50267669 equity valuation and analysis manual

ILPIP Members

Course ManualCourse ManualCourse ManualCourse Manual

Equity Equity Equity Equity

Valuation and AnalysisValuation and AnalysisValuation and AnalysisValuation and Analysis

Copyright © 200Copyright © 200Copyright © 200Copyright © 2008888, , , , AZEKAZEKAZEKAZEK/ILPIP/ILPIP/ILPIP/ILPIP, Geneva, Geneva, Geneva, Geneva

EQUITY VALUATION AND ANALYSIS

COURSE MANUAL

Copyright © 2008, AZEK/ILPIP

EQUITY VALUATION AND ANALYSIS Copyright 2008, AZEK/ILPIP All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AZEK/ILPIP.

1) Equity Markets and Structures

2) Understanding the Industry Life Cycle

3) Analysing the Industry Sector and its Constituent Companies

4) Valuation Model of Common Stock

5) Exercises: Questions

6) Exercises: Solutions


Chapter 1

EQUITY MARKETS AND STRUCTURES


Table of contents

11.. EEqquuiittyy MMaarrkkeettss aanndd SSttrruuccttuurree 11

11..11 TTyyppeess ooff eeqquuiittyy sseeccuurriittiieess ...................................................................................................................................................................................................................................... 11

11..11..11 CCoommmmoonn sshhaarreehhoollddeerrss’’ rriigghhttss ...................................................................................................................................................................................................................... 11 1.1.1.1 Control......................................................................................................................................... 1 1.1.1.2 Dividend Income ......................................................................................................................... 3 1.1.1.3 Limited Liability.......................................................................................................................... 3 1.1.1.4 Asset rights.................................................................................................................................. 3 1.1.1.5 Pre-emptive rights ....................................................................................................................... 3 1.1.1.6 Right of transfer........................................................................................................................... 4

11..11..22 AAuutthhoorriisseedd aanndd oouuttssttaannddiinngg sshhaarreess........................................................................................................................................................................................................ 44 11..11..33 IIssssuuiinngg EEqquuii ttyy ...................................................................................................................................................................................................................................................................... 44

1.1.3.1 Approval from the Board of Directors ........................................................................................ 5 1.1.3.2 The role of an investment banker ................................................................................................ 5

11..22 IInnddiicceess.................................................................................................................................................................................................................................................................................................... 66

11..22..11 TThhee uusseess ooff ssttoocckk iinnddeexxeess.................................................................................................................................................................................................................................... 66 11..22..22 HHooww ssttoocckk iinnddeexxeess aarree ccaallccuullaatteedd .......................................................................................................................................................................................................... 66

1.2.2.1 Number of stocks in an index ...................................................................................................... 6 1.2.2.2 Method of calculating an index ................................................................................................... 7

chapter 1 / page 1

1. Equity Markets and Structure

1.1 Types of equity securities

The most popular securities among investors throughout the world are the shares of common stock or equity of a firm. These shares represent the residual claim on the firm’s earnings. The term residual claim implies that the earnings of the firm belong to the common shareholders of the firm after satisfying all other claims. These claims are employees’ wages/salaries, interest and principal payments to creditors who have advanced short- and long-term loans to the firm, taxes, and claims of preferred shareholders. Thus, common shares are junior to all other corporate securities. Common share capital (or common stock) represents the risk capital provided by the owners of the firm. Because of the risk borne by common shareholders through their investment in the firm, they enjoy certain rights that are not available to owners of corporate debt or preferred stock.

1.1.1 Common shareholders’ rights

1.1.1.1 Control Since the common shareholders own the firm, they enjoy the right to manage the firm. Typically, the majority of a firm’s shares are held by tens of thousands of small shareholders. Therefore, day-to-day management of the firm is entrusted to professional managers, who, in turn, report to the board of directors. The firm’s stockholders elect the members of the board of directors every year. The elections for the membership of the board of directors can be made either by the system of majority voting or by cumulative voting. Under the majority voting system each share represents the right to cast one vote for each position on the board. Any candidate receiving more than 50% of the votes cast will get elected to the board. This system gives the majority shareholder absolute control over the board as he can elect all the members of the board. A number of state and local governments frown upon the practice of majority voting because the majority shareholder will usually pack the board with his supporters thus denying the minority shareholders any voice in the running of the firm. These governments may require that the election of the board be organised under the cumulative voting system, wherein each share represents as many votes as the number of directors to be elected. In the majority voting, only one vote per share can be assigned to one candidate. But in the cumulative voting system, all the votes per share (i.e., number of directors to be elected) can be assigned to a single candidate. This increases the chances that minority shareholders may be able to elect a few directors on the board. One can, in fact, calculate the number of shares needed to elect one member of the board, as follows:

11N

TSmin +

+=

where. Smin minimum number of shares needed T total number of shares outstanding N total Number of directors to be elected

chapter 1 / page 2

The following example will make the concept clear:

Example The Zodiac Corp. has 10 million shares outstanding. If Zodiac has nine members on the board of directors who get re-elected every year, calculate the number of shares needed to elect one member on the board of directors. In Zodiac’s case, each share has nine votes and these can be assigned to the member the minority shareholders wish to elect. The minimum number of shares so that one member of your choice can be elected will be

shares 1'000'001119

10'000'000min

S =++

=

Thus, even a shareholder who only owns 10% of the firm’s stock can get a member of his/her choice elected to the board. Under the majority-voting scheme, this will not be possible.

Alternatively, the following formula will allow one to determine how many members on the board can be elected with a given number of shares.

T

)1N)(1S(n

+−=

where: n number of directors who can be elected S given number of shares N total number of directors to be elected T total number of shares outstanding

Example: If Walter Hadlee owns 2.5 million shares of Zodiac Corp. (see above), how many directors can he hope to elect? The total number of votes available with Walter will be 2.5 million x 9 directors to be elected = 22.5 million votes. He must use these votes judiciously to maximise the number of directors he can elect.

( ) ( ) 2.5

10'000'000

1912'500'000n =+⋅−=

(rounding down, as fractional directors are meaningless) Thus, Walter can hope to elect two directors. Walter should therefore distribute his votes to two candidates of his choice.

Sometimes, a group of shareholders that is unhappy with the way the firm is being managed may challenge the existing management. This “dissident” group will try to wrest control of the firm by challenging the controlling group of shareholders. These challenges are usually in the form of proxy fights. Proxy fights will involve the existing management and the challenger group both appealing to the shareholders of the firm to vote in their favour so that the firm can be managed better. Mergers and acquisition are other methods of taking over the control of a firm. The strategies involved in mergers and acquisition are discussed in detail in a subsequent chapter.

chapter 1 / page 3

1.1.1.2 Dividend Income As mentioned above, common shareholders have the residual right to the earnings of the firm. Residual earnings are earnings of the company after meeting the claims of all other security holders, the government, and the employees of the firm. Each share is entitled to receive an equal amount in cash dividends. The shareholders of a profitable firm expect the firm to pay dividends to its shareholders. However, shareholders have no legal rights to dividends and firms occasionally skip cash dividends. The cash not paid out as dividends still belongs to the shareholders and will therefore be treated as capital reinvested by them in the firm. This reinvestment is reflected in the balance sheet of the firm as additions to Retained Earnings (or Reserves, as they may be called in some countries). Some companies resort to paying stock dividends to conserve cash, or when they are in financial difficulties, or if they face contractual restrictions. Stock dividend payment involves issuing additional shares to the existing shareholders of the firm. A 2% stock dividend will require the firm to give 2 additional shares for every 100 shares owned by a shareholder. When the stock dividend percentage exceeds 25%, it is called a stock split under NYSE guidelines.

1.1.1.3 Limited Liability The reason why shares of corporations are very attractive investments for the public at large is that the investors’ liability with regard to the firm is limited to their investment in the firm. This feature is called the limited liability. Unlike the common shareholders who own assets of a corporation, the owners of sole proprietorship and partnerships do not enjoy the benefit of limited liability. If a sole proprietorship or a partnership ends up owing more than the value of its assets, the creditors of the firm have the right to recover the difference between the amount of debt and the value of the firm’s assets from the owners of the firm. Thus, the owners of a sole proprietorship or partnership have unlimited liability. The limited liability enjoyed by common shareholders is more like a call option owned by shareholders. If the company is profitable and growing, the shareholders participate in the profits and the growth of the firm after all the fixed claims are met. On the other hand, if the firm keeps on making losses and has debts larger than the value of the assets, the shareholders can simply walk away from the firm leaving the assets for other claimants.

1.1.1.4 Asset rights Just as in the case of earnings, shareholders also have the residual claims on the assets of the firm. If the firm goes bankrupt, the firm’s assets have to be liquidated and the claims on the firm’s assets have to be paid off. Since the common shareholders’ claims are the most junior, all other claimants such as creditors, governments, bondholders and preferred stockholders have to be paid off first. If any funds are left after all other claims are settled, the common shareholders will share equally in the same. The residual nature of shareholders’ claim makes common shares the most risky among all securities issued by corporations.

1.1.1.5 Pre-emptive rights The pre-emptive right is a provision that entitles shareholders to maintain their fraction of ownership in the firm. Thus, if the firm issues any new shares of common stock, the existing shareholders will have the right to purchase new shares in the same proportion as their current holding. Firms may eliminate this right by amending their charters so that they may be able to issue new shares for the purpose of mergers, acquisition or to meet the needs of ESOPs (Employee Stock Ownership Plans).

chapter 1 / page 4

The pre-emptive right necessitates what is called the rights offering. A rights offering is the issue of new shares of the firm, which is open for subscription only to the existing shareholders. Usually, shares are offered for subscription in a rights offering at a substantial discount to the market price. Each existing share will receive one right. The number of rights needed to purchase a share depends upon the ratio of new shares issued to currently outstanding number of shares. Assume that a company, which has 10 million shares outstanding at present wishes to issue 1 million new shares through a rights offering. Since each existing share receives one right, ten million rights will be created. These ten million rights are created to purchase one million new shares. Therefore, ten of these rights will be needed to purchase one share in the new issue. Because the share price in the rights offering is below the market price of the common stock, the rights have a value by themselves. Investors who may not wish to exercise their right benefit by simply selling it to an investor who wishes to buy the shares in the offering. The valuation of rights is discussed elsewhere in the course material.

1.1.1.6 Right of transfer Common shareholders can easily transfer their ownership in the firm to another investor. In publicly traded companies, the owner may seek help from a registered securities broker to sell the stock. In countries where securities markets are well developed, the transfer is affected within a few working days and the purchaser of the shares is registered with the firm as the owner of the shares. He will receive cash dividends from the firm that day onwards.

1.1.2 Authorised and outstanding shares

In reading the financial statements of a firm, one comes across the terms “authorised,” and “outstanding” shares. The firm’s charter specifies the maximum number of shares the company is legally entitled to issue. If the firm needs to issue more than this number of shares, it has to amend the charter to do so. Most firms will have a very large number of shares as authorised shares, while they may initially issue a much smaller number of shares. This allows them to raise additional funds through common stock issues without amending the charter. The shares in the hands of public are called outstanding shares. In some cases, the number of shares issued and shares outstanding may not be the same. The difference between the two arises due to the stock repurchase (or stock buyback, as it is called in some countries) wherein the issuing firm may repurchase its own stock on the open market. The number of shares repurchased will make up a block of shares called treasury shares. Thus, the number of shares issued will be equal to the sum of the number of shares outstanding and treasury shares.

1.1.3 Issuing Equity

Established companies sparingly use common stock as a source of external financing. But smaller firms, start-ups and high-growth firms use equity to raise funds needed for their growth. It is therefore important for an analyst to understand the mechanism of issuing equity to raise funds. The steps in the process of issuing equity will vary from country to country. The following discussion is based on the practices used by firms to issue equity.

chapter 1 / page 5

1.1.3.1 Approval from the Board of Directors The issue of new equity to public will require the approval of the board of directors.

1.1.3.2 The role of an investment banker Once the approval of board of directors is obtained, the firm selects an investment banker (or a merchant banker, as they are called in some countries) to manage the issue. If the issue size is small, one investment-banking firm will be retained to undertake the issue. If the issue size is large, a syndicate of investment bankers may perform the task. The investment banker is retained by the issuing firm to advise and counsel the issuing firm about the regulations regarding equity issue. The investment banker is also expected to evaluate the market conditions to determine the timing of the issue and at what price the security should be issued. Depending on the reputation of the issuing firm, the issue may be underwritten. When an equity issue is underwritten, the investment banker or bankers will guarantee the sale of the issue. If the public does not subscribe the entire issue then the underwriter will purchase the balance of the issue. This guarantees the issuing firm that the entire issue will be sold out and the necessary funds raised. However, this guarantee will be available only to the most reputable firms whose shares will be sought after by the public. Lesser known firms will not be able to get their equity issue underwritten, but will have to be satisfied with a best-efforts deal from the investment banker. The investment banker also undertakes the distribution of the shares. To do this, the investment banker must first register the issue with the regulatory authorities. The registration will require that the issuing firm provides information about itself, the type and the amount of security being offered and the purpose for which the funds are being raised. To inform the public about the issue of equity, the investment banker will then publish a Prospectus, which outlines the price of the share, offering date and the financial information about the issuing firm. The investor is expected to decide to subscribe to the share issue only upon receiving the information contained in the prospectus. After the issue of the shares, they are generally listed on a stock exchange (a marketplace where shares are traded). Each stock exchange has its own listing requirements. The issue of shares by a firm entering the capital market for the first time is called an initial public offering (IPO). The question of pricing IPOs is particularly interesting for analysts. When a company issues shares for the first time, the correct value of the shares can only be guessed. The investment bankers usually err on the conservative side when pricing IPOs, i.e., IPOs are usually under priced. It is not uncommon for the IPOs to experience huge price increases during the first few sessions of trading after listing. This phenomenon ensures that the investment bankers will have a strong demand for IPOs.

chapter 1 / page 6

1.2 Indices

Stock indexes (or indices) are created to provide investors with the information regarding the average share price on the stock market. Since shares of thousands of companies (around 2,000 on NYSE and 3,300 on NASDAQ) are traded on any given day in the stock market, it is impossible to keep track of all the price movements and discern the direction in which the market is going. A stock index represents the average price of shares trading on a stock exchange. The average is computed using the prices of only a handful of stocks that are deemed to be the most representative of the market as a whole.

1.2.1 The uses of stock indexes

The first and foremost use of a stock index is as a measure of performance of the market. Since the index is based on representative stocks, an increase in the index signifies an increase in prices of a majority of stocks. Investment analysts find the stock index a useful tool in determining the factors underlying stock price movements. Historical information about the index and macro-economic variables can be correlated to analyse factors related to share price movements. A number of analysts (“Technical analysts”) believe that historical share price movements can help one to predict future price movements. These analysts use the stock index data to forecast the direction of the market. Stock indexes have been very useful in portfolio management. A broad-based stock index is normally used as a proxy for the “market” portfolio and used in determining the systematic risk of portfolio being managed. This helps portfolio managers make investment decisions. Free market economies are subject to business cycles; thus, the economic growth varies from one period to another. It is extremely important for businesses to predict when the economy will start expanding or when it will slide into a recession. Stock prices have been found to be leading indicators (i.e., stock prices rise/fall before the economic expansion/recession) of the economy. Thus, the changes in stock indexes can be used as an indicator of the direction of the economy.

1.2.2 How stock indexes are calculated

There are two important factors in determining the utility of a stock index: the number of stocks to be included in the index and the method of calculating the average price.

1.2.2.1 Number of stocks in an index Ideally, a stock index should be based on as many stocks in a given market as possible. This index will then be truly representative of the market. However, in the past, the cost of calculating such an index on a continuous basis was found to be too much. Thus, most stock indexes created prior to the computer age included very few stocks. A prime example of this is the best-known stock index in the world: the Dow-Jones Industrial Average (DJIA). DJIA was created in the year 1896 with only 12 stocks. Over the years, more stocks have been added to it and now it is based on 30 stocks. On the other hand, more modern Standard and Poor’s 500 index consists of 500 stocks, while NYSE Composite Index is based on the prices of all stocks traded on the New York Stock Exchange.

chapter 1 / page 7

The following table shows how many stocks are included in some of the indexes on the most important stock exchanges in the world:

Stock Market Index Name No. of Shares New York SE DJIA, S&P 500, NYSE Comp. Index 30, 500, around 2000 NASDAQ NASDAQ Composite Around 3300 London Financial Times 100 Paris CAC40 40 Frankfurt DAX 30 Zurich SMI 27 Milan MIB30 30 Tokyo TOPIX100 100 Toronto Toronto Composite 223 Singapore Straits Times 45 Hong-Kong Hang Seng 33

1.2.2.2 Method of calculating an index Stock indexes are calculated using different methods of determining the average price of shares. The two most widely used methods are: 1) Price-weighting and 2) Value-weighting. Price-weighted indexes Price-weighted indexes are calculated simply as the average share price of stocks included in the index on a given day. Thus, on the very first day the DJIA was calculated, the share prices of all the 12 stocks were added and then divided by 12 (called the divisor) to calculate the value of the index. Over the long run, however, this calculation method will introduce errors in the value of the index due to stock splits and stock dividends. To eliminate these errors, the divisor has to be continuously adjusted. Thus, even though the index is now based on 30 stocks, the divisor used in calculating the index is closer to 2 and is continually adjusted to reflect the changes in the number of shares outstanding of the member firms due to stock splits and stock dividends. The price-weighting scheme suffers from a number of drawbacks. High-priced stocks affect the index much more than low-priced stocks. The divisor is usually not adjusted for stock dividends of less than 10%. This creates another error in computing the index. The DJIA in particular is based on a very small sample (30) chosen from the 2,000 or so stocks trading on the NYSE. These stocks represent mainly large industrial firms. Thus, the DJIA cannot be truly representative of the market as a whole. Value-weighted indexes The alternative method of index calculation is the value-weighting scheme. Here the market values of all the firms included in the index are added and divided by the market value of the firms on the day the index was first calculated. The Standard and Poor’s 500 index is calculated using the following formula:

chapter 1 / page 8

10qp

qp

Index500

1j

j0

j0

500

1j

jt

jt

⋅⋅

⋅=∑

∑

=

−

where: j0

jt p ,p share price of stock j on day t and 0, respectively.

j0

jt q,q number of shares outstanding of stock j on day t and 0, respectively.

This method of calculation eliminates some problems inherent in the price-weighting method. Stock splits and stock dividends do not affect the index as the index accounts for the market value of equity rather than the price of a share. High-priced stocks do not necessarily have a bigger impact on the index. It is market value that matters. Large market value firms will affect the index more than small market value firms. Finally, as it is based on a sample of 500 stocks, S&P 500 is more broad-based and thus more representative of the market as a whole. An exception to the above two types of stock indexes is the Value Line Index that is calculated as the geometric mean of share prices of all stocks included in the index.


Chapter 2

UNDERSTANDING THE INDUSTRY LIFE CYCLE


Table of contents

22.. UUnnddeerr ssttaannddiinngg tthhee iinndduussttrr yy ll ii ffee ccyyccllee** 11

22..11 TThhee ttoopp--ddoowwnn aapppprr ooaacchh** ...................................................................................................................................................................................................................................... 11

22..22 TThhee bboott ttoomm--uupp aapppprr ooaacchh** .................................................................................................................................................................................................................................. 11

22..33 TThhee ““ nneeww”” ttoopp--ddoowwnn aapppprr ooaacchh** .............................................................................................................................................................................................................. 33

* final level

chapter 2 / page 1

2. Understanding the industry life cycle* The top-down approach (see below) is an institution. Almost every international investment strategy relies on it. A large number of studies have proved that the behavior of the major economic aggregates determines the performances of financial assets, i.e. stocks and bonds. In the case of stocks, the top-down process most often involves two successive decisions: allocation by country and/or region and then, within each country and/or region, individual stock selection.

2.1 The top-down approach*

Basic assumption The performance of an equity portfolio depends primarily on the asset allocation by country/region. Process

1. Each country's economic aggregates, e.g. GDP, inflation, interest rates and exchange rates are analyzed.

2. Forecasts of those aggregates are then made. 3. Market valuations are assessed. 4. Each market’s upside potential is estimated. 5. Assets are allocated by market. 6. Individual stocks are then selected within each market.

Conversely, most individual investors follow a bottom-up approach in selecting their stocks (although they quite often skip the first five stages of the following process).

2.2 The bottom-up approach*

Basic assumption The performance of an equity portfolio depends primarily on the selection of individual stocks. Process

1. Variables (business, management, financing, etc.) for each company are analyzed. 2. Company forecasts are made (earnings, free cash flows, etc.). 3. The risk associated with those forecasts is estimated. 4. The company is valued on the basis of its asset value and its return value (for instance

by using a DCF model). 5. The upside potential of each stock is estimated (for various time horizons). 6. Individual stocks are then selected.

Some famous asset managers, in particular Peter Lynch and Warren Buffet, also favour the bottom-up approach. But as professionals, they would for surely strongly suggest that you spend most of your time on the first 5 steps of the above process.

chapter 2 / page 2

Understanding the industry life cycle has always been considered as a central issue by corporate analysts, because there is a close correlation between the company-specific product cycle and the corresponding industry cycle. Most economists and strategists, on the other hand, have neglected this factor for a long time, for both good and bad reasons: The good reasons � Until recent years, diversifying an international equity portfolio by region proved much

more effective than diversifying it by industry.

� The industry cycle is supposed to be captured by the equity analysts, who should take it into account at the last stage of the top-down process, i.e. when selecting individual stocks.

The bad reasons � Country economic aggregates, e.g. the United States’s GDP, are available, whereas useful

industry aggregates are still missing. Admittedly, however, that does not mean that spending time analyzing industry cycles is not a key factor in successful asset allocation.

� There is no widely-accepted classification as regards industries, whereas everyone (with the exception of nations claiming their independence) acknowledges the official country “classification”. We all agree that the United States and the United Kingdom are different countries, even though they share the same language. What about the software and the semiconductor industries? Are they really different, or just “sub-industries” belonging to the same sector, i.e. technology? Once again, that does not mean that spending time analyzing industry cycles is not a key factor in successful asset allocation.

Recently, a new body of research has focused on assessing a strategy aimed at optimally shifting exposure among global industry sectors. It had become increasingly obvious that more value could be added by selecting the right industries at the right time than before, because of:

1. The emergence of new industries (particularly those related to the Internet). Emerging industries are similar to emerging countries. Because of their low correlation with more mature industries, they offer a good way to improve the expected return of a portfolio while reducing its risk. After the Case for International Diversification, here comes the Case for Interindustry Diversification.

2. The increasing correlation between the most developed equity markets, which can be explained by several factors: - the convergence of European monetary, fiscal and economic policies - the ongoing expansion of large, multinational companies - the gradual reduction of barriers to international trade and investment.

In other words, diversifying assets by country has become less and less effective over the past few years, whereas allocating money by industry has proved increasingly attractive, so much so that the authors of some recent articles have suggested that strategists implement a “new” top-down approach.

chapter 2 / page 3

2.3 The “new” top-down approach*

Basic assumption The performance of an equity portfolio depends primarily on the asset allocation by industry. Process

1. Each industry's aggregates are analyzed. 2. Forecasts of those aggregates are then made. 3. Sector valuations are assessed. 4. Each sector’s upside potential is estimated. 5. Assets are allocated by industry. 6. Individual stocks are selected within each industry.

