Introduction to Equity Valuation

1. Introduction to Equity Valuation Chris Argyrople, CFA Concentric LLC Enterprise Valuation & Cash Flow Analysis

2. Today in the Financial Markets(1998) • Hollywood Entertainment had a tender offer for $11 / share that fell through. • Not enough investors wanted to sell at the $11 price • What happened ??? • The stock fell 20% to close at $8.8125 !! • DOES THIS MAKE SENSE ?? ARBs Unwinding ??

3. Today in the Markets, 9/15/98 • Dow rose above 8,000 again, nobody knows where it will go next. • Port Mgr: Likes Rainforest Café (RAIN) • Stock closed at $6 5/16 • He says $3 net cash • 98 EPS estimate is $0.75 • Is it a screaming buy??? • Feb 1, 1999 Price $ 5 7/8 • STOCK ULTIMATELY FELL TO $1

4. M&M’s Theory • The Value of An Asset is Independent of How it is Financed • Example: Buy a $300,000 house. At closing, the seller just wants a certified check for $300,000. He doesn’t care whether the money came out of your passbook account or whether you wrote a mortgage. • This logic holds for all assets

5. Modigliani & Miller (M&M) • M&M Postulated that, “Capital Structure Does Not Matter” • Do you Agree?? Why or Why not? My View: • At any instant, CS DOESN’T MATTER • But, as time horizon lengthens, CS DOES Matter. • Debate??

6. P/E Ratio can be Misleading Company A & B are Identical Identical: Assets, CashFlow, Growth Rates P/E’s: A = 15.0 , B =8.5

7. Why P/E is Misleading • Why is P/E Misleading? Comments? • Why doesn’t Interest Expense properly account for associated cost of the debt? • Capitalized Interest • Yield Curve: ST Debt vs. LT Debt • This is part of it, but: • Cost of Debt NOT = Cost of Equity • You can’t compare Apples & Oranges

8. So, is B Cheaper than A? • Which firm’s stock is cheaper, B or A? • My answer: B is cheaper (lower P/E), but A is probably a better equity investment. • A is less risky, throws off more free cash flow, and has less constraints (less debt) • B’s debt constrains its choices, and if something goes wrong, B gets hammered • Debt can make managements either: Very Aggressive OR Very Risk Averse

9. Enterprise Value • Total Enterprise Value (TEV) = Firm Value • TEV = Debt + Equity - Cash • Use Market Values, NOT Book Values, but, it is ok to use Book Debt as a Proxy for Market Debt (usually) • Measures the value of the entire company, independent of capital structure. • This is the right way to do it. Any arguments??

10. Why Subtract Cash from TEV? • Cash is not really part of the business, it is portable & fungible • It can be used to pay down debt (same as subtracting off cash from TEV) • It can be dividended to equityholders (same as subtracting cash from TEV) • IMAGINE A SHELL COMPANY WITH ONLY CASH, WHAT IS THE COMPANY WORTH? This is why you subtract cash.

11. More Sophisticated TEV TEV = Debt + Equity - Working Capital • If there is extra working capital, it may make sense to subtract off the WC • This technique is difficult to implement because companies require a certain amount of WC to sustain operations, so it is difficult to ascertain how much to subtract. Subtracting WC is sophistic.

12. TEV Trick • Subtract Working Capital when it is Negative • Why? Because negative Working Capital usually requires additional funding, thus diluting current stockholders (somehow) • Subtracting a negative is equivalent to adding the Working Capital to TEV • When WC < 0, it would be kind of erroneous to subtract cash (wrong way)

13. Valuation: Operating Cash Flow • How do we value a company using TEV? Answer: • Compare Enterprise Value to Operating Cash Flow • EBITDA = Earnings Before Interest Taxes Depreciation & Amortization • EBITDA = Operating Cash Flow • EBITDA = Operating Income + NonCash Charges

14. What is EBITDA? • EBITDA is the Cash Flow thrown off by the underlying business • Because it is before Financing Charges, Taxes, and Accounting Choices it is more difficult for management to “game.” • Obviously, EBITDA is still subject to Revenue Recognition and Inventory Accounting issues

