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Equity Valuation and Analysis with

eVal

Chapter 10
Valuation

Framework for Business Analysis


and Valuation
STEP 1
Understanding the Past

STEP 2
Forecasting the Future

1. Information
Collection

1. Structured
Forecasting

2. Understanding the
Business

2. Income Statement
Forecasts

3. Accounting Analysis

3. BalanceSheet
Forecasts

4. Financial Ratio
Analysis
5. Cash Flow Analysis

4. CashFlowForecasts

STEP 3
Valuation
1. CostofCapital

2. ValuationModels

Residual Income-Based
Valuation
Cash Flow-Based
Valuation

3. ValuationRatios
4. Complications

Negative Values
Value Creation and
Destruction though
Financing Transactions

Key Valuation Inputs


Cost

of Capital

Forecast
Value

Financial Statements

of Contingent Equity Claims

Alternative Approaches to Valuation


Discounted

Dividends

Discounted

Free Cash Flow

Discounted

Residual Income

Earnings

Multiples and Related Heuristics

Dividend Discounting Model

Div t
P0
t
t 1 (1 re )
where
P0 = equity value at the end of period 0
Divt = net cash distributions to equity at the end of period t
re = cost of equity capital

Problems With Discounting


Dividends
Most

growth companies pay no dividends,


and may plan not to pay dividends for many
years
Most companies reinvest a large proportion of
their earnings rather than paying them out as
dividends
Dividends measure wealth distribution rather
than wealth creation

Traditional Discounted Free Cash


Flow Model (to All Investors)

FCFt
P0
Debt 0
t
t 1 (1 rW )
where
P0 = equity value at the end of period 0
FCFt = free cash flows to debt and equity holders during
period t
rW = weighted average cost of capital
Debt0 = value of debt at the end of period 0

Discounting Free Cash Flows to


Equity

FCFE t
P0
t
(1

r
)
t 1
e

where
P0 = equity value at the end of period 0
FCFEt = free cash flows to equity holders during period t
re = cost of equity capital

Problems With Discounting Free


Cash Flows
Cash

flows are difficult to forecast because


they depend on the timing of events that do
not have a big impact on value (e.g., timing of
equipment/inventory purchases)
For growth companies, cash flows may be
negative for many years to come
Cash flows provide a noisy and untimely
measure of firm performance

Discounted Residual Income Model


NI t re * CE t 1
P0 CE 0
(1 re ) t
t 1

where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of common equity at the end of period t

Discounting Residual Income to All


Investors (Debt and Equity)
NOI t rW * NOA t 1
P0 NOA 0
Debt 0
t
(1 rW )
t 1

where
P0 = equity value at the end of period 0
NOIt = net operating income (after taxes)
rW = weighted average cost of capital
NOAt = net operating assets at the end of period t
Debt0 = value of debt at the end of period 0

Two Stage Discounted Residual


Income Model (used in eVal)
NI t re * CE t 1 NIT 1 re * CE T
P0 CE 0

t
T
(1

r
)
(r

g
)
(1

r
)
t 1
e
e
e
T

where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of equity at the end of period t
g = constant terminal growth rate in residual income beyond period
T+1

Advantages of Discounting Residual


Income
Unlike

dividends and cash flows, earnings


provide a reasonably reliable and timely
measure of firm performance
Accounting analysis and ratio analysis
provides a framework for evaluating earnings
performance
Most practicing investors seem to use
earnings to evaluate equities

Discounted Residual Income Model


Focuses on Key Value Drivers
NI t
CE t 1
(
re ) *
CE
P0
CE 0
t 1
1
t
CE 0
(1

r
)
t 1
e
This expression indicates that value is created by:
1. Generating a long-run ROE that exceeds the cost of
capital (focus on profit margin and asset turnover)
2. Growing the size of the investment base on which the
ROE is generated (focus on sales growth)

Subsequent Performance for Firms


With Extreme Residual Income
0.1
0.05

Residual Income

0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35
0

Years Since Portfolio Formation

Bottom Line on Valuation Models

Discounted dividends, discounted free cash flow and


discounted residual income are all theoretically valid
valuation models.
Your valuations should always be based on a complete
and consistent set of forecast financial statements, in
which case you will get the same value regardless of
the valuation model used.
Your forecast horizon must extend out far enough that
you reach a constant terminal growth rate in the flow
that you are discounting at which point you can make
a terminal value computation.

Valuation Using Price Multiples

Examples include price-earnings, enterprise valuesales and market-book multiples.


A popular heuristic is the PEG Ratio, which uses an
earnings multiplier that equals the long-run expected
growth rate in earnings.
The major problem with these approaches is that they
implicitly make restrictive assumptions that are very
often unrealistic.
We will explore determinants of common valuation
multiples in session 19.

Contingent Claims on Equity


Value to Existing Equity Holders
= PV of FCF to Common Equity
- Value of Contingent Claims on Common Equity

In building your free cash flow forecasts, assume that


all future expenses are ultimately paid for in cash or
stock and not with contingent equity claims.

Note that FAS123R essentially does this for employee stock options, in that it
requires an expense equal to the estimated cash value of the options granted
but we dont currently have similar accounting for convertible bonds

Valuation Example
EnCom

Corporation Stage 3

Illustrates equivalency of valuations using the DCF


Model and the Residual Income Model
Illustrates how accounting distortions can change
the sequence of residual income, but not the value
of the firm.

Solution (double click to see computations)


0
1
2
3
Residual Income Valuation (expense marketing costs as incurred)
Residual Income
-42
218
238
Discounted Residual Income
-38.18
180.17
178.81
Residual Income Valuation
2,160.17

0
1
2
3
Residual Income Valuation (amortizing marketing costs over 3 years)
Residual Income
158
98
128
Discounted Residual Income
143.64
80.99
96.17
Residual Income Valuation
2,160.17

108
73.77

128
79.48

-60
-33.87

108
73.77

128
79.48

-60
-33.87

Stage 3 Questions
2. In question 1 above, you should have arrived at the same
valuation regardless of the accounting method employed.
Provide a qualitative explanation as to why the different
accounting methods have no impact on the valuation.
The accounting technique selected has no effect on cash
flows or dividends, and hence has no impact on the
valuation. Note that conservative accounting leads to low
residual income in earlier years and high residual income
in later years. Conversely, aggressive accounting leads to
high residual income in earlier years and low residual
income in later years.

Upcoming Cases

Overstock.com E

Evaluating Intels Earnings Torpedo

Understand why a small reduction in earnings can lead to a large drop


in price.

The Restaurant Industry in 2003

Critical evaluation of analyst valuation. What are the implicit


assumptions and are they reasonable?
Conduct your own valuation of Overstock.com using eVal. Focus on
sales growth and ROE as the key drivers of value.

Understanding the determinants of common valuation ratios.

The AOL Time Warner Merger

Illustrates how value can be created and destroyed through financing


transactions