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Valuation: Best Practices by Michael R. Vetsuypens, PhD.

Valuation: Best Practices by Michael R. Vetsuypens, PhD. Overview. 1. Review of key ideas 2. Inflation 3. Valuation and Forecast Horizon 4. CAPM inputs (weights, cost of debt, cost of equity). 1. Discounted Cash Flow: Key ideas. Present Value of project’s relevant cash flows

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Valuation: Best Practices by Michael R. Vetsuypens, PhD.

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  1. Valuation: Best Practices by Michael R. Vetsuypens, PhD.

  2. Overview 1. Review of key ideas 2. Inflation 3. Valuation and Forecast Horizon 4. CAPM inputs (weights, cost of debt, cost of equity)

  3. 1. Discounted Cash Flow: Key ideas • Present Value of project’s relevant cash flows • Relevant= incremental (no sunk costs), after tax • Popular tool: FCF discounted at WACCAT • Free Cash Flows (FCF) = Operating Income after-tax (EBIAT) + Depreciation – Capital Expenditures – Increase in Working Capital

  4. Key Ideas(cont’d) • Theory says: Cost of Equity = Risk-free Rate plus Premium for Risk (market or beta risk, not total risk which is diversifiable – see CAPM) • WACC: blends cost of equity, cost of debt, and market value (not book value) proportions of debt and equity; these proportions are assumed to be constant, and imply that the firm will lever up (down) if cash flows later turn out to be better (worse) than expected • Company WACC reflects the average firm risk and financing choice; non-typical projects require their own WACC • Unique risks (expropriation etc): put in the cash flows, not in the hurdle rate

  5. Key Ideas (cont’d):Potential stumbling blocks 1. Avoid fudge factors: do not increase hurdle rate to reflect every instance of high perceived risk Project-specific risk: reflect them in the cash flow estimates Economy-wide market risk: put in the beta, and thus in the discount rate • Positive NPV=‘$$ left on the table’ (economic rents); what is it about your company that allows you to obtain a competitive advantage? 3. NPV ignores value of follow-on options. Such options are hard to value, but may be worth significantly more than the project itself (cutting-edge: field of Real Options)

  6. 2. Inflation: Make sure the cash flows match the discount rate. • How to handle inflation? Consistently! • Real/real or Nominal/nominal • Nominal/nominal leads to fewer mistakes • Almost everyone uses nominal discount rates and capital costs (unless otherwise specified), so you might as well stick to nominal cash flows

  7. 3. Valuation and Forecast Horizon • NewAmerica Drill, Boeing 7E7: All the cash flows were explicitly forecasted until the end of the project • But Firms have unlimited lives, so no ‘project end’ • Typical: Forecast firm’s free cash flows explicitly for 5 or 10 years • Need a Terminal Value for value beyond explicit forecast horizon

  8. How to calculate Terminal Value 3.0. Ignore it (conservative, may be small anyway) 3.1. TV = Book Value? No, BV is rarely same as MV 3.2. TV = Liquidation Value? No, unless co. is “terminally” ill 3.3.TV= Going Concern Value 3.3.1 DCF: Perpetuity of last forecasted cash flow 3.3.2 Multiple of something

  9. 3.3.1 Using DCF to estimate terminal value • Growing perpetuity of last FCF • E.g.: forecast FCF for 2007, 2008, 2009, 2010, 2011 • TV in 2011=(2011 FCF)*(1+g)/(r-g) • g=0 represents level perpetuity • Nominal growth= real growth + inflation • if g>3% (average US inflation): implies some real growth FOREVER! • If g=7%: implies same real growth as US GNP (4% average) FOREVER • Careful: high g requires more CapEx, WC; do your Cash Flows reflect that?

  10. 3.3.2 Using multiples to estimate TV + Private, Inc. EPS=$2.50, but no stock price; a similar Public Co. has EPS=$0.55, and stock price=$11.00; Public P/E multiple= $11/$0.55= 20 times; Private, Inc. is worth 20*$2.50=$50 per share + Multiple reflects what market is willing to pay today for comparable firm (like price/square foot in real estate) + Easy, ignores need to forecast future profitability and growth + Can be “creative”: Price/subscriber, Price/PhD multiples • “Something”: should have same valuation implication for peer firms as for valuation firm • EBITDA better than EBIT if depreciation patterns differ • EBIT better than EPS if financing differs

  11. Problems when using multiples to estimate TV • Problem 1: the multiple is used at the TV horizon, but it is obtained from peer firms today! Will today’s valuation be the same later? ex: peer firm has high growth today, but valuation firm has low growth at TV • Problem 2: Distinguish Equity multiples (EPS, BVPS) from total Enterprise multiples (EBITDA, EBIT, Total Capital) Do not use a stock price multiple when the valuation (e.g. FCF) requires you to calculate the enterprise TV; use EBIT, EBITDA, … multiple • Problem 3: Subject to accounting distortions • Problem 4: Meaningless with negative values • Problem 5: Difficult to identify comparables

  12. 4. Technical issue: what are proper CAPM inputs? • The Weights of D, E: value weights, not book weights. • The cost of Debt: current, not historic yields • The cost of Equity: • Equity Risk Premium: Arithmetic, not Geometric • Risk-free rate: short- or long-term? (see below) • Beta: estimation issues (see below) • Beta: conceptual issues (see below) • Beta: unlevering and relevering (see below)

  13. Short-term or Long-term Risk-free rate in CAPM? • CAPM is a 1 period model, so theory only recognizes THE risk free asset (=1 period) • 2 approaches: • K=T-Bill Rate + beta * E{ Market ret. – T-Bill rate} • K=T-Bond Rate + beta * E{ Market ret. – T-Bond rate} • Example for 2004 with arithmetic market premia: • ST: 1% + beta * {8.4%} (3 month T-Bill) • LT: 5% + beta * {6.4%} (30 yr T-Bond) • Best: Maturity of Risk free asset matches CF maturity (reflects opportunity cost of shareholders)

  14. What does Risk-free mean? • What is a truly risk-free asset ? • There must be no risk of default • There must be no reinvestment risk • So to value a 5 year cash flow, we need: • A government security (one that will not default!) • A 5 year zero-coupon security: • Rolling over 3 month Treasury Bills has reinvestment risk after each 3 month period • 5 year positive coupon bond has reinvestment risk on the interest  we need a 5 year zero-coupon default free government bond • Discount year 1 CF by 1-year zero coupon bond yield, year 2 CF by 2-year zero coupon bond yield, and so on (rarely done, except in pricing fixed-income securities)

  15. Beta Estimation • Beta=slope coefficient of regression of stock return on market return • Source: Do it yourself (SLOPE or LINEST in Excel) or get it from someone else (Bloomberg/Value Line/BARRA/your friendly Investment Banker…) • 4 Technical Issues: • Frequency of data (daily? weekly? monthly?...) • Length of estimation window (2yrs? 5yrs?…) • Choice of Market Index • Estimation errors

  16. Issue #1: Frequency of data • High frequency data (e.g. daily returns) allow for longer time series, more precise estimation • but: daily returns underestimate beta for illiquid stock that do not trade every day • Use weekly, monthly returns for illiquid stocks (or add lagged market return as additional explanatory variable if using daily data in the beta regression)

  17. Issue #2: Length of Estimation Window • The more data, the better the estimate (usually) • If you go back too far : stale data? (different business environment, regulation, asset portfolio) • If you stick to the recent past: recent history in capital markets may be temporary

  18. Issue #3: Choice of market Index • Theory requires “The market portfolio of all securities” (including real estate, foreign stocks, human capital) • With perfectly integrated capital markets: the World Market Portfolio • In Practice: Use a broad market index relevant to the company’s shareholders. In U.S.: S&P500, CRSP Value-weighted Index, Wilshire…

  19. Issue #4: Estimation Errors • If a stock has a high (low) estimated beta, it is likely that it has a positive (negative) estimation error (if you had a 750 GMAT, does that mean you are truly smart or were you lucky with some of the questions on the test?) • Why estimation errors? • 1. Inaccurate raw data • 2. Estimation window too short/long • 3. Good (bad) firm-specific info is released at the same time as good (bad) overall market news (by coincidence or big bath theory) • Bloomberg smoothes beta (reverts to 1) to ‘handle’ estimation errors

  20. Conceptual Issue: Beta and cash flow horizon • Common practice: use the same beta for each cash flow • This is incorrect when: • Leverage varies, and so does equity beta! See Project Finance applications later in course. Not an issue when using WACC: same % of Debt assumed! • Distant cash flows may have different systematic risk than short horizon cash flows (example: Assume GM launches a new vehicle. GM’s year 2 CF beta will be greater than its year 5 CF beta if high returns in year 2 attract competition and erode GM’s profits!)

  21. Unlevering and relevering betas Equity Beta Beta 1. = * asset equity Equity + Debt Equity Beta Beta = * 2. equity asset Equity + Debt * (1 – tax rate) Formula 1 applies in the no-tax case, AND with positive taxes when the firm has a constant debt proportion (as in WACC). Formula 2 applies with positive taxes and when Debt is fixed in dollar terms.

  22. “Too often in business, we measure with a micrometer, mark with a pencil, and cut with an ax. Despite advances in financial theory, the “ax” available for estimating company capital costs remains a blunt one…Be careful not to throw out the baby with the bath water. Do not reject the cost of capital …because your finance people are not able to give you a precise number. When in need, even a blunt ax is better than nothing” (Bruner et al, “Best Practices in Estimating the Cost of Capital: Survey and Synthesis”, Financial Management, Spring/Summer 1998)

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