Valuation

1. Valuation FIN 449Michael Dimond

2. Introduction • What this class will cover • How do I get an A in this class? • Relevance • Schedule • Tools & resources • Syllabus • Student Information • On my website, please fill out the form with your information

3. Definitions • Investment: Purchase of an asset which will create future cash flows. • Speculation: Taking a significant business risk to obtain a commensurate gain. So what’s the difference? • Gambling: To bet or wager on an uncertain outcome. "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." -- Graham and Dodd's Security Analysis (original 1934 edition)

4. Value • A fundamental question which must be addressed in any business decision is: “What is this worth?”

5. Valuation Concepts There is no single value. Value can change dramatically depending on the answers to these questions: • What is being valued? • Why is it being valued? • What is the appropriate standard of value? • What is the appropriate premise of value? • When is it being valued? • How will you value it? • What discounts or premiums are appropriate?

6. What is being valued? • Certain assets • Interest-bearing debt • Preferred stock • Common stock • Controlling interest • Non-controlling interest • Enterprise Value (or market value of invested capital)

7. Why is it being valued? • Transactions • Buying/Selling/Merging • Privatization • Strategic internal decisions • ESOPs • Tax • Estate, gift & inheritance taxes • Estate recapitalizations • Charitable contributions • Ad valorem taxes • Buy/Sell agreements • Litigation • Dissolution of corporation or partnership • Review/critique of another expert’s report • Damages • Lost profits • Marital dissolution

8. What is the appropriate standard of value? • FMV (Market Value) • The “cash value” of an asset to a non-specific, hypothetical buyer when there is no compulsion to sell and both parties have reasonable knowledge of relevant facts. • Investment Value • Intrinsic value. The value to a specific strategic buyer, not a hypothetical buyer. For private firms, this is often used on family law courts. • Fair Value • Created by State legislatures, “Fair Value” is defined differently in different states. It is usually used as a standard of value for dissenting stockholder lawsuits and minority oppression lawsuits.

9. What is the appropriate premise of value? • Value as a going concern • Assets in continued use as a viable business enterprise • Value as an assemblage of assets • Assets not in current use in the production of income and not as a going-concern business enterprise • Value as an orderly disposition • Assets sold individually with normal exposure to the market • Value as a forced liquidation • Assets sold individually with limited or no exposure to the market

10. When is it being valued? • Valuation date is at a particular moment in time • Could be historic date or as of the current date • Only data that is “known or knowable” as of the valuation date should be incorporated in the report • Date depends on purpose • Transaction-related (expected event, e.g. purchase) • Tax-related (date of gift, date of death, etc.) • Litigation (event date or change of value over a range of dates)

11. How will you value it? • General Valuation Concepts: • The economic value of any investment asset is derived from the present value of future economic benefit that will accrue to the owner • The most theoretically correct way to value an investment is to project the future economic benefits of ownership and discount those benefits to present value at a rate which reflects the time value of money and the uncertainty (risk) associated with ownership.

12. Value • A fundamental question which must be addressed in any business decision is: “What is this worth?” • “Value” is the present value of future cash flows. • We will be valuing companies based on their free cash flows • Damodaran has variations on FCF which we will learn: FCFF = Free Cash Flow o the Firm FCFE = Free Cash Flow to Equity

13. Considerations in Valuation • Price buyers are paying for similar assets • Cash flow generating ability • Risks associated with achieving projected cash flows • Value of the net assets owned by the business • Percent of ownership interest • Right to vote and influence business decisions • Marketability of ownership position • Special perquisites of ownership or management

14. Approaches to Valuation • Market Approaches • Example: Relative valuation estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales. • Income Approaches • Example: Discounted cashflow valuation relates the value of an asset to the present value of expected future cashflows on that asset. • Asset-based Approaches • Example: Adjusted net asset value method adjusts all individual assets and liabilities to market value. The amount by which asset value exceeds liability value is the equity value. • Option-based Approaches • Example: Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

15. Basis for all valuation approaches • The use of valuation models in investment decisions (i.e., in decisions of which assets are under valued and which are over valued) are based upon • a perception that markets are inefficient and make mistakes in assessing value • an assumption about how and when these inefficiencies will get corrected • In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