Whatever the investment process, understanding industry cycles is key to building an equity portfolio. The life cycle (or long-term cycle) can be distinguished from the business cycle (or short-term cycle). The first is very similar to a product life cycle. Like Bodie, Kane and Marcus, and other authors, we can highlight four successive stages in any industry life cycle: Start-up stage The first stage is characterized by the emergence of a new product, technology and/or business model. Internet-related services, such as on-line investment research dedicated to individuals, are typical examples. It is very difficult to predict which firms will survive and potentially become industry leaders. Selecting the right stocks is not an easy task, to say the least. Therefore, individual investors, and also most investment professionals, are strongly advised to play the industry through mutual funds managed by true experts. Consolidation stage The second stage is characterized by the appearance of industry leaders. The mobile phone sector is a quite obvious example. The product has become established. Sales and earnings growth – although higher than average – are easier to forecast. Hence, selecting stocks is less risky, and well-informed investors may start buying individual stocks. But those who do not have enough time to closely monitor their investments should stick to mutual funds.

Sales

Time

Start-up

Consolidation

Maturity Decline

chapter 2 / page 4

Maturity stage The third stage is characterized by greater price competition. TV sets are in this stage. The product has reached its full potential for use by consumers, and it has become more or less standardized. Profit margins are gradually coming under pressure and cost-cutting programs may already be necessary. Companies are much more exposed to the business cycle (see below). Selecting individual stocks can nevertheless be quite safe (if the industry – such as food & drinks – is not cyclical and the maturity stage is due to last for a long time). But it can also be much riskier (if the industry – such as car makers – is cyclical, and/or if the product – such as video cassettes – is about to be replaced by a new one). Decline stage The fourth stage is, after lower-than-average growth, characterized by shrinking sales. This is often due to the obsolescence of the product. Selecting individual stocks here – as in the start-up phase, ironically – is a difficult task. The focus should be on turnaround situations and asset plays. Once again, individual investors and most investment professionals would be wise to play such industries through mutual funds managed by true specialists, instead of trying to do the job themselves. Peter Lynch uses another – although related – industry classification system. He divides firms into the following six groups: Slow growers Large and aging companies that will grow only slightly faster than the broad economy. This category corresponds to the beginning of the maturity stage described above. Stalwarts Large, well-known firms like Coca-Cola. They grow faster than the slow growers, but are not in the very rapid growth start-up phase. This category corresponds to the end of the consolidation stage described above. Fast Growers Small and aggressive new firms with annual growth rates in the neighbourhood of 20% to 25%. This category corresponds to both the start-up stage and the beginning of the consolidation stage described above. Cyclicals These are firms with sales and profits that regularly expand and contract along with the business cycle. This category does not correspond to any of the stages described above, because it refers to the short-term cycle, i.e. the business cycle, not to the long-term cycle, i.e. the life cycle. In fact, cyclical firms can be either in the start-up stage (digital books), in the consolidation stage (mobile phones), in the maturity stage (TV sets) or in the decline stage (turntables). Turnarounds These are firms that are in bankruptcy or soon might be. That can be due to a continuous sales drop, i.e. the company is in the decline stage. But it may also be the result of a cash squeeze, and in this case, the company could be in any of the stages described above. We might, for instance, be faced with a start-up that was not able to raise new funds because of troubled stock markets. In other words, this category does not strictly correspond to any of the stages described above.

chapter 2 / page 5

Asset plays These are firms that have valuable assets not currently reflected in the market prices of their stocks. Like cyclicals, this category does not correspond to any particular life-cycle stage. You may find asset plays – usually companies with sizable tangible assets, for instance real estate – in all four stages. As regards industry classifications, we would suggest that you forget about special situations like turnarounds and asset plays, which are stock-specific, and not industry-specific concepts. As we have already said, the slow-grower, the stalwart and the fast-grower categories can be viewed as life-cycle stages. The cyclical companies category, for its part, refers to the business cycle, not to the life cycle. So does another category, that of the so-called “defensive” firms. These companies are not – or less – affected by economic downturns, and they do not benefit – or benefit less – from economic recoveries. The following table provides examples for both the life cycle and the business cycle:

Defensive Cyclicals Start-up Health-promoting nutrients Digital books Consolidation Diet food Mobile phones Maturity Washing powder TV sets Decline High-tar cigarettes Turntables

Paul and Carole Huebotter have suggested dividing the business cycle into four phases, with the objective of optimizing industry allocation. Their theory applied to the U.S. equity market, but it could well be extended to all the developed markets. Phase 1 This phase starts at the bottom of a recession. People who are still working – probably 90% to 93% of those who want to – are not much afraid of losing their jobs. Family purchases deferred during times of uncertainty start being made again. Sales of big-ticket items such as cars and major appliances pick up. Interest rates are at their lowest, so it's a good time to buy or build a house. With growing confidence, families go out more, travel more, and indulge in entertainment more. For different reasons, the energy industries are also doing well. It is clear to business leaders that a new cycle has begun, and that the energy needs for the new cycle will exceed those of the previous one. Phase 2 The economy is growing too fast. At this point, the Federal Reserve begins to raise interest rates to prevent overheating and an upsurge of inflation. During such periods, interest-sensitive industries such as utilities and financials do poorly, as does the bond market. The consumer cyclical group falls out of investor favour as higher interest rates start putting pressure on housing starts and big-ticket purchases. At this stage of the economic recovery, manufacturing is operating at close to full capacity and raw-material inventories are low. The metals, chemicals, paper and forest products industries are now producing flat-out to restock the finished-goods industries. Higher prices start appearing on these building-block materials, and their producers have the best of all possible worlds – strong demand and higher prices. As full-capacity utilization nears, efficiency and productivity begin to be emphasized. At that

chapter 2 / page 6

point, the industry invests in computers, software, automation equipment and communications in an effort to meet demand with existing plant capacity. Phase 3 Interest-rate hikes during phase 2 finally have their intended effect on the economy, and the desired soft landing is achieved. GDP growth declines, though it remains strongly positive. Transport industries thrive due to the brisk pace of commerce and the large volume of goods being shipped. Capacity expansion benefits the capital-goods industry. Interest rates, though high, are now stable. This helps the financial industries, which cash in on strong loan demand and reliable margins. Phase 4 This phase begins with a sharp decline of the growth rate. Inflation fears are now subordinate to fears of recession. At this stage, the Fed tries to stimulate the economy with a series of interest-rate cuts. Despite layoffs and less job security, the demand for utility services and food and other consumer noncyclicals is relatively unaffected.


Chapter 3

ANALYSING A SECTOR OR INDUSTRY AND ITS CONSTITUENT COMPANIES


Table of contents

33.. AAnnaallyyssiinngg aa SSeeccttoorr oorr II nndduussttrr yy aanndd ii ttss CCoonnsstt ii ttuueenntt CCoommppaanniieess** 11

33..11 TThhee sseeccttoorr oorr iinndduussttrr yy** ............................................................................................................................................................................................................................................ 11

33..11..11 TThhee UU..SS.. CCeennssuuss BBuurreeaauu ccllaassssii ff iiccaattiioonn** ........................................................................................................................................................................................ 11 33..11..22 TThhee MMSSCCII//SS&& PP ccllaassssii ff iiccaattiioonn** .................................................................................................................................................................................................................. 22 33..11..33 TThhee DDooww JJoonneess ccllaassssii ff iiccaattiioonn** .................................................................................................................................................................................................................... 33

33..22 CChhaarr aacctteerr iisstt iiccss ooff tthhee iinndduussttrr yy** ................................................................................................................................................................................................................ 44

33..22..11 CChhaarraacctteerriissttiiccss ooff tthhee pprroodduuccttss aanndd sseerrvviicceess** ........................................................................................................................................................................ 44 33..22..22 CChhaarraacctteerriissttiiccss ooff tthhee ccll iieennttss** ...................................................................................................................................................................................................................... 55 33..22..33 CChhaarraacctteerriissttiiccss ooff tthhee ssuuppppll iieerrss** .............................................................................................................................................................................................................. 55 33..22..44 CChhaarraacctteerriissttiiccss ooff tthhee llaabboorr ffoorrccee** ........................................................................................................................................................................................................ 66 33..22..55 CChhaarraacctteerriissttiiccss ooff sshhaarreehhoollddeerrss ((aanndd ooff ootthheerr ccaappii ttaall ssuuppppll iieerrss))** ............................................................................................................ 66 33..22..66 CChhaarraacctteerriissttiiccss ooff tthhee eennvviirroonnmmeenntt** .................................................................................................................................................................................................... 77

33..33 MM aaccrr oo ffaaccttoorr ss** ........................................................................................................................................................................................................................................................................ 88

33..44 FFoorr eeccaasstt iinngg ffoorr ccoommppaanniieess iinn tthhee iinndduussttrr yy** ...................................................................................................................................................................... 1155

33..55 BBaallaannccee--sshheeeett ffaaccttoorr ss** ............................................................................................................................................................................................................................................ 1177

33..66 CCoorr ppoorr aattee ssttrr aatteeggyy** .................................................................................................................................................................................................................................................. 1199

33..77 VVaalluuaatt iioonnss** .............................................................................................................................................................................................................................................................................. 2211

* final level

chapter 3 / page 1

3. Analysing a Sector or Industry and its Constituent Companies*

3.1 The sector or industry*

How to define a sector and/or an industry? We have said in chapter 2.2 that there is no widely -accepted classification as regards industries, whereas everyone acknowledges the official country “classifications”. In fact, as regards industries, there are several classifications competing with one another. Which one is going to win? Nobody knows.

3.1.1 The U.S. Census Bureau classification*

The U.S. Census Bureau is part of the U.S. Department of Commerce. Its mission is to be the pre-eminent collector and provider of timely, relevant and quality data about the people and the economy of the United States. The North American Industry Classification System (NAICS) was developed jointly by the U.S., Canada and Mexico in 1997 to provide new comparability in statistics on businesses across North America. This new system is replacing the U.S. Standard Industrial Classification (SIC) system. It recognizes the following 20 broad sectors:

Code NAICS Sectors 11 Agriculture, Forestry, Fishing and Hunting 21 Mining 22 Utilities 23 Construction 31-33 Manufacturing 42 Wholesale Trade 44-45 Retail Trade 48-49 Transportation and Warehousing 51 Information 52 Finance and Insurance 53 Real Estate and Rental and Leasing 54 Professional, Scientific, and Technical Services 55 Management of Companies and Enterprises 56 Administrative and Support and Waste Management and Remediation Services 61 Education Services 62 Health Care and Social Assistance 71 Arts, Entertainment, and Recreation 72 Accommodation and Food Services 81 Other Services (except Public Administration) 92 Public Administration

The previous classification (SIC) recognized only 10 divisions (i.e. Agriculture, Forestry and Fishing; Mining; Construction; Manufacturing; Transportation, Communication and Public Utilities; Wholesale Trade; Finance, Insurance and Real Estate; Services; Public Administration). You will note that a great deal of improvement has been made in the field of services, which have now been divided into 7 new categories.

chapter 3 / page 2

NAICS industries are identified by a 6-digit code, in contrast to the 4-digit SIC code. The longer code accommodates the larger number of industries and allows more flexibility in designating sub-industries. It also provides for additional detail not necessarily appropriate for all three NAICS countries. The international NAICS agreement sets only the first five digits of the code. The sixth digit, where used, identifies subdivisions of NAICS industries that accommodate user needs in individual countries. Thus, 6-digit U.S. codes may differ from their counterparts in Canada or Mexico, but at the 5-digit level they are standardized.

Example of NAICS Hierarchy Sector 51 Information Subsector 513 Broadcasting and telecommunications Industry group 5133 Telecommunications Industry 51332 Wireless telecommunications carriers, except satellite U.S. Industry 513321 Paging

350 new industries were separately recognized for the first time with NAICS. A few of those industries reflect “high tech” developments such as fiber optic cable manufacturing, satellite communications and the reproduction of computer software. More of them recognize less technological changes in the way business is done: bed and breakfast inns, environmental consulting, warehouse clubs, pet supply stores, credit card issuing, diet and weight reduction centers. Note that the U.S. Office of Management and Budget (OMB) has already made proposals as regards the North American Industry Classification System (NAICS) updates to be adopted in 2002. The OMB's Economic Classification Policy Committee (ECPC) recommends an update of the industry classification system to extend the harmonized three-country classification structure to construction and to recognize important changes in retailing and information.

3.1.2 The MSCI/S&P classification*

The world's two premier providers of index services, Morgan Stanley Capital International (MSCI) and Standard & Poor's (S&P), together have launched a new global industry classification standard aimed at making the investment research and management process easier for financial professionals worldwide. The classification standard consists of 10 Sectors aggregated from 23 Industry Groups, 59 Industries, and 123 Sub-industries covering almost 6’000 companies in all.

Code MSCI Sectors 10 Energy 15 Materials 20 Industrials 25 Consumer Discretionary 30 Consumer Staples 35 Health Care 40 Financials 45 Information Technology 50 Telecommunications Services 55 Utilities

chapter 3 / page 3

Example of MSCI Hierarchy Sector 45 Information Technology Industry group 4520 Technology Hardware & Equipment Industry 452010 Communications Equipment Sub-industry 45201010 Networking Equipment

3.1.3 The Dow Jones and FTSE classification - ICB *

Dow Jones Indexes and FTSE have created a classification system called the Industry Classification Benchmark (ICB). The system is supported by the ICB Universe Database, which contains over 40,000 companies and 45,000 securities worldwide from the FTSE and Dow Jones universes. SWX indices have adopted the Industry Classification Benchmark (ICB) sector definitions since January 2006. The ICB structure is also used by the NASDAQ, NYSE, London Stock Exchange, Euronext, STOXX, Hang Seng, Russell, Dow Jones Wilshire, the Financial Times, The Wall Street Journal, CNBC and SmartMoney. ICB is a detailed and comprehensive structure for sector and industry analysis, facilitating the comparison of companies across four levels of classification and national boundaries. The system allocates companies to the Subsector whose definition most closely describes the nature of its business. The nature of a company's business is determined by its source of revenue or where it constitutes the majority of revenue.

� 10 Industries help investors monitor broad industry trends � 18 Supersectors can be used for identifying macroeconomic opportunities for

investment and trading decisions � 39 Sectors provide a broad benchmark for investment managers � 104 Subsectors allow for more detailed quantitative and qualitative analysis

The 10 Industries are

� Oil & Gas � Basic Materials � Industrials � Consumer Goods � Health Care � Consumer Services � Telecommunications � Utilities � Financials � Technology

Example of ICB Hierarchy for the company 'Puma AG': Industry 3000 Consumer Goods Supersector 3700 Personal & Household Goods Sector 3760 Personal Goods Subsector 3765 Footwear Description: Manufacturers and distributors of shoes, boots, sandals, sneakers and other

types of footwear.

chapter 3 / page 4

3.2 Characteristics of the industry*

In order to assess both the growth potential and the risk of a specific industry, we might go through the following checklist, and answer the questions as precisely as possible. Note that these same questions may also be useful for analyzing a specific company.

3.2.1 Characteristics of the products and services*

Which life-cycle stages are the products/services in? Start-up-stage industries usually exhibit the highest sales growth. But they are faced with losses and negative cash flows. As we highlighted in Chapter 2.2, those industries are much riskier than average. Consolidation-stage industries usually exhibit the highest earnings growth. Those industries are less risky than start-up-stage industries, since the products/services have become established. Maturity-stage industries usually exhibit low sales and earnings growth, but they generate a lot of cash. Those industries are normally the least risky of the four life-cycle categories, provided that 1) competition within the industry is not too intense (slow industry growth contributes to competition) and 2) they are not near the decline stage yet. Decline-stage industries exhibit – by definition – a decrease in sales and/or profits. They may still be cash cows, but this cannot last for long unless, for whatever reason, they enter a revival phase (which happens sometimes). They are riskier than maturity-stage industries, and sometimes even riskier than start-ups (for instance, when most companies of the industry are close to bankruptcy). To what extent do the products/ services fulfill basic needs? Industries corresponding to basic need are usually less sensitive to changing market conditions, i.e. to the business cycle. In other words, they are less risky. Note that this factor has nothing to do with profitability and/or long-term earnings prospects. Cyclical industries may be just as profitable, and grow just as fast as defensive ones. How uniform are the products/services? Industries selling very uniform products/services are usually riskier than the ones providing relatively complementary ones. If something goes wrong in the first case – say, for instance, volumes are under pressure because the industry is faced with an economic downturn – all the companies in the industry are affected in the same way. In addition, as competition is often higher in the uniform industries, margins may be under pressure. How transportable are the products/services? As competition from abroad is potentially higher, industries selling easily-transportable products/services are usually riskier than average. Internet services, for instance, are much more exposed to international competition than voluminous, heavy, and/or perishable goods. In addition, because of competition, margins may be under pressure.

chapter 3 / page 5

To what extent can the products/services be legally protected? Industries that can protect their products – and/or their production processes – through patents are usually less risky and more profitable than the ones that cannot. Trademarks and copyrights are also useful protections. Generally speaking, physical goods can be protected better than services. How intense is the pressure from substitute products/services? Industries facing competition from firms in related industries are usually less profitable than average. The availability of substitutes limits the price that can be charged to customers. Furthermore, those industries are riskier because their clients may – more or less easily – switch from their products/services to the ones offered by the related industries. In addition to existing substitutes, potential substitutes must also be addressed. What about new products/services that may emerge and threaten the industry? This factor is obviously most important in technology-related industries.

3.2.2 Characteristics of the clients*

What is the bargaining power of clients? Industries with a large number of small clients are usually less risky than ones with a small number of large clients. As they do not face price concessions demanded by their buyers, they are also more profitable. Both the end users (who are the final buyers) and the intermediaries (who are the actual clients) should be considered. If there are only a few intermediaries distributing the products/services, the industry may well be under pressure, in spite of the large number of end users. In other words, the distribution channels of the products/services should be carefully analyzed. Industries that sell their output in different countries with different types of distribution are usually less risky than average. That does not mean that they are more profitable, because a larger number of markets and/or types of distribution implies higher costs. Last but not least, the bargaining power of clients also depends upon the intensity of competition within the industry. How loyal are the clients? As keeping existing clients is often more profitable than trying to attract new ones, industries that benefit from strong client loyalty usually achieve higher profits with less risk.

3.2.3 Characteristics of the suppliers*

What is the bargaining power of suppliers? Industries with a large number of small suppliers are usually less risky than ones with a small number of large suppliers. As they can impose price concession to the suppliers, they are also more profitable. More generally, the degree of rivalry between suppliers should be assessed. Intense competition benefits the industry, through lower purchasing prices.

chapter 3 / page 6

How loyal are the suppliers? As keeping existing suppliers is often more profitable than regularly switching from one to another, industries that benefit from strong supplier loyalty usually achieve higher profits with less risk. It might be argued that this factor is much less important than client loyalty. That may be right for growth industries that need to finance their expansion. But note that the management of production tools – plant, computers, furniture etc. – has become a true challenge for most industries, probably as important as product innovation and client satisfaction. Here, products, clients and logistics are the three keys. And since the above production tools are quite often provided by suppliers (and not built by the industry itself), securing their loyalty – for instance by treating them as partners and not simply as providers – may well prove very helpful in the long run.

3.2.4 Characteristics of the labor force*

What is the bargaining power of workers? Industries where the labor market is highly unionized are usually considered as riskier and less profitable than others, because labor unions can engage in collective bargaining to increase the wages paid to workers. In other words, a significant share of the potential profits can be captured by the workforce at the expense of the shareholders. However, it should be acknowledged that industries (or countries) where labor unions hardly exist can, at the end of the day, prove riskier and less profitable than average because workers, being treated as nonentities, suffer from a lack of motivation. This could even lead, in some cases, to substantial social unrest. Another important element is the phase of the business cycle. How tight is the labor market? This also determines the bargaining power of workers. How loyal are the employees? As keeping existing employees is often more profitable than hiring new ones, industries that benefit from strong employee loyalty usually achieve higher profits with less risk.

3.2.5 Characteristics of shareholders (and of other capital suppliers)*

How loyal are the shareholders? Keeping existing shareholders is also more profitable and less risky than trying to attract new ones. Shareholder “volatility” tends to increase the cost of capital, which is really bad news for growth industries that need to finance their expansion. But it is also negative for more mature industries, even though they do not need to raise new funds. As you know, any increase in the return required by the shareholders translates into lower stock prices. Therefore, stock-option plans prove less effective, and company managements and employees must be compensated by higher wages, which decrease reported profits.

chapter 3 / page 7

3.2.6 Characteristics of the environment*

What are the side-effects of the business on the environment? Industries selling products that can be dangerous to human and/or animal health are obviously riskier than average. The ones that potentially or actually pollute the air, the ground and/or the water are also under pressure. In the long run, those industries may also prove less profitable, because they will be required to pay for the risk to the environment. Industries operating in regulated markets are usually riskier as well. Because they have been protected for a long time, they may be hit hard when the markets get liberalized. These industries are often more profitable than average, but their returns are likely to prove unsustainable.

chapter 3 / page 8

3.3 Macro factors*

The departure point for assessing the dynamics of the business cycle is the long-run sustainable real growth rate of the economy. Economies are constrained by the capital and labour available for production. The availability and growth, over time, of these production factors determine the long-term potential growth rate of the economy. Deviations in GDP growth from its potential rate are either unsustainable or suboptimal. Deviations from the potential rate build an output gap. The existence of an output gap in an economy, by definition, indicates disequilibrium within that economy and implies inflationary or deflationary forces within the system. Jon Gregory Taylor, Chief Investment Officer at Commonwealth Funds Management, an international investment firm based in Melbourne, Australia, has suggested – like Paul and Carole Huebotter – dividing the business cycle into four successive phases. Phase I: Expansion to Potential The beginning of phase I is identified by a trough in economic activity. The trough and subsequent upturn are normally heralded by the end of an inventory rundown, i.e. excess inventories have been worked off, and production has returned to near-normal levels. A resumption of normal production results in an increase in hours worked, incremental job creation and commensurate increases in disposable income and consumption. Depending on the severity of the downturn, monetary policy is often very accommodating at this stage of the cycle and characterized by a steep yield curve with short-term rates substantially below long-term rates. Phase I features the absorption of existing capacity in the system, but it is not associated with inflationary pressures because excess capacity exists in both the labour and capital markets at this juncture. In this phase of the cycle, corporate margins tend to expand sharply because greater utilization of fixed capacity results in lower marginal costs. Strong corporate profitability and sharply increasing earnings per share translate into strong stock market performance. Phase II: Growth above Potential When growth accelerates above a sustainable level, the output gap turns negative, capacity constraints begin to emerge and inflationary pressures begin to build within the system. Growth above potential generates inflationary concerns, which, if borne out by statistical evidence, causes weakness in the bond market as it begins to anticipate a policy response in the form of higher interest rates from the Federal Reserve Open Market Committee (FOMC). Early in this phase, a tug-of-war develops between earnings growth and expectations of higher inflation and higher interest rates. The emergence of capacity constraints does, however, lead to increased capacity. Investment in capital equipment accelerates as businesses endeavour to keep up with surging demand. During this phase of the growth cycle, capital goods producers tend to perform well. At the peak of the cycle, interest and inflation fears clearly win out over earnings growth, with the stock market being weak to falling.

