You are on page 1of 33

Valuation

MPA FIN 286


Alessandro Previtero
Slide Pack Week 1 Part 2
Company Valuation Cost of Capital

Todays Content
I.

Announcements:

HW1 Due this Monday.

TA Review Sessions: Every Thursday from 5 to 6pm (room TBD)

Classroom Policy Survey Results:


o
Attendance: not required (76%).
o
Using Laptops: anytime (47%).
o
Arriving on time: students can walk in and out at any time (71%).
o
Displaying name tags: not required (65%).
o
Turning your assignments in late: 30% penalty (88%).

II.

Discount Rate
a.
Why we discount FCF
b.
Risk-Return Tradeoff
c.
CAPM
d.
Compute Betas

Regressions

Comparables

III.

Homework Assignment #2

I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics: LBOs, M&A, etc.

Recap: How to Value a Firm


FFCF = EBIT (1 tC ) + DA NWC Capex + AS CGT

E[FFCFt ]
VA =
t
(
)
1
+
r
t =0

MVE = VA + NOA MVD


MVE
P=
N
Company Valua-on DCF Models Discount Rate 4

Why discounting Cash Flow?


One dollar received today is more valuable than one dollar received
in the future (Time Value of Money).
Which would you choose?
I. $50 for sure TODAY or $50 for sure 1 YEAR FROM NOW
II. $40 for sure TODAY or $50 for sure 1 YEAR FROM NOW
Individuals are usually risk-averse:
Which would you choose?
I. $50 for sure or $0 / $100 at 50% each
II. $40 for sure or $0 / $100 at 50% each
The higher the risk, the higher the return (i.e. the discount rate)

r = rf + Premium for risk

Company Valua-on DCF Models Discount Rate 5

Why discounting Cash Flow?

Return ( r )

Risk-Return: Empirical Evidence

Common

Unique

Standard Deviation ()
Total Risk = Systematic (Common) Risk + Idiosyncratic (Unique) Risk

x =

Cov (rx , rm )
Var (rm )
Company Valua-on DCF Models Discount Rate 6

Why discounting Cash Flow?

Return ( r )

Risk-Return: Empirical Evidence

Security Market Line (SML)


Common

Unique

Standard Deviation ()

Capital Asset Pricing Model (CAPM)

r = Intercept + Slope = rf + (rm rf )


Risk-free Rate

re = rf + e (rm rf )
rd = rf + d (rm rf )
rOA = rf + OA (rm rf )
rx = rf + x (rm rf )

Market Risk Premium


Company Valua-on DCF Models Discount Rate 7

Valuation in the real world (2/2)


Estimation of cost of capital
CAPM

Arithmetic average hist.


return

Multibeta CAPM

Dividend discount model

Investor expectations

Regulatory decisions

10

20

30

40

50

60

70

80

Legend: % of CFOs who always or almost always uses a certain technique


Source: Graham and Harvey, Journal of Financial Economics 2001
Company Valua-on DCF Models Discount Rate 8

Risk-free rate (1/2)


r = rf + (rm rf )

Source:
h?p://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualiza-on.aspx
Company Valua-on DCF Models Discount Rate 9

Risk-free rate (2/2)


The CAPM is an opportunity cost model, where the riskfree rate represents the rate you would earn on an
equivalent maturity investment with no risk
I use the return on the 20-year or 30-year Treasury
(Matches the long-term maturity of equity, is risk-free).
However, if I need to value a short term project, I will use a
risk free rate that matches the duration of the project.

Company Valua-on DCF Models Discount Rate 10

Market risk premium


r = rf + (rm rf )
Market risk premium
r rf
(rm r(or
f ) controversy) regarding the
There is some disagreement
magnitude
the risk premium,
sinceregarding
the estimate
There
is some of
disagreement
(or controversy)
the
magnitude
of theon
riskthe
premium,
since
the estimate
Depends
sample
period
Depends
thethe
sample
period
Varies on
with
fixed
income instrument used
Varies with the fixed income instrument used
Depends on whether arithmetic or geometric means are used
Depends on whether arithmetic or geometric means are used
Which
type
of average
shouldshould
we use?we
Which
type
of average

Arithmetic
Average
ooArithmetic
Average
=

use?

= =1/

o Geometric Average
=&=1(1+) - 1

o Geometric Average =

1+

-1

http://faculty.london.edu/icooper/assets/documents/

http://faculty.london.edu/icooper/assets/documents/ArithmeticVersu
ArithmeticVersusGeometric.pdf
sGeometric.pdf

Company Valuation DCF Models Discount Rate 11

Company Valua-on DCF Models Discount Rate 11

0.00%
Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011

Market risk premium


Annual market risk premium:
Stock - bond - Annual

60.00%

40.00%

20.00%

-20.00%

-40.00%

-60.00%

-80.00%

Source: Aswath Damodarans Website. http://pages.stern.nyu.edu/~adamodar/

Company Valua-on DCF Models Discount Rate 12

Market risk premium


Average market risk premium with 5-year rolling periods:
5-yr moving average
0.3
0.25
0.2
0.15
0.1

Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011

0.05

-0.05
-0.1
-0.15

Source: Aswath Damodarans Website. http://pages.stern.nyu.edu/~adamodar/


Company Valua-on DCF Models Discount Rate 13

0
Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011

Market risk premium


Average market risk premium with 10-year rolling periods:
10-yr moving average

0.25

0.2

0.15

0.1

0.05

-0.05

-0.1

Source: Aswath Damodarans Website. http://pages.stern.nyu.edu/~adamodar/

Company Valua-on DCF Models Discount Rate 14

Market risk premium


r = rf + (rm rf )
Stocks-T.Bills (US)
Period

Stocks-T.Bonds (US)

Arithm. Mean

Geom. Mean

Arithm. Mean Geom. Mean

1928-2012

7.65%

5.74%

5.88%

4.20%

1962-2012

5.93%

4.60%

3.91%

2.93%

2002-2012

7.06%

5.38%

3.08%

1.71%

Source: Aswath Damodarans Website. http://pages.stern.nyu.edu/~adamodar/


Company Valua-on DCF Models Discount Rate 15

Market risk premium


Volatility of Dow Jones Industrial Index returns over time:
Is the whole time series from 1897-2013 relatively
uniform?
Annualized 1-yr Moving Average Daily Return Volatility

Company Valua-on DCF Models Discount Rate 16

Market risk premium


VIX index for the last 25 years

Company Valua-on DCF Models Discount Rate 17

Market risk premium - Conclusion


Some economists (especially before the 2009 financial
crisis) believe that the earlier sample does not look
representative of todays market
The vol stats show that the market was more volatile
pre-1950
We know that important mechanics of the market such
as liquidity and information are much better today
The 20 and 30 year periods starting after about 1950 show
MRP of around 5%-6%
The academic community is in virtual agreement that
6%-7% is too high, and a reasonable number is 4-6%
What happen if you use a low MRP?
Company Valua-on DCF Models Discount Rate 18

Estimating beta
r = rf + (rm rf )

Two approaches are used to estimate the beta of the


equity of a company:
1. Regression Approach: compute how the stock
returns co-vary with the stock market returns
2. Comparables Approach: Choose comparable
companies, unlever and relever betas.

Company Valua-on DCF Models Discount Rate 19

Estimating beta using regressions


Firms historical or predicted e
Estimated by regressing the firms excess stock returns
on the excess returns of a market portfolio
USE SAME rf

(r r ) = + (r
e

f t

Firms excess returns

rf )t + t

Markets excess returns

Many practitioners simply regress returns, not excess


returns, because monthly Treasury returns are not as easy
to find as equity returns, and theres not much difference
in the calculated beta
Time Period: As a default, we aim for 3-5 years of monthly
data (trade-off: more data is better, but use recent data)
Company Valua-on DCF Models Discount Rate 20

Estimating beta using regressions


Market Portfolio: There are plenty of choices for the
market portfolio (S&P 500, NYSE, NYSE/NASDAQ)
Thankfully, market proxies are so highly correlated it
doesnt matter much what you use.
I almost always use the S&P 500, and so does almost
everyone else in practice (is easy to get)
in academic papers we use the bigger index
measures like NYSE/AMEX/NASDAQ

Company Valua-on DCF Models Discount Rate 21

HOG Beta Calculation (I)

Company Valua-on DCF Models Discount Rate 22

Estimating beta using regressions


e is an estimate subject to random error
Individual stock beta estimates have HIGH sd.s
Sometime stock returns are not available:
New/IPO companies
Private companies
Unique projects/assets
Subsidiary
Use COMPARABLES approach

Company Valua-on DCF Models Discount Rate 23

Estimating beta using comparables (1/4)


Take two identical companies (same size, industry, products,), but
one with high leverage, and the other with low leverage
e1

d1

E1

D1

A1

E2

e2

D2

d2

A2

Which one has higher betas?


The higher the leverage, the higher the e and d
e s are not directly comparables between companies
A s are not affected by leverage comparable
NB: The textbook calls
A =Unlevered Equity Betas
E =Levered Equity Betas

Company Valua-on DCF Models Discount Rate 24

Estimating beta using comparables (2/4)

e_c1 Ec1

e_c2 Ec2

e_c3 Ec3

d_c1 Dc1

d_c2 Dc2

d_c3 Dc3

A_c1

A_c2

e??

Levering

Unlevering

Comparables

A_c3

A_c

A
Levering/Unlevering Formula

D
E
A =
d +
e
D+E
D+E
Company Valua-on DCF Models Discount Rate 25

Estimating beta using comparables (3/4)


To find the e of a company using the Comparables approach:
1. Find a set of comparable public firms matching in size, industry,
product, life-cycle, (but not in Leverage!)
2. Unlever the comp e to find the A (unlevered e )
3. Compute weighted-average of the comp A
4. Re-lever the average A to the target firms capital structure

Comparables
e_c1

Ec1

e_c2

Ec2

e_c3

Ec3

d_c1

Dc1

d_c2

Dc2

d_c3

Dc3

A_c1

A_c1
A_c

e??