16. What discounts/premiums are appropriate? Value may be influenced by extenuating factors • Premiums • Control • Strategic acquisition • Discounts • Lack of control • Lack of marketability (liquidity) • Trapped-in capital gain • Key person • Known (or potential) environmental liability • Pending litigation • Concentration of customer base or supplier base

17. Where are we going with all this? Facts & Information Risk & Cost of Capital Forecast Financials Recasting & Sustainable OCF Exam DCF Calculations Strawman Valuation #1 Valuation #2 Comps Final Project Value & Perspective

18. Valuation – The Big Picture

19. Relative Valuation

20. Relative Valuation • What is it?: The value of any asset can be estimated by looking at how the market prices “similar” or “comparable” assets. • Example: Price implied by Earnings, Sales, Book Value etc. • Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) • Problem: “A biased analyst who is allowed to choose the multiple on which the valuation is based and to pick the comparable firms can essentially ensure that almost any value can be justified.” – AswathDamodaran

21. Relative Valuation (cont’d) • Information Needed: To do a relative valuation, you need • an identical asset, or a group of comparable or similar assets • a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) • and if the assets are not perfectly comparable, variables to control for the differences • Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected.

22. Standardizing Value • Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues. • Earnings Multiples • Price/Earnings Ratio (PE) and variants (PEG and Relative PE) • Value/EBIT • Value/EBITDA • Value/Cash Flow • Book Value Multiples • Price/Book Value(of Equity) (PBV) • Value/ Book Value of Assets • Value/Replacement Cost (Tobin’s Q) • Revenues • Price/Sales per Share (PS) • Value/Sales • Industry Specific Variable (Price/kwh, Price per ton of steel ....)

23. SOURCE: Pablo Fernandez, Valuation Methods and Shareholder Value Creation

24. SOURCE: Pablo Fernandez, Valuation Methods and Shareholder Value Creation

25. Understanding Multiples • Define the multiple • In use, the same multiple can be defined in different ways by different users. When comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated • Describe the multiple • Too many people who use a multiple have no idea what its cross sectional distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low. • Analyze the multiple • It is critical that we understand the fundamentals that drive each multiple, and the nature of the relationship between the multiple and each variable. • Apply the multiple • Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.

26. Definitional Tests • Is the multiple consistently defined? • Both the value (the numerator) and the standardizing variable (the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. • Is the multiple uniformly estimated? • The variables used in defining the multiple should be estimated uniformly across assets in the “comparable firm” list. • If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets. The same rule applies with book-value based multiples.

27. Descriptive Tests • What is the average and standard deviation for this multiple, across the universe (market)? • What is the median for this multiple? • The median for this multiple is often a more reliable comparison point. • How large are the outliers to the distribution, and how do we deal with the outliers? • Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate. • Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? • How has this multiple changed over time?

28. Analytical Tests • What are the fundamentals that determine and drive these multiples? • Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. • In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple • How do changes in these fundamentals change the multiple? • The relationship between a fundamental (like growth) and a multiple (such as PE) is seldom linear. For example, if firm A has twice the growth rate of firm B, it will generally not trade at twice its PE ratio • It is impossible to properly compare firms on a multiple, if we do not know the nature of the relationship between fundamentals and the multiple.

29. Application Tests • Given the firm that we are valuing, what is a “comparable” firm? • It is impossible to find an exactly identical firm to the one you are valuing. • While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals. • Damodaran says, “There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics.” This is not necessarily the case. Legal requirements may dictate limits in some applications but, more importantly, the underlying economics must make sense.

30. Capital Structure Credit Status Depth of Management Personnel Experience Nature of Competition Maturity of the Business Products Markets Management Earnings Dividend-paying Capacity Book Value Position in Industry Criteria to Identify Comparable Firms SOURCE: Pratt et al, Valuing A Business (4th edition)

31. Choosing Comparable Firms (1) • In valuing a manufacturer of electronic control equipment for the forest products industry, we found plenty of manufacturers of electronic control equipment but none for whom the forest products industry was a significant part of their market. • What to do? • For guideline companies, we selected manufacturers of other types of industrial equipment and supplies which sold to the forest products and related cyclical industries. We decided the markets served were more of an economic driving force than the physical nature of the products produced. Adapted from: Pratt et al, Valuing A Business (4th edition)

