Company Valuation Presentation to Háskóli Íslands

1. Company Valuation Presentation to HáskóliÍslands Haraldur Yngvi Pétursson, Equity Research – IFS Research 9 March2008

2. 1 Introduction 2 Multiples / Comparables 3 Discounted Cash Flow (FCFF) 4 Bank valuation

3. Introduction

4. Haraldur's Personal Introduction • Academic: • University of Iceland – Cand. Oecon • Professional • Deloitte – Accounting – 3 years • Preparations of financial accounts • Auditing of financial accounts • Kaupthing Bank – Equity Research – 4 years • Focus on the Icelandic market • Part of Kaupthing Scandinavian equity research from 2006 • IFS Research – Equity Research – Since November 2008 • Focus on Icelandic equities • Selected Scandinavian companies • S&P 500 selected sectors

5. Goal of Presentation • Discuss company valuation generally and main obstacles • Review in some detail the main currently employed valuation methods • Don't worry if you don't fully understand everything said • To most ordinary humans this is entirely foreign material • Valuation and Equity Research is very much "on site training" • Hopefully you'll enjoy picking up some of the terminology and the next valuation presentation you sit through should be slightly more bearable

6. Reasons for Valuing Companies • Key to successful trading in (and managing) corporations • Ability to estimate their value • Understanding the sources of their value • Investors do not buy corporations for aesthetic or emotional reasons – but for their expected future cashflows • Inherent value of a company based on forward-looking estimates and judgements • Valuation is fundamental for any decision & negotiations relating to e.g. • Company investments • Mergers • IPO / rights issues • Management project evaluation • Portfolio valuation

7. Valuation – Basics • Valuation a science or an art? A bit of both Science: Certain methods are based on solid mathematical pillars. Has (and is) being researched by entire university departments, thousand's of professors/PhD's/market practitioners Foundation of the world's financial system Art: Modelling and forecasting of the future (?!?) • management/key employees, tastes/fashion/sentiment, disruptive technologies… Material role of fickle (and difficult to model) behavioural issues and biases • overconfidence, overreaction, loss aversion, herding, regret, misestimating of probabilities.. Fact remains – companies need to be valued and the following methods are the best tools currently available

8. Valuation - Reservations • Assumptions and inputs into the models are of paramount importance • Garbage in -> Garbage out • Several "difficult-to-model" factors hugely important • Is it for sale? Is there a buyer? Sale under distressed circumstances? is funding available? • Output from valuation models ≠ current price • Additionally some types of companies are tremendously difficult to value analytically • Start-ups • Biotech/pharmaceutical research • Highly cyclical companies • Companies with large "real options" • Rights to unexplored oil-fields / mining • Online companies (social networking, search engine..)

9. Valuation Methodologies • Discounted Cash-flow (DCF) • Free Cash Flow to Firm (FCFF), FCF to Equity, Adjusted Present Value (APV) • Multiples / Comparables • P/E, EV/EBITDA, EV/Sales etc. • Other methods • Invested capital, VC Capital Method, Option Pricing, Last round of financing, Break-up value and Dividend Models • ..and then the more "sketchy" methods • e.g. Technical Analysis • Balance between model relevance, complexity and number of assumptions • Usually at least two methods used in any valuation exercise

10. Valuation Method: Multiples / Comparables

11. Multiples / Comparables (comps) - Introduction • The idea is to approximate a company's value by comparing it to companies with known value • Source of figures • Comparable public company multiples • Recent private company transactions • Important to only compare relative value of similar companies (apples with apples) • Similar Industry Scope • Similar Growth • Similar Risk • Similar Results (ROE)

12. Multiples / Comparables (comps) - Introduction • Many benchmarks can be used (usually industry specific) • Enterprise Value / EBITDA • Enterprise Value / Sales • Price / Earnings (I: V/H) • Price / Book (I: Q-hlutfall) • Price / Net Asset Value (NAV) • Monthly Rent Multiple • Funds under management • # subscribers, # patents, # employees, #website hits / Enterprise Value • etc.

13. Multiples / Comparables (comps) – Introduction cont. • Positives • Quicker and easier than analytical methods (DCF) • Reflects current market conditions (investor sentiment, bargaining power..) • Helpful in "reality-checking" DCF valuations • Disadvantages • Are the comparable companies similar enough? • E.g. public vs. private, future prospects, sector, management quality, market position, capital structure, tax-scheme… • Doesn't capture value of different scenarios/"what-ifs" • E.g. post acquisition cost-cutting is successful, synergies are achieved, pending lawsuit goes one way or the other.. • Disconnect between a multiple and inherent firm value. Hence does not capture systemic under-/overvaluation of companies by the market

14. Enterprise Value / EBITDA (1/5) • Currently the most common "valuation" method for several industries • Typically in the range of 5-15x depending on • Company type • CAPEX requirements • Prospects • Market conditions • "EBITDA" = Earnings before interest, taxes, depreciation and amortization • Proper to use Forecasted EBITDA (the future is what you're paying for) • Trailing 12 month / 4 Quarter EBITDA is commonly used • EBITDA is adjusted for one-off items (e.g. merger costs) Sales - Cost of Goods Sold - Administrative Costs + Depreciation & Amortization = EBITDA

15. Enterprise Value / EBITDA (2/5) • Enterprise Value (EV) • A measure of company's entire value • Vehicle & Apartment prices are quoted as enterprise value i.e. without any reference to current debt structure (the price assumes no debt is included) • Imagine how cumbersome it would be to hunt for a flat if prices referred to the value of equity in the flat Flat's quoted price: 10 million (50 (its value) – 40 (debt included) ) • Company share price refers to equity value -> very reasonable to calculate and work with company's EV Share Price x Number of Shares EV = Equity Value + Net Debt* * and + Minority Interest– Associates+ Operating lease commitment + Unfunded pension liabilities Borrowing – Cash

16. Enterprise Value / EBITDA (3/5) • Multiple in some ways better indicator of value than other measures • Helpful in comparing companies with different capital structures (w/o interest on debt) • Depreciation and amortization schedules vary between companies • Easier to approximate how much debt the company can support • Has several weaknesses • Capital Expenditure (CAPEX) requirements between companies vastly different • Some companies capitalize significant amounts of cost (e.g. R&D) and thus raise their EBITDA figure • Does not include different interests expenses, tax rate and required rate of return

17. Enterprise Value / EBITDA (4/5) • Example Question: (1) Value the company (EV and Equity Value) (2) Approximate its share price Figures for Caveat Emptor Ltd. EBITDA=1.000 Net Debt = 2.000 #Shares outstanding=300 Similar companies are trading at average EV/EBITDA multiples of 8.0x

18. Enterprise Value / EBITDA (5/5) • Solution to Example Question

19. Price / Earnings (PER or P/E) • Price Earnings (I: V/H) ratio shows how much accounting profit its owners are entitled to • Example: Stock price = 20, EPS= 2 => PER= 20/2 = 10 • Compared to companies similar in risk and prospects PER is an indicator of whether a particular stock is under or overpriced • Several variants • Trailing PER or forward PER (using forecasted earnings) • Primary shares outstanding or diluted number of shares • Average price over period • Generally: • High PER (>16) indicates that the market believes significant growth is on horizon • Low PER (<8) indicates that the market believes current profit levels are unsustainable

20. Price/Book (P/B) and Net Asset Value (NAV) • Price / Book = Value of Equity / Book Value of Equity (I: Q-hlutfall) • Purpose of ratio is to show the market premium to the accounting equity • P/B is used for valuing investments whose value is derived primarily from the underlying value of their tangible assets • Holding companies • Real estate companies • Banks • Companies up for liquidation (solvency value) • Net Asset Value (NAV) is a significantly better measure than book equity • Calculated by correcting the value of assets & liabilities in the accounts • Book value of associates • Book value of fishing quota • Goodwill justified? • Deferred tax liability going to be paid in the near future (Real Estate)? etc.

