Module I: Investment Banking and Valuation

1. Module I:Investment Banking and Valuation September 4, 2002

2. Objectives • Understand how investment bankers value firms • Liquidation or adjusted-asset value • Public comparables (multiples approach) • Discounted-cash-flow methods • WACC (entity) approach • Flow to equity (fundamental analysis) methods • Adjusted present value • Compare and contrast these methods and understand advantages and limitations of each

3. Liquidation or Adjusted-Assets • Value of equity in firm is simply:Equity = Assets – Liabilities • A crude estimate of value is the book value of equity and is used as a reference (times book) • Adjust assets for market value rather than accounting values • An adjusted estimate of equity value is:Equity = Adjusted Assets - Liabilities

4. Comparables using Public Firms • Using comparables of publicly traded firms is very widely used by analysts (both buy and sell side) • Often called multiples approach • Uses a combination of accounting and market numbers to value companies. Most common multiples are: • Price/earnings • Asset/sales • Market/book

5. Example of Comparables Method • Greens Health Inc., a privately owned Supermarket chain has expected earnings of $20 million per year on sales of $205 million with total assets of $80 million. • In a proposed IPO, Greens will issue 10 million shares so forecast EPS is $2 per share; the firm is all equity. • Using data on suitable comparables, compute a valuation matrix

6. Valuation Matrix: P/E Ratios Comparables PE Ratio Implied Stock Price Vons 18 Safeway 19 36 38 Average 18.5 37 Source: Compustat (Wharton) Raios for 1995 Using an average stock price of $37, firm value is estimated to be $25  10m = $370 million

7. Valuation: Price/Sales Ratios Comparables P/S Ratio Implied Firm Value Vons .24 Safeway .38 49.2 77.9 Average 1.3 63.6 Firm value is estimated to be $63.6 million

8. Valuation: Market/Book Ratios Comparables M/B Ratio Implied Firm Value Vons 2.0 Safeway 6.9 160.0 552.0 Average 1.3 356.0 Firm value is estimated to be $356.0 million

9. Compare Results • Range of values is $63 to $360 million • Wide differences in Vons and Safeways ratios • What are differences in firms and how do they affect comparability of valuations? • Vons has debt-to-asset ratio of .66 • Safeway’s debt-to-asset ratio is .82 • Both firms are highly leveraged • P-E and P/B valuations are closer than P/S approach

10. Remember when using P/E ratios that the estimated value is the value of equity, not firm value. Example: Suppose Greens carried $114 million of debt. With equity of $250 million and debt of $114, firm value is now V = E + D = $364 million. How does this affect value using P/S ratios? Pitfalls in Comparables: I

11. Are the comparables really comparable? Firms differ in many significant dimensions including Growth rates Cash flows Risk (most obviously capital structure; note that Greens equity value was unchanged by the fact that it carried debt. Is this realistic? Pitfalls in Comparables: II

12. Pitfalls in Comparables: III Suppose the unobserved true relation between stock price and earnings is Price = $9.00 + 12EPS For Vons, say EPS =$1.50, so Price = $27 and P/E =18 For Greens, we have value = $9.00 +12 x 2 = $33 The multiples approach misprices by $4.00 or twelve percent of firm value -- other relations could be off more.

13. Assessment • Advantages • Quick, easy to understand, and widely used • Disadvantages • Based on accounting concepts • Ignores growth opportunities and future cash flows • Fails to account for differences in capital structure

14. DCF Approaches • All DCF approaches discount cash flows by the appropriate discount rates • Ingredients • Cash flow forecasts for future periods (the past is irrelevant) • An associated discount rate which measures the return on investments of comparable risk • Three main approaches • WACC, APV, Flow to Equity

15. DCF Approaches • Simplest approach is to assume first-year cash flow and perpetual growth and discount rates • More convincing approach is to use explicit cash flow projections over a forecast period and discount continuing value using simplest approach for cash flows after forecast period

16. Computing the Discount Rate • The discount rate applied to these cash flows represents the opportunity cost of capital • It can also be thought of as the expected or required return for an investment that is equally risky

17. Equity Discount Rates • Unlevered Cost of Equity (rA) • What the cost of capital would be if the firm had no leverage. • Depends on asset risk, but not not capital structure • Equals weighted-average cost of capital (WACC) • Levered Cost of Equity (re) • Cost of equity capital at a given leverage. Clearly depends on asset risk and also on leverage.

18. Discount Rates • We obtain discount rates for equity using a model of risk such as the CAPM • CAPM states that the expected or required return on an asset the sum of two components • The risk free rate • A risk premium • The risk premium is b times the market risk premium, historically about 8%

19. CAPM The Capital Asset Pricing Model states that the expected return on an asset is Beta measures the sensitivity of the stock’s return to the return on the market portfolio. Note that beta depends on the firm’s leverage.

20. Next Week – September 9 and 11 • Be prepared to discuss Eskimo Pie case • Review textbook discussion of capital structure and the issues of capital structure and corporate valuation • Read Continental Carriers Inc. case to familiarize yourself with the issues and data available