أسباب الاختلاف في تقييمات الشركات

1. أسباب الاختلاف في تقييمات الشركات أ.د. أسامة الخزعلي kazali@aus.edu الجامعة الامريكية فى الشارقة مقدمة الى هـيـئــة الأوراق الـمالــيـة والسـلع

2. Disclaimer • The information reported and discussed in this presentation do not represent the views or the opinions of the Securities and Commodities Authority (SCA) nor the American University of Sharjah (AUS. They represent my own views based on information that are publically available in books or newspapers. SCA or AUS are not responsible for the content of this seminar.

3. Seminar's Outline • Introduction: • What Purpose Does a Valuation Serve? • Main Valuation Methods • The Most Common Errors in Valuation

4. Introduction What is The Goal of the Financial Management? To Maximize the current value per share of the existing stock (maximizing the value of the firm)

5. Introduction How can we maximize the value of the firm? By • Finding the right investment • Finding the right source of Financing • Minimizing risk

6. Introduction Some important questions that need to be answered by you • What long-term investments should the firm take on? • Where will we get the long-term financing to pay for the investment? • How will we manage the everyday financial activities of the firm?

7. Introduction What is Valuation • Valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

8. Introduction Steps of Valuation • Historic and strategic analysis of the company and the industry • Projections of future cash flows • Determination of the cost (required return) of capital • Net present value of future flows • Interpretation of the results

9. The Purpose of Valuation WHY?

10. 1. In company buying and selling operations: For the buyer, the valuation will tell him the highest price he should pay. For the seller, the valuation will tell him the lowest price at which he should be prepared to sell.

11. 2. Valuations for listed companies: • The valuation is used to compare the value obtained with the share’s price on the stock market and to decide whether to sell, buy or hold shares. • The valuation of several companies is used to decide the security that the portfolio should concentrate on: those that seem to it to be undervalues by the market. • The valuation of several companies is also used to make comparisons between companies.

12. 3. Public offerings: The valuation is used to justify the price at which the shares are offered to the public The valuation is used to compare the shares’ value with that of other assets. 4. Inheritances and wills:

13. 5. Compensation schemes based on value creation: The valuation of a company or business unit is fundamental for quantifying the value creation attributable to the executives being assessed. The valuation of a company or business unit is fundamental for identifying and stratifying the main value drivers. 6. Identification of value drivers:

14. 7. Strategic decisions on the company’s continued existence: The valuation of a company or a business unit is a prior step in the decision to continue in the business, sell, merge, milk, grow or buy other companies. The valuation of the company and the different business units is fundamental for deciding what products/business lines/countries/customers… to maintain, grow or abandon. The valuation provides a means for measuring the impact of the company’s possible policies and strategies on value creation and destruction. 8. Strategic planning:

15. Main Valuation Methods

16. Discounted Cash flow where CFt is the expected cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and n 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.

17. Discounted Cash flow • Inputs needed for DCF • Expected Cash flows • Discount Rate • Terminal Value

18. Generic DCF Valuation Model

19. VALUING A FIRM Cashflow to Firm Expected Growth EBIT (1-t) Reinvestment Rate - (Cap Ex - Depr) * Return on Capital Firm is in stable growth: - Change in WC Grows at constant rate = FCFF forever Terminal Value= FCFF /(r-g ) n+1 n FCFF FCFF FCFF FCFF FCFF FCFF 1 2 3 4 5 n Value of Operating Assets ......... + Cash & Non-op Assets Forever = Value of Firm Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) - Value of Debt = Value of Equity Cost of Equity Cost of Debt Weights (Riskfree Rate Based on Market Value + Default Spread) (1-t) Riskfree Rate : - No default risk Risk Premium Beta - No reinvestment risk - Premium for average + X - Measures market risk - In same currency and risk investment in same terms (real or nominal as cash flows Type of Operating Financial Base Equity Country Risk Business Leverage Leverage Premium Premium

22. First Principle of Valuation • Never mix and matchcash flows and discount rates. • The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm.

23. Cash Flows and Discount Rates • Assume that you are analyzing a company with the following cashflows for the next five years. Year CF to Equity Interest Exp (1-tax rate) CF to Firm 1 $ 50 $ 40 $ 90 2 $ 60 $ 40 $ 100 3 $ 68 $ 40 $ 108 4 $ 76.2 $ 40 $ 116.2 5 $ 83.49 $ 40 $ 123.49 Terminal Value $ 1603.0 $ 2363.008 • Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) • The current market value of equity is $1,073 and the value of debt outstanding is $800.

24. Equity versus Firm Valuation Method 1: Discount CF to Equity at Cost of Equity to get value of equity • Cost of Equity = 13.625% • Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 + (83.49+1603)/1.136255 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = $1873 Value of Equity = Value of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073

25. The Effects of Mismatching Cash Flows and Discount Rates Error 1: Discount CF to Equity at Cost of Capital to get equity value PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 + (83.49+1603)/1.09945 = $1248 Value of equity is overstated by $175. Error 2: Discount CF to Firm at Cost of Equity to get firm value PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 + (123.49+2363)/1.136255 = $1613 PV of Equity = $1612.86 - $800 = $813 Value of Equity is understated by $ 260. Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity Value of Equity = $ 1613 Value of Equity is overstated by $ 540

26. Discounted Cash Flow Valuation: The Steps • Estimate the discount rate or rates to use in the valuation • Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm) • Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real • Discount rate can vary across time. • Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm) • Estimate the future earnings and cash flows on the firm being valued, generally by estimating an expected growth rate in earnings. • Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does. • Choose the right DCF model for this asset and value it.

27. Discounted Cash Flow Valuation: The Inputs

28. Estimating Inputs: Discount Rates • Critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. • At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. • Equity versus Firm: If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. • Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. • Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal

29. The Cost of Equity: Competing Models Model Expected Return Inputs Needed CAPM E(R) = Rf+  (Rm- Rf) Riskfree Rate Beta relative to market portfolio Market Risk Premium APM E(R) = Rf+ j=1j (Rj- Rf) Riskfree Rate; # of Factors; Betas relative to each factor Factor risk premiums Multi E(R) = Rf+ j=1,,Nj (Rj- Rf) Riskfree Rate; Macro factors factor Betas relative to macro factors Macro economic risk premiums

30. The CAPM: Cost of Equity • Consider the standard approach to estimating cost of equity: Cost of Equity = Rf+ Equity Beta * (E(Rm) - Rf) where, Rf= Riskfree rate E(Rm) = Expected Return on the Market Index (Diversified Portfolio) • In practice, • Short term government security rates are used as risk free rates • Historical risk premiums are used for the risk premium • Betas are estimated by regressing stock returns against market returns

31. Short term Governments are not riskfree in valuation…. • On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. • For an investment to be riskfree, then, it has to have • No default risk • No reinvestment risk • In valuation, the time horizon is generally infinite, leading to the conclusion that a long-term riskfree rate will always be preferable to a short term rate, if you have to pick one.

32. Everyone uses historical premiums, but.. • The historical premium is the premium that stocks have historically earned over riskless securities. • Practitioners never seem to agree on the premium; it is sensitive to • How far back you go in history… • Whether you use T.bill rates or T.Bond rates • Whether you use geometric or arithmetic averages.

33. If you choose to use historical premiums…. • Go back as far as you can. A risk premium comes with a standard error. • Be consistent in your use of the riskfree rate. Since we argued for long term bond rates, the premium should be the one over T.Bonds • Use the geometric risk premium. It is closer to how investors think about risk premiums over long periods.

34. Two Ways of Estimating Country Equity Risk Premiums for other markets • Default spread on Country Bond: In this approach, the country equity risk premium is set equal to the default spread of the bond issued by the country • Relative Equity Market approach: The country equity risk premium is based upon the volatility of the market in question relative to U.S market. Total equity risk premium = Risk PremiumUS* Country Equity / US Equity • Country ratings measure default risk. Country Equity risk premium = Default spread on country bond* Country Equity / Country Bond

35. Implied Equity Premiums • If we assume that stocks are correctly priced in the aggregate and we can estimate the expected cashflows from buying stocks, we can estimate the expected rate of return on stocks by computing an internal rate of return. Subtracting out the riskfree rate should yield an implied equity risk premium. • This implied equity premium is a forward looking number and can be updated as often as you want (every minute of every day, if you are so inclined).

36. Implied Equity Premiums • We can use the information in stock prices to back out how risk averse the market is and how much of a risk premium it is demanding. • If you pay the current level of the index, you can expect to make a return of 7.87% on stocks (which is obtained by solving for r in the following equation) • Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.87% - 4.22% = 3.65%

37. Estimating Beta • The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) – Rj = a + Rm • where a is the intercept and is the slope of the regression. • The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. Beta is sensitive to: • Data interval (monthly, weekly, daily) • Study period • Index

38. Beta Estimation: The Noise Problem

39. Beta Estimation: The Index Effect

40. Solutions to the Regression Beta Problem • Modify the regression beta by • changing the index used to estimate the beta • adjusting the regression beta estimate, by bringing in information about the fundamentals of the company • Estimate the beta for the firm using • the standard deviation in stock prices instead of a regression against an index • accounting earnings or revenues, which are less noisy than market prices. • Estimate the beta for the firm from the bottom up without employing the regression technique. This will require • understanding the business mix of the firm • estimating the financial leverage of the firm • Use an alternative measure of market risk not based upon a regression.

41. In a perfect world… we would estimate the beta of a firm by doing the following

42. Adjusting for operating leverage… Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable costs))

43. Equity Betas and Leverage • Conventional approach: If we assume that debt carries no market risk (has a beta of zero), the beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio L = u (1+ ((1-t)D/E)) In some versions, the tax effect is ignored and there is no (1-t) in the equation. • Debt Adjusted Approach: If beta carries market risk and you can estimate the beta of debt, you can estimate the levered beta as follows: L = u (1+ ((1-t)D/E)) - debt (1-t) (D/E) • While the latter is more realistic, estimating betas for debt can be difficult to do.

44. Bottom-up Betas

45. Why bottom-up betas? • The standard error in a bottom-up beta will be significantly lower than the standard error in a single regression beta. Roughly speaking, the standard error of a bottom-up beta estimate can be written as follows: Std error of bottom-up beta = • The bottom-up beta can be adjusted to reflect changes in the firm’s business mix and financial leverage. Regression betas reflect the past. • You can estimate bottom-up betas even when you do not have historical stock prices. This is the case with initial public offerings, private businesses or divisions of companies.

46. The Cost of Equity: A Recap

47. Estimating the Cost of Debt • The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level of interest rates in the market. • The two most widely used approaches to estimating cost of debt are: • Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded • Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm

48. Weights for the Cost of Capital Computation • The weights used to compute the cost of capital should be the market value weights for debt and equity. • As a general rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.

49. Recapping the Cost of Capital

50. E B rWACC = × re + × rB ×(1 – TC) E+ B E + B Equity Debt rWACC = × rEquity + × rDebt ×(1 – TC) Equity + Debt Equity + Debt The Cost of Capital (WACC) The Weighted Average Cost of Capital is given by: • Because interest expense is tax-deductible, we multiply the last term by (1 –TC).