chapter 3 / page 9

Phase III: Contracting Growth from Unsustainable Levels Even after growth or the business cycle has peaked, inflationary pressures persist. Firms continue to face capacity constraints that prompt upward pressure on the costs of production. In this phase, monetary policy is generally restrictive. A flat to inverted yield curve in the U.S. means repeated increases in the Fed funds rate during the period. Yet growth remains above its potential rate. In addition, long-term bond rates increase in response to higher inflationary expectations which are, in part, validated by the Fed raising the Fed funds rate. The environment of a tight monetary and credit policy will induce a pronounced downturn in the interest-sensitive segments of the economy, such as housing and capital spending. These two areas will lead the economy down. Phase IV: Contracting Growth to below Potential Often, growth cycles in the United States have been determined by inventory cycles. Downturns are precipitated by inventory imbalances with excess inventories prompting manufacturing slowdowns. The slowdowns are normally accompanied with declines or sluggishness in business capital investment as excess capacity increases and the need for and profitability of capital investment diminish. The resulting impact on employment and consumer and business confidence precipitates a widespread slowdown. From the four phases described above it can be derived that there are two major macro factors determining short-term business performance: GDP growth (or decline) and changes in interest rates. Jon Gregory Taylor has classified the various industries according to their sensitivity to these two factors. GDP Growth-Sensitive Sectors Basic and Industrial Materials Basic and industrial materials companies, as primary and intermediate producers, immediately benefit from a pickup in economic activity given their high fixed costs and long lead times in adding new or expanded capacity. Increases in activity and material demand are generally met out of existing production capacity with only marginal changes in variable costs. This improvement in asset utilization translates directly into earnings growth. Energy The performances of energy companies relative to the broader market are directly related to changes in energy prices and, to a lesser extent, to the performance of the economy. Energy companies tend to have high operating leverage – high fixed costs and relatively low variable costs – and they benefit directly from increased demand or higher energy prices. Industrial Cyclicals The S&P industrials index closely tracks the broader S&P index and shows minimal variation, as might be expected. Industries such as computers, technology, electronics, telecommunications and conglomerates are all sensitive to economic downturns when the economy dips below trend-growth levels.

chapter 3 / page 10

Transportation As might be expected, transportation companies are quite sensitive to changes in economic activity, given their high fixed capital costs and fixed capacity. As freight increases and idle capacity is utilized, a reduction in average costs will show up immediately. Conversely, a downturn in volume, caused by a decline in activity, immediately pushes up average costs because transport fleets must operate below capacity or stand idle. Capital Goods Capital goods spending is heavily influenced by actual orders as well as by changes in the level of capacity utilization. Rising rates of capacity utilization trigger investment in capital equipment while falling levels of capacity utilization result in a pronounced slowdown in business investment. Consumer Cyclicals The auto industry is extremely sensitive to changes in the economy and to disposable income. In large part, this is because of the leads and lags involved in production and the inventory control problem that constantly looms so large for the industry. Other consumer cyclical industries, such as household furnishings and appliances, are also sensitive to the economy in general, and to interest rates in particular given their impact on residential construction and new home purchases. Growth and Interest-Sensitive Industries Construction and Housing Residential construction is sensitive to both economic growth and the interest-rate environment. Growth, however, appears to exert the dominant influence. Interest-Sensitive Industries Banking and Financial Services Banks and thrifts are sensitive to both the level of interest rates and the shape of the yield curve, or the spread between short- and long-term interest rates. Loan demand is obviously influenced by the level of interest rates. Consequently, banks and thrifts tend to perform well in declining interest-rate environments. Insurance Insurance companies – both life and property/casualty insurers – are highly sensitive to both the growth and the interest-rate environment. Insurance companies, on average, have outperformed the market during periods of declining growth and have underperformed during periods of accelerating growth. Investment Banking and Brokers Investment banks and brokerage firms significantly outperform the market during periods of growth while underperforming, on average, during periods of declining growth. Robust economic performance underpins financial markets and corporate activity, providing a lucrative environment for these firms. The direction of interest rates, although important, is secondary to the overall performance of the economy and is exhibited the most in the relative performance of financial assets.

chapter 3 / page 11

Stable Growth/Defensive Stocks Stable or defensive stocks are stocks that tend to have a low sensitivity to changes in the overall economy. These stocks tend to underperform during periods of strong economic growth and to outperform during economic downturns. In general, the underlying companies have limited pricing power and incur margin erosion during inflationary periods, but they fare relatively well when inflation is low. This is because of the considerable resistance of consumers to price increases. Healthcare, Drugs and Cosmetics Healthcare, drugs and cosmetics stocks are classic defensive stocks in that they tend to outperform in a declining market. Healthcare stocks performed exceptionally well in both rising and falling macroeconomic environments. Defensive Consumer Industries Defensive consumer industries comprise stocks that have had steady performances with minimal swings in response to changes in the economy. Food, beverages, alcohol, tobacco and the companies that distribute these goods tend to outperform the market during downturns because consumer expenditures on those categories are income-inelastic. Utilities As regulated entities, utilities encounter serious resistance to rate increases and, consequently, underperform in growth and inflationary environments. That is, utilities find it difficult to pass on input cost increases because of regulatory constraints and the inherent time delays in price changes. Utilities therefore tend to underperform the broad market during periods of economic growth. As you may conclude from Taylor's analysis, all industries – perhaps with the exception of pharmaceuticals – are more or less sensitive to the state of the broad economy. Even the so-called “interest-sensitive” industries are in fact both growth and interest-sensitive. Banks, for instance, are faced with bad loans during recessions, which can offset the benefits of declining interest rates. And the so-called “GDP-sensitive” industries are also interest-sensitive. As regards nonfinancial industries, answering the following three questions should help you assess their sensitivity to the business cycle. Sales sensitivity What is the sensitivity of sales to GDP growth? This question is related to the characteristics of the products/services. Do they fulfil basic needs, like eating? Or do they correspond to investments that can be postponed, like buying a car? In the first case, sales sensitivity is low. In the second, it is much higher. Note that sales volatility can be due to changing volumes and/or changing prices. Once again, it depends upon industry characteristics. When the products/services are very uniform – if not identical – prices tend to react strongly to new market conditions. As the companies in the industry cannot differentiate themselves through their products, they are forced to compete with one other through price cuts.

chapter 3 / page 12

When the products/services are less uniform, price competition is also less intense. Some companies will gain market share thanks to the quality of their output, but at the industry level, volumes are likely to go down. Operating income sensitivity What is the sensitivity of operating income to sales growth? Operating income can be defined as sales less operating costs, which include all costs with the exception of interest paid and income taxes (and possibly other non-operating costs like exceptional losses incurred through the disposal of assets). Operating leverage refers to the level of fixed costs as a percentage of operating costs. Variable costs are those that rise or fall along with the production level. Fixed costs are those the firm incurs regardless of its production level. Note that non-operating costs such as exceptional gains and losses (due, for instance, to asset disposals), interest paid and income taxes are not taken into account at this level of the analysis. Operating leverage can be considered as an industry-specific factor, more than a company-specific one. Imagine you were an independent taxi driver. You could then not afford not to buy a car, or at least not to lease it. Your fixed costs – whatever your decision, to buy or to lease – would in any case be higher than the ones you would be faced with if you had chosen to become a writer. The relationship between operating income growth and sales growth can be formalized as follows:

Operating income growth in % = DOL · Sales growth in %

where DOL = Degree of Operating Leverage = 1 + Fixed operating costs

Operating income

Example Year 1 Year 2 Growth Sales 100’000 110’000 10% Variable costs 25’000 27’500 10% Fixed costs 45’000 45’000 0% Operating income 30’000 37’500 25%

DOL = 1 + 45,00030,000 = 1 + 1.5 = 2.5

Operating income growth = 2.5 · 10% = 25%

Net income sensitivity What is the sensitivity of net income to operating income growth? Net income can be defined – when ignoring exceptional gains and losses – as operating income less interest paid, and less income taxes. The level of indebtedness is, in principle, a company-specific decision. So we will address this issue in the section dedicated to balance-sheet factors (Part 3.5). Note, however, that the pressure exerted by the capital suppliers (the shareholders and the lenders) for optimising their risk/return leads – within a particular industry – to much more uniform debt-to-equity ratios

chapter 3 / page 13

than theory would suggest. It is a matter of profitability – some industries would never make enough money if they did not resort to high borrowing.

High indebtedness means higher risk for two reasons:

� The sensitivity of net income to GDP changes depends upon 1) the sensitivity of sales to GDP changes and 2) the proportion of total fixed costs (operating fixed costs and interest paid). So the higher the level of indebtedness, the higher the sensitivity of net income to GDP changes.

� Interest paid, a cost that reduces earnings, depends on 1) the level of indebtedness and 2) the level of interest rates. So the higher the level of indebtedness, the higher the sensitivity of net income to interest-rate changes.

Companies – or industries – with high debt-to-equity ratios are very vulnerable when the economy starts slowing down from its peak, while interest rates are still high. On the other hand, they achieve impressive earnings growth when the economy starts recovering from a trough, while interest rates are still low. Do not forget that, in addition to the fundamental effect (increase or decrease of the cost of debt, along with interest-rate rises or drops), interest-rate changes impact company valuations. This second effect is even more important than the first from the investor’s standpoint. A surge in interest rates would hit share prices much more because of the valuation effect than because of the fundamental effect. Income taxes have nothing to do with the industry-related factors. Basically, the tax rate depends upon the mix of countries in which a specific company operates and the tax optimisation system that it uses. In addition to GDP and interest rates, a third macro factor must be addressed, i.e. exchange rates. The major U.S. and European indices are dominated by multinationals, selling their products/services worldwide. Although these companies are international from an economic standpoint, they are still considered as American, British, German, French or Swiss depending on the location of their head office. This would have no impact if all the countries around the world had adopted the same currency. Although the trend is very clear (there are fewer and fewer currencies in use, and it may be imagined that sooner or later, the major currency blocs – the dollar, the euro and the yen – will enter a common currency system), companies are still faced with exchange-rate risks. There are basically two types of currency risk: Operating risk Most companies – whatever the industry – do business in more than one currency. As orders, deliveries, and payments usually do not occur at the same time, firms are exposed to the exchange risk if they bill their products in foreign currencies.

chapter 3 / page 14

Example Company X (reference currency = euro) gets an order from one of its American clients. The selling price of the product is EUR 10’000. At that time, the exchange rate of the U.S. dollar against the euro is just 1.00. So, Company X sets the price in dollars at USD 10’000. The delivery and billing is done one month later. Company X is glad because the dollar now trades at 1.05 against the euro. Which means that the value of the sale in euros has increased to EUR 10’500. This is the figure that Company X captures in its accounting system. The payment is received after two months. Company X gets USD 10’000 and converts this amount into euros. Unfortunately, the dollar has slumped to 0.95. So, the bank credits Company X’s account with only EUR 9’500. From an economic standpoint, Company X has lost EUR 500 (the difference between the price wanted, EUR 10’000, and the amount received, EUR 9’500). But from an accounting standpoint, it has lost more money, namely EUR 1’000 (the difference between the value of the bill, EUR 10’500, and the amount received, EUR 9’500). Those EUR 1’000 will appear as a loss in Company X’s income statement.

Conversion risk Many companies – whatever the industry – own assets (e.g. subsidiaries) abroad. Once, twice or four times a year, they must draw up their balance sheets. Consequently, they must convert the value of all their foreign assets (which are not for sale, it must be emphasized) into their reference currency. Since exchange rates are not fixed, even though the local-currency value of these assets would be unchanged, their value translated into the reference currency changes with time.

Example Company Y (reference currency = euro) owns a subsidiary in the U.S. At the end of last year, the value of this subsidiary was USD 1 million. The U.S. dollar was 1.10 against the euro. Hence, the value of the subsidiary in euros was EUR 1.1 million. This is the figure that Company Y reported in its last annual report. One year later, nothing has changed as regards the U.S. subsidiary. Its value in local currency is still USD 1 million. But the dollar has plummeted against the euro. It now trades at 0.85. Therefore, the value of the subsidiary in euros is down to EUR 850’000. Has Company Y really lost EUR 250’000? From the operating standpoint no, because 1) the value of the subsidiary in local currency has not changed and 2) the subsidiary has not been sold, and will not be sold in the near future. Hence, those EUR 250’000 will not appear as a loss in the income statement. However, since the total asset value of Company Y (with its subsidiary) has come down, this amount will be deducted from the shareholders’ equity.

As we have already highlighted, currency risk is not an industry-specific factor. There are local and multinational companies in all industries.

chapter 3 / page 15

3.4 Forecasting for companies in the industry*

Forecasting companies’ future results is a challenge, to say the least. So much so that many investment professionals have given up the idea of making earnings or cash flow estimates beyond the current year, or possibly the next year. Is it easier to make forecasts in some industries than others? Definitely yes. In fact, this issue is closely related to the industry characteristics described above. Characteristics of the products/services � Forecasting the results of maturity-stage companies is easier than predicting the ones of

start-ups or declining firms.

� Forecasting the results of defensive companies (those which sell products/services fulfilling basic needs) is easier than predicting the ones of cyclicals.

� Predicting the results of companies active in a uniform industry is more difficult than forecasting those of the ones selling more differentiated products/services.

� Predicting the results of companies offering easily-transportable products/services is more difficult than forecasting the ones of firms less exposed to international competition.

� Forecasting the results of companies that can protect their products/services through patents is easier than predicting the ones of firms that cannot.

� Predicting the results of companies that face competition from substitute products/services is more difficult than forecasting the ones of firms that do not.

Characteristics of the clients � Forecasting the results of companies with a large number of small clients is easier than

predicting the ones of firms with a small number of large clients.

� Forecasting the results of companies that benefit from client loyalty is easier than predicting the ones of firms that suffer from high client turnover.

Characteristics of the suppliers � Forecasting the results of companies with a large number of small suppliers is easier than

predicting the ones of firms with a small number of large suppliers.

� Forecasting the results of companies that benefit from supplier loyalty is easier than predicting the ones of firms suffering from high supplier turnover.

Characteristics of the labour force � Predicting the results of companies in highly unionized industries is, in the short run at

least, more difficult than forecasting the ones of firms in less unionized industries.

� Forecasting the results of companies that benefit from employee loyalty is easier than predicting the ones of firms suffering from high employee turnover.

Characteristics of the shareholders (and of other capital suppliers) � Forecasting the results of companies that benefit from shareholder loyalty is easier than

predicting the ones of firms suffering from high shareholder turnover.

chapter 3 / page 16

Note that shareholder loyalty depends a lot upon all the other company characteristics mentioned above. Moral of the story? “The riskier the company, the less loyal the shareholders. And the less loyal the shareholders, the riskier the company”. It sometimes becomes a true vicious circle. What about specific companies within the industry? Not surprisingly, their results tend to evolve in the same way, at the same time. All car makers benefit from an improvement in consumer confidence. All investment brokers get hit when investor sentiment turns negative. The more uniform the products/services offered by the companies in the industry, the more similar their earnings and cash flow growth. And conversely. Drug companies, for instance, may achieve quite distinct results, because their products are not identical. Which means that a better knowledge of company-specific fundamentals can add value. Furthermore, understanding individual firms’ characteristics is even more important if they are in the start-up phase, like most biotech companies. This is mainly because their current portfolio of products is not diversified, which means that the impact of new drug development is spectacular. As regards company-specific factors, you should try to identify the barriers to entry from which the firm benefits. Here are a few ideas, some of them being close to what has already been said. � To what extent is the product/service different from the competition’s? � To what extent does it fulfill proven customer needs? � How well known is it (brand awareness and brand loyalty)? � What is its market share? � What is the amount of capital required to replicate it? � To what extent is it protected by proprietary knowledge? � To what extent is it protected by patents, copyrights, etc.? � What is the critical mass necessary to have a competitive edge? � To what extent does the company control its distribution channels? Last but not least, we should not forget, as regards specific companies, the degree of risk arising from regulations, anti-trust laws, protectionism, litigation, fair competition issues, political instability and specific environmental and social aspects.

chapter 3 / page 17

3.5 Balance-sheet factors*

There are two major factors to be highlighted. The first is financial leverage, i.e. the interest-bearing debt to equity ratio. The higher the ratio, the higher the sensitivity of earnings to GDP changes. Let’s come back to the example we used in the macro factors section (2.3.3), and make an assumption regarding the level of interest paid (15’000) and the tax rate (40%).

Year 1 Year 2 Growth Sales 100’000 110’000 10% Variable costs 25’000 27’500 10% Fixed operating costs 45’000 45’000 0% Operating income 30’000 37’500 25% Interest paid 15’000 15’000 0% Income before taxes 15’000 22’500 50% Income taxes 6’000 9’000 50% Net income 9’000 13’500 50%

The relationship between net income growth and operating income growth can be formalized as follows:

Income before taxes growth in % = DFL · Operating income growth in %

As net income growth = Income before taxes growth, then:

Net income growth in % = DFL · Operating income growth in %

where DFL = Degree of Financial Leverage = 1 + Interest paid

Income before taxes

As regards our example:

DFL = 1 + 000'15

000'15 = 1 + 1 = 2

Net income growth = 2 · 25% = 50%

We could combine the degree of operating leverage and the degree of financial leverage into a single factor, to assess the sensitivity of net income to sales changes.

Year 1 Year 2 Growth Sales 100’000 110’000 10% Variable costs 25’000 27’500 10% Fixed costs* 60’000 60’000 0% Income before taxes 15’000 22’500 50% Income taxes 6’000 9’000 50% Net income 9’000 13’500 50% * fixed operating costs + interest paid

chapter 3 / page 18

The relationship between net income growth and sales growth can be formalized as follows:

Income before taxes growth in % = DL · Sales growth in %

As net income growth = Income before taxes growth, then:

Net income growth in % = DL · Sales growth in %

where DL = Degree of Leverage = 1 + Fixed costs

Income before taxes

As regards our example:

DL = 1 + 000'15

000'60 = 1 + 4 = 5

Net income growth = 5 · 10% = 50%

The second factor to be highlighted is working capital and cash flow. The company's solvency, i.e. its ability to pay back its short-term debt, must be assessed. Two ratios are widely used for assessing the risk of a cash squeeze:

Current ratio = Short-term assetsShort-term debt

Quick ratio = Short-term assets less inventories

Short-term debt

chapter 3 / page 19

3.6 Corporate strategy*

Assessing a corporate strategy is one of the most difficult tasks for investment professionals. First, most companies do not want to reveal their strategy in detail. That is understandable, since this factor is absolutely key to success. Why offer your business objectives to your main competitors? Nevertheless, since it is a key factor, analysts and portfolio managers must spend most of their time on this issue. Second, corporate strategy refers to management quality. As a capital supplier, when investing in a company, you implicitly give the company executives the power of investing your money in a discretionary way. So, before empowering the management, you had better check whether it is capable or not. But how to assess the competence of people whom you have probably never met? The best possible answer would be to make appointments with them. As they are likely not to accept (who, apart from investment banks, has ever met all the members of a management team?), and as you may not have enough time to investigate the company in so much depth, you will have to assess the management's quality through its past decisions and the information it passes on to its shareholders. Whatever your degree of access to the board of directors, you should address the following issues. To get answers to your questions, you might start by viewing the company's Website, before visiting the CEO, the CFO or, failing that, the Investor Relations Officer. Strategy Does management seem capable of working out a coherent strategy and achieving sustainable long-term growth?

� Consistency of the company's vision and mission statement. Do they fit with your own long-term view on the industry?

� Accuracy of the company's financial objectives. Are they measurable, i.e. are they expressed in figures, with a clear deadline?

� Adequacy of the company's values. Do they correspond to your own values and to your view on the way any business should be run to be successful in the long term? Does management take social and environmental aspects into account?

Decision-making process Does management seem capable of making suitable decisions, and implementing them in an effective way?

� Consistency of decisions. Do they fit with the company's vision, mission and values? � Timeliness of the decisions. Is their timing appropriate? � Communication of the decisions. Are they widely known and supported by staff? � Implementation of the decisions. Do they materialize almost naturally thanks to clear

operating procedures? � Outcome of the decisions. Do they actually help improve the company's resource

allocation?

chapter 3 / page 20

Monitoring Does management seem capable of closely monitoring its operations? Furthermore, does it seem capable of adapting to changing market conditions?

� Management information system. Is it effective? In other words, is management well informed about its own business (feedback from operating units) and about market developments (surveys conducted by the company's market research team)?

� Corrective action. Is it prompt and effective? In other words, after detecting gaps between its expectations and actual outcomes, does it rapidly make new – and suitable – decisions to take that information into account?

Media and investor relations Does management seem capable of keeping the press and the financial community informed of the company's developments?

� Press releases. Are they frequent and detailed? Does the company also communicate bad news in a transparent way? Does management willingly answer journalists' questions?

� Financial reporting. Is it frequent and reliable? Does management willingly answer the analysts', portfolio managers' and investors' questions?

chapter 3 / page 21

3.7 Valuations*

Here comes the dilemma. Should this section be the longest or the shortest of chapter 3? Many investment professionals argue that you should not use the same valuation techniques for assessing the fair price of companies operating in different industries. In other words, that you should use industry-specific tools for valuing banks, pharmaceuticals or technology stocks. If they are right, this section should be the longest of the chapter. But do analysts really use specific models for each industry? Definitely no. Admittedly, particular tools have been developed for valuing certain sectors, such as financials or high-growth stocks. But those tools are all based on the approaches developed in chapter 4. And anyway, are there theoretical foundations justifying differentiated approaches? No again. All shareholders – whatever the industry – own, by definition, a certain percentage of the firm's net assets. What is, from the theoretical standpoint, the most straightforward way to assess the value of the shareholders’ equity? Simply draw up a list of the firm's assets, and deduct the amount of debt from their total current value. Quite simple, isn’t it? The problem is that the value of some assets – especially intangibles – is very difficult to estimate, because there is no market for them. Consequently, investors are generally forced to appraise the value of their equity through the flow of funds the company is expected to generate over the years. Flows of funds can be analyzed from two standpoints. The first is the shareholders’ standpoint. Which operations lead to cash transfers between the company and them?

� Dividend payments � New issues � Share buybacks Therefore, the value of the shareholders’ equity should be appraised by 1) assessing the level of those cash flows in the future and 2) discount them back to their present value. If you ignore new issues and share buybacks, you get the well-known dividend discount model (DDM). The DDM has been criticized because it cannot deal with companies which do not pay any dividends. That is right if you suppose that these firms will never pay any dividends. However, if you think that Company X may start paying dividends from Year 5 (i.e. five years from now), then the DDM can be used to appraise the company's value. What about companies which will never pay any dividends? There are two possibilities. The first is that they will never pay any dividends, and never buy back any shares. In other words, they will never give any money back to shareholders. Why invest in such firms? These are probably start-ups that will never enter the consolidation stage, and go bankrupt before then.

chapter 3 / page 22

The second is that they will never pay any dividends, but buy back shares for tax purposes. Depending on the country, share buybacks may be a more effective way of returning money to shareholders than paying dividends. Some firms also combine the two ways of compensating their shareholders. Provided the firm keeps up – or will keep up, starting in 5 or 10 years – with a share buyback program (meaning that share buybacks are more or less predictable, which is actually more and more the case, especially in the U.S.), the dividend discount model could be adapted and converted into a “dividend and share buyback discount model” that would be usable for almost any stock. As regards new issues, you may forget them, because they can be considered as purely random. The second possible standpoint is the company's (or management's). Which operations – regardless of those concerning the shareholders and the lenders – lead to cash transfers between the company and its clients, suppliers, employees, and the tax authorities?

� Capital expenditures � Working capital changes � Cash flow from operations Using those flows of funds, instead of dividends, new issues and share buybacks, leads you automatically to the DCF model (and its variants, the EVA model and the CFROI model). Once again, from a theoretical point of view, there is no reason not to use the DCF model for all industries. Cash inflows and outflows are cash flows, whatever the sector. Therefore, the issue is not to know whether the DDM and the DCF models – which are just tools – are valid for valuing stocks in all industries. They are. The question is rather to know which valuation model is the easiest to implement for assessing the fair price of high-growth companies versus low-growth companies, or cyclicals versus defensive stocks, or financials versus nonfinancials. High-growth versus low-growth companies It is easier to appraise the value of start-ups and consolidation-stage companies through the DCF model than through the DDM, which applies better to maturity-stage firms. For single-product start-ups and troubled firms that may go bankrupt, option pricing models may be helpful. Cyclicals versus defensive stocks As for cyclicals, you should first normalize future dividends and cash flows, because business cycles are almost impossible to predict. You can then compute the present value of those normalized dividends (DDM) and cash flows (DCF), exactly in the same way as you would discount the forecasted results of a defensive stock. Apart from the normalization process, the methods to be used for both categories are the same. Financial versus nonfinancial firms The DDM model applies to both financial and nonfinancial firms. As regards the DCF model, it should be stressed that the use of the DCF model, as defined above, may be quite risky for valuing financials, because the cost of debt (one of the components of the discount factor, i.e. the WACC) is very likely to be underestimated (banks’ main source of financing is low-cost customer deposits raised through the retail bank, not borrowing in capital markets; in the case

chapter 3 / page 23

of insurance companies, very high provisions tend to distort the cost of debt downward). It would be better to forecast free cash flows to equity (i.e. free cash flow to the firm, as defined above, adjusted for the cash transfers between the shareholders and the lenders) and calculate their present value, so as to use the cost of equity instead of the WACC as the discount factor. There are a few specific methods for valuing banks and insurance companies, but it should be stressed, once again, that these particular techniques are just extensions of the standard ones. Last but not least, note that “the most straightforward way to assess the value of shareholders' equity”, i.e. the net asset value, is – generally speaking – a more reliable tool for valuing financial (banks, insurance firms, and also real estate and holding companies) than nonfinancial stocks.


Chapter 4

VALUATION MODEL OF COMMON STOCK


Table of contents

44.. VVaalluuaatt iioonn mmooddeell ooff ccoommmmoonn ssttoocckk 11

44..11 DDiivviiddeenndd ddiissccoouunntt mmooddeellss .................................................................................................................................................................................................................................... 11

44..11..11 ZZeerroo ggrroowwtthh mmooddeell ........................................................................................................................................................................................................................................................ 22 44..11..22 CCoonnssttaanntt ggrroowwtthh mmooddeell .......................................................................................................................................................................................................................................... 33 44..11..33 MMuull ttiippllee ggrroowwtthh mmooddeell ............................................................................................................................................................................................................................................ 66

44..22 FFrr eeee ccaasshh ff llooww mmooddeell .................................................................................................................................................................................................................................................... 77

44..22..11 TThhee rreeccoommmmeennddeedd ddiissccoouunntteedd ccaasshh ff llooww ffrraammeewwoorrkk ................................................................................................................................................ 77 44..22..22 OOtthheerr ddiissccoouunntteedd ccaasshh ff llooww ffrraammeewwoorrkkss...................................................................................................................................................................................... 88 44..22..33 FFoorreeccaassttiinngg ffrreeee ccaasshh ff lloowwss.............................................................................................................................................................................................................................. 99

4.2.3.1 Definition of free cash flow....................................................................................................... 10 4.2.3.2 Introductory examples ............................................................................................................... 11 4.2.3.3 Estimating the initial investment ............................................................................................... 12 4.2.3.4 The importance of tax deductions ............................................................................................. 12 4.2.3.5 Estimating residual value........................................................................................................... 13

44..33 EEVVAA,, MM VVAA,, CCFFRROOII ,, AAbbnnoorr mmaall eeaarr nniinnggss ddiissccoouunntt mmooddeell** .................................................................................................................... 1144

44..33..11 EEccoonnoommiicc VVaalluuee AAddddeedd aanndd MMaarrkkeett VVaalluuee AAddddeedd** .............................................................................................................................................. 1144 4.3.1.1 Introduction* ............................................................................................................................. 14 4.3.1.2 Definitions*............................................................................................................................... 14 4.3.1.3 Valuation with EVA* ................................................................................................................ 16 4.3.1.4 Performance Measurement with EVA* ..................................................................................... 23 4.3.1.5 Conclusions* ............................................................................................................................. 24

44..33..22 CCaasshh FFllooww RReettuurrnn oonn IInnvveessttmmeenntt** .................................................................................................................................................................................................... 2244 4.3.2.1 Definition*................................................................................................................................. 24 4.3.2.2 Valuing a firm*.......................................................................................................................... 27

44..33..33 AAbbnnoorrmmaall eeaarrnniinnggss ddiissccoouunntt mmooddeell** .............................................................................................................................................................................................. 2299 4.3.3.1 Valuing cyclical companies*..................................................................................................... 29 4.3.3.2 Valuing start-ups* ..................................................................................................................... 30

44..44 MM eeaassuurr eess ooff rr eellaatt iivvee vvaalluuee.............................................................................................................................................................................................................................. 3322

44..44..11 PPrriiccee//EEaarrnniinngg rraattiioo aanndd vvaalluuaattiioonn........................................................................................................................................................................................................ 3322 4.4.1.1 General considerations .............................................................................................................. 32 4.4.1.2 Interpretation ............................................................................................................................. 33 4.4.1.3 Empirical accuracy of the method ............................................................................................. 34 4.4.1.4 Problems of the P/E ratio valuation method .............................................................................. 36

44..44..22 PPrriiccee// bbooookk vvaalluuee rraattiioo ........................................................................................................................................................................................................................................ 3377 44..44..33 PPrriiccee// ccaasshh ff llooww rraattiioo.............................................................................................................................................................................................................................................. 3377 44..44..44 PPrriiccee // ssaalleess rraattiioo.......................................................................................................................................................................................................................................................... 3388

* final level

chapter 4 / page 1

4. Valuation model of common stock Firms finance new projects, acquisitions, and working capital requirements by issuing claims against the income generated by these investments. These claims include, among others, bonds and common stocks. The return on these claims is in the form of dividends, interest, and principal repayments. These future cash flows determine the value of the securities. Knowing how to value corporate securities is important for both the firm's management and investors. Current and prospective shareholders may want to compare their valuation of a firm's securities with actual market prices. Equally important, managers need to understand how their investment and financing decisions are likely to affect security prices. Furthermore, firms can be valued by separately estimating the values of their debt and their equity.

4.1 Dividend discount models

When an investor acquires a share of common stock, he/she receives two types of return:

1. all the future cash dividends, and 2. the price at which he/she sells the share at the end of the holding period. The current price of a share is thus the present value of these cash flows added together, or

P0 = sum of discounted, expected future dividends + discounted, expected future sale price

( )( )

( )T

TT

1ttt

0 )k1(

PE

k1

DivEP

++

+=∑

=

where: P0 stock price in period t = 0

E(.) expectations operator Div t dividend in period t PT future proceeds from stock sale kE discount rate (assumed here to be constant over time)

The maturity of shares is not fixed. At its limit, T will be infinity, in which case the present value of the proceeds from the sale of the stock will approach zero. Thus, the present price of a stock is determined exclusively by its discounted, expected future dividends, i.e. the present value of the expected future dividend stream. This leads us directly to the following general pricing formula

( )( )∑

∞

= +=

1ttt

0k1

DivEP

The above expression is the dividend discount model. In this form, the pricing formula for shares is correct, but not very practical. To make it more useful, some additional restrictions need to be imposed.

chapter 4 / page 2

4.1.1 Zero growth model

Suppose dividends are not expected to grow at all, but to remain constant forever. Assume that dividends expected in future years are equal to some constant amount - that is,

Div1 = Div2 = ... = Div

The dividends of a zero growth stock therefore may be thought of as a perpetuity. By rearranging the above formula, we get

P0 = k

Div

Example: Jelmoli Jelmoli bearer share paid the following (non-adjusted) dividends in 1987-1989 (on the 30th of March of each year):

Year 1987 1988 1989 Dividend 35 CHF 35 CHF 35 CHF

Assume the discount rate of 10%. Immediately after the stock went ex-dividend in 1989, the theoretical price would have been:

P0 = 0.1

35 = 350 CHF

In fact, the stock sold for 2'350 CHF at the time. One problem in our calculation might be that we simply assumed the discount rate. To avoid this assumption, we can use the 1988 figures to calculate an appropriate discount rate. Since we know that PApril 1988 = 2'300 CHF Div = 35 CHF we can use the pricing formula to calculate the discount rate

kE= Div

P0

= 35 CHF / 2'300 CHF = 1.5%

If this is the appropriate discount rate, then the theoretical price of the stock in 1989 should be 35 CHF / 0.015 = 2'300 CHF. (As it turns out, there was no need to compute anything. The model predicts that, if discount rates and dividends do not change, the price will not change either: the 1989 price will equal the 1988 price). Our computation of the implied discount rate shows that the zero growth model does not do well in the case of Jelmoli. It yields a discount rate that is far below the yield to maturity on Swiss government bonds at the time.

chapter 4 / page 3

In principle, this model has the following implications:

• If discount rates do not change, than the predicted price equals previous year's price; • If discount rates change, than the predicted price will differ from the previous year's price,

but there is need to calculate the appropriate discount rate to compute it; • The model is applicable even if previous years price is not available (in other words, if the

stock is not traded), provided the appropriate discount rate is known or calculated. The model can be used as shown above to calculate the discount rate for traded stocks in similar risk classes and apply that rate to the dividend stream to be valued. The following example illustrates this case.

Example: Grands Magasins Suppose you want to compute the stock price of “Grands Magasins”, a privately held corporation. The firm has paid a constant dividend of 40 CHF over the past several years. We can make this calculation by taking the example of “Loeb”, assuming that Loeb pays a constant dividend and is in the same business as Grands Magasins. We apply the zero growth model to Loeb and get a discount rate of 8%, which means that the theoretical value of Grands Magasins' stock is 40 CHF / 0.08 = 500 CHF.

4.1.2 Constant growth model

Empirically, almost all firms pay a dividend each year. In fact, firms go to great pains to prevent having to cut that dividend. If anything, they strive to increase it every year. The zero growth model loses a lot of its appeal. As an alternative, we can derive a pricing model under the assumption that dividends increase at a constant growth rate every year. If the dividend grows at a constant rate of g, we get Div1 = Div0 ⋅ (1+g) Div2 = Div1 ⋅ (1+g) = Div0 ⋅ (1+g)2 ... Divt = Div0 ⋅ (1+g)t Using this method of estimating future dividends in the general valuation formula

( )( )∑

∞

= +=

1ttt

0k1

DivEP

we get

( )( )

PDiv g

k

t

E

tt

00

1

1

1=

⋅ ++=

∞

∑

With the help of some simple algebraic transformations, we can rearrange this formula as written below. This is the so-called constant dividend growth model (or J.B. Williams model).

( )( ) ( )P

Div g

k gDiv

k gE E0

0 11=

⋅ +−

=−

chapter 4 / page 4

Since

Div1 = EPS1 ⋅ π

where Div1 Dividend in period 1 EPS1 Earnings per share in period 1 (earnings are cash earnings) π Payout ratio 1 – π Earnings retention rate

we can substitute

( )PEPSk gE

01= ⋅−

π

Note that, if the return-on-equity is r, we can write

( )EPS EPS r EPS1 0 01= + ⋅ − ⋅π

since ( )1 0− ⋅π EPS are the reinvested earnings. Consequently

( ) ( )EPSEPS

g r1

0

1 1 1= + = + ⋅ − π

which implies

( )g r= ⋅ −1 π

We can therefore substitute for g in the valuation expression and write

( )P

EPS

k rE0

1

1= ⋅

− − ⋅ππ

This is commonly referred to as the Gordon-Shapiro model.

Example: Nestlé Bearer Share (1989) The following table shows the adjusted dividends Nestlé paid on its bearer shares (in CHF):

Year 1984 1985 1986 1987 1988 1989 Dividend 133.29 142.32 142.32 147.23 171.76 175

On the basis of the J.B. Williams model, what is the theoretical stock price of Nestlé bearer share 1989? a) To estimate the historical growth rate of Nestlé's bearer share dividends, we calculate the

arithmetic average of the one-year growth rates. We know that

Div1 = Div0 ⋅ (1+g) The dividend growth rate between 1984 and 1985 can be calculated as

g = −142 32133 29

1..

= 6.77%

chapter 4 / page 5

If we do this for every year, in the end, we get 5 one-year growth rates for which we can calculate the arithmetic average (g)

%75.5=5

89.1+66.16+45.3+00.0+77.6=g

b) To estimate the appropriate discount rate, we can use the formula for the year 1988 (Nestlé

pays its dividends at the end of May). Since

• Share price Nestlé June 1988 = 8'445 CHF (historical data)

• dividend growth rate g = 5.75% (from above)

( )( )gk

g1DivP 0

0 −+= or

( )0575.0k

0575.176.1718445

−⋅= which yields

0575.08445

0575.176.171k +⋅= = 7.9%

c) Now we can use these figures to estimate the theoretical stock price for 1989:

( )0575.0079.0

0575.1175P0 −

⋅= = 8'607 CHF

In fact, the stock price in June 1989 was about 7'150 CHF.

As before, we could have reached this conclusion with less effort and more thought. Remember:

( )

( )PDiv g

k gE0

0 1=

⋅ +−

and

( ) ( )P

Div g

k g

Div g

k gE E1

1 021 1

=⋅ +−

=⋅ +

− or, in other words,

P1 = P0 ⋅ (1 + g)

In the case of Nestlé (denoted here by P

-1, Nestlé's 1988 bearer price of 8'445 CHF), we could have

computed

P0 = P-1 ⋅ (1 + g) = 8'445 ⋅ 1.0575 = 8'931 CHF. Note that 8'931 CHF does not correspond exactly to the 8'607 CHF we found above. The difference in the two results is due to the fact that the 1989 dividend payment of 175 CHF is not exactly equal to the 1988 dividend payment times 1.0575 (171.76 ⋅ 1.0575 = 181.64 CHF). If the dividend actually increased by 5.75% from 1988 to 1989, we would have obtained

)0575.0079.0(

0575.176.171P

2

0 −⋅= = 8'934 CHF

chapter 4 / page 6

The constant growth model can be used in the following situations:

• to identify mispriced stocks (if you believe in the model) • to value non-traded stocks. If you are going to use it, keep the following guidelines in mind:

• If you think dividend growth and discount rates have not changed, the predicted price equals last year's price times one plus the rate of growth of dividends;

• If you think discount rates have changed, you can use the model, but you need to determine both the appropriate discount rate and the appropriate rate of growth of dividends;

• If you don't have last year’s price (in other words, if the stock is not traded), you can use the model the way we did to infer the discount rate for traded stocks in similar risk classes and apply that to the dividend stream under analysis.

4.1.3 Multiple growth model

Firms typically go through life cycles, with growth varying with the age of the firm. As growth varies, so do dividends. The multiple growth model allows dividends to follow different growth patterns. The analyst could for instance forecast the first T dividends separately and assume a constant dividend growth model thereafter. He might be able to forecast individual near-term dividends with some precision; for later dividends, he might just be able to make an average prediction. The model is best demonstrated with an example.

Example: Nestlé (1993) The following table lines up (in CHF) four historical dividends figures (1990-1993), along with an analyst's expectations of Nestlé's dividends per share of registered stock for the next three years (1994-1996).

Year 1990 1991 1992 1993 1994 1995 1996 Dividend 20 21.5 23.5 25 27 30 33

Using the four historical dividends, we calculate the most recent dividend growth rate g. (As in the example before, we calculate average one-year dividend growth).

g =+ +7 50% 9 30% 6 38%

3

. . . = 7.73%

Here, we assume that the dividend will keep growing at a constant rate of 7.73% after year 1996. Therefore, the expected dividend in 1997 is 33 CHF · 1.0773 = 35.5 CHF. To calculate the discount rate, we rely on the 1993 data, and arrive at a stock price at the end of 1993 of approximately 1'320 CHF. Employing the constant growth model, we get

)0773.0k(

)0773.01(25 CHFCHF 1320

−+⋅

= or

kE = 9.77%

With these figures, we can now calculate the theoretical price of Nestlé registered stock as follows

( )P0 2 3 3

271 0977

30

10977

33

1 0977

35 5

10977 0 0977 0 0773= + + +

⋅ −. . .

.

. . . = 1'390 CHF

Note that the stock price of Nestlé registered stock in mid 1994 was approximately 1'200 CHF. There are alternative methods for computing stock values - one of them entails computing firm values (via the cash flows the firm can be expected to generate) and deducting the market value of debt.

chapter 4 / page 7

4.2 Free cash flow model

4.2.1 The recommended discounted cash flow framework

To use discounted cash flow (DCF) analysis to value a stock is just the same as it is for calculating the present value of any other asset. We discount the cash flows by the return that can be earned in the capital market on securities of comparable risk. Therefore, we need a framework that answers the following questions:

• How are the cash flows defined? • What are the relevant cash flows? • What is the appropriate discount rate? • What is the most appropriate method of forecasting the future cash flows? • What is the appropriate period for which the cash flows can be forecasted? • How can we compute the market values? To estimate the firm value, we can either estimate the market value of the debt and the market value of the equity separately and add them up. Alternatively, we can estimate the firm value directly by discounting the firm's future cash flows. To estimate the value of equity, we can simply discount the cash flows accruing to equity-holders (dividends and share repurchases). The problem is that this procedure involves less explicit information about the sources which lead to value creation, making a sensible sensitivity analysis more difficult. Consequently, we prefer to value the firm by discounting its forecasted future cash flows. The market value of the equity can then be computed by subtracting the market value of the debt from the market value of the firm. The three basic steps of the DCF valuation approach are the following: a) Estimating free cash flows (FCFs)

FCF is equal to the after-tax operating earnings of the company plus non-cash charges, less investments in net working capital, property, plant and equipment, and other assets. It does not include any financing-related cash flows such as interest expense or dividends. It reflects the cash flow available to all providers of capital (debt and equity). A more formal definition is provided below. One may ask the question why we have been talking about ‘cash flows’ so far and are now suddenly using the term ‘free cash flows.' The question is legitimate. The reason is that up to now we have been talking about the discounted cash flow approach in general. The emphasis was on the general principles, not on the technical details. To do the actual valuations, one cannot ignore these details. As we will show directly, with the discounted cash flow approach, we always use the same specific definition of cash flow: free cash flow.

b) Estimating the appropriate discount rate To be consistent with the cash flow definition, the discount rate reflects the opportunity costs of all providers of capital weighted by their relative contribution to the total capital of the company (Weighted Average Cost of Capital: WACC).

chapter 4 / page 8

c) Determining forecast horizon and terminal value The value of the business is separated into two components, during the explicit forecast period and after the explicit forecast period. It is usually possible to make accurate cash flow forecasts during the explicit forecast period. Thereafter, this task becomes increasingly difficult or completely impossible. Nevertheless, we have to find ways to determine the firm's value after the explicit forecast horizon. This value is called terminal value or continuing value.

d) Treat inflation consistently Competition tends to depress output prices over the life of a product. Variable costs tend to increase in time. Free cash flow projections should reflect these considerations. Care should be taken, however, that, if these projections are in nominal terms, they should also be discounted with nominal rather than real (= nominal rates net of expected inflation rates for the period under consideration) rates. Working with nominal values is generally simpler. First, interest rates are quoted in nominal terms. Second, management is accustomed to thinking in nominal terms.

Table 2-1 shows an example of the principles of the DCF valuation approach.

Year

Free Cash Flow

Discount factor @ 20%

Present value of free cash flow

1998 15 CHF 0.8333 12.5 CHF 1999 22 CHF 0.6944 15.3 CHF 2000 31 CHF 0.5787 17.9 CHF 2001 35 CHF 0.4823 16.9 CHF 2002 42 CHF 0.4019 16.9 CHF Continuing value* 210 CHF 0.4019 84.4 CHF Value of operations 163.9 CHF – Debt value** –50.0 CHF Equity value 113.9 CHF

* calculated as 42 CHF / 0.2 = 210 CHF ** assumed

Table 4-1: DCF approach: an example

4.2.2 Other discounted cash flow frameworks

There are valuation principles other than the DCF framework. One approach is to work with pre-tax instead of after-tax cash flows. Working with pre-tax cash flows involves discounting cash flows with a pre-tax discount rate (which is higher than the corresponding after-tax discount rate). However, after-tax cash flows are not simply pre-tax cash flows adjusted by the tax rate. This is because taxes are based on accounting figures. For example, the tax benefit of purchasing a machine is received in a different period from when the machine is paid for. So it is virtually impossible to perform a valid discounted cash flow analysis using the pre-tax approach.

chapter 4 / page 9

Second, some people recommend the use of an option-pricing framework to estimate the value of a firm. The justification for this approach is that investment policy is not fixed and unchangeable. Managers revise their investment strategy as they learn about the market, as new technologies become available, as uncertainty about input and output prices is resolved, etc. Ex-ante, the possibility of adjusting one's investment policy (the possibility of expanding or contracting, postponing investment decisions, switching from one technology to another, etc.) represents options that cannot be valued with the standard DCF approach. To handle this valuation problem, option pricing models are necessary. In what follows, we will ignore this interesting aspect of investment policy and focus instead on investment activities without option characteristics. To value these simpler activities, we strongly recommend using the DCF approach. So far, we have talked about the appropriate valuation framework in general. This is, however, not sufficient for actual valuation problems. We will therefore now deal with the technical details of real-world valuation problems. In the next section, we start by determining the relevant free cash flows.

4.2.3 Forecasting free cash flows

Forecasting free cash flows involves two different aspects. First, free cash flows have to be defined so that everybody is talking exactly about the same thing. We will provide you with the definition of free cash flows in the next section. In section 4.2.3.2 we will give you a few very simple examples of how free cash flows have to be computed. The second, and probably more difficult aspect of forecasting free cash flows is to determine which cash flows are relevant to the valuation at all.

chapter 4 / page 10

4.2.3.1 Definition of free cash flow Free cash flows (FCF) are defined in the following table:

Earnings from operations before interest and taxes (EBIT) – Taxes (calculated as EBIT ⋅ marginal tax rate) + non cash relevant expenses (depreciation, provisions for doubtful debt, etc.) – non cash relevant revenues (adjustments for currency changes, etc.) = Gross cash flow1 – Changes in net working capital2,3 – Investment outlays (buildings, equipment, etc.)4,5 = Free cash flow from operations6

Table 4-2: Definition of free cash flows

Net working capital is defined as current assets (cash + receivables + inventories) minus payables. Financing considerations (interest and dividend payments, debt and equity issues, debt repayments, equity repurchases, etc.) should not be taken into consideration since they represent the use of free cash flow. Given its definition, free cash flow is the amount of money available to the providers of capital to the firm. Firm value (the value of the firm’s total capital) can therefore be computed by discounting projected future free cash flows with the cost of total capital. If we were interested in valuing only equity, instead, we could compute residual cash flows (i.e., free cash flows minus all net payments to the providers of capital other than equityholders) and discount them at the cost of equity.

1 Source: COPELAND Th., KOLLER T. and MURRIN J., 1991, “Valuation: Measuring and Managing

the Value of Companies”, John Wiley. 2 These changes can be positive or negative. Increases in net working capital represent cash drains and

should be deducted; decreases represent liquidations, or cash inflows, and should be added. 3 The item (Gross cash flow – Changes in net working capital) is occasionally defined as “Cash flow from

operations ”, (Working capital exclusive of cash balances), see STICKNEY C.P. and WEIL R.L., 1994, “Financial Accounting”, p. 229.

4 Also known as “Cash flow from investing”, see STICKNEY C.P. and WEIL R.L., 1994, “Financial Accounting”, p. 217.

5 Again, investments can be positive or negative. Positive investments are increases in fixed assets (and should therefore be deducted), negative investments are liquidations of assets (and should therefore be added).