Levering

Unlevering

A_c1
A

Company Valua-on DCF Models Discount Rate 26

Levering and un-levering beta: Example


Compute Genentechs e using the comparable companies below,
assuming that
Genentechs and the comparables d =0.20
Genentechs Market Leverage = 15%
Company Name
Abbott Laboratories
Johnson & Johnson
Merck
Pfizer
Average

e
0.36
0.35
0.81
0.71

Market
Leverage
30.05%
3.30%
10.00%
17.65%

A
0.31
0.35
0.75
0.62
0.51

Genentech e = 0.56
D
E
d +
e = L d + (1 L) e
D+E
D+E
D
Where : L =
= Leverage
D+E

A =

NB:

e =

A
1 L

d L
1 L

Company Valua-on DCF Models Discount Rate 27

HOG Beta Calculation (II)

Company Valua-on DCF Models Discount Rate 28

A few caveats on comparables (4/4)

If you assume d=0 if the company is not in financial distress


If d=0 then the levering/unlevering formula is:

A =

E
e = (1 L)e
D+E

Be consistent! If d=0 then rd= rf

Several indicators can be used to measure the financial health of the


company (Leverage, Interest coverage ratio, etc)

Never rely only on one comparable. Choose at least 3 or 4, and then take a
weighted average

Compute weights using a score card approach (similarity in Products,


Size, life-cycle statges)
Some textbooks (including ours!) use a different levering/unlevering
formula where D is replaced by D(1-T):
Well see later on why different levering formulas exist

Company Valua-on DCF Models Discount Rate 29

Homework Assignment #2
Individual Assignment posted on the course website
Objective: Find the cost of equity capital for your
company.
Three Approaches
Regression analysis
Comparables approach
Due Wednesday Jan 27th at the beginning of class
Paper format only. Do not email me or the TA with
the assignment.

Company Valua-on DCF Models Discount Rate 30

Problem #1
Firm 1 Firm 2 Firm 3
You are the manager of the hockey helmet
division of your Firm. There are three rms Total Assets
20000 1000
500
that compete with you in the hockey
Debt
500
200
200
helmet business. Firm 1 is a large,
15000 800
300
diversied plas-cs business which derives Equity
Total Liab + Equity 20000 1000
500
10% of its revenues from hockey helmet
sales. Firm 2 is a single-division hockey
Earnings
1500
100
-5
helmet manufacturer that has been in
Bond Ra-ng
AA
AA
BBB
business for 30 years (prior to that hockey
Shares Outstanding 1000
100
100
players didnt wear helmets). Firm 3 is a
Share Price
20
15
2
recent entrant into the hockey helmet
Equity Beta
1.3
1.5
2.2
business a[er many years in the football
helmet business.
The table shows some nancial informa-on on the comparable rms (all units
are in millions except the share price). The risk-free rate is 5%, the market risk
premium is 6%, and the marginal corporate tax rate is 35%. The target debt-to-
value for the division is 1/3. Compute the cost of equity capital for the hockey
helmet division.
Company Valua-on DCF Models Discount Rate 31

Problem #2
In 1989, General Motors (GM) was evalua-ng the acquisi-on of Hughes Aircra[
Corpora-on. Recognizing that the appropriate discount rate for the projected
cash ows of Hughes was dierent than its own cost of capital, GM assumed
that Hughes had approximately the same risk as Lockheed and Northrop, which
had low-risk defense contracts and products that were similar to Hughes.
Specically, assume the following inputs:


Comparison
E
D/E

GM
1.20
0.4


Lockheed
0.90
0.9


Northrop
0.85
0.7


Also assume that GMs target debt/equity ra-o, in market value terms, for the
Hughes acquisi-on is 1. Hughes expected nominal cash ow next year will be
$300 million and will grow therea[er at the rate of 5 percent per year, the risk-
free rate is 8%, and the market risk premium is 6%.
Compute the equity cost of capital for the Hughes acquisi-on, assuming no
taxes.
Company Valua-on DCF Models Discount Rate 32

Problem #3
Your so[ware rm is considering a diversifying investment in the donut business. The logic at
headquarters is that your programmers eat so many donuts that you might as well get a piece
of the ac-on. There are two other publicly-traded rms compe-ng in the donut business: one
is a mature rm with signicant interests in other businesses and a young, upstart rm which is
a pure-play in the business you are considering. Summary nancial data (in $ millions) for the
two comparables are given below:


Mature comp
Upstart comp

Total assets
1000
200
Short-term debt
25
5

Long-term debt
475
20

Equity
500
175

Total liab+equity
1000
200

Earnings
100
1
EPS
(
$)
1
0.05

Share price ($)
10
40

Dividend yield
5%
0

Equity beta
0.8
1.5

To get a be?er understanding of the mature comparable, you es-mate that half of its revenue
is generated in the donut business and the remaining half of its revenue is generated in a
variety of businesses which have average market risk.
(a) Ignoring taxes, give an es-mate of the cost of capital of asset using the CAPM (assume risk-
free rate is 5% and whatever market risk premium you deem appropriate). Jus-fy all other
assump-ons.
(b) What three other pieces of informa-on would you like to have to improve your es-mate?
Company Valua-on DCF Models Discount Rate 33