15. Why EBITDA is Better • EBITDA is not Subject to acceleration of Depreciation or Amortization • EBITDA is not affected by Capitalized Interest • EBITDA is not altered by Capital Structure • EBITDA is not subject to Tax tricks • It is a cash flow measure, and businesses are propelled by cash

16. Valuation: TEV & EBITDA • Use TEV / EBITDA as one of your primary metrics. • Low TEV / EBITDA ratios are good • TEV / EBITDA = measures the value of entire business vs. the operating cash flow • Better Apples to Apples Comparison than: P/E, P/Book, and Price/Revenue ratios

17. Key Valuation Points • Ratios like P/E are of little value by themselves. They must be compared to similar firms to identify “Relative Value” • Growth Rate drives Valuations, if this is not the case, then you have a mis-pricing • Estimating Growth Rates is very difficult, Very Difficult if not Impossible. • So, what do you do?

18. Valuation: Cash Flow Ratios • TEV / EBITDA = Firm Value to OCF • TEV / Revenue = Firm Value to Revenue • EBITDA / Sales = Cash Flow Margins • MV Equity/FCFE = “Real” P/E, Free Cash Flow (FCFE) Mult. • EBITDA / Interest = Interest Coverage • Debt / EBITDA = Leverage Indicator

19. Asset Valuation • Asset Value = PV(cash flows) • Cash flows are independent of financing, BUT • Financing can dominate the Enterprise Value of a company • What does this Mean???

20. FREE CASH FLOW • Above all: FREE CASH FLOW IS KING • (if you could predict growth, then growth would be King) • Free Cash Flow to Equity = FCFE • FCFE = NI + Depreciation & Amort - Capex • NI = Net Income • Capex = Capital Expenditures

21. How Free Cash Works Balance Sheet Year 1 Year 2 Cash 10 10 Other Assets 400 400 Total Assets 410 410 Debt 65 35 Debt Other Liab & Eq. 345 375 O.E. Free Cash Flow 30

22. Back to Company A & B

23. Free Cash Improves the B/Sheet • In the Example, Free Cash of 30 can be used to: • PAY DOWN DEBT A GOOD THING • INCREASE CASH A GOOD THING • DIVIDEND PAYMENT A GOOD THING • ACQUISITIONS A GOOD THING • SHARE BUYBACK A GOOD THING • UPGRADE PP&E A GOOD THING • NEW PROJECTS A GOOD THING

24. If Free Cash was -30 • After dipping into cash of 10, THE COMPANY WOULD HAVE TO COME UP WITH THE OTHER 20 !!! HOW? • BORROW MORE A BAD THING • ISSUE EQUITY A BAD THING • GO BANKRUPT A BAD THING • SQUEEZE WORKING CAP. A BAD THING • SELL ASSETS A BAD THING • CUT DOWN CAPITAL EXP. A BAD THING

25. Argyrople Intro. Rule of Thumb Buy Stocks: Positive Free Cash Flow Short Stocks: Negative Free Cash Flow You wouldn’t believe how many people don’t understand this. This is a simple rule that will keep you out of some trouble.

26. Assuming No Valuation Change (TEV) • With No Valuation Change, Free Cash Flow is what determines the change in stock price. This is a simple concept, but most students don’t understand it. • Company A & B are Identical from the OCF line up, but due to capital structure, A’s stock rises & B’s stock falls. • I DON’T BELIEVE M&M EXPLAINS THIS PROBLEM

27. M&M was Right & Wrong • In our No-Growth example, Capital Structure does not affect the value of the assets (partially because the positive free cash flow firm builds cash & does not add to assets) • Enterprise Value stays constant BUT • Stock of Positive FCF firm Rises • Stock of Negative FCF firm Falls

28. Thus, Modified M&M • At any point in time, Capital Structure does not matter -- Value of the Assets is Independent of Financing • Over time, Capital Structure does matter for stockholders AND it is important to the total enterprise value of the firm too (because eventually the stock of firm B will be wiped out) -- Cash Flow thrown off by Assets is altered by Financing