32. Choosing Comparable Firms (2) • At the valuation date in the estate of Mark Gallo, there was only one publicly traded wine company stock, a tiny midget compared with the huge Gallo and, for other reasons as well, not a good guideline company. • What to do? • Experts for the taxpayer and for the IRS agreed it was appropriate to use guideline companies which were distillers, brewers, soft drink bottlers, and food companies with strong brand recognitions and which were subject to seasonal crop conditions and grower contracts. Adapted from: Pratt et al, Valuing A Business (4th edition)

33. Advantages of Relative Valuation • Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when • the objective is to sell a security at that price today (as in the case of an IPO) • investing on “momentum” based strategies • With relative valuation, there will always be a significant proportion of securities that are under valued and over valued.

34. Advantages of Relative Valuation (cont’d) • Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs (but remember the “biased analyst” warning cited earlier). • Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)

35. Disadvantages of Relative Valuation • A portfolio that is composed of stocks which are under valued on a relative basis may still be overvalued, even if the analysts’ judgments are right. It is just less overvalued than other securities in the market. • Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail • Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

36. When relative valuation works best… • This approach is easiest to use when • there are a large number of assets comparable to the one being valued • the appropriate multiple for the potential guideline companies does not show wide dispersion of data. • these assets are priced in a market • there exists some common variable that can be used to standardize the price • This approach tends to work best for investors who • have relatively short time horizons • are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.) • can take actions that can take advantage of the relative mispricing; for instance, a hedge fund can buy the under valued and sell the over valued assets

37. PE Ratio and Fundamentals • Other things held equal, higher growth firms will have higher PE ratios than lower growth firms. • Other things held equal, higher risk firms will have lower PE ratios than lower risk firms • Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates. • Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rats.

38. PE Ratio: Understanding the Fundamentals • To understand the fundamentals, start with a basic equity discounted cash flow model. • With the dividend discount model, Dividing both sides by the earnings per share, If this had been a FCFE Model,

39. Consider this… • You have valued Earthlink Networks, an internet service provider, relative to other internet companies using Price/Sales ratios and find it to be under valued almost 50% .When you value it relative to the market, using the market regression, you find it to be overvalued by almost 50%. How would you reconcile the two findings? • One of the two valuations must be wrong. A stock cannot be under and over valued at the same time. • It is possible that both valuations are right. What has to be true about valuations in the sector for the second statement to be true?

40. Why use Fundamental Analysis? January 2000: Internet Capital Group was trading at $174. “Valuation is often not a helpful tool in determining when to sell hypergrowth stocks”, Henry Blodget, Merrill Lynch Equity Research Analyst in January 2000, in a report on Internet Capital Group. There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers (inefficiencies of the market), and not by anything as prosaic as cash flows or earnings. Perceptions do matter, but they are not everything. Asset prices cannot be justified by merely using the “bigger fool” theory.

41. “Irrational Exuberance” January 2000: Internet Capital Group was trading at $174. January 2001: Internet Capital Group was trading at $ 3.

42. Mistaken notions of how the market works? January 2000: Internet Capital Group was trading at $174. January 2001: Internet Capital Group was trading at $ 3.

43. Discounted Cash Flow Valuation What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Fundamental Analysis derives those cash flows from the underlying, or fundamental, operations of the business.

44. Discounted Cash Flow Valuation (cont’d) Information Needed: To use discounted cash flow valuation, you need to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

45. Advantages of DCF Valuation Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions. If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. DCF valuation forces you to think about the underlying characteristics of the firm (fundamentals) and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

46. Disadvantages of DCF valuation Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.

47. Disadvantages of DCF Valuation (con’t) In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. This can be a problem for equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector equity portfolio managers, who have to be fully (or close to fully) invested in equities

48. When DCF Valuation works best This approach is easiest to use for assets (firms) whose cashflows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available. It works best for investors who either have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to “true” value or are capable of providing the catalyst needed to move price to value, as would be the case if you were an activist investor or a potential acquirer of the whole firm

49. Discounted Cashflow Valuation where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

50. Equity Valuation versus Firm Valuation Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm