Joy Global (JOY) Module 9: Valuation of Equity

1. Joy Global (JOY) Module 9: Valuation of Equity Thomas Maguire 3/24/2014

2. Joy Global Background • Manufactures and services mining equipment • Focus on: Coal, Copper, Iron Ore, Oil Sands, and Gold • Revenue split between • Surface Mining Equipment • Underground Mining Machinery

3. Introduction • Prior modules focused on valuation of Enterprise Operating Activities • Now, we want to transition to valuation of equity • Equity Value can be derived from enterprise operation value or valued directly • Up to this module, we focused solely on what is owned by BOTH debt and equity holders • As investors in the general equities markets, we may be concerned only about the portion owned by equity holders

4. Adjusting Enterprise Value to Equity Value • Enterprise Operating Activities valued thus far– belong to both debt AND equity holders • How do we determine the value of the equity ownership? • Subtract the Value of the debt • Often a relatively straightforward process: • Debt is shown on the company’s balance sheet at approximately market value • If not, disclosures must be made as required under GAAP: • ASC 825-10-50-10

5. Determining Value of Equity in Joy • In prior modules, we calculated the enterprise value of Joy Global: • $8,612,485 • Value of both debt and equity holder’s interest • Need to subtract the value of the debt holder’s interests from the enterprise value

6. Determining Value of Equity in Joy • In module 2, we reformulated the balance sheet to identify NFL:

7. Determining Value of Equity in Joy • Enterprise Value: • $8,612,485 • 2013 NFL: • $1,010,141 • Note, Joy Global does not carry preferred stock or have non-controlling interests, however if these two items were present they would need to be accounted for– these amounts are not available to equity holders • The book value of these amounts rarely differ materially from their fair values, however if they did disclosure would be made • Value of Equity = Enterprise Value- value of NFL • $7,602,344– divided by 100,140,000 shares= $75.92/ share

8. Valuation Formulas for Equity • When we began doing valuations, we focused on cash flows to debt AND equity holders • This was identified as free cash flows of the firm, distinguished from free cash flows to equity • The latter would be the amount that eventually is available to equity holders • These payoffs to equity holders are known as dividends • We have formulas at our disposal to value the firm based on expected payoffs made to the equity holders

9. Valuation Formulas for Equity • Free cash-flow based valuation to equity holders • is the net dividend to the equity holders • is the cost of capital for equity • As before, we can transition from a cash flow based valuation to an accounting based valuation, previously we saw:

10. Valuation Formulas for Equity • Now, we can come up with a relationship between dividends (free cash flow to the equity holders), comprehensive income and book value of common equity: • repr3esents the comprehensive income for period t • is the book value of common stockholders’ equity at time t • Can use this equation and the dividend discount model to derive the residual earnings model: • is the residual earnings in period t

11. Valuation Formulas for Equity • Finally, as we derived abnormal enterprise income growth by using the next period capitalized earnings of the enterprise as our anchor, we can use the next period earnings of the firm to derive the abnormal earnings growth model: • is abnormal enterprise in period t+1

12. Valuation Formulas for Equity • It should be noted that “other comprehensive income” included in comprehensive income that are not included in net income will expected to be zero in future periods • Often financial statement translations and hedging gains/losses • Our best estimate of these in future periods is zero– any forecasting would be saying that the firm could anticipate foreign currency/ asset changes

13. Choosing between an Enterprise Operations or Equity Valuation Model • Though we now have derived formulas to calculate the value of equity directly, we still chose to focus on valuation of enterprise activities, WHY? • When we estimate the cost of capital, module 6, we assume stability of risk going forward so that we can assume a constant rate of capital in the future • When we are valuing enterprise activities, we use the cost of enterprise capital, not expected to change in future periods unless the risk of enterprise operating activities change • However, if we want to directly value equity, we would need to assume that equity risk will be the same in future periods

14. Choosing between an Enterprise Operations or Equity Valuation Model • Making the assumption that equity risk will be the same in future periods is very bold • Assuming a constant rate of enterprise capital, using the weighted average cost of capital formula is much more realistic • The risk of equity however, is a combination of the risk of enterprise and the leverage that the debt offers to the equity holders • The cost of capital of equity is dependent upon the leverage of the firm • As such, we must assume that leverage will be constant in the future in order to assume a constant cost of equity– NOT EASY

15. Using Analysts’ Forecasts as a Shortcut to Valuation • Though the advantage of valuation through enterprise activities has clearly been outlined, it may be appropriate that using direct equity valuation models with analyst estimates as inputs may be beneficial • We can look at the delta between direct valuations through analyst estimates and per share values derived from enterprise operations

16. Using Analysts’ Forecasts as a Shortcut to Valuation • Analysts tend to focus on dividends and earnings and the estimates are available from a wide variety of sources • For Joy Global, I looked at Valueline, Zack’s, and Bloomberg aggregated analyst forecast to get a sense of the future direction of joy global • I chose to focus solely on the Valueline for this exercise as I felt they produced solid estimates

17. Value Line Forecasts

18. Implied forecasts for Joy Global • Assume 2017-2019 forecasts reflect a point estimate for 2018 and then compute the annual rate of growth that ValueLine is implicitly forecasting • For earnings, to grow from $3.60 in 2014 to $7.20 in 2018 • 18.92% growth rate • For dividends, to grow from $.70 in 2014 to $.70 in 2018 • 0% growth rate

19. Implied forecasts for Joy Global

20. Valuation Using Analyst Forecasts • Using these analysts forecasts and the dividend discount model/residual earnings model, we can get valuation to compare to our prior calculated equity per share • Assume cost of equity capital to be 13.9% as calculated in Module 6

21. Dividend Discount Model Using Analyst Forecasts • However, we need to come up with an estimate for continuing value • We can use the projected future price, target price of $80, from ValueLine • This is a forecast of the amount an investor would get if he/she liquidated the investment at the forecast horizon • With these inputs, we get a value of $39.37

22. Residual Earnings Model Using Analyst Forecasts • = $28.54

23. Residual Earnings Model Using Analyst Forecasts • To estimate a continuing value, we can assume a growth rate of 2.5% however, it should be noted steady state is not achieved in this case • With these inputs, we get a value of $31.63 • Should be noted that steady state is not achieved by the end of the horizon as evidenced by the differing estimates from the dividend discount model and the residual earnings model • Also, it should be noted that analysts often optimistic bias in forecasts may lead to an inflated equity value • However, these estimates are significantly under our original valuation of $75.92

24. Adjusting Valuation to the Valuation Date • So far, we have been estimating the value of the enterprise as of the balance sheet date • However, we are not interested in the value of enterprise at the balance sheet date, but rather we are interested in today’s value • We can expect the value of the enterprise operations to increase at the price of enterprise capital • So, we must roll forward the value estimate at the cost of enterprise capital to arrive at March, 31, 2014 estimate • =$8,612,485 * (1+.123)^(5/12) • =$9,038,992

25. Mid-Year Adjustment • Valuation models assume that payoffs occur at year-end and are discounted for the entire year • We could however, assume that payoffs occur evenly during the year • Can achieve this by multiply the estimated value by a mid year adjustment factor defined as: • Applying this adjustment factor using our cost of enterprise capital of 12.3% yields a new valuation of $9,726,915

26. Sensitivity Analysis We can analyze the effect of both a change in growth rate and a change in required return

27. Questions? Thank You!