Investment Management Internship Class

1. Investment Management Internship Class Equity Valuation I: A Practitioners Framework Special thanks to Jim Seaberg of Lodestar Commercial Partners who shared this analysis framework with the Asset Management and Internship classes

2. Objectives A. Understand the valuation process B. Understand a framework for valuation and the four key types of valuation models C. Understand the various company/cash flow generation types and which valuation models work best with which company types

3. Understand the Valuation Process What is valuation? It is the estimation of an asset�s value based on: A. Variables/forecasts related to future investment returns (forecasts, risks, hurdle rates, etc.) B. Variables in relation to comparisons with other assets (comparables), or C. Variable related to actions of potential acquirers

4. What is equity valuation? It is the estimation of a firm�s equity value, not including debt, based on: A. Earnings forecasts and estimates of key statistics, B. Estimates based on comparisons with other similar companies, or C. Estimates based on acquisition values Valuation Process (continued)

5. Valuation Process (continued) Why is valuation important? It helps the analyst answer the question: �What is this company worth?� It is the process of determining the fair value of a company, or the price at which the company is fairly valued What happens after that? Once a value is determined, the investor can then sets a price at which to buy or sell the security. Generally, a buy and sell range is set at that time, i.e., buy at 10% below the valuation level, sell at 40% above the valuation level Both steps, determining the fair value and setting the buy sell range are critical to the process

6. Valuation Process (continued) What is the valuation process? There is a five step process in equity valuation: 1. Understand the company and the business 2. Download historical data and forecast earnings 3. Select the appropriate valuation model or models 4. Run the appropriate models and convert the forecasts to a share price valuation 5. Make the investment decision (or recommendation) based on share price valuation

7. Valuation Process (continued) What have we done? Step 1: Understand the company and business You have created a comprehensive analysis of the industry in which the company operates, its strengths, weaknesses, opportunities and threats (your industry report) You have analyzed the company, you understand its earning model and how it makes money, have articulated its positive and negative factors and where you think the company will go in the future, and have determined the key drivers of firm profitability (your company report)

8. Valuation Process (continued) Step 2: Download historical data and forecast earnings You have created a comprehensive 5 year forecast of company earnings based on provided economic forecasts, 10 years of historical data, and your understanding of company strengths and weaknesses of your company (your financial report) Do you mean we are only 2/5 of the way done? You have completed 75% of the required spreadsheet work and time thus far You have 50% of the thinking work still ahead

9. Valuation Process (continued) So what is left to do? Step 3: Select the appropriate valuation model or models for your company We will be teaching a number of valuation models for use with this project. Select the appropriate model or models for your company Some of these models will be determined by the type of company, others will be determined by your industry In this internship, we calculate all the models for each company, and then you can select the models which are most valid for your company

10. Valuation Process (continued) Step 4: Run the appropriate models and convert your forecasts to a dollar valuation Determine your required rate of return, i.e. 15%, then determine a dollar value for the company. Use individual or multiple models to forecast a correct valuation for your company Step 5: Make the investment decision After you have made your assumptions, models, and valuation, and you have your value for the stock, set your buy and sell range and make your investment decision

11. Understand a Framework and the Key Types of Valuation Models We have developed a framework for valuation that includes key models and metrics. Key valuation models generally fall under four main types. They are: 1. Intrinsic Value models 2. Relative Value models 3. Acquisition/Breakup models 4. Technical models Within each of these key models, there are many different types of models that can and are being used. The purpose of this framework is to help you understand which valuation models should be used with which types of companies.

12. 1. Intrinsic Value Models Intrinsic value models are models which assume that stocks value is a function of the net present value of its cash flows or dividends Key Intrinsic Value models include: Dividend Discount Models Single stage Multiple stage Free Cash Flow Models Free Cash Flow to the Firm Free Cash Flow to Equity Other Discounted Cash Flow models

13. Intrinsic Value Issues Key Issues Intrinsic value models have a large number of assumptions which limit the practical applicability of the models Key assumptions which are difficult: K and g are hard to establish Terminal value has a huge impact on valuation

14. 2. Relative Value Models Relative value models are models which assume that a company�s value is determined by comparing that company to similar or peer companies, or perhaps even indices or benchmarks. Relative value models can use numerous metrics to compare, i.e., P/E, P/B, P/EBITDA, etc. Key Relative Value models include: Relative to S&P 500 Relative to peers Relative to other indices/industry benchmarks

15. Relative Value Issues Key Issues Relative value models give no indication of the current level of the peers or index, just how it compares to them The index or peers may all be overvalued (or undervalued for that matter) These models only express relationships to the benchmark or peers, not fair valuation levels There also may not be any true peer group that is directly comparable

16. 3. Acquisition/Breakup Models Acquisition or breakup models are models which assume a stock�s value is determined by its worth to a third party acquirer Key acquisition / breakup models include: LBO Valuation: It is a financial buyer with no ability to generate operating synergies Operating Company Buyer Valuation: It is a financial buyer but includes an ability to add operating synergies Breakup Valuation: It is a buyer that assumes the company is worth more dead than alive, and will purchase the company and sell off the parts

17. Acquisition/Breakup Issues Key issues While we can determine a value to an acquirer, it remains speculation as to whether: 1. The acquiring company will actually want to acquire the firm 2. The timing is right as to when the firm will be acquired

18. Technical Value Models Technical value models are models which assume a stock�s value can be determined by prior trading patterns Key Technical Value models are: Relative Strength Index (RSI) Moving Average Convergence Divergence (MACD)

19. Technical Value Issues Key Issues The timing of the trend analysis can completely change the final recommendation, i.e., a weekly, monthly, annual, versus decade charts The view of same chart by different technical analysts often results in different recommendations While there is question as to the value of technical models, they may be helpful in determining entry and exit points for purchases and sells

20. C. Understand Key Company/Cash Flow Generation Types Different types of companies generally will use different valuation models. By understand the type of companies, you can get a rough idea which valuation models are best for that type of company. Key company types are: 1. Industrial manufacturer or service business 2. Unique/unstable cash flow (not earnings) business 3. Natural resource business 4. Financial industry business 5. Speculative, early stage business 6. Distressed businesses and turnarounds

21. 1. Industrial Manufacturer or Service Businesses These are companies with improving sales and cash flows over time. They tend to be more stable companies with longer track records. Examples include KO, ADP, CMP and PG These would generally be classified as stalwarts or cyclicals by Peter Lynch

22. Industrial Manufacturer (continued) Key Valuation models and metrics Because of their cash flow history and improving cash flows, key valuation models in their order of priority would be: 1. Intrinsic value models DDM, FCF models 2. Relative value (versus peers) P/E, P/B, P/S Key metrics Traditional P/E, P/B, P/CF, P/S

23. 2. Unique/Unstable Cash Flow Businesses These are companies which are very capital intensive or which have special needs. These would generally be classified as slow growers or cyclicals by Peter Lynch There are three main types of these businesses:

24. Unique/Unstable (continued) 1. Capital intensive, quasi-monopolies Examples include cable TV (CMCSA), radio (SIRI), cellular phones (T, S, VZ) Key Valuation models Because of their cash flow needs, key models: 1. Intrinsic value models (DDM, FCF) 2. Relative value models Key metrics EV/EBITDA, EV/subscribers, ARPU (average revenue per unit)

25. 2. Firms with heavy depreciation schedules Examples include hotels (MAR, IHG) Key Valuation models Because of their heavy depreciation charges, key models: 1. Intrinsic value models (DDM, FCF) 2. Relative value models Key metrics Real estate: P/FFO as proxy for EPS as cash flow more important as earnings are masked by depreciation, EBITDA/basis, NAV/Share, EV/EBITDA Unique/Unstable (continued)

