SSE Riga Investment Fund Board 2011/2012 Elections

1. SSE Riga Investment Fund Board 2011/2012 Elections 23/05/2011

2. Agenda Info about iFund Elections’ procedure Questions

3. iFund Structure 5 board members Several associates from Y2 ~40 supporting people from Y1

4. iFund Structure: Board Chairman of the Board Investment Game Organizer Corporate Relations Manager Portfolio Manager Macroeconomist/Y1 coordinator

5. iFund Activities Fundraising Investment Game Portfolio management Educational seminars Investment [UN]limited Guest lectures Scholarships

6. Elections’ Procedure Signing up Valuation of a company Presentations Interviews Handover party

7. Signing up Send an email to ifund@sseriga.edu.lv expressing your wish to participate ASAP

8. Valuation of a Company Main part of elections Time - from May 23rd to June 8th More on it later tonight

9. Presentations & Interviews Presentations on June 10/13th 10 minutes + time for questions Interviews on June 14-15th Short interviews with current board members

10. Handover Party One of the most exclusive events Time – June 18th Place – Laba pirts Members of new board announced Elections of the chairman

11. WHY? Managerial Experience Something to put on your CV Networking Some way to get good contacts for good internship during Year 2 Real investment opportunities Portfolio worth of 1500LVL

12. WHY (2)? There is a robust tendency that iFund ex-board members get sexy future employment positions Barclay’s Capital Merrill Lynch Central Banks (LV) BCG

13. Thank you for your attention Questions?

14. Valuation Instructions May 23, 2010

15. Your Task • Prepare a DCF valuation of a company listed on any of Baltic stock exchanges • Refrain from financial and insurance companies! • Task has been developed by 2001/2002 board

16. Introduction to the Model Your output must consist of two parts: • Valuation model: • Excel file • Valuation report: • Up to 10 pages of text excluding appendices

17. Valuation Report • General company data • Company’s market environment: • Industry outlook • Company’s market position • Products/services of the company • Evaluation and analysis of financial performance • Results of the valuation model • Advice to investors

18. DCF Steps #1: Forecast and construct future IS, BS, CF #2: Calculate Free Cash Flows (FCF) #3: Find the equity risk () and risk premium (rm-rf) #4: Find required rate of return on equity (re) #5: Find the discount rate (WACC) #6: Find the Terminal Value, and discount all cash flows

19. DCF Steps #1: Forecast and construct future IS, BS, CF #2: Calculate Free Cash Flows (FCF) #3: Find the equity risk () and risk premium (rm-rf) #4: Find required rate of return on equity (re) #5: Find the discount rate (WACC) #6: Find the Terminal Value, and discount all cash flows

20. Forecasting Financial Statements (1) • Choose a listed company from any of the Baltic stock exchanges • Create the model in MS Excel first • Make separate sheets for: • Inputs, IS, CF, BS, (Sales, Costs, Investments, etc) • For Free Cash Flows (CFC) calculations • Construct IS, BS, CF for the future • IS and BS of 2010 as a starting point • Do not try to re-create previous CF statements! • Make sure the model is error-free

23. Forecasting Financial Statements (2) • Revenues disaggregated by products or countries: • i.e. industry / market growth (%), market share (%) • Creditors, debtors (credit days), inventories, COGS depend on sales • Interest income and expense depend on financial assets (cash and other), and loans • Dividends follow earnings in the long run • Investments depend on company’s strategy • Check for consistency of past and future ratios (profitability, credit days, margins, turnovers)

24. Forecasting Financial Statements (3) In theory, to calculate a company value, future cash flows should be forecasted as long as they last No sense to forecast up to infinity Two-stage valuation: Forecast 4 - 5 years in detail to get cash flows Calculate company’s value (terminal value) after explicit forecast period assuming constant future growth and profitability

25. Calculating FCF • Which cash flows to discount? • Dividends (equity value) • Earnings * payout ratio (equity value) • FCF (company value) • FCF advantage over dividends and earnings: • no need to forecast how cash flows will be distributed among capital providers • Free Cash Flows (FCF) – cash flows to all providers of capital • FCF is obtained by modifying Cash Flow statement

