Valuation

1. Valuation

2. Today • Valuation • Discounted cash flow models • DDM • FCFE • Relative valuation • over time • across assets at a given time • relative to comparables • relative to the market

3. Today • Getting started with S&P’s research insight. • A powerful tool for getting financial information and producing reports • Maybe too powerful – if you use numbers generated by S&P analysts, you must understand how they are derived! • Available on library computers. • You can use RIWeb to compute the financial ratios you need for next class.

4. Today • Getting started with S&P’s research insight. • A powerful tool for getting financial information and producing reports • Maybe too powerful – if you use numbers generated by S&P analysts, you must understand how they are derived! • Available on library computers. • You can use RIWeb to compute the financial ratios you need for next class.

5. Today • First of three accounting statements • Income statement first • Balance sheet • Cash Flows • Interrelationships can reveal important facts and trends • Settle group and sector assignments

6. General Thoughts on Valuation • We will be using quantitative models. • But one size does not fit all. • Obviously, a DDM won’t work for a company that doesn’t pay dividends. • Estimating growth for a cyclical company is problematic. • Sometimes, it’s easier to compare ratios with comparables. • But this comparison should be both across comparables and across time. • Use more than one valuation metric • The more metrics that produce the same answer, the better. • Sensitivity analysis is vital.

7. Valuation Models • Discounted Cash Flow • DDM • FCFE • Relative Valuation • P/E • P/B • Other ratios (some predict better than others for different industries.

8. Valuation Methods • Valuation Versus Own History • Is it relatively cheap now? • Valuation Versus Peer Group • Is it undervalues relative to peers now? • How has that relationship evolved over time? • If a company always sells at a discount, there’s probably a reason. • Valuation Versus Market • Is it undervalued relative to the market now? • How has that relationship evolved over time? • Absolute Valuation

9. What you may find • Companies that look cheap, and always have. • Firms that look good in industries that look bad. • That is, the industry currently looks expensive but the firm is the cheapest thing in the industry. • Industries that look good with firms that are average for the industry. • How can you tell?

10. DCF • DDM’s • FCFE • The holy grail: the numerator should be the cash flows that can be distributed to shareholders while retaining enough cash to support the assumed growth rate • The holy grail 2: your discount rate should match your numerator type

11. Basic Dividend Discount Model P= D1 (r-g)

12. Two Stage DDM • Pо=∑ D1_____+ ___Pn___ (1+Khg)† (1+Khg)ⁿ Where Pn=DPSn+1 (Kst-Gn)

13. Citigroup: Gordon Growth DDM

14. DDM Challenges • Certainty and Growth Rate of Dividends • Appropriate Discount Rates • Length of Growth Period(s) • Normal growth is what??? • Small Changes in Assumptions Lead to Widely Disparate Values • Outliers Most likely to be Misspecified

15. Growth Failure: Companies Maintaining 20% Growth

16. Discount Model Applications • Testing of Assumptions: Solve for Implied Values. • Take P as given, pick R and solve for g. • Must have Stable Growth and Leverage Companies • Cross Sectional, Time Series Analysis • DDM may produce low values for a particular industry. • Prefers Low PE/High Dividend Payers over High PE Cash Retainers • The high P/E cash retainers can perhaps be better valued by FCF. • FCF is often a good Alternative to Dividends

17. Free Cash Flow Valuation • Simple Definition: FCF= Operating Earnings+Depreciation -Capital Expenditure-∆Working Capital • You may be able to do better, but this is useful for forecasting. Why Could This Be More Effective than DDM?

18. Relative Valuation • Measure Comparable Assets with a Common Measure • Evaluate Price vs. Fundamental Factors (P/E, P/FCF, P/S, P/Bk, EV/EBITDA) • Look at Time Series Data

19. Large Capitalization Stocks Key Valuation Metrics

20. Large Capitalization Stocks Performance of Valuation Measure By Sector

21. Relative Valuation • Commonly Used against Company Historical Range, Peers, or Market • Easy to Access, Easy to Misuse • Yields Different Answers Than DCF • If it Looks Too Good to be True it Probably is…Too Good to Be True

22. What are Comparable Assets?

23. Comparable Assets • Similar Cash Flow, Growth and Risk • Generally in Similar Industries • Complicating Issues: Size, Business Mix, Leverage, Profitability • Understand Implicit Assumptions

24. GE ($33.75) 2004 estimate $1.57 LTG estimate 9.4% PTax Margin 15.12% Mkt Cap $356bn ROE 21% Debt/Tot Cap 43.6% 2003 PE 21.4x C ($47.00) 2004 estimate $4.01 LTG estimate 11.36% PTax Margin 27.8% Mkt Cap $243bn ROE 19.52% Debt/Tot Cap 23.3% 2004 PE 11.7x Comparable Assets 2004?

25. GE ($31.79) 2003 estimate $1.56 LTG estimate 11.3% Op Margin 14.14% Mkt Cap $318bn ROE 23.8% Debt/Equity 421% 2003 PE 23x Price 9/13/04 $33.75 UTX ($79.48) 2003 estimate $4.64 LTG estimate 11.6% Op Margin 12.26% Mkt Cap $37.2bn ROE 26.6% Debt/Equity 51% 2003 PE 18x Price 9/13/04 $94.64 Comparable Assets 9/03

26. When to use what? • P/E • P/FCF • P/B • P/Sales • EV/EBITDA • Other measures???

27. 1. PE Ratio Sensitive to Volatility, Growth, Profitability • P/E = 1/r + PVGO/E • Affected by Accounting Issues • Multiple Definitions (Operating Eps, Historic, Forward, Pro-forma, Fully Diluted vs Basic) • Affected by leverage

28. 2. Free Cash Flow Yield(instead of earnings) • Operating Earnings+Depreciation Expense- Cap Ex-∆Working CAP • Cash Available for Distribution to Shareholders • Strips Back Some Accounting Artifice • Incorporates Info from Balance Sheet

29. 3. Price to Book Value • Less Meaningful Today • Useful in Distressed Situations • Useful in Lower Growth Industries (Energy, Utilities, Financials)

30. 3. Price to Book Value • Useful in Financials Where Reserves can be Manipulated • Influenced by ROE and Cost of Equity • Significant Accounting Issues (Buybacks, Repurchase, Restructuring) • Can be Useful in Mean Reverting Mature Industries (Energy, Utilities)

31. 4. Price to Sales • Tougher to Manipulate • Revenues Tend to be Positive! • Useful in Absence of Profitability (Highly Cyclical Situations) • Enterprise Value to Sales (MV of Equity+MV of Debt-Cash)/Sales Corrects for Companies with Different Leverage

32. 5. Enterprise Value to Ebitda • (Market Value of Equity+Debt-Cash)/(Earnings Before Interest, Taxes, Depreciation, and Amortization) • Used in the Absence of Profits • Used Where EBITDA is Free Cash • Corrects For Varying Leverage • But Ignores Depreciation as Real Expense

33. 6. Alternative Measures? • PE to Growth Ratio • Market Value per Subscriber • Market Value per Home Passed • Market Value per Member • Market value per Pet HOLD ON TO YOUR WALLET!