26. 3. Companies with large goodwill accounts Examples include FO, FII Key Valuation models Because of their large goodwill accounts, key models include: 1. Relative value models 2. Intrinsic value models (DDM, FCF) Key metrics EV/EBITDA Unique/Unstable (continued)

27. Natural Resource Businesses These are companies which participate in commodity products where the product is basically the same. Success is determined by low cost and ability to replace reserves. Low/no current income but large potential Examples include oil (XOM,BP,CVX), mining (RTP, BHP, AA. VALE), agriculture (MON, DOW, DD, SYT) These would generally be classified as slow growers, cyclicals or stalwarts by Peter Lynch

28. Natural Resource (continued) Key Valuation models and metrics Because of their reserves, key valuation models in their order of priority would be: 1. Acquisition/Breakup models 2. Intrinsic value (DDM, FCF models) 3. Relative value (versus peers) Key metrics Market value of resources under control, value of other assets, including working capital, less liabilities plus intangibles (ability of management to replenish the reserve base), P/NAV, relative ranking among peers, break up value

29. Financial Industry Businesses These are companies with tangible assets of most paper contracts in the form of loans or bonds. Liabilities are highly leveraged with uncertain obligations that need to be underwritten. Leverage on equity base (spread) and quality of underwriting key drivers of performance These would generally be classified as stalwarts or slow growers by Peter Lynch There are three main types of these companies.

30. Financial Industry (continued) 1. Finance companies These companies cash flow results from auto loans, home equity loans, credit card, and consumer lending Key Valuation models and metrics These is a packaging, not a spread business. Key valuation models would be: 1. Intrinsic value (DDM, FCF models) 2. Relative value (versus peers) Key metrics Packagers (not spread business) that originate and sell loans valued using P/E (relative EPS)

31. 2. Commercial banks These companies cash flow results from loan composition and spread, fee income, and underwriting Key Valuation models and metrics These is a spread business. Key valuation models would be: 1. Intrinsic value (DDM, FCF models) 2. Relative value (versus peers) Key metrics P/B (loans rarely have a value in excess of historical costs), some P/E Financial Industry (continued)

32. 3. Insurance companies These companies cash flow results from ratemaking, underwriting, and investment performance Key Valuation models and metrics Cash flow is from ratemaking, underwriting and investments. Key valuation models would be: 1. Intrinsic value (DDM, FCF models) 2. Relative value (versus peers) Key metrics Combination of relative value (P/E) and DCF methods Financial Industry (continued)

33. 5. Speculative, Early Stage Businesses These are companies cash flows are speculative, with no or limited sales or earnings track record Examples include biotech (AMG, GENZ,GILD), technology (RAX, AKAM, SVVS), venture start ups These would generally be classified as fast growers or turnarounds by Peter Lynch

34. Speculative (continued) Key Valuation models and metrics Because of their reserves, key valuation models in their order of priority would be: 1. Intrinsic value (DDM, FCF models) 2. Relative value (versus peers) Key metrics DCF with a discount rate of 25%, basing sales on market share % over time, and using a higher multiple for terminal value. Also use of EV/Sales, P/S

35. 6. Distressed Businesses or Turnaround These companies are near bankruptcy (low z-score) or established companies with negative earnings or temporary operating problems which can be improved through better leadership and management Examples include companies with temporary operating problems (ADPT) or with net cash on balance sheet equal to or in excess of market capitalization These would generally be classified as turnarounds by Peter Lynch

36. Distressed /Turnaround (continued) Key Valuation models and metrics Because of their reserves, key valuation models in their order of priority would be: 1. Intrinsic value (DDM, FCF models) 2. Relative value (versus peers) 3. Acquisition/Breakup models Key metrics Screen based on P/B, EV/S, EV/EBITDA

37. Questions Do you have any questions on the various types of metrics used in valuing companies?

38. Review of Objectives A. Do you understand the valuation process? B. Do you understand our framework for valuation and the four key types of valuation models? C. Do you understand the various company/cash flow generation types and which valuation models work best with which company types