26. DCF Steps #1: Forecast and construct future IS, BS, CF #2: Calculate Free Cash Flows (FCF) #3: Find the equity risk () and risk premium (rm-rf) #4: Find required rate of return on equity (re) #5: Find the discount rate (WACC) #6: Find the Terminal Value, and discount all cash flows

28. DCF Steps #1: Forecast and construct future IS, BS, CF #2: Calculate Free Cash Flows (FCF) #3: Find the equity risk () and risk premium (rm-rf) #4: Find required rate of return on equity (re) #5: Find the discount rate (WACC) #6: Find the Terminal Value, and discount all cash flows

29. Finding Discount Rate Recall: • For company valuation, Weighted Average Cost of Capital (WACC) is the appropriate discount rate • Assume constant D/E ratio • It is reasonable to assume that MV(D)=BV(D) • MV (Equity) – capitalization (number of shares outstanding multiplied by share price) • If substantial changes in WACC inputs are expected, it should be recalculated each year

30. Discount Rate (WACC) CODib – Cost of interest bearing debt Tc – Corporate tax rate MV – market value requity – required rate of return of equity

31. Required Rate of Return (re) (1) • Cost of Debt can be calculated and estimated from IS and BS: • CODib = [Interest expense] / Dib • Required rate of return on equity? • CAPM: Capital Asset Pricing Model • Finding required returns on all risky assets • Re – Required rate of return • (Rm – Rf) – Risk premium (Rm – market return) • Rf – Risk free interest rate •  - Asset risk

32. Required Rate of Return (re) (2) • Risk free interest rate (Rf) • Risk premium (Rm – Rf) in mature (US) market (in 1926 – 1998) was 6.1%) • If country of interest is not US, additional country risk exists • Adjustment for Re calculations in emerging markets is offered by A. Damodaran

33. Risk Premium for Emerging Markets • Re = Rf +  * RPb + RPc • Rf - Risk free interest rate (Gov. bonds/interbank rate) • RPb – Base risk premium for mature market (US) • RPc – Country risk premium, calculated: • RPc = Ds * (Qe / Qb) • Ds – country default spread http://www.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html • Qe – standard deviation of local equity index • Qb – standard deviation of local bond index • More information in A. Damodaran paper “Estimating equity risk premiums” http://www.stern.nyu.edu/~adamodar/pdfiles/papers/riskprem.pdf

34. Equity Risk – Beta (1) Var Company Specific risk Systematic risk Number of companies in portfolio • Holders of a risky assets are paid only for systematic risk (health of economy, interest rates, etc) and not for company specific risk (delays in product launch, etc) • Company specific risk can be diversified • Beta () – measurement ofsystematic risk • Beta shows by how much the asset price changes when themarketrisk premium increases by 1%

35. Equity Risk - Beta (2) security,market – covariance between the returns on the security and market returns m2 – market return variance For calculations daily/weekly returns can be taken To estimate beta it is recommended to calculate industry beta by taking industry stocks portfolio (weighted according to capitalization) returns instead of stock ones.

36. Equity Risk - Beta (3) • Betas calculated according to emerging markets returns can be rather misleading • Possible way out • Use already calculated relevant industry’s betas http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html • Try calculating both for local market and taking already calculated numbers. Use the one, which you think to be more appropriate. Discuss your choice

37. Terminal Value (1) • If you have forecasted cash flows for n years, what is the company value at the end of nth year? • CFn+1 – cash flow for the (n+1)th year • g – growth rate (industry growth pace) • T=(CFn+1)/(r-g) • Where, g- growth rate and r - WACC

38. Recap Select forecasting horizon (4 - 5 years) Project future sales, costs, working capital, etc Construct IS, BS, CF statements Using financial ratios check for consistency Find Beta and risk premium, calculate required rate of return on equity Calculate Weighted average cost of capital Calculate Free Cash Flows and Terminal value Discount using WACC

39. Recommendations • V(equity) = V(company) – Net Debt • Share price = V(equity) / number of shares • Sensitivity analysis before making recommendations is suggested: • Check how results change if you increase / decrease by 1% or 2% WACC and growth rate (g) • Because future forecasts are obviously inaccurate, suggestions to buy (or sell) stock can be made only if value obtained by calculations is bigger (or smaller) than the current market price by at least 15%

40. Submission Your valuations (excel file and report) should be received at ifund.sseriga@gmail.com no later than 23:59 June 8th

41. Good luck!