HIGHER value if the assets are of similar risk • Effect of Risk on Value • If asset C and asset D are both offering R1m per year, but C is more risky, then asset D will have a HIGHER value • Value and rates of return • Assume cost = R10m and annual return (forever) = R1m. If required return = 12%, then value < 10m. Why? Because the actual return is only 10%. To offer 12%, the price must fall to R8.333m.

8. Required Return • To determine the present value of future cash flows, we need a discount rate?How do we determine the discount rate or required rate of return? • Are there similar assets trading on financial markets? • Comparison of debentures to ordinary shares • The required return on ordinary shares is called the cost of equity • This is dealt with in Chapter 7 on the cost of capital

9. Valuation of Debentures / Bonds • TERMS • Par Value (Face Value) • Coupon interest rate • Maturity date (redemption date) • Yield to Maturity • Yield to Call

10. Valuation of Debentures / Bonds • Debentures in perpetuity (non-redeemable debentures) • No redemption date • Face value = R100 and coupon rate = 15% per year. If the required return is 9%, then the value is; • R15/0.09 = R166.67 • Redeemable debentures / bonds • Face value is repaid on the set maturity date, plus interest until that date. • Face value of R100, the coupon rate is 15% and the redemption date is in 5 years time. Market yield = 9%. • PV of interest: R15 x 3.8897 = R58.34 • PV of redemption of face value: R100 x 0.6499 = R64.99 • Total value = R58.34 + R64.99 = R123.34 (slight rounding difference)

11. Valuation of Debentures / Bonds • Formula • Using Excel

12. Debentures – Yield to Maturity • Assume that the debenture (bond) is trading at R118. What is the yield to maturity (YTM)? • Use the IRR function on a financial calculator OR use Excel. You can also use trial and error (not recommended) • YTM = IRR. In Excel you need to indicate an estimate of IRR. Then Excel starts with this will do many trial and error calculations (iterations) super quickly until it gets to IRR

13. Preference Shares • Preference shareholders receive a fixed dividend whilst debenture (bond) holders receive interest. • Dividends are paid only after all expenses have been incurred, including interest. This means that dividends are more risky and therefore preference shares need to offer a higher return. • What is the effect of taxation? • Types of preference shares • Cumulative • Redeemable • Participating • Convertible

14. Cumulative Preference Shares In Arrears • 100 preference shares with an issue price of R1 each, is two years in arrears. The preference dividend rate is 12% and similar shares are offering yields of 14%. • If non-redeemable and will be paid in the future, then the value would be; R12/0.14 = R85.71 • If the next two years’ dividends will not be paid, then the value will be determined in two parts; • Value of perpetuity at end of year 3 = R12/0.14 = R85.71 • Dividend at end of year 3 = R12 x 3 = R36 • Present value today: (R36.00 + R85.71) x 0.675 = R82.71 • Note: • In terms of the new Companies Act, which is expected to come into force sometime in 2011, preference shares will no longer have a face value (par value). It will have an issue price and a redemption value (if applicable).

15. Valuation of Ordinary Equity • Dividend Discount Model • Free Cash Flow Model • Price Multiples (relative valuation) • EVA Discount Model

16. Valuation of Ordinary Equity – Zero Dividend Growth • Assume a company is expected to maintain the same dividend in future years. What are we valuing? • We are valuing a perpetuity. • Value = D / k • If dividend is R0.80 and the Cost of Equity is 11%, then the value is 0.80/.11 = R7.27

17. Valuation of Ordinary Equity • Dividend Growth Model • Value = PV of future dividends • If dividends are growing at a constant rate, then; • PV = D(1+g)/(k-g) • Where • D(1+g) = next year’s dividend • k = cost of equity • g = future constant growth rate in dividends

18. Dividend Growth Model • How do we estimate growth in dividends? • Use surrogates such as; • Growth in earnings • Growth in cash flow • Sustainable growth rate formula as a check • Growth in dividends over the long term should reflect earnings growth. If EPS is growing at 10% per year, and if current dividend growth is 20%, then this is not sustainable over the long term. Earnings growth is a long-term anchor for dividends.

19. Dividend Growth – Two Stage Model • How do we value a company which is experiencing a high growth in dividends which is followed later by a lower but stable growth rate in dividends? • Example: HiFly Ltd is expected to experience a growth rate of 30% for the next 3 years and thereafter will experience a growth rate of 6% per year. The cost of equity is 12% and the current dividend is 60 cents.