6 Also known as “Operating free cash flow”.

chapter 4 / page 11

4.2.3.2 Introductory examples Example: Paintball Company Consider the following investment opportunity for Paintball Co.

Initial Investment 100'000 CHF Annual Cash Revenues 50'000 CHF Annual Operating Costs (incl. depreciation) 35'000 CHF Life 10 years Salvage Value 0 CHF Depreciation for Tax Purposes 10'000 CHF a year Tax Rate 40% Cost of Capital 10%

How can we calculate the value of this investment project? Solution: In a first step, we calculate the relevant free cash flows (FCF) of the project. They are the same for years 1 to 10. We have FCF = Revenues – costs (incl. depreciation) – taxes + depreciation FCF = 50'000 – 35'000 – taxes + 10'000 = 50'000 – 35'000 – (50'000 – 35'000) · 0.4 + 10'000 = (50'000 – 25'000) · (1–0.4) + 10'000 · 0.4 = 19'000 CHF. Hence, the NPV of the project is: NPV = –100'000 + 19'000 ⋅ PVIFA10,10 = –100'000 + 19'000 ⋅ 6.1446 = 16'747 CHF where: PVIFA 10,10 (=Present Value Interest Factor of a ten-year Annuity at 10%) is the factor

typically used to value annuities. PVIFA is available from tables. Example: Black versus Greene Mr. Black and Mr. Greene are planning to manufacture a new product. The initial investment is 3'000'000 CHF. Mr. Black, an accounting expert, has prepared the following cash flow projections for the project (in 1'000 CHF):

1998 1999 2000 2001

Net Sales 5'500 6'400 7'000 7'000 ./. Cost of Goods Sold –3'000 –3'300 –3'500 –3'500 ./. Depreciation –800 –700 –600 –500 = Gross Profit 1'700 2'400 2'900 3'000 ./. Selling and Administrative Expenses –700 –690 –680 –680 = Net Income before Taxes 1'000 1'710 2'220 2'320 ./. Taxes –400 –710 –820 –820 = Net Income 600 1'000 1'400 1'500

Bills and taxes are paid promptly. Sales are all on credit; payments for 50% of sales will be received the same year, the remaining the following year. The appropriate discount rate for the project is 20%. After 2001, the project is worthless. Having considered these figures carefully, Mr. Black concludes that the investment is unprofitable, because it has a negative net present value (NPV):

NPV (Black) = − + + + + = −3 000 000600 000

12

1 000 000

12

1 400 000

12

1 500 000

12271 990 7

2 3 4' '

'

.

' '

.

' '

.

' '

.' . CHF

chapter 4 / page 12

Mr. Greene disagrees. Unable to reconcile their differences, the two gentlemen hire you as a consultant. What do you recommend? Solution: As in the example of Paintball, we first have to identify the relevant free cash flows. Cash inflows have to be computed according to the historical pattern. Since 50% of the sales are paid one year later, we will have some cash inflows in the year 2002 (50% of the 2001 sales, or 3.5 Mio. CHF). Second, since we do not have any information to the contrary, we have to assume that the stated tax figures are correct. The following table shows the estimated free cash flows (in 1'000 CHF):

1998 1999 2000 2001 2002 Cash Receipts 2'750 5'950 6'700 7'000 3'500 ./. Cost of goods sold –3'000 –3'300 –3'500 –3'500 ./. Selling and adm. expenses –700 –690 –680 –680 ./. Taxes –400 –710 –820 –820 = Free Cash Flows -1'350 1'250 1'700 2'000 3'500

Given the initial outlay of 3 Mio. CHF, the net present value of the project is

NPV = − − + + + + =30000001350000

12

1250000

12

1700000

12

2000000

12

3500000

122 3 4 5' '' '

.

' '

.

' '

.

' '

.

' '

. 97’929.5 CHF

Consequently, the project is worth undertaking.

4.2.3.3 Estimating the initial investment Make sure that you take the initial investment into account, the cost of placing the necessary assets into service, any increase in net working capital, the net proceeds from the sale of existing assets, and any tax considerations (investment tax credits, taxes on recapture of depreciation, capital gains taxes, etc.).

4.2.3.4 The importance of tax deductions Tax deductions can be important considerations in valuing acquisition targets. What follows shows an example, although it would not be acceptable under most current tax codes.

Example: MP Inc. You own a company, ABC Inc., which is expected to earn a taxable income of 60'000 CHF for the foreseeable future. The tax rate is 48%. You are considering buying another company, MP Inc., with the following projected cash earnings before taxes: Year 1 –20'000 CHF Year 2 –20'000 CHF Year 3 40'000 CHF After 3 years, MP Inc. is worthless. MP Inc. also has an accumulated loss of 30'000 CHF which it can deduct from taxable income in year one or any subsequent year for a maximum of 7 years. The cost of capital of MP Inc. is 10%. What is the maximum amount of money you are willing to pay to take over MP? Solution: The value of the MP Inc. stems primarily from the tax savings it generates for your own firm. In the first year, you don't have to pay full taxes on your taxable income of 60'000 CHF since you can deduct MP's operating loss (20'000 CHF) as well as the accumulated loss of 30'000 CHF. Overall, you don't have to pay taxes on the combined total of 50'000 CHF. This yields tax savings of:

Tax savings by ABC (1) = 50'000 ⋅ 0.48 = 24'000 CHF

chapter 4 / page 13

At the same time, MP incurs an operating loss of 20'000 CHF. The net cash flow in year 1 to the acquirer, ABC Inc., therefore equals 24'000 – 20'000 = 4'000 CHF. In year two, ABC Inc. can again save taxes of 20'000 ⋅ 0.48 = 9'600 CHF. Nevertheless, MP Inc. incurs an operating loss of 20'000 CHF. Taken together, the net cash flow of year two to the acquirer, ABC. Inc., is 9'600 – 20'000 = –10'400 CHF. And finally in year 3, MP Inc. generates an after-tax cash flow of 40'000 ⋅ (1 – 0.48) = 20'800 CHF. The maximum you should therefore be willing to pay is:

NPV = 4'000 ⋅ 1.1-1 –10'400 ⋅ 1.1-2 + 20'800 ⋅ 1.1-3 = 10'668.7 CHF

4.2.3.5 Estimating residual value Residual value is either the residual cash flow from the project, a salvage value, or the value of the cash flow we could obtain from investing the project's resources in alternative uses.

chapter 4 / page 14

4.3 EVA, MVA, CFROI, Abnormal earnings discount model*

4.3.1 Economic Value Added and Market Value Added*

4.3.1.1 Introduction* The EVA Financial Management System was pioneered by Stern Stewart & Co., a global consulting firm that specializes in helping client companies to measure and create shareholder wealth. It is a consistent performance measurement and valuation tool and is also the basis for a value based incentive plan. Every value-based management intends to increase the wealth of its shareholders. This wealth can be seen as the difference between the actual market value of a company minus the money the providers of capital have paid in historically. Stern Stewart calls this difference Market Value Added, or MVA. MVA, though, is not a manageable measure. It depends on the market expectations and fluctuates daily. Operating managers need a day-to-day periodic measure that guides them to maximize MVA. This is where EVA comes into play. Mathematically, MVA can be expressed as the present value of all future EVA. Managing for a higher sustainable EVA is therefore managing for a higher MVA and, ultimately, for a higher share price. EVA, or Economic Value Added, is nothing else than a periodic profit after taking into account the opportunity cost of the capital invested in the operating business. This section demonstrates the two major applications of EVA: Valuation (ex ante view, see 4.3.1.3) and performance measurement (ex post view, see 4.3.1.4). But before discussing valuation and performance measurement, we will define a few important terms.

4.3.1.2 Definitions* MVA is defined as follows:

Market Value of the Firm (market value of debt + equity) – Invested Capital = Market Value Added (MVA)

= Present Value of future EVA The market value is the observable market capitalization of the firm (if the firm is traded) plus the actual value of any interest bearing debt plus the market value of any financing vehicles that are hybrid forms of debt and equity, such as preferred stock or convertibles. Invested capital is an accounting number. It corresponds to the amount of money all investors (debt and equity investors) have historically invested in this company (net of depreciation). For equity, this investment can take the explicit form of an IPO or a seasoned equity offering or the implicit form, where net income will be reinvested in the company that otherwise could be paid out as dividends.

chapter 4 / page 15

EVA is defined as a Net Operating Profit After Tax (called NOPAT) minus a charge for the invested capital (called capital charge).

Earnings before interest and tax (EBIT) – Taxes (tax rate x EBIT) = Net Operating Profit After Taxes (NOPAT) Invested Capital (book value of debt + equity) x Weighted Average Cost of Capital (WACC) = Capital Charge Net Operating Profit After Taxes (NOPAT) – Capital Charge = Economic Value Added (EVA)

In determining NOPAT, all financing related line items (such as interest expense) are ignored. It is therefore a pure operating profit that is not influenced by the capital structure choice. The invested capital is usually determined by the book value of net assets, i.e. fixed assets plus net working capital (net working capital is defined as current assets minus current liabilities). Of course, this is equivalent to book equity plus interest bearing debt. The cost of capital is defined as the Weighted Average Cost of Capital (WACC). Since capital is defined as debt plus equity, the corresponding cost of capital has to incorporate both sources of capital. WACC is therefore defined as:

ED

EEquityofCost

ED

DRate)Tax(1DebtofCostWACC

+×+

+×−×=

It is important to note that the weights (D stands for Debt, E stands for Equity) should correspond to market values of debt and equity. The market value of debt can usually be approximated with its book value. The book value of equity, on the other hand, is typically much different from its market value. Here, we run into a problem of circularity. We need a market value based WACC as the discount rate to estimate the market value itself. This is not only an EVA problem but it’s the same circularity if you value firms with the DCF approach (Discounted Cash Flow approach). The typical solution to that is to use a target capital structure for the weights (still, the target has to be expressed in market value terms). The cost of equity is an opportunity cost. It is estimated with a capital market model such as the Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT). The cost of debt is an opportunity cost as well. It can be approximated either by the CAPM, by the yield to maturity on the outstanding loans or alternatively, especially if the debt is not traded, by the sum of the risk free rate plus a risk premium based on the rating of the firm. Because of the tax deductibility of interest payments, the cost of debt is taken after tax.

chapter 4 / page 16

4.3.1.3 Valuation with EVA* 4.3.1.3.1 Valuation of an investment project* As stated above, the capitalized future EVA of a given investment project corresponds to the MVA, which is exactly the net present value. We want to show this with an example: Consider the following investment opportunity: Initial investment is 100. The project generates after-tax free cash flows in the following two years in the amount of 100 each. There will be no salvage value left after two years. What is the NPV of this project with a discount rate of 10%? NPV = - 100 + 100 / 1.1 + 100 / 1.12 = 73.55 To use the EVA approach we need NOPAT and a balance sheet to calculate the yearly EVA. NOPAT is nothing else than free cash flow minus depreciation. Since the acquired asset has no salvage value, it has to be depreciated over the two years (linear, by assumption). Based on these assumptions, we get the following numbers:

Year 1 Year 2 Free Cash Flow 100 100

– Depreciation 50 50 = NOPAT 50 50

Invested Capital (at the beginning of the year)

100 50

× Weighted Average Cost of Capital 10% 10% = Capital Charge 10 5

NOPAT 50 50

– Capital Charge 10 5 = Economic Value Added 40 45

The present value of the future EVA (or MVA) is equal to: PVEVA = 40 / 1.1 + 45 / 1.12 = 73.55 We see that we get the net present value of the project. Note that ‘Invested Capital’ is clearly defined. Since a valuation is forward looking, the amount of invested capital at the beginning of the project is equal to the cash outlay for the initial investment. We can also look at the difference between free cash flow and EVA to investigate where this equality comes from. Free cash flow is defined as follows: Free Cash Flow = EBIT – Tax + Depreciation – Incremental Investments NPV of project = – Initial Investment + PV of Free Cash Flows EVA = EBIT – Tax – Capital Charge NPV of project = PV of EVA

chapter 4 / page 17

To test for the conditions, under which both approaches lead to the same result, we can write:

PV of EVA = PV of Free Cash Flows PVEBIT – PVTax – PVCapital Charge = PVEBIT – PVTax + PVDepreciation – PVIncremental Investments

Since all investments are made up front, PVIncremental Investments is equal to the initial investment and also equal to the invested capital. We can simplify the last equation to:

– PVCapital Charge = + PVDepreciation – PVIncremental Investments

PVIncremental Investments = PVDepreciation + PVCapital Charge If the present value of any initial and future investments is equal to the present value of all future depreciation plus the present value of all future charges on the invested capital (net of depreciation), then both approaches lead to the same result. In fact, this equality is always true.7 This also shows us the reason for a measure like EVA. Whereas in a DCF approach, all investments occur in the period where the cash is spent, the EVA approach divides this capital spending over its useful life in the form of depreciation. The capital charge is necessary to make both approaches equal in their present values. Although the example here is a very simple one, the general insight remains the same. An ex ante valuation in terms of free cash flow is always identical to an EVA based valuation. 4.3.1.3.2 Valuation of a firm* In a firm valuation context, MVA corresponds to the NPV of all investment projects the firm currently has or is expected to initiate in the future. Since a firm is nothing else than a portfolio of projects and from the MVA definition above, we can say that: Firm Value = Invested Capital + Market Value Added = Invested Capital + PV of future EVA = PV of future Free Cash Flows Let’s consider an example to illustrate this equivalence:

Year 1 Year 2 Year 3 Year 4 Year 5 Free Cash Flow (FCF) USD 30.0 USD 25.0 USD 20.0 USD 15.0 USD 10.0


40.0 32.0 24.0 16.0 8.0

Depreciation 8.0 8.0 8.0 8.0 8.0 Invested Capital (at the end of the year)

32.0 24.0 16.0 8.0 -

NOPAT (FCF – Depreciation) 22.0 17.0 12.0 7.0 2.0 Capital Charge (@ 10%) 4.0 3.2 2.4 1.6 0.8 EVA 18.0 13.8 9.6 5.4 1.2

7 See Loderer et al (2000) for a numerical illustration of this fact.

chapter 4 / page 18

The free cash flows are as given in the table. They – and nothing else – determine the value of the firm (we assume no terminal value in this example), which is:

41.791.1

10

1.1

15

1.1

20

1.1

25

1.1

30V

54320 =++++=

How do we apply the EVA approach? EVA is calculated as the difference between NOPAT, which is equal to free cash flow minus depreciation (linear, 20% per year), and the capital charge, which is the cost of capital (10%) multiplied by the invested capital at the beginning of the period8, i.e. in year 1, the capital charge corresponds to 4 (10% of USD 40). EVA for year 1 is therefore 30–8–4 = 18. If we capitalize the future expected EVA, we get:

41.391.1

2.1

1.1

4.5

1.1

6.9

1.1

8.13

1.1

18EVAofPV

5432=++++=

To get the firm value, we have to add the invested capital as of today: Firm Value = PV of EVA + Invested Capital = 39.41 + 40 = 79.41 As we see, we get the same result under both approaches, not only for new investment projects, but also for firm valuation purposes. A question that often arises is the following: How can both approaches always lead to the same result, if EVA uses a book value of capital in the valuation that can be influenced by accounting rules? The answer is: Invested capital is irrelevant in the valuation of the firm, as we see in the next example. In this example, we present a different firm, but one that promises to generate exactly the same future free cash flows as before.

Year 1 Year 2 Year 3 Year 4 Year 5 Free Cash Flow (FCF) USD 30.0 USD 25.0 USD 20.0 USD 15.0 USD 10.0


100.0 80.0 60.0 40.0 20.0


80.0 60.0 40.0 20.0 -

NOPAT (FCF - Depreciation) 10.0 5.0 - (5.0) (10.0) Capital Charge (@ 10%) 10.0 8.0 6.0 4.0 2.0 EVA - (3.0) (6.0) (9.0) (12.0)

8 It is important that we take the capital charge based on the invested capital at the beginning of the

period. We have to make sure, that in both approaches, we make the same assumptions. In the DCF approach, we assume that all cash flows occur at the end of the year. This has to be true for the cash flows from investments as well. This means, that the invested capital over the whole year corresponds to the number at the beginning of the year.

chapter 4 / page 19

Since firm value is determined solely by the future free cash flows, the value has to be 79.41 as well. What do we get with the EVA approach?

59.201.1

12

1.1

9

1.1

6

1.1

3

1.1

0EVAofPV

5432−=−−−−=

All future EVA will be negative, since depreciation and capital charge are much higher for this firm. But as we have seen above, the present value of these two line items are equal to the invested capital as of today. Since invested capital is added to the present value of EVA, the whole thing is a wash. Firm Value = PV of EVA + Invested Capital = –20.59 + 100 = 79.41 The interested reader might have realized that depreciation has changed and one might assume that this is the reason why both approaches yield the same result. But even if we do not depreciate the invested capital to zero, we arrive at the same result under both approaches.

Year 1 Year 2 Year 3 Year 4 Year 5 Free Cash Flow (FCF) USD 30.0 USD 25.0 USD 20.0 USD 15.0 USD 10.0 Invested Capital (at the beginning of the year)

100.0 92.0 84.0 76.0 68.0


92.0 84.0 76.0 68.0 60.0

Salvage Value 60.0 NOPAT (FCF - Depreciation) 22.0 17.0 12.0 7.0 2.0 Capital Charge (@ 10%) 10.0 9.2 8.4 7.6 6.8 EVA 12.0 7.8 3.6 (0.6) (4.8)

In this example, the depreciation schedule is the same as in the initial example. Capital though is 100. What is important to note, is that the depreciation should reflect a true economic reduction in the value of the invested capital. So, if capital is not depreciated to zero, it can be sold for a positive salvage value at the end of the forecast horizon. Therefore the last free cash flow has to include any cash inflows resulting from liquidating the firm, in our case USD 60. The firm value based on the DCF approach is then:

67.1161.1

6010

1.1

15

1.1

20

1.1

25

1.1

30V

54320 =+++++=

With the EVA approach, we get:

67.161.1

8.4

1.1

6.0

1.1

6.3

1.1

8.7

1.1

12EVAofPV

5432=−−++=

Firm Value = PV of EVA + Invested Capital = 16.67 + 100 = 116.67

chapter 4 / page 20

So far, we have neglected any terminal value assumptions. Terminal values are calculated after explicit forecast periods to capture the value impact in the long run of a firm’s life. To focus on the important issues, we now look at firm valuations using only terminal value formulas. Let’s take a look at the following two firms: Company B is a firm that is not growing, company D is a firm that is growing. Let’s start with company B first. It’s invested capital today is 1’000’000. That capital is maintained over the years, i.e. investments replace the depreciation. In this specific case, where investments are equal to depreciation, free cash flow is equal to NOPAT. The return on the invested capital (NOPAT / Invested Capital) is equal to 10% and so equal to WACC. This means that all future EVA are exactly zero and that firm value is equal to invested capital (1’000’000). This has to be equal to the DCF approach, which is just an annual free cash flow of 100’000 capitalized as a perpetuity at a discount rate of 10% (100’000 / 10% = 1’000’000). In one year from now, everything stays constant. The company B has still an invested capital of 1’000’000 and no future EVA, meaning: it still has a value of 1’000’000. How did the investors in company B get their required rate of return of 10%. Because there are no incremental investments, the free cash flows can be paid out, therefore, investors get 100’000 every year on an investment worth one million, i.e. exactly 10% (= 100’000 / 1’000’000).

Company B Year 1 Year 2 Year 3 Free Cash Flow USD 100’000 USD 100’000 USD 100’000 Invested Capital (at the beginning of the year)

1’000’000 1’000’000 1’000’000

Depreciation 50’000 50’000 50’000 Incremental Investments - - - Total Investments 50’000 50’000 50’000 NOPAT 100’000 100’000 100’000 Capital Charge (WACC = 10%) 100’000 100’000 100’000 EVA - - -

Company D Year 1 Year 2 Year 3

Free Cash Flow USD 50’000 USD 52’500 USD 55’125 Invested Capital (at the beginning of the year)

1’000’000 1’050’000 1’102’500

Depreciation 50’000 52’500 55’125 Incremental Investments 50’000 52’500 55’125 Total Investments 100’000 105’000 110’250 NOPAT 100’000 105’000 110’250 Capital Charge (WACC = 10%) 100’000 105’000 110’250 EVA - - -

chapter 4 / page 21

Let’s now look at company D. This company is growing at 5% p.a. At the end of year 1, it invests 50’000 in additional growth (the total investment is 100’000 from which 50’000 is to offset depreciation and 50’000 is an incremental investment). Using the DCF approach, the value of the firm, as of today, is: V0 = FCF1 / (WACC – g) = 50’000 / (0.1 – 0.05) = 1’000’000 What do we get with the EVA approach? Invested capital today is 1’000’000. Because all future EVA are zero, their present value is zero as well. Therefore, the fair value of the firm is equal to its invested capital at the beginning of the year, 1’000’000 and equal to the DCF value. What is the value of company D in one year from now (at the end of year 1)? The first incoming free cash flow will then be 52’500. It has grown by 5% because it is assumed that the incremental investment yields a return on investment of 10%9. The value of company D one year from now is: V1 = FCF2 / (WACC – g) = 52’500 / (0.1 – 0.05) = 1’050’000 With the EVA approach, future EVA and also their present value are zero. Therefore, the fair value of the firm is still equal to its invested capital. In one year from now, the invested capital and the fair value of the company D is 1’050’000, the same as with the DCF approach. In company D, the investors get their required rate of return of 100’000 in the form of free cash flow (50’000) and a capital gain, since the firm value increases by 50’000 over that year. In the second year, investors require still a 10% return on the market value, i.e. 105’000 = 10% of 1’050’000. They get half of it in free cash flow (52’500) and half of it in a capital gain. How can it be possible, that both firms (B and D) have the same value if one is growing and the other not? The EVA approach gives us an intuitive view. Because future EVA are still zero, it must be that the incremental investment does not add anything to the value of the firm. If we look at our assumptions, it’s clear why this is the case. The incremental investments promise a return of 10% which is equal to the required rate of return. Therefore, the incremental investments have a zero net present value and the firm value is not increased by these investments. It is important to note, that growth is not equal to wealth creation. EVA does a much better job in the indication of future wealth creation and/or destruction and is therefore helpful in finding reasonable assumptions about future investment behavior and its outcome. It is important to note that the growth rate g, that is used in terminal value assumptions is not equal under the EVA and the DCF approach. The growth rate g, generally, corresponds to the annual growth in NOPAT. Under constant growth assumptions, this means, that the annual investment and depreciation also have to grow with g. If this is the case, then FCF also grows with g (this is the typical assumption in the terminal value calculation with the DCF

9 In fact, if we assume a 10% return on incremental investment, there will be an addition to NOPAT of

10% of the investment. Since we assume a constant perpetual growth, depreciation, incremental investments, and ultimately, free cash flow will grow with 5% as well.

chapter 4 / page 22

approach). In the EVA approach, if NOPAT grows with g, EVA does not. Therefore, the terminal value calculation with the EVA approach cannot simply be defined as: Capital + EVA / (WACC-g). The EVA valuation formula for perpetual growth is as follows:

gWACC

WACCROIC

WACCI

WACCEVA

CapitalValueFirm 1T1TTT −

−×++= ++

In the formula, CapitalT is the invested capital at the beginning, EVAT+1 the first EVA, one year from now, IT+1 the incremental investment and ROIC is the return on the incrementally invested capital. Let’s look at the application of this formula with a specific example:

Company X Year 1 Year 2 Year 3 Free Cash Flow USD 50’000 USD 51’250 USD 52’531.25 Invested Capital (at the beginning of the year)

1’000’000 1’050’000 1’101,250.00

Depreciation 50’000 51’250 52’531.25 Incremental Investments 50’000 51’250 52’531.25 Total Investments 100’000 102’500 105’062.50 NOPAT 100’000 102’500 105’062.50 Capital Charge (WACC = 10%) 100’000 105’000 110’125.00 EVA - (2’500) (5’062.50)

Company X is a growing company as well. We show only the first three years and assume a perpetual growth afterwards. The growth rate (FCF, NOPAT) is 2.5% (e.g. 51’250 / 50’000 – 1 = 102’500 / 100’000 – 1 = 2.5%). The value of the firm with the DCF approach is therefore: V0 = 50’000 / (0.1 – 0.025) = 666’667 Doing this valuation provides no information about where this value comes from. If we look at the EVA approach instead, we gain further insights. As can be seen in the table, future EVA are negative. In the beginning, the firm has an invested capital of 1’000’000 and creates NOPAT in the amount of 100’000. So it breaks even on the actual investment, resulting in a zero EVA (100’000/1’000’000 = 10% = WACC). But then, the firm invests even more money. In the first year, 50’000 will be incrementally invested. But this incremental investment only adds 2,500 to NOPAT in the following years. Although the firm is growing (in the sense that its operating profit is growing), it actually destroys value: The incremental investment has only a ROIC10 of 2’500 / 50’000 = 5%, whereas the required rate of return (WACC) is 10%. This incremental investment is therefore value destroying, which is shown in the negative EVA in year 2. If we want to value the firm with the EVA approach, we use the above mentioned formula:

10 ROIC is the abbreviation of Return On Incremental invested Capital. It is defined as Incremental

NOPAT / Incremental Investment.

chapter 4 / page 23

667'666025.01.0

1.005.0

1.0

000'50

1.0

0000'000'1V0 =

−−×++=

We see again that we get the same value as under the DCF approach. But we have more insights with this valuation procedure. First of all, the value is less than the actual invested capital which automatically means that in the future, EVA will be negative, i.e. value will be destroyed. We also see that ROIC lies below the required rate of return (WACC). From a value based management perspective, this means, that management (and ultimately shareholders) would be better off, if the company would not invest and not grow as assumed.