21. Misc. Industry Specific Multiples • Enterprise Value is the most common numerator • Airlines & retail businesses • EV/EBITDARoften used (notice that Rent (R) is excluded) • Takes into account that some companies buy their aircraft/stores while other companies rent them • Real Estate • Rent Multiplier or Yield% is often used EV = Monthly Rent * Multiplier (e.g. 125-250) = Monthly Rent / Yield% * 12 • Appropriate Yield% can be found in sector research and depends on factors such as country, type of building, quality of area, sub-sector vacancy and market conditions • Commodity Companies (Oil refineries, mining etc.) EV = Number of units of the commodity in reserves (e.g. barrels of oil) * Value per commodity unit • Asset Management EV = Assets under Management * Multiple (1%..4%) • Multiple depends e.g. on investor type (private banking % higher than institutional %) • …and other industry specific "rules of thumbs"

22. Valuation Method: Discounted Cash Flow (FCFF)

23. Discounted Cash Flow Valuation • DCF is the cornerstone of valuations and is the "analytically most correct" way • In reality: several "fudge-factors" and disagreement between practitioners • Robust in valuing anything that gives cash-flow in the future given assumptions • Bonds, derivatives, companies, etc. • Valuation of future cash that the investor will get from holding the firm. At the end of the day: "Cash is King" "Cash is fact – profit is an opinion" "Earnings do not pay the bills" • Used when significant information is available on company and its prospects • Also used to select between internal projects and to price the impact of various scenarios e.g. during negotiations

24. Fundamentals of any Discounted Cash Flow Valuation • Expected cashflow in each period • Divided by the appropriate discount factor that reflects the riskiness of the estimated cashflows • Example: How much is an infinite stream of ISK 15 million/year worth? Assuming a 10% discount rate: Expected cashflow Discount rate Year

25. Discounted Cash Flow Valuation in 4 Steps • Step 1 Compile information • Historical accounts (last 2-3 years). Review sales, margins, CAPEX, WC ratios, notes etc. • Research business, strategy, products, customers, markets, competition etc. • Industry and environment forecasts (official forecasts, research from experts, news etc.) • Discuss main risk factors • Look up information on similar companies

26. Discounted Cash Flow Valuation • Step 2 Estimate the appropriate discount factor weighted average cost of capital (WACC) Components of WACC are: 1) Cost of Debt (Kd) • Risk Free Rate (e.g. 10 year government bond) Nominal or real – must harmonize with forecasts • Appropriate Credit Risk Premium 2) Cost of Equity (Ke) (CAPM) • Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most common • Equity risk premium is an estimate of the premium investors require in excess of risk-free assets for owning equities (4-7% most typically used) • Beta is a measurement of firm's/similar firms volatility compared to themarket (if higher than 1 company/sector is riskier than market in average). When compiling and averaging betas it is necessary to take into account different company leverage

27. Discounted Cash Flow Valuation • Step 2 cont. • WACC calculation example (typical Icelandic firm) • Or… ... as is very common: Present WACC as a figure (8..15%) and provide a sensitivity table

28. Discounted Cash Flow Valuation • Step 3 Prepare a "visible" forecast period (5-10 years and longer for some industries) • Forecast Sales, margins, capital expenditure, working capital requirement • And derive Free Cash Flow to Firm

29. Discounted Cash Flow Valuation * Forecasts should trend downwards to achieve long run growth rates • Step 3 cont. * Assumptions should be reviewed for consistency with past performance and business model * Depreciation should harmonize with CAPEX & the value of property, plant and equipment (PP&E) in the long run * COGS & SG&A include Depreciation so it needs to be subtracted (non-cash item)

30. Discounted Cash Flow Valuation • Step 3 cont. * Helpful to create a balance sheet and model the difference in inventories, receivables and payables between years. * CAPEX needs to be sufficient to fund the strategy (e.g. the opening of new stores) * Tax relief from debt is included in the discount factor

31. Discounted Cash Flow Valuation • Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to Firm with the WACC • Deal properly with Terminal Values • Beyond the visible cashflow period, the value of the company is captured using a terminal value calculation (using either a DCF to perpetuity or comps calculation) * 0..5% often used for perpetual growth * 30-70% split is a rough guide for mature companies * Equity Value calculated from EV

32. Discounted Cash Flow – Presenting the Results • The Ultimate Answer to the Great Question of Life, the Universe and Everything -Hitchhiker's guide to the Galaxy • All diligent valuations are presented as sensitivity tables • Demonstrate the link between assumptions and the final value • Allow the reader, which probably disagrees with some assumptions, to use the analysis

33. Discounted Cash Flow Valuation • Other DCF methods: • Free Cash Flow to Equity (FCFE) Same as Free Cash Flow to Firm but • Interest (and tax savings from interest) and changes in net debt (repayments) are subtracted from the FCFF. Discounted with cost of equity (not WACC) • Has many proponents arguing (a) more intuitive measure of cashflow (b) overleveraged companies in jeopardy more obvious, etc. • Adjusted Present Value (APV) – less common • Takes into account changing debt structure – helpful for leverage finance/private equity • Calculate value of firm assuming no debt • Calculate the present value of tax savings due to interest (discounted with kd) • Value the effect of borrowing on likelihood and cost of bankruptcy (difficult)