20. Two Stage Valuation • Dividend per share in year 1, 2 and 3 will be; • Yr 1: 0.60 x 1.3 = 0.78 • Yr 2: 0.78 x 1.3 = 1.01 • Yr 3: 1.01 x 1.3 = 1.31 • Present Value of future dividends in years 1-3 = R2.43 • What is the value of the ordinary equity at the end of year 3? • Value3 = D3(1+g)/(k-g) • Value3 = 1.31(1.06)/(0.12-.06) = 23.17 • Present value today = 23.17/(1.12)3 = 16.49 • Total Value of the shares = 16.49 + 2.43 = 18.92

21. Valuations – Distant Dividends • What about a company that is growing at a rapid rate in terms of market share and will only pay a dividend in the distant future? • Example: A biotech company expects to only start making a profit from year 8 and paying a dividend from year 11, which will double until year 13 and then grow at 7.5% per year. • Cost of Equity = 14%. If Cost of Equity falls to 11%, then value will rise to R6.71

22. Dividend Growth – From the real world • Let’s apply the dividend growth model to Woolworths • Assume a long-term sustainable growth rate of 8% (approximately 4.5% inflation and 3.5% real growth). Assume the cost of equity is 13% (Risk free rate of 7.2% + risk premium of 5%). • Assume that the high growth in earnings and dividends will continue for the next 5 years, before falling to 8% per year. Expected growth rate for 5 years is 15% per year, which reflects the growth in earnings and dividends 2004-2010. • Compare to current listed price

23. Price Multiples - Price Earnings • Use of price multiples such as price-earnings (P/E) ratios and market to book ratios to determine whether shares are over or under-valued. • A Co. with a high growth rate will normally have a high P/E ratio. Yet this may also be due to very low earnings for a particular year. • High P/E ratios may indicate that shares are over valued. Use P/E ratios of comparable companies. • Use of listed company P/E ratios to value unlisted companies • P/E is based on historical earnings • P/E is based on accounting earnings

24. Price Earnings • Assume a company has an EPS of 1.50 and comparable firms have an average P/E ratio of 10. Value = R15.00 • Do high P/E ratios indicate that company shares are overvalued? • Research by Schiller of Yale indicates that high P/E ratios generally do indicate over-valued shares • Refer to Internet Bubble in year 2000. • Average P/E ratio in South Africa is about 17.

25. What Returns do High PE companies Achieve in Subsequent Years? Low PE = High return in next 10 yrs High PE = Low return in next 10 yrs

26. Enterprise Value • P/E ratio used to value ordinary equity • Use EBIT or EBITDA multiples to determine the value of the firm or enterprise value • Use of EBITDA enables us to ignore differences in depreciation policies and use of EBIT or EBITDA multiples means we can ignore differences in financial leverage • EBITDA of R240m x 7.5 = R1800m. Deduct value of debt to get to value of equity

27. Market to Book Ratio • Book value per share = shareholders equity/no. of shares • High growth companies will have high market to book ratios • Market to book ratios are dependent on the industry sector • Is the sector capital intensive? • Specific sectors • Pharmaceutical sector – High R&D – is this an asset or expense? • Branded products – advertising costs – asset or expense? • Are Tiger Brands and Shoprite capital intensive? • Market to Book is an important ratio in the valuation of banks

28. Free Cash Flow Model • Value of the Firm = present value of future operating cash flows discounted at the firm’s cost of capital (WACC) • FCF = Net operating profit after tax (NOPAT) + depreciation – capital expenditure –increase in net working capital • Value of Ordinary Equity = Value of Firm less value of debt

29. Alternative: Free Cash Flow to Equity • We can determine the value of ordinary equity by discounting the cash flows due to shareholders after financing costs and changes in financing flows • FCFE = NOPAT + depreciation – capital expenditure – increase in net working capital – financing costs plus (minus) increase (decrease) in debt financing • Discount rate = cost of equity • Recommended for valuing firms with high levels of debt and banks. For other firms, use FCF to operations to value the firm and then deduct debt.

30. Free Cash Flow - Continuing Values • Using the Free Cash Flow Model, we estimate the future cash flows for an explicit period, normally 7-10 years, and determine a continuing value after the initial period, assuming a constant sustainable growth rate and margin. • Continuing values (terminal values) are determined at the end of the initial period as follows; • Note that FCF1 or FCFE1 in this context is the following year’s cash flow (at the end of the initial period).

31. Free Cash Flows - Example • Assume a company, Stop-to-Shop Ltd, has current earnings before interest and tax (EBIT) of R72m on sales of R600m. The following parameters apply;

32. Stop-to-Shop Ltd

33. Free Cash Flow - Workings • Stop-to-Shop Ltd

34. EVA Approach • EVA = NOPAT – (WACC x Asset Book Value) • Assume Asset Book Value = Invested Capital • Value of firm = Book value + PV of future EVAs • Example: GoFlow Ltd is earning a return of 25% for next 3 years and its WACC is 10%. The book value of its assets is expected to remain at R180m. The return after year 3 will be 10%.

35. The Process of Valuation • Value what is and what could be. • Valuation Questions

36. Valuations and the Financial Manager • Focus on shareholder value means that the financial manager will focus on value maximisation. • Why is valuation important? • Valuation of company and divisions for listing purposes • Valuations for purpose of divestures or acquisitions • Valuation for purpose of determining an optimal capital structure • Valuation for determining cost of equity and WACC • Share buybacks • Managerial remuneration

37. Valuations - Pitfalls • Confusing the valuation of equity with the valuation of the firm • Using the wrong discount rate - use the cost of equity for cash flows to ordinary equity and the WACC for cash flows to the firm • Adjusting for risk in the cash flows and the discount rate • Not recognising the risk of a changing capital structure in the discount rate • No comparable firms • Double counting for synergy by increasing cash flows and reducing the discount rate • Increasing the discount rate for country risk when this is already included in the risk free rate • Misestimating the value of control.