4.3.1.4 Performance Measurement with EVA* As said in the introduction, EVA is not only a valuation tool it is also a tool to measure managerial performance ex post. In fact, this is the major application of the concept. Before, we have shown, that for valuation purposes, the choice of capital is irrelevant. But how about measuring managerial performance? One could argue that market values are typically higher than book values. If we then define EVA on book values instead of market values, the required return in dollars would be typically underestimated and EVA would be overestimated. Using EVA as the basis for determining executive compensation, so the argument goes, would lead to an unjustified gift from the shareholders to the managers. Book capital is the amount of money that has been historically invested in the company. This is the amount of money, management received from the providers of capital to run the business. Usually, and on purpose, EVA is measured based on this invested capital. The reason for this can be found in the following table. We look at three companies, A, B and C. Each company has a perpetual constant NOPAT of 90’000, 100’000 and 110’000, respectively and each has the same invested capital of 1’000’000 (book value). The opportunity cost of capital of these firms is 10%. The market values of the firms can be found by capitalizing future free cash flows. Since there is no incremental investment, there is no growth. Investments are only made to offset depreciation. Therefore free cash flow is equal to NOPAT and the market values are 90’000 / 10% = 900’000 for company A, 100’000 / 10% = 1’000’000 for company B and 110’000 / 10% =1’100’000 for company C, respectively.

Company A Company B Company C

NOPAT (= FCF) USD 90’000 USD 100’000 USD 110’000 Invested Capital (Book Value) (at the beginning of the year)

1’000’000 1’000’000 1’000’000

Market Value (at the beginning of the year)

900’000 1’000’000 1’100’000

NOPAT 90’000 100’000 110’000 Capital Charge (on Book Value) 100’000 100’000 100’000 EVA (10’000) - 10’000 NOPAT 90’000 100’000 110’000 Capital Charge (on Market Value) 90’000 100’000 110’000 EVA - - - Return on Invested Capital 9% 10% 11% Return on Market Value 10% 10% 10%

chapter 4 / page 24

If we calculate EVA based on book values we find that company A is not able to generate a NOPAT high enough to cover the charge for the capital in place, i.e. it has a negative EVA. Company B is neutral whereas company C has “very good” managers. They are able to generate NOPAT that are higher than the capital charge, i.e. they generate positive EVA. If we use market values instead, and assume that market prices are fairly set, every company has an EVA of zero in each year, by definition. Company A, with the “bad” managers (earning a return on the book value of 90’000 / 1’000’000 = 9%) now has the same EVA as Company C with the “good” managers (earning a return on the book value of 11%). The problem with this approach is that market prices incorporate information about inferior or superior operating performance. If the prices are fairly set, each company promises a return on market value (= NOPAT / Market value of firm) of 10%, irrespective of the underlying operating performance. Companies with a bad operating performance, such as Company A in our example, don’t promise a lower return on its stocks but the stocks will just sell for a lower price. Therefore, the right basis for measuring managerial performance is the money given to them by the providers of capital and this amount of money is the book value. A “good” management, where the market expects a superior performance, would otherwise never be able to profit from its superior ability to generate positive EVA in the future.

4.3.1.5 Conclusions* EVA is a measure for periodic economic profit. It is defined as an after tax operating profit minus a charge for the invested capital. For valuation purposes, and therefore, for evaluating future investment opportunities, it can be shown that the EVA approach and the DCF approach are absolutely equivalent. EVA is typically used to measure managerial performance ex post. The major advantage in using EVA is that management is held accountable for the money they received from their investors. If management decides to invest such money in the operating business, they have to deliver returns high enough to offset the economic depreciation of the assets in place and also the opportunity cost of the capital invested; only then, EVA will be positive. This requirement, reinforced by an EVA based compensation system, generates strong incentives to invest only in positive NPV investments and to manage projects to create the most possible value for the shareholders.

4.3.2 Cash Flow Return on Investment*

4.3.2.1 Definition* The Cash Flow Return on Investment (CFROI) model has been developed by another global consulting firm, HOLT Value Associates. HOLT's basic premise is that the stock market sets prices based on cash flows, not traditional accounting measures of corporate performance like reported earnings. The CFROI model is, like the EVA model, its major competitor, rooted in discounted cash flow principles (more cash is preferred to less, sooner is preferred to later, less uncertainty is preferred to more). But it is supposed to be substantially more accurate than EVA, because 1) it deals with inflation-adjusted figures and 2) it minimizes accounting distortions. This means that CFROIs are more comparable over time and across companies in different industries and different countries.

chapter 4 / page 25

From a theoretical standpoint, CFROI is a cross-sectional return measure of a portfolio of ongoing projects. Each project a) has a life cycle, b) requires an initial outlay of depreciating assets (plant, goodwill) and non-depreciating assets (net working capital, land), c) generates cash flows over the life of the project and d) releases the non-depreciating assets at the end of the project. Individual projects cannot be identified by outside investors. But financial statements do reveal the amount of total depreciating assets, total non-depreciating assets, and total cash flow. Consequently, it is possible to compute the CFROI without knowing the specific returns of all projects. Asset life Asset life can be defined as follows:

Asset life = Adjusted gross plant

Depreciation of gross plant

The gross plant amount is the cost of all tangible fixed assets. However, land is excluded because there is no associated depreciation expense. Depreciating assets Depreciating assets can be defined as follows:

Inflation-adjusted gross plant + Capitalized value of operating leases + Goodwill = Depreciating assets Gross plant assets must be adjusted for inflation. In other words, we should estimate the current value of these assets, and not simply use reported figures, which are usually a mix of different purchasing-power dollars. Some operating assets are not mentioned in the balance sheet, because they are not owned but leased by the company:

Capitalized value = Annual rental expense

Real debt rate

In HOLT's database, the amount of intangibles (goodwill) is included in assets for measuring CFROIs. This is basically a good decision, because the firm's capital suppliers paid for the goodwill. Unfortunately, accounting standards differ between companies which purchase intangible assets through acquisitions and companies which generate goodwill by increasing the value of their own intangible assets (for instance by training their staff). In the first case, goodwill is considered as an asset. In the second, it is not, and the CFROI may appear much higher than it really is.

chapter 4 / page 26

Non-depreciating assets Non-depreciating assets can be defined as follows:

Net monetary assets + Current-dollar inventory + Current-dollar land = Non-depreciating assets Net monetary assets (excluding inventories) are cash, short-term investments, receivables and other current assets, less current liabilities (accounts payable, income taxes payable, other current liabilities). Inventory must be valued in current dollars, i.e. by using the FIFO (first-in, first-out) method. As with plant, land is usually stated in historical dollars. This value should also be adjusted to take inflation into account. Gross cash flow Gross cash flow (the amount of cash flow resulting from the company's business operations, regardless of how they are financed) can be defined as follows (we have ignored the effects of pension and tax accounting):

Net income + Depreciation & Amortization + Adjusted Interest Expense + Rental expense + Inflation adjustments + Minority interest = Current-dollar gross cash flow Depreciation and amortization are added to net income because they are non-cash operating expenses. Interest expense is added too, because it is viewed as a financing cost, not an operating cost. Since in the depreciating assets calculation, leases were capitalized, rental expenses must be added to net income as well. Inflation adjustments come from:

- the restatement of LIFO inventories to their FIFO value - the adjustment of nominal interest revenues and expenses to real values A minority owner is treated as a supplier of capital in the CFROI model. Therefore, minority interest is added back to net income.

chapter 4 / page 27

Example:

Company H Asset life 5 years Depreciating assets USD 500’000 Non-depreciating assets

USD 50’000

Annual gross cash flow

USD 150’000

Total investments in year 0 = USD 500’000 + USD 50’000 = USD 550’000 Total cash flow in years 1 to 4 = USD 150’000 Total cash flow in year 5 = USD 150’000 + USD 50’000* = USD 200’000 * non-depreciating assets are supposed to be released at the end of the asset life CFROI = internal rate of return of the “project” =13.34%

4.3.2.2 Valuing a firm* Theoretically, DCF valuation requires forecasting the entire stream of future net cash receipts (i.e. gross cash flow less investment in depreciating and non-depreciating assets plus release of non-depreciating assets) for the life of the firm. The CFROI model separates the forecast net cash receipts (NCR) stream into two parts:

1. NCRs from existing assets 2. NCRs from future investments

Each of the NCR streams can be separately discounted, giving separate net present values for existing assets and for future investments. Value of existing assets The stream of NCRs from existing assets depends on:

a) the current level of gross assets (depreciating assets + non-depreciating assets) b) the current level of CFROI c) the asset life d) the age of existing plant e) the fade rate of CFROI

It is assumed that the value of depreciating assets will come down to zero over the asset life. Non-depreciating assets are supposed to be progressively released over the asset life. The age of existing plant is an important factor. The older the plant, the more rapid the wind-down of cash flows because of greater plant retirements in earlier years. The fade rate of CFROI is even more important. HOLT has demonstrated that CFROIs tend to fade over time, down (or up) toward the average. The magnitude of change depends on 1) the CFROI level (the higher – or the lower – the CFROI, the quicker the move toward the average), 2) the variability of past CFROIs (the higher the variability the quicker the move toward the average) and 3) the dividend payout ratio (the lower the ratio – i.e. the higher the reinvestment rate – the quicker the move toward the average; it is, however, worth noting that as for below-average CFROI firms, the payout ratio is not significant). In other words, high-growth companies with high and variable CFROIs exhibit the most rapid profitability

chapter 4 / page 28

declines, whereas firms with low and variable CFROIs (whatever their payout ratio) improve their returns at the greatest pace. The estimates of future NCRs from existing assets are then discounted so as to get their present value. Interestingly, the discount rate is part of HOLT's model (which is not the case in the EVA model). As in the case of deriving a bond's yield to maturity from its market price and its expected stream of interest payments plus principal repayment, the discount rate employed in the CFROI model is a real market discount rate derived from the market's price for an aggregate of firms and a forecasted net cash receipts stream for the aggregate which is consistent with the model itself. The real debt rate is calculated as the nominal rate less inflation expectations. The CFROI model – unlike the EVA model – employs a before-tax debt rate, since the tax deductibility benefit is captured by higher CFROIs. The real equity rate, for its part, can be derived from the real market discount rate (calculated as explained above) and the real debt rate (remember that the real market discount rate is a combination of the real debt rate and the real equity rate). Firm-specific discount rates are computed as follows:

Market discount rate + Risk differential related to the firm's size + Risk differential related to the firm's financial leverage = Firm-specific discount rate Risk differentials (positive, negative or nil) appear because the effects of financial leverage and size (i.e. equity market capitalisations) cannot be eliminated through portfolio diversification. They are also derived from market observations. Value of future investments There are two basic steps in calculating the present value of the NCR stream generated by future investments. First, the incremental wealth created from each future investment is computed as the present value of that investment in the year undertaken less the amount invested. Second, that incremental wealth is discounted to a present value for “today”. The cumulative amount of these present values represents the estimated value of the firm's future investments. The fade-toward-average effect of competitive forces applies to both the wind-down of cash flows from existing assets and the profitability of future investments. This means that sooner or later, the CFROI will be equal to the discount rate. Consequently, from that date onward, the incremental wealth from new investments is supposed to be nil. You may relate this effect to the “competitive advantage period” defined in the EVA model.

chapter 4 / page 29

Value of the firm Finally, the total value of the firm can be defined as follows:

Value of existing assets + Value of future investments = Value of the firm

4.3.3 Abnormal earnings discount model*

4.3.3.1 Valuing cyclical companies* The financial results of cyclical firms are, by definition, volatile and depend upon the state of the economy. Their earnings explode in economic booms while they collapse in economic downturns. May we nevertheless use standard discount models (like the DCF) for valuing such companies? The answer is definitely yes. But in order to do so, we first have to deal with the following issues:

1. How can we predict the cash flows of cyclical firms? 2. What discount rate should we use to compute their present value?

Predicting the results of cyclical firms Cyclical companies’ earnings volatility is basically due to sudden and often sharp changes in sales volumes and/or selling prices. Above-average operating leverage (cyclical firms’ fixed costs usually account for a large part of total costs) and financial leverage (cyclical firms’ debt-to-equity ratios are usually high) expand the impact of sales cyclicality on the companies’ profitability. Suppose that you had perfect foresight about the industry cycle, and that you were able to predict the future peaks and troughs of Company X’s earnings. It would then be easy to compute its fair value by using the DCF model. Because high cash flows mathematically cancel out low cash flows, the DCF value of company X should theoretically prove to be much less volatile than earnings. And in practice, it can be observed that the market values of cyclical firms are indeed not as volatile as their results, although they are less stable than theory would suggest. This may well be due to the fact that analysts tend to extrapolate the firms’ latest results, as if those results were going to break out of their old cycle and establish a new trend. As you – like all analysts – are not a seer, the best way to predict the performance of a cyclical firm is to normalize its stream of expected cash flows. Depending upon at what stage of the economic cycle a valuation is done, the current year’s earnings may be too low (if there is a recession) or too high (if the economy is at a peak) to be used a base year. In order to avoid significant errors in valuation, you should first adjust the current-year figures, as if you were precisely at the middle point of the economic cycle. You would then apply an average growth rate to the adjusted base earnings to assess the normalized stream of future cash flows. Just as if you were dealing with a high-visibility firm, such as a food & drink company.

chapter 4 / page 30

Be aware that the implicit assumption in the use of normalized earnings as base-year earnings is that cyclical firms will quickly revert back to this level when the economic cycle turns. This may sometimes prove unrealistic, in particular if the firm’s fundamentals have changed. You could use the following two-scenario approach to take this possible change into account:

1. Assess future cash flows as if the firm's fundamentals had not changed (in other words, assess normalized cash flows on the basis of past cycles)

2. Assess future cash flows as if the firm's fundamentals had changed (in other words, assess normalized cash flows on the basis of recent results)

You would then assign probabilities to the two scenarios and compute a weighted value of future cash flows. Calculating the present value of cash flows Because we have given up the idea of predicting future recessions and recoveries, the stream of future cash flows may well look too optimistic. The trend is fine, but the volatility of earnings has been erased thanks to the normalization process. How can we then take the real earnings visibility (which is low) into account? Simply by increasing the discount factor (the cost of equity or the WACC, depending on the model used), which should be consistent with the fact that normalized earnings are unlikely to turn out as actual earnings. In other words, you must use a higher rate for discounting the normalized (and unrealistic) cash flows of a cyclical firm than for discounting the non-normalized (and more realistic) cash flows of a food & drink company. However, should the discount rate be artificially increased? The answer is no. Do not forget that over the entire economic cycle, high cash flows cancel out low cash flows (i.e. the present value of a steady stream of cash flows discounted at 10% is more or less equal to the present value of a volatile stream of cash flows discounted at 10%, provided that earnings trends are similar). In other words, just assess the fundamental risk (sales volatility, operating leverage, financial leverage, etc.) of investing in a cyclical company, convert that risk into the proper discount rate – which is likely to be quite higher than the food & drink’s one – and apply that discount rate to the normalized stream of cash flows, as if you had not gone through the normalization process.

4.3.3.2 Valuing start-ups* Assessing the value of start-ups is a difficult task, and this is no news. But it has now become part of the day-to-day job of analysts, at least of those in charge of monitoring technology and healthcare stocks. Can you use standard models (like the DCF) to estimate the fair value of such companies? Once again, the answer is definitely yes. Valuing Internet companies Most Internet companies make losses. Shorthand valuation approaches, in particular the well-known price/earnings ratio, are meaningless. Some practitioners recommend using alternative methods such as revenue multiples (when revenues are high enough) or market share multiples. But these shortcuts are often misleading, since they do not take into account what drives the company’s value in the long run, i.e. earnings and/or cash flows (depending on the model you are referring to).

chapter 4 / page 31

The best way to value Internet companies is to return to economic fundamentals. The absence of meaningful historical data doesn't matter, since the DCF model relies solely on forecasts. In other words, this model can easily capture the worth of businesses which experience several years of initial losses. How to predict Internet firms’ future cash flows? You are not a seer, as we have already noted. Does that prevent you from building scenarios on what those companies might look like in a few years from now? Provided they do not go bankrupt in the meantime, all high-growth companies are due to become moderate-growth companies. Consequently, sooner or later, the usual measures such as the penetration rate or the revenue per customer will apply. Although it requires some imagination, you should be able to assess the “normalized” earnings that an Internet company could achieve in, say, 15 years from now, as well as its long-term growth rate (the one that will be valid from Year 15 onward). What about the cash flows from Year 1 to Year 14? You could estimate them by “extrapolating back” the Year 15 performance to ensure consistency with the company's current figures. As regards discount rates, don't miss the point! Internet firms are riskier than average, even riskier than cyclical companies. The DCF model can't eliminate the need to make difficult forecasts. But it does address the issues of high growth rates and uncertainty in a coherent way. Don't be content with a single scenario. You should draw up three or four of them, and then assign probabilities to them. You will then get a more accurate result than by trying to compute a single fair value. Valuing biotech companies Valuing biotech companies is no more difficult than valuing Internet firms from a technical standpoint. Here again, you should stick to standard models. The main issue lies in the fact that developing a new drug takes much more time than creating new software. In other words, biotech companies are likely to experience losses for more years than dot.coms. In addition, assessing the potential sales of a drug that won't be on the market before 5 or even 10 years is not an easy task, to say the least. Although future cash flows are very difficult to predict, analysts with a good knowledge of the healthcare industry can rely on the DCF model. Theoretically, you could also use an option pricing model to value biotech companies, since those firms look like out-of-the-money call options. But this approach is almost impossible to implement in practice.

chapter 4 / page 32

4.4 Measures of relative value

4.4.1 Price/Earning ratio and valuation

An alternative and widely used method to value stock relies on P/E ratios. The P/E ratio shows how much investors are willing to pay per unit (CHF, USD, etc.) of reported profits (price/earnings). The method is very adaptable since it can be used for traded as well as for non traded stocks. Moreover, it is simple and doesn't require time-consuming data analysis; only two numbers need to be known to apply the method: the earnings of the firm to value and the P/E ratio of the industry in which the firm does its business. After a short introduction to the method, we'll discuss in detail an empirical investigation that considers the accuracy of this valuation method before we take a look at its main weaknesses.

4.4.1.1 General considerations The easiest way to start is with an example. Suppose you want to determine the value of Firm Z's stock, which is not traded. To apply the P/E ratio pricing model, all you have to know is Firm Z's earnings and the average P/E ratio of Firm Z's industry. For instance, if the industry P/E ratio is 10.0 and Firm Z has current earnings of 100 CHF, the value of the firm can be calculated by multiplying the firm's earnings with the firm's industry P/E ratio (the average of the ratios of comparable firms). Of course, the implicit assumption is that the differences among different P/E ratios in the industry are random. Following this procedure for Firm Z, we arrive at the following equality

Value Firm Z = Firm Z's earnings ⋅ Firm Z's industry P/E ratio = 100 CHF ⋅ 10.0 = 1’000 CHF

One of the advantages of the P/E ratio method is that it can be used to value stocks for a variety of situations: acquisitions, mergers, initial public offerings, valuation of non-traded firms and securities, stock price forecasting or investment strategies.

Example: Use industry P/E ratios to impute the value of Novartis bearer stock The following table shows average P/E ratios (January 2003 prices) for different Swiss industries:

Industry P/E ratio Banks 13 Health Care 16 Food 15 Electronics 15 Insurance 8

To value the Novartis stock, we need to know the earnings per share (EPS) of Novartis. In 2002 they were 2.91 CHF. Using this estimate (the alternative would be to update it), in January 2003, the implied bearer stock price could have been computed as

2.91 CHF ⋅ 16 = 46.6 CHF The assumption is that Novartis is mostly in the health care industry. The actual bearer stock price (January 2003) is 50 CHF.

chapter 4 / page 33

4.4.1.2 Interpretation To interpret what we do when we compute equity values with this valuation method, assume that the payout ratio is 1 (earnings are all paid out, i.e., dividends per share = earnings per share = EPS) and that earnings are a constant perpetuity. Under these circumstances, stock value can be computed using the constant dividend model as

P0 =

EPS

kE

where kE is the cost of equity capital. Notice that we can use this expression to calculate the P/E ratio

P

EPS kE

0 1=

This result shows that in a world of constant earnings and full payout, P/E ratios can be interpreted as the reciprocal of the cost of capital. Consequently, in a world of constant earnings and full payout, the industry average P/E ratio is a measure of the inverse of the cost of equity capital of the representative firm in the industry. In the above example, a P/E ratio of 17 implies a discount rate of

kE = 1

17 = 5.9%

Clearly, this figure is too low to be an average cost of equity capital. A more realistic alternative is to assume a constant dividend growth model. In that case, rearrangement of the Gordon-Shapiro model yields the following expression for the P/E ratio:

( )P

EPS

g

k gE

0

0

1=

⋅ +−

π

As one can see, the P/E ratio is now a function, among other things, of the rate of growth of earnings (dividends), g, and of operating and financial risk (as reflected in the cost of equity capital kE).

chapter 4 / page 34

4.4.1.3 Empirical accuracy of the method In a paper, Loderer and Trunz11 analyse the performance of the P/E valuation method of estimating the value of traded and non-traded firms. First, they compute the theoretical stock price of a share with the P/E ratio method ($P). Then, from this value, they subtract the observed market price of the share (P) and divide the difference by P. Formally, this valuation error, e, can be written as

eP P

P= − ⋅

$

100

Table 4-1 provides descriptive statistics of the valuation error for a sample of 88 traded firms (188 stocks, respectively) on the Zurich Stock Exchange for the period 1983-199212. The results are qualitatively identical for a sample of non-traded stock.

