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Valuation

Valuation. Valuation Overview. Valuation Discounted cash flow models DDM FCFE Relative valuation over time across assets at a given time relative to comparables relative to the market. General Thoughts on Valuation. We will be using quantitative models. But one size does not fit all.

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Valuation

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  1. Valuation

  2. Valuation Overview • 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. 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.

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

  5. 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

  6. 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?

  7. 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

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

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

  10. Citigroup: Gordon Growth DDM

  11. 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 Mis-specified

  12. Growth Failure: Companies Maintaining 20% Growth

  13. Growth Failure: Persistence of Excessive Growth Seventh Year First Year

  14. 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

  15. 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?

  16. 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

  17. 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

  18. What are Comparable Assets?

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

  20. 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% 2004 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?

  21. GE ($31.79) 2003 estimate $1.56 LTG estimate 11.3% Op Margin 14.14% Mkt Cap $318bn ROE 23.8% Debt/Equity 214% 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

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

  23. 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

  24. 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 • Note that we are still stuck with perpetual growth assumption

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

  26. Value of Firm Going Concern Value Liquidation Value Going Concern Value 3. Price to Book Value

  27. Value of Firm Going Concern Value Liquidation Value Going Concern Value 3. Price to Book Value

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

  29. 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

  30. 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

  31. 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!

  32. Why Are Comparables/Relative Value So Important? • Arbitrage • Relies on “close substitutes” • Be careful of stocks “obviously” cheaper than comparables

  33. Why Use Multiples Analysis? • Used prevalently in practice • Research reports full of multiples • Rules of thumb based on multiples • Quick – can evaluate large #s of stocks • Understandable/sellable/defensible • Current market data • DCF relies on multiples in the end • Terminal value

  34. Problem with Multiples Analysis • Quick can be too quick – and dirty

  35. Issues When Using Multiples • Definitions • What are “earnings”? • Consistency • Equity versus Firm (enterprise) • Uniform • Over time • Cross-section (across firms) • Scaling • Common sizing is useful • Range/Distribution • Mean versus median • outliers

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