34. Discounted Cash Flow Valuation • Key Drivers of Cashflow • Sales growth rates • Market, strategic considerations, pricing, economy, competition • EBITDA margin • Cost development, fixed vs. floating costs etc. • Capital expenditure (CAPEX) • Maintenance and investment CAPEX • Working capital requirement • Must support current operations and strategy (inventories, receivables & payables) • Cash tax rate • A specialist area (legislation, relief from previous tax loss, deferred tax) • Model also highly sensitive to • Discount factor • Terminal value growth

35. Bank valuation

36. Value Measures – banks equity • Book Value • Reported value of equity, based on the prevailing accounting standards • Economic Value • Difference between market value of assets and liabilities at a given time • Market Value • Current share price multiplied by the number of outstanding shares • Intrinsic Value • Discounted value of future earnings • Analyst's most used tool • DDM the most common valuation model • Analysts may argue for a discount or a premium

37. Premiums and discounts • Discounts • Size (or lack thereof) • Liquidity and free float • Asset quality • Balance sheet structure • Capital raising risk • Ownership, corporate governance and transparancy • Holding company and conglomerate discount • Management quality • Demand

38. Premiums and discounts • Premiums • Wheight of money • Mutual fund inflows • Asset-class allocation • Liquidity and free float • Excess capital • Index issues • Takeover or other speculation

39. The dividend discount model (DDM) • Some DDM Strengths • Communicability and basis • Absolute valuations • Comparability • Simple sensitivity measures • Key assumptions • Cost of Equity • Return on Equity • Long term growth

40. The dividend discount model (DDM) • DDM has various forms • Basic one stage model • Multistage models • The most basic DDM • Fair value P/B multiple = • ROE = return on equity • COE = cost of equity • g = long-run growth • Book value per share * P/B multiple = Fair value per share • Fair value per share * number of shares = Total fair value

41. The dividend discount model (DDM) • Cost of Equity • Risk free rate • Varies by markets • Normally 10yr government bonds are used for base • Market risk premium • Generally 4-5% • The troublemaker – Beta • Historic vs. future • Time period and frequency • Liquidity • Earnings volatility • Judgement

42. The dividend discount model (DDM) • Return on Equity (Net profit / average equity) • Earnings • Trading profits and loss, included? • Goodwill writedown? • Other one-offs? • Place in the economic cycle • Bad debt charges • Numerous other company specific issues • Aim to estimate the "through the cycle" ROE

43. The dividend discount model (DDM) • Growth – long term • A banks earnings growth can not be higher in perpetuity than long term GDP growth • Better to err on the side of caution • Higher growth in developing than developed countries • One of the reasons for a multiple stage models

44. The dividend discount model (DDM) • Example – 3 banks

45. Valuation Method: Multi stage DDM

46. The dividend discount model (DDM) • Underlying assumption in the one stage model • Value of equity grows at the same rate as earnings • Dividend payout ratio therefore must be • A bank can not payout more than this ratio in the long run as capital restrictions will eventually come into place • The payout ratio can be higher, but that would lead to less gearing, lower ROE and actual value of discounted dividends will be lower • Is there an excess capital? • A war chest • A fear factor

47. The dividend discount model (DDM) • Two stage models are common • Give short term flexibility in e.g. • Earnings estimates • Growth • Lets look at one simple example • COE is 10% • Growth is 4% • ROE (long term) is 14,8% • Assume dividends at 5% during forecast period • Payout ratio (POR) =>

48. The dividend discount model (DDM) • Our basic assumptions • Equity = last year + earnings – dividends • Equity in perpetuity = Equity last forecast * (1+g) • Earnings in perpetuity = Earnings last forecast * (1+g) • Dividend last year (and perpetuity) according to our POR

49. The dividend discount model (DDM) • The valuation process is in two parts (hence two stage model) • First we calculate the present value of dividends in the forecast period • Discount rate = COE • Then we calculate the PV of perpetuity • Fair value multiple as before • Add PV of dividends over forecast

50. Questions and Answers Q & A