Valuation Error of Traded Firms (1983-1992)

Number of observations 1123 Average 3.1% Median –1.0% Lower 25% of Cases ≤ –22.6% Upper 25% of Cases ≥ 21.7% Maximum 267% Minimum –92.8% Standard deviation 44.6%

Table 4-3: Descriptive statistics of the valuation error

These findings can be summarised as follows: the average as well as the median valuation errors are almost zero. Nevertheless, the valuation errors are characterised by significant variation. In 50% of all cases, the absolute valuation error is greater than 22%. To give an intuitive idea for the minimum (maximum) errors reported in the study, consider a stock with value of 100 CHF. A valuation error of –92.8% means an imputed value of 7 CHF instead of 100 CHF. Conversely, a valuation error of 267% implies a theoretical price of 367 CHF for a stock that is worth only 100 CHF. Figure 4-1 shows that the relative frequency distribution of the valuation error is not symmetric, but skewed to the right. It is characterised by a large number of relatively small negative valuation errors and a comparatively small number of relatively large positive valuation errors.

11 See LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer Treuhänder,

Nr. 10, pp. 741.747. 12 From LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer

Treuhänder, Nr. 10, pp. 741.747.

chapter 4 / page 35

2%

7%

15%

28%

26%

11%

7%

3%1% 1% 1% 0% 0% 0% 0%

0%

5%

10%

15%

20%

25%

30%

-10

0 b

is 7

5%

-75

bis

-5

0%

-50

bis

-2

5%

-25

bis

0%

0 b

is 2

5%

25

bis

50

%

50

bis

75

%

75

bis

10

0%

10

0 b

is 1

25

%

12

5 b

is 1

50

%

15

0 b

is 1

75

%

17

5 b

is 2

00

%

20

0 b

is 2

25

%

22

5 b

is 2

50

%

25

0 b

is 2

75

%

Percentage Valuation Error

Figure 4-1: Frequency distribution of valuation error full sample (1983-1992)13 Overall, Loderer and Trunz14 draw the following conclusions:

1. The average valuation error for quoted stocks is remarkably small. The variance of this number, on the other hand, is rather large. When using the P/E valuation method, the true value of our individual firm lies in the range between –84% to +91% with 95% confidence (Relying on an approximately normal distribution, the 95% confidence interval can be computed as 3.1% ± 1.96 ⋅ 44.6%).

2. The distribution of the valuation error is skewed to the right. 3. The results depend on the industry considered. The method seems to be especially effective

for valuing banks. 4. The results for a sample of non-quoted stocks are comparable to the ones for quoted stocks. In practice, a financial analyst’s job is usually to value a single firm. The fact that the P/E valuation method yields good estimates on average, i.e. when valuing a lot of firms, is not particularly helpful here. In the case of a single firm, the variance of the value estimate is very important. And clearly, a 95% confidence interval between –84% to +91% for traded stocks (between –103% and +122% for non-traded stocks) is quite large. This should be kept in mind when using the P/E valuation method as a tool for determining investment strategies.

13 Source: LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer

Treuhänder, Nr. 10, pp. 741.747. 14 See LODERER C. and TRUNZ R., 1993, “Das Price-Earnings Verfahren”, Der Schweizer Treuhänder,

Nr. 10, pp. 741.747.

chapter 4 / page 36

4.4.1.4 Problems of the P/E ratio valuation method In principle, there are various reasons why the P/E valuation method should be fraught with measurement error. This can be seen by referring to the Gordon-Shapiro model and noticing that P/E-ratios can differ systematically across firms because of differential growth, and differential financial and operating risk. As the following considerations will show, this is true in general. Problem 1: The method does not take differential growth into consideration To see this, consider a specific industry. Table 3-2 below shows the average expected income growth of the industry (“average income”). For simplicity, we assume a three-year horizon. Given these figures, and assuming a 10% cost of equity capital, the value of the representative stock at the beginning of year 1 is 249 CHF. That implies an industry P/E ratio of 249 / 100 = 2.49. Firm Z does business in the same industry. In year 1, Firm Z's earnings are expected to grow in line with the industry. Thereafter, they are expected to grow at a faster rate. Clearly, if we price Firm Z's stock with the industry's P/E, we ignore this faster growth and obtain a stock value that underestimates the true value 2.49 ⋅ 100 = 249 CHF instead of 482 CHF.

Average income Income of firm Z Previous year 100 CHF 100 CHF Year 1 100 CHF 100 CHF Year 2 100 CHF 200 CHF Year 3 100 CHF 300 CHF Value (i = 10%) 249 CHF 482 CHF Average P/E ratio in Year 1 2.49

Table 4-4: P/E ratio and earnings growth

Problem 2: Earnings depend systematically on financial and operating risk Let us consider financial risk. We know that leverage (financial risk) has a systematic influence on P/E ratios, i.e. that higher risk implies lower P/E ratios. To see this effect, consider an industry in which all firms but one (Firm Z) are 100% equity financed. The average industry P/E ratio is 10. Firm Z, however, is financed with 50% equity and 50% debt. As shown earlier, higher financial leverage reduces P/E ratios. So the P/E ratio for firm Z is lower than the industry average. Consequently, using the industry P/E ratio to value the stock of Firm Z systematically overestimates the value of Z stock. Problem 3: Earnings are accounting-based numbers Since earnings are accounting-based figures, it is possible, at least in principle, to manipulate earnings figures (depreciation, hidden reserves etc.). To the extent that a firm uses accounting principles that differ from other firms in the industry, we cannot use the industry average P/E ratio to compute its theoretical stock price.

chapter 4 / page 37

4.4.2 Price/ book value ratio

As we have seen in the previous section, price/earnings ratio is the most popular ratio of relative valuation. However, it is not proper for an analyst to use only one ratio. So, we recommend three more ratios. These are to be used along with the P/E ratio. These are:

• Price/ book value ratio • Price/ cash flow ratio • Price/ sales ratio

Let us look at the price/ book value ratio. This ratio is calculated by

PBV ratio = Market price / book value of the common stock

where

Book value = tangible net worth of the business / number of shares outstanding

Here, tangible net worth is calculated as,

Paid up capital + free reserves less intangibles

It must be noted that this ratio, is calculated net of depreciation. As this depends on the balance sheet figures, it suffers from the same defect of dependence on accounting information. As you might have read in the binder on financial statement analysis, the accounting policies and treatment of different items will distort this ratio. This ratio is useful in old economy stocks or companies which are in existence for some years. This is not very useful in the case of new economy companies. Another drawback of this ratio is that it can be used only for valuation of full firm. This cannot be used for valuation of parts of business such a division or a product or a brand. We also know that the book value is a substitute for retention policies of the past. Thus, if a company keeps paying less dividends and ploughs the profits into business, its book value is likely to be higher. Hence, a lower price/ book value ratio is a measure of market’s view about the organization’s dividend policy as well as future growth. Thus, in association with price/earnings ratio, this gives useful results.

4.4.3 Price/ cash flow ratio

The above two ratios, P/E ratio, as well as P/BV ratio are affected by the accounting policies of the firm. To correct for the distortion, the analyst could also use two more ratios of relative valuation. These are,

• Price/ cash flow ratio • Price/ sales ratio

Price to cash flow ratio is an extremely important measure of relative valuation. This eliminates the accounting treatment effect on profits. Another important aspect is that this ratio can be used as a surrogate for Price / EBITDA ratio (earnings before interest, taxes,

chapter 4 / page 38

depreciation and amortization). This is one ratio which is becoming very popular in evaluating fast growth, new economy stocks which do not have a long history. Price to cash flow ratio is calculated as:

Market Price/ Free cash flow per share of ordinary stock outstanding.

Example: a) ABC Co. had a profit of 100’000 CHF during the year N. Depreciation for the year was 20’000 CHF. Other intangibles charged to income statement were 25’000 CHF. At the end of the year, number of common stock outstanding were 100’000. Market Price as at the closing of March 23, N+1 was 100 CHF at the principal stock exchange. Calculate the P/CFW ratio as at March 23, N+1. b) Compare this with XYZ Co. with same profits, but with only a depreciation of 20’000 CHF. There are no intangibles. Solution: a) Free cash flow = Net profits + depreciation + other intangibles = 100’000 + 20’000 + 25’000 CHF = 145’000 CHF P/FCW ratio = 100/ (145’000 / 100’000) = 100 / 1.45 = 69 (roughly) b) Free cash flow = Net profits + depreciation + other intangibles = 100’000 + 20’000 CHF = 120’000 CHF P/FCW ratio = 100/ (120’000 / 100’000) = 100 / 1.20 = 83.3 (roughly)

Now, you can clearly see that Price/ Earnings ratio of both the firms will be the same. But, the price to cash flow ratios are different. We find that the second firm enjoys a higher market appeal. This may be due to various reasons. Perhaps, the intangibles in the first case are not viewed as highly by the market. May be, the market values the dividend paying capacity of the second firm higher. The advantage of this ratio, is that it can be used for both new economy and old economy stocks and can be used to value firms in different industries as well. It also can be used even for valuation for mergers, corporate restructuring, valuation of different geographical segments etc.

4.4.4 Price / sales ratio

Valuation is not only used for finding whether a stock is under- or overvalued, but also for deciding the price to be paid if the business is to be purchased. The need for valuation of different segments of business has grown in the last ten years. We value parts of business in the case of mergers, restructuring, sale of a product or a brand or intangibles. Obviously, price earnings ratio and price to book value ratio fail in this respect. So, we use price to cash flow ratio to determine the value of parts of business. Apart from this, another quick and

chapter 4 / page 39

convenient ratio used for this purposes, is the price to sales ratio. This can be used even for determining different segments of business separately. Say, we want to value a company like 3M or Hyundai or DUPONT or PCCW. These are large conglomerates. They are also into many areas of business. To value the company, we may use a method called sum of the parts. That is, we value each of the separate line of activity. Finally, we arrive at the final value by adding the value of each of the lines of activity. For this, we may use Price/ Sales ratio. Price/ Sales ratio = Market price / Sales of each of the lines of activities or the firm per share outstanding.

Example Let’s take ABC Co. which is in three lines of business and the details are given below: Market price: 100 CHF per ordinary share Number of ordinary shares outstanding: 100’000

Sales in CHF P/S ratio of industry Division A 100’000 13 Division B 200’000 15 Division C 250’000 25

Calculate the value of each division. If the composite Price to sales ratio is 16 in the respective country, then comment on the valuation of ABC Co.

Solution:

Sales in CHF P/S ratio of industry Valuation of parts* Division A 100’000 13 1’300’000 Division B 200’000 15 3’000’000 Division C 250’000 25 6’250’000 Total 550’000 10’550’000

(Price per share / sales per share) * Sales = valuation of the part Price/ sales ratio of ABC Co. = (10’550’000/550’000) = 19.18 Sum of parts = (10’550’000) / 100’000 = 105.5 CHF per share Here, we find that the sum of the parts gives a market valuation of 105.5 CHF per share while the actual market price is 100 CHF only. Other things being equal, we may conclude that market values the conglomerate at a lower value or that this firm is undervalued marginally. For detailed analysis, we need to look at other qualitative factors.

Main use of this ratio will be, for the sale of a division. If we want to sell one of the three divisions, we have an idea of what the market price for that division should be. We can also separately find out the cash flow generated by that division. Using similar technique, we can calculate the market valuation using cash flow to price ratio. From these two ratios, we can arrive at an average valuation of the division to be sold. It can be seen that some of the problems associated with price/ earnings ratio exist here also. But, the biggest advantage of the above two ratios is that they are fairly independent of accounting policies, divisional distortions as well as independent of payout policies. Thus, they are very useful in valuing conglomerates, segments and new economy stocks such as internet, dotcom and biotech companies.


Exercises: Questions Level I


questions I / page 1

Q3 Sept 02: Equity valuation

Alpha Ltd has just paid a dividend of EUR 0.75 per share. It has a retention ratio of 40% and a current market price of EUR 10. Dividends are paid annually and the CAPM holds for annual returns. The expected annual return on the market is 11% and the riskless rate is 5%. Alpha’s stock has a beta of 1.5. The expected return on book equity each year is a constant (ROE). When appropriate, please use the constant growth model. a) What is the expected annual return on Alpha’s stock? b) What are the expected growth rate of dividends for Alpha's stock, the expected return on

book equity (ROE) and the book value per share as of today? c) If you buy Alpha stock today and hold it for one year, what is your expected holding

period return? d) What are the main points of strength and weakness of the constant growth model?

Q2 March 03: Equity valuation

Ms Clear is evaluating Petrol Asia Limited for potential inclusion in her investment portfolio. She has gathered the following information about the company:

Expected net earnings for next year USD 1 million Number of shares outstanding 500’000 Dividend payout ratio 30% Dividend growth rate 10% Risk-free rate 5% Market risk premium 6% Beta for Petrol Asia 1.2 Current stock price USD 25

a) Estimate the dividend per share for each of the next two years. b) Using the dividend discount model, estimate the value of the stock. Should Ms Clear buy

the stock at the current market price? Explain your answer. c) Assuming that the price-earnings ratio remains constant over time, calculate the rate of

return for a one-year holding period. Show how this return can be expressed in terms of dividend yield and growth rate. Is your answer dependent on the hypothesis of a constant P/E ratio and that of a constant growth rate?

d) Assume that Ms Clear bought the stock at the beginning of the first year (t=0) at 25. The

dividend for the first year was 0.8, the growth rate for the second year was 10% as expected, but dropped to 5% the third year. The payout ratio remains constant at 30%. At the end of the second year (t=2), when Ms Clear sold the stock, the P/E ratio was 8.


Calculate the internal rate of return (IRR) of the investment of Ms Clear over the two-year period.


Company Alpha Income Statement Year N (in CHF ‘000)

Sales 600’000 Cost of goods sold 350’000 Gross operating profit 250’000 Selling, general and administrative expenses 100’000 EBITDA 150’000 Depreciation and amortization 75’000 EBIT 75’000 Interest expenses 20’000 Pre-tax income 55’000 Income taxes 19’250 Net income 35’750

Other Information

Shares outstanding 21’000 Earnings per share (EPS) 1.70 Dividend paid 14’300 Total assets 578’000 Current liabilities 162’000 Long term liabilities 250’000

a) Based on the data contained in the above table, compute the rate of sustainable growth,

i.e. the growth rate of the company that can be achieved through internal financing all things being equal.

b) Estimate the value per share using the DDM (dividend discount model) with the

following hypotheses: a growth rate of 12% for the first three years, 6% for the subsequent years, and a cost of equity of 9.5%.

c) One of your colleagues is suggesting that the value of equity should be computed by

determining first the present value of the WACC of free cash flows to firm and then deducting debt. What do you think? Explain your answer.

d) Compute the free cash flow to firm for year N knowing that the investments in fixed

assets for the year amount to CHF 50 million and that the net working capital has decreased by CHF 10 million.

e) Is it correct to say that the ratio EBITDA/Sales is a good indicator to rank companies

across industries?



You work for a fund management company and specialize in companies working in the metal and mining sector. At the end of 2003, you have been asked to perform an analysis of Australian Metal Company (AMC) for which you have collected the following information: Financial Statements (in Australian $ - AUD - million, except if stated otherwise)

2000 2001 2002 2003 2004E

Total revenues 21'665 22'346 23'564 22'786 23'780Operating expenses 20'456 21'983 21'980 21'800 22'009Interest expense 340 348 347 498 440Pre-tax income 869 15 1'237 488 1'331Taxes 300 8 420 165 480Net income 569 7 817 323 851Tax rate (in %) 34.5% 53.3% 34.0% 33.8% 36.1%

Book value 9.75 11.31 13.18 15.25 15.91

Outstanding shares (in million) 240 240 242 251 251Avg. stock price (in AUD) 37 39 35 35 *EPS (in AUD) 2.37 0.03 3.38 1.29 3.39Dividend per share (in AUD) 0.6 0.62 0.67 0.73 0.8* today's share price

2000 2001 2002 2003 2004ECurrent assets 3'230 3'454 3'857 4'400 4'645Fixed assets 4'657 4'898 5'243 6'001 6'100Total assets 7'887 8'352 9'100 10'401 10'745

Current liabilities 2'658 2'727 2'900 3'121 3'300Long-term debt 2'890 2'911 3'011 3'453 3'452Shareholders' equity 2'339 2'714 3'189 3'827 3'993Total liabilities & SE 7'887 8'352 9'100 10'401 10'745 In addition to the data in the table above, you downloaded from Bloomberg the following information: Depreciation in 2003: AUD 408m Depreciation estimated for 2004: AUD 420m Coupon rate on long-term debt 8% (Debt trades at par value) Market risk premium: 6.5% Beta: 1.2 Risk-free rate: 5% a) Based on the above information, compute the firm’s weighted average cost of capital (for

the market value of debt, only consider the long-term debt) as of today. What assumption is made by the suggestion to discard short term liabilities when computing the market value of debt?

b) Compute the free cash flow to firm for year 2004 and show the details of your

computation.


c)

c1) A friend of yours estimates the free cash flows to firm (FCFF) of AMC for years 2004 to 2006 as follows: FCFF 2004 = 1’000 FCFF 2005 = 1’050 FCFF 2006 = 1’080 Furthermore, your friend calculated a WACC of 13% and assumed that the company will grow at 8% per year after 2006. Compute AMC’s value as of the beginning of 2004 using your friend’s estimates.

c2) In the above calculation of the value of the firm, assume that AMC had in addition financial assets amounting to AUD 500m and a financial revenue of AUD 30m. How would you have taken into account these figures in computing the total value of the firm? (no computations are required)

c3) Assuming that the total value of the firm is 16’000m, estimate the value per share of

AMC’s common stock. Discuss the current share price level.


Cabernet Inc. and Merlot Inc. are two US companies in the same business risk class. Cabernet is a quoted company with a debt/equity ratio of 1/3. The company’s equity beta is 1.6 and the debt capital can be assumed to be riskless. Merlot is an unquoted and all equity-financed company. The expected return on the S&P Index is 16%. The return on Treasury Bills (and also the return on Cabernet’s debt) is 10%. Assume that both Cabernet and Merlot pay out constant annual dividends. Cabernet’s debt is irredeemable. Ignore taxation. a) Explain what is meant by the term “same business risk class”. What will be the

consequence as far as the betas are concerned? Estimate the equity beta of Merlot. b) Estimate the weighted average cost of capital (WACC) of each company and comment

briefly on the significance of your figures in the Modigliani and Miller's capital structure framework with no tax.

c) A small shareholder of Merlot just received his regular dividend of USD 150 and, at the

same time, an investor offered him USD 1,000 per share. However, he does not know whether or not to sell his shares as he relies heavily on his annual dividend. Knowing that the payout ratio is 100%, a financial analyst correctly computes the theoretical price of his shares as USD 872.0. He therefore tells the shareholder that he should accept the offer and use the proceeds of the sale to buy Cabernet's securities. Explain how this shareholder can make a profit from this arbitrage suggestion. What would be his resulting gain?



You are asked to evaluate a privatization candidate - DNIPROTUBE, a Ukrainian tube producer for the State Property Fund of Ukraine. You are provided with the following simplified information on DNIPROTUBE assets (in Ukrainian Hryvnias, UAH): Total assets UAH 650 billion Liabilities UAH 250 billion Common shareholders’ equity UAH 400 billion The Company is expected to generate revenues of UAH 510 billion next year and earnings before interest and taxes (EBIT) of UAH 160 billion. The interest expenses amount to UAH 80 billion and the corporate tax rate in Ukraine is 28%. DNIPROTUBE is expected to maintain sales in its niche product, oil country tubular goods, and grow at 5% a year in the foreseeable future, primarily by expanding exports to Russia and Asian markets. In addition to the above data you downloaded from the Internet the following information: - The average beta, based upon metallurgical counterparts from Eastern European and CIS

countries, equals 1.1 - The government bond rate in Ukraine (risk-free rate) is 8.5% - The risk premium for Ukrainian stocks over bonds is assumed to be 4.0%. a) Calculate the required rate of return on DNIPROTUBE’s equity.

b) The formula: P/BV = (ROE - g)/(r - g) is derived from the Gordon growth model, using g = ROE · Retention Ratio, where P value of equity BV book value of equity g growth rate ROE return on equity (based upon expected earnings in the next time period) r required rate of return on equity. Compute the P/BV ratio for DNIPROTUBE and estimate the Company’s Value of Equity.

c) State two major advantages and two major disadvantages of the price-to-book value ratio

valuation methodology. d) Explain how changes in the return on equity of a company influence its price-to-book

value ratio. e) Is it correct to say that the market value of a company might deviate significantly from its

book value? If you agree with the statement, specify the fundamental reason for this deviation. If you disagree, explain with reasons.



You are working for an investment firm and are currently involved in the valuation of an IPO by Interlink, an internet company. The company was founded three years ago and still has no debt. As a first step, conduct an analysis on the following data: Sales (for t = 0): USD 25 million Expected annual growth in sales: 20% (for the first 5 years) Net operating profit margin: 10% of sales Marginal tax rate: 35% Net working capital: 5% of the sales Capex (capital expenditure) 10% of the sales increase Risk free rate: 4% Return on market: 11% Interlink’s beta: 1.2 The company has no non-operating incomes / expenses. a) Estimate the gross cash flows (i.e. annual after-tax cash flows before taking into account

the changes in working capital and Capex) for the first 5 years (from t=1 to t=5). Assume that that the annual depreciation is USD 0.75 million and that there are no other relevant non-cash expenses or incomes.

b) Estimate the annual fixed capital expenses (capex) and the changes in working capital

needs. For the sake of simplicity, assume they occur at the end of the years. Then calculate the annual free cash flow from t=1 to t=5.

c) What would be the appropriate discount rate for Interlink’s free cash flows? d) Assume that a firm value at the end of the fifth year is estimated by applying the Gordon-

Shapiro formula. A colleague of yours argues that the use of the cost of capital found above is not appropriate for this calculation. What do you think? Motivate your answer.



The income statement and balance sheet for the years 2004 and 2005 of SE Company are given under Tables 1 and 2. All figures are in USD million.

Table 1: Income statement 2005 2004 Net sales 310.3 208.9 Cost of goods sold 71.6 52.9 Selling and administrative expenses 17.8 14.1 Income before depreciation and amortization 220.9 141.9 Depreciation and amortization 81.6 63.1 Interest expenses 27.6 27.3 Non-operating income -10.2 -0.9 Income before tax 101.4 50.7 Provision for income tax 33 16.5 Income after tax 68.5 34.3 Net income before extra items 68.5 34.3 Extra items - -4.4 Net income 68.5 29.9

Table 2: Balance sheet (as of 31/12)

2005 2004 Cash 4.9 1.1 Receivables 39 27.4 Other current assets 10.4 5 Total current assets 54.4 33.5 Property, plant, and equipment, gross 1,572.60 1,383.30 Accumulated depreciation 649.2 567.5 Property, plant, and equipment, net 923.4 815.8 Deferred charges 12.7 10.5 Total non-current assets 936.2 826.4 Total assets 990.6 859.8 Accounts payable 29.4 26.2 Accrued expenses 31.7 38.2 Other current liabilities 7.5 4.9 Total current liabilities 68.6 69.4 Deferred charges to income 73.1 43.5 Long term debt 357.5 340.3 Other long term liabilities 17.2 9.3 Total non-current liabilities 447.8 393.1 Total liabilities 516.4 462.4 Common stock, net 0.3 0.3 Capital surplus 343.5 334.9 Retained earnings 138.5 70.1 Treasury stock 6.9 7.6 Other comprehensive income (loss) -1.3 -0.3 Total shareholders' equity 474.2 397.4 Total liabilities and shareholders' equity 990.6 859.8


Additional information:

2005 2004

Weighted average shares outstanding (million) 27.8 27.3

Exercisable share options (million) 1.71 1.48

Exercise price (in USD) 15.00 13.71

Average stock price (in USD) 21.62 15.89 a) Calculate the basic EPS for 2004 and 2005 and the diluted EPS for 2005 only. b) State two drawbacks of using EPS for valuing firms. Discuss the idea that cash flow per

share is a better criterion than EPS when comparing and ranking companies across industries.

c) The analysts predict that SE Company is at the end of a supernormal growth period and

estimate that the EPS would grow at a rate of 25% p.a. for the next 5 years before settling down to a normal growth rate of 10% p.a. The company is not expected to pay any dividends for the next 5 years after which the payout ratio is estimated to be 30%. The company’s beta is 1.36, market risk premium is 7.35% and risk free rate is 5%. What is the estimated share price of SE Company’s stock? Assume the current EPS of SE Company to be USD 2.46.


The details of the dividends per share paid by company ABC during the last three years and this year (assume today is 0t = ) are:

t=-3 t=-2 t=-1 t=0 Dividend (in CU) 12 14 15 16

a) Determine the yearly average rate of growth g of the dividends from year t = -3 to t = 0. b) Assume that the company ABC has a beta of 1.3, that the expected rate of return of the

market is [ ] 1.0rE mkt = and that the risk-free rate of return is 04.0rf = . Determine the

price in 0t = of company’s ABC share if you assume that the average rate of growth g computed in a) remains the same for the future.

c) Using Gordon-Shapiro’s formula, explain the relationship between the discount rate k

estimated with CAPM formula and the price/earnings ratio. What is the effect on the price/earnings ratio of an increase in the discount rate k ? Explain.

d) With the objective of an acquisition, Company ABC is evaluating a competitor that shows

lower growth and similar pre-tax margin. The acquisition would be completely financed by a bond issue of CU 500 million. With this acquisition, the total revenues of company ABC will increase significantly.


d1) Discuss the effect of this acquisition on the value of the three parameters of the constant-growth dividend discount model used to valuate company ABC.

d2) Discuss the effect of this acquisition on the P/E multiple of company ABC.


a) In mid May 2006, immediately after the release of the new earnings-per-share figures of Company A of 174 CHF and a dividend per share of 42 CHF, you buy A shares at a price of 2,058 CHF. You believe that earnings and dividends will increase at a rate of 7.8% per year. You require a rate of return of 10% on this investment.

a1) What will be the required selling price that will satisfy your expectations when you

sell your shares in May 2008? a2) Does this result imply a change in the P/E ratio? Explain your answer.

Last year, Company B paid out dividends of 0.75 USD per share. The market expects a constant growth rate of earnings and dividends of 10%. Last year, 25% of the earnings have been paid out as dividends. It is commonly expected that this payout ratio stays constant. The firm’s expected cost of equity is 15%. Based on this information, answer the following questions (Assume we are at the beginning of the year and that both dividends and earnings accrue at the end of the year). b) What is the theoretical P/E ratio of the firm based on the expected earnings for the current

year? c) Assume that Company C operates in the same industry as Company B. Both firms use the

same product technology, have the same capital structure, have the same expected earnings per share (EPS) for this year and the same constant payout ratio. The P/E ratio of Company C (based on expected earnings for the current year) is 10. Would you conclude from the P/E ratio (which is higher than that of Company B) that Company C is overvalued? What could explain the differences between the P/E ratios? Justify your answer with calculations.

d) The P/E ratio has often been proposed to estimate share prices. For this calculation, you

simply have to multiply the adequate P/E ratio with the equivalent estimate of earnings per share (EPS). Is there any relation between this valuation method and the dividend discount model? Answer this question generally.

e) Is there any relation between P/E ratios and the cost of equity of a firm? Answer this

question under the assumption that a firm has a P/E ratio of 20, a constant payout ratio of 40% and an expected constant dividend growth rate of 10%. What is the cost of equity kE of the firm?


Exercises: Questions Level II


questions II / page 1

Q3 March 03: Equity Valuation and Analysis

In early 2002, Steve Larson, Senior Portfolio Manager of a London based group of mutual funds, was considering whether to add shares of Glamour Woman, Inc. (GW) in their small-capitalization equity portfolio. GW is a cosmetic marketing company that sells its products exclusively through catalog mail order. Steve believes that the mail order and catalog business will steadily increase over time. Steve wants to evaluate the recent performance and suitability of acquiring GW stock. Recently, he received the 2001 annual report from GW. Use the data provided in Table 1 to answer the following questions. a) Compute the sustainable growth rate and actual growth rate in sales for the years 2000 and

2001. Note: Sustainable growth rate is defined as a maximum rate of growth a firm can sustain without increasing

financial leverage. You may assume that sustainable growth rate is equal to the product of return-on-equity and retention ratio.

b) GW's actual sales growth rate in 2001 is more than the sustainable growth rate. Describe

and briefly discuss two courses of action GW could take if the actual growth rate continues to exceed its sustainable growth rate.

c) Briefly discuss how an increase in the dividend payout ratio will affect the stock price. d) Assuming that GW will be able to maintain a constant growth rate of 9 percent forever,

calculate the required rate of return on equity and theoretical value of the stock at the beginning of 2002. Based on your result, would you recommend Steve to purchase this stock?

e) After a meeting with GW’s Chief Financial Officer (CFO), Steve informs you that in the

CFO’s opinion, the long-term growth rate you assumed above may not be sustainable. The CFO believes that dividends could grow at a rate of 7 percent a year for the next four years, after which they are more likely grow at a constant rate of 5 percent per year indefinitely. Recalculate your estimate for GW’s stock value and discuss whether your recommendation about acquiring GW stock has changed in light of your new estimate?


Table 1. Glamour Woman, Inc.

Income Statement (USD million, except per share data) for the years 1999, 2000, and 2001

1999 2000 2001 Sales 48 976 47 171 54 597 Cost of Goods sold 23 808 21 085 24 855 Gross Profit 25 168 26 086 29 742 Operating Expenses 20 578 18 408 21 279 Operating Income 4 590 7 678 8 463 Interest Expense 714 837 940 Earnings before taxes 3 876 6 841 7 523 Income Tax 1 527 2 531 2 633 Net Income 2 349 4 310 4 890

Glamour Woman, Inc. Balance Sheet (USD million, except per share data)

for the years ended December 31, 1999, 2000, and 2001

1999 2000 2001 Assets Current assets 22 556 25 776 30 964 Property plant and equipment 17 446 17 455 19 220 Other fixed assets 382 544 485 Total assets 40 384 43 775 50 669 Liabilities and Stockholder Equity Current Liabilities 10 290 11 644 14 073 Long-term debt 9 243 9 734 11 655 Deferred taxes 844 1 316 1 395 Other non-current liabilities 734 844 1 002 Stockholders' equity 19 273 20 237 22 544 Total Liabilities and Stockholder Equity 40 384 43 775 50 669 Other Information: Common Dividends (USD million) 1 582 2 474 2 979 Number of shares outstanding (million) 3 955 4 123 4 255 Closing price per share 15.25 22.75 24.30 Risk free rate of return 3.0% Expected return of S&P500 10.5% GW's Beta 1.22


Q4 March 04: Equity Valuation and Analysis / Corporate finance

Company ABC is reportedly considering acquisition of Company XYZ. Company ABC has net earnings of EUR 1 million, outstanding shares of 250,000, and a share price of EUR 100. Company XYZ has net earnings of EUR 400,000, outstanding shares of 100,000, and a share price of EUR 40. Neither company has any debt.

Status of ABC and XYZ Company ABC Company XYZ Net earnings (EUR) 1,000,000 400,000 Number of outstanding shares 250,000 100,000 Earnings per share (EUR) 4 4 Price-to-earnings ratio 25 10 Share price (EUR) 100 40

a) Bob Sapp, an analyst, estimates that the synergy resulting from Company ABC acquiring

Company XYZ has a present value of EUR 1.5 million. If Company ABC acquires Company XYZ for EUR 5 million cash, what will be the total profit to the shareholders of Company ABC from the acquisition? (In other words, how much will Company ABC's value increase?)

b) Mr. Sapp's investment guideline is that a company considering a merger or acquisition is a

potential ‘buy’ if its earnings per share will increase as a result of the merger/acquisition. Evaluate this valuation method.

c) Company ABC decides to attach a premium of EUR 10 to Company XYZ’s share price,

valuing XYZ at EUR 50. It proposes to acquire XYZ by exchanging one newly issued ABC share for two shares in XYZ. Given Mr. Sapp's estimate for the present value of the synergy effect from the acquisition of EUR 1.5 million, calculate the total profits brought to the shareholders of the old ABC.

d) Given Mr. Sapp's estimate of the synergy effect, which would be more advantageous for

the shareholders of Company XYZ, a cash tender offer for EUR 5 million or a stock offer at one ABC share for two shares of XYZ?

e) Several papers have been published showing that acquiring companies’ share prices rise

slightly after the announcement of a cash acquisition, but that share prices decline after the announcement of a stock offer. Discuss two reasons that can help explain this result utilizing the “asymmetric information” concept.


Q2 Sept 04: Equity Valuation and Analysis

Apex Heavy Vehicles Ltd is evaluating a proposal to manufacture commercial vehicles. The project will require an initial investment (in year 0) of CU 500,000 in plant and equipment. This initial investment will be depreciated on a straight-line basis, down to a salvage value of CU 100,000 at the end of the fourth year. During the first year, the investment is expected to generate revenues of CU 300,000 and operational expenses of CU 100,000. The CFO of Apex, who analyzed the project in detail, estimates that the revenues and expenses can be expected to grow at an annual rate of 5%, from the first to the fourth year. The marginal income tax rate applicable to the company is 36%. The cost of capital of the company after tax is 10% (see below for definition).

The CFO discussed at length the treatment of inflation in evaluating the project and finally decided to completely ignore inflation in estimating the cash flows. He also considers that the cost of capital should be calculated after tax, but without any adjustment for inflation. He used the CAPM to estimate the cost of equity capital. As no reliable information on the risk-free rate suitable for the project's time horizon was available, he used the 90-day Treasury bill rate as proxy. He was also concerned about the possibility of a change of the income tax rate and was wondering how it will impact the net present value of the project.

a) For years 1 to 4, calculate the cash flows from operations of the investment project. b) Based on the net present value (NPV) criterion, is this project acceptable? What will be

the impact on the shareholders' wealth if the project is accepted? c) Discuss the main assumption made when ignoring inflation in the free cash flow

estimation process. How should one treat inflation in (i) estimating the free cash flows and (ii) calculating the net present value?

d) Discuss the impact of a higher income tax rate on the net present value of the project.

Then compute the impact on the NPV of the depreciation tax shield using a tax rate of 40% instead of 36%.

e) Discuss the use of the interest rate on 90-day Treasury bills as a proxy for the risk-free

rate. What could be the impact of a wrong estimation of the cost of capital on the decision to accept or reject an investment proposal? As an illustration, consider two projects with differing cash flow profiles but whose NPVs are equal when using the appropriate cost of capital. What will be the effect of using incorrect cost of capital?



At the beginning of 2005, you are analyzing the three following manufacturing companies: • Alpha Electric (US) is one of the largest and most diversified industrial companies in the

world. Business segments include aircraft engines, appliances, locomotives engines, industrial systems, power generation and turbine generators, as well as consumer finance and insurance.

• Beta Computer (US) is the world’s largest computer manufacturing and direct marketing

company. The company makes notebooks and desktop computers, workstations, servers and storage products.

• Gamma Motor (US) is a large automobile manufacturer with foreign sales accounting for

about 40% of the business. The company also operates in the vehicle leasing and rentals as well as financial services.

a) Using the financial data in appendix 1 and considering the highest price and relevant

financial data of the year 2003, complete the following table for 2003:

Alpha Beta Gamma MFG 500 P/CF (Price/Cash flow) P/E (Price/Earning) Dividend yield in %

Compare the results of the three companies to those obtained for the MFG 500 Index, which represents the benchmark. Explain the reasons for the observed differences. Are the reasons you gave confirmed by the four-year data history of the three companies?

b) A colleague applied the discounted cash flow model (DCF) to estimate the value of the

three firms as of end 2004 by using a discount rate of 10%. For the next five years, he assumed that Alpha and Beta maintain the growth rate of the year 2004, and assumed a 7% growth rate for Gamma. The perpetual rate after five years is supposed to be equal to the expected market growth of 5%. He obtained the followings results:

• Estimated value of Alpha stock = 47.60

• Estimated value of Beta stock = 70.77

• Estimated value of Gamma stock = 170.79

Comment upon the results obtained by your colleague and compare them to the 2004 price range. Why is the estimated value of Gamma Motor so far above the highest price observed in 2004? Using the same hypotheses as your colleague, estimate the share price of Gamma by applying the dividend discount model (DDM) (show all your data and calculations). Which discounting method is more appropriate for Gamma Motor and why?

c) Assume that currently the world economy is in a recession with two quarters of negative

growth. Elaborate on the possible implications for the three companies by referring to the ratios calculated above in a) and the estimated stock prices calculated in b). Then, discuss


the implications of a strong economic recovery (after the recession). Are there different implications?

APPENDIX 1

Financial Data (all numbers in US Dollars) 2001 2002 2003 2004

Alpha Electric Stock price range (max/min) 25/16 34/23 53/31 60/41 Sales per share 5 5,25 5,65 6,42 Cash flow (CF) per share 1 1,18 1,32 1,51 CF growth rate % 18 12 14,67 Earnings per share 0,83 0,93 1,07 1,27 Dividends per share 0,36 0,42 0,49 0,57 Book value per share 3,52 3,96 4,32 5,08 Operating margin % 19 21,2 21,4 21,8 Return on equity % 23,8 23,9 25,2 25,2

Beta Computer Stock price range (max/min) 13/3 40/10 55/31 60/16 Sales per share 4,79 7,17 9,81 12,26 Cash flow (CF) per share 0,39 0,61 0,72 0,98 CF growth rate % 56 18 36,67 Earnings per share 0,32 0,51 0,68 0,84 Dividends per share nil Book value per share 0,5 0,91 2,06 2,16 Operating margin % 11,2 11,8 10,3 9,4 Return on equity % 73 62 35 41

Gamma Motor Stock price range (max/min) 50/30 66/39 68/46 57/22 Sales per share 126 126 133 90 Cash flow (CF) per share 11,9 13,2 13,5 7,46 CF growth rate % 11 2 -45 Earnings per share 5,62 5,28 5,86 3,22 Dividends per share 1,65 1,72 1,88 1,8 Book value per share 24,8 20,63 22,5 9,75 Operating margin % 25 25 23,7 22,6 Return on equity % 22,5 28,1 26,3 25,9

MFG 500 Price range (max/min) 1470/1212 Cash flow (CF) per share 82,2 Earnings per share 48,17 Dividends per share 16,7 Price to book 7,2 Return on equity 18



The JUN Corporation's share price is currently 95 euros, and its book value per share was 100 euros at the end of last year. The Research Department at MKI Asset Management has published an investment opinion on JUN's stock, forecasting a return on equity (ROE) of 10% and a payout ratio of 30% into perpetuity. The risk-free rate is 3%, the stock market risk premium 7% and JUN's estimated beta is 1.1. Assumptions used in the JUN Corporation investment opinion:

Return on shareholders' equity (ROE) 10% Payout ratio 30% Book value per share (BVPS) at the end of last year 100 euros Risk-free rate 3% Stock market risk premium 7% JUN's beta 1.1 JUN's share price 95 euros

a) Based on the forecasts from the MKI Asset Management Research Department, calculate

the expected rate of return (implied return) on JUN’s shares at the current share price, by using the constant growth dividend discount model. Then, discuss whether JUN’s shares are trading at a discount or at a premium if the CAPM holds.

b) Mr. White, an analyst at MKI Asset Management, uses a different approach. He calculates

the theoretical share price by adding the present value (PV) of the future residual income per share to the current book value per share (BVPS) using the following formulae: Theoretical share price = (BVPS at end of last year) + (PV of residual income per share in and after this year) Residual income per share = EPS – (BVPS at end of last year) · (Required rate of return on equity) Show the calculations following Mr. White’s approach. Then, discuss whether JUN’s shares are trading at a discount or at a premium.

c) Mr. Field, a fund manager at MKI Asset Management, aggressively includes in his

portfolio shares with a price-to-book ratio (PBR) below 1, based on the rationale that such shares are trading at a discount, as they are cheaper than liquidation value. Based on this philosophy, he has decided to invest in JUN’s shares. Explain what is wrong with Mr. Field's investment decision.

d) Provide two arguments that could support Mr. Field's investment philosophy mentioned

above.



You are at the end of Year 2005. Company X operates a major portal site on the Internet that provides a full range of services, including an online shopping mall and a search engine. It is considering acquiring Company Y, a game software developer. The acquisition would take the form of a stock-for-stock exchange, with 2 stocks in Company X allotted per 1 stock in Company Y. Answer questions a) through d) referring to the information in Tables 1 through 3. Assume that the risk-free rate is 2% and the market risk premium is 4%. a) Calculate the cost of equity capital for Company X and Company Y based on the CAPM.

Then, calculate the dividend growth rate for Company X and Company Y by using the constant-growth dividend discount model. You may assume that current stock prices are at theoretically appropriate levels.

b) At the beginning of Year 2006, the merger is processed as planned above. The market

welcomes the acquisition of Company Y by Company X, and the merged Company XY's stock price rises by JPY 40 to JPY 540. Company XY has a payout ratio of 50% and cost of equity capital of 5.2%. Analyst A postulates that there will be no immediate effect on sales and net income after the merger between Company X and Company Y. Analyst A therefore judges the rise in the post-merger stock price to be driven by investor expectations of a long-term rise in the dividend growth rate only. Assuming it is possible to use the constant-growth dividend discount model to evaluate the stock value and that Analyst A's judgment is correct, calculate the dividend growth rate. Then discuss whether you support Analyst A's judgment.

c) Analyst B anticipates a synergy effect from the merger and says that if the acquisition

succeeds, Company XY's sales will be 5% higher in the future than the total sales of Company X and Company Y on their own. Analyst B also makes the following assumptions about the post-merger Company XY. Payout ratio = 50% Ratio of EBIT to sales = 7.9% Ratio of interest payments to sales = 2.5% Corporate tax rate = 40% Dividend growth rate = 3.2%

Analyst B uses the results of the regression analysis shown in Table 3 to conclude that Company XY's cost of equity capital will be 5.2%. By using the constant growth dividend model, calculate Company XY's theoretical price per stock based on Analyst B's assumptions.

d) Analyst C agrees with Analyst B that Company XY will see a 5% increase in sales.

However, Analyst C thinks that if the acquisition succeeds Company XY's fundamental value will be even higher than Analyst B says. There are two reasons for this. Analyst C has different expectations than Analyst B about the merger effect, and Analyst C estimates post-merger Company XY's cost of equity capital to be lower than Analyst B.

d1) Show how Analyst B presumably estimated Company XY’s cost of equity capital at

5.2%.


d2) Using the figures in Table 2, discuss factors that would support Analyst C's judgment (in contrast to Analyst B’s assumptions) about the merger effect.

d3) Discuss problem areas that would account for the different estimations of the cost of

equity capital by Analyst B and Analyst C and describe alternative estimation methods.

Table 1: Next year's (2006) results forecasts, current stock prices, and stocks issued and outstanding for Company X and Company Y Sales, net income and dividends are forecasts for next year (2006; in million JPY). Stock prices are in JPY. Issued and outstanding stocks are in million stocks. Net assets are in million JPY.

Company X Company Y

Sales 135,000 4,200

Net income 4,000 200

Dividends 2,000 60

Stock price 500 1,000

Number of shares 200 10

Net assets 71,500 1,600 Table 2: Results for the past 3 years (million JPY)

Company X Company Y 2003 2004 2005 Past 3 year

average 2003 2004 2005 Past 3 year

average Sales 123,339 124,598 131,952 126,630 3,022 2,043 4,905 3,323 Cost of sales 80,069 81,290 85,164 82,174 1,953 1,335 3,214 2,167 Selling, general & administrative expenses

27,344 27,402 29,037 27,928 743 518 1,207 823

Depreciation charges

6,339 6,456 6,443 6,413 101 102 98 100

EBIT 9,587 9,450 11,308 10,115 225 88 386 233 Interest expense 2,733 2,739 2,748 2,740 202 194 199 198 EBT 6,854 6,711 8,560 7,375 23 -106 187 35 Corporate taxes 2,776 2,678 3,475 2,976 8 0 76 28 Net income 4,078 4,033 5,085 4,399 15 -106 111 7 EBIT/Sales 7.77% 7.58% 8.57% 7.99% 7.45% 4.31% 7.87% 7.01% Interest expense/ Sales

2.22% 2.20% 2.08% 2.16% 6.68% 9.50% 4.06% 5.97%


Table 3: Results of regression analysis The regression analysis was conducted by using monthly rate of return for the latest 36 months. tXr , ( tYr , ) is the excess return over risk-free assets for Company X (Company

Y); tMr , denotes the excess return of the value weighted stock index. Numbers in

parentheses are t values of regression coefficients. Company X t,Xt,Mt,X r700.0 100.0 r ε+⋅+−=

(5.354) (-3.265) R-squared = 0.456 Company Y r800.1 002.0 r t,Yt,Mt,Y ε+⋅+−=

(2.537) (-6.265) R-squared = 0.246


IT Corporation was established just a year ago and is planning a EUR 5 million equity financing so that it can begin fully-fledged operations. Mr. Young, a venture capitalist, is considering purchasing newly issued shares of IT and then selling his equity when the company goes public. According to the business plan submitted by the IT management team, IT Corporation plans to go public in five years time with net income of EUR 20 million. It anticipates a price earnings ratio (PER) at the time of the IPO of 30, which is the industry average. IT currently has 1 million shares issued and outstanding and no plans for further stock issues or dividend payments until the IPO. Mr. Young thinks that the required rate of return on IT equity should be 50%. a) Calculate the total market capitalization (theoretical price) after the equity financing of IT

from Mr. Young’s perspective. b) Calculate the share price at which Mr. Young should purchase new shares of IT. c) It is common for venture capitalists to employ extremely high required rates of return of

between 40% and 100% when making equity investments in new startups. Discuss two reasons why privately-held startups are required to have far higher rates of return than publicly-traded companies.

d) “Real options” are the options, inherent in corporate management and business operations,

to modify, cancel and defer investment projects as conditions warrant. It is possible to use option valuation theory to calculate the impact of this inherent flexibility in corporate management on the value of an investment project or a company as a whole.

d1) Mr. Young is considering applying the “real option” approach to evaluate venture

capital investments. Discuss why the real option approach is considered to be a suitable evaluation method for venture capital investments.


d2) Briefly explain, in general, under which circumstances it might be better to use real options to valuate projects and list three examples you can think of.


Exercises: Solutions Level I


solutions I / page 1

SQ3 Sept 02: Equity valuation

a) From the CAPM: E[R] = 5% + 1.5 · (11% - 5%) = 14%.

b) From the constant growth dividend discount model: gk

DP

E

10 −

=

And so g14.0

)g1(75.010

−+⋅=

1.4 – 10 · g = 0.75 + 0.75 · g Therefore the growth rate g = 0.65/10.75 = 0.060465 and ROE = g/(1-π) = 0.060465/0.4 = 0.15116 Since the expected dividends in one year’s time are: E(D1) = D0 · [1+g] = 0.75 · [1+0.060465] = 0.79535 and E1 = E(D1)/π = 0.79535/0.6 = 1.3256 then the book value of equity per share today is: K0 = E(E1)/ROE = 1.3256/0.15116 = 8.7692

c) We know that the expected holding period return is 14%. So the answer is exactly 14%. d) The principal advantage of the model is its simplicity.

However, some assumptions are needed for the model to hold (stable growth rates, stable leverage. Furthermore, the "constant" and "stable" growth rate cannot be higher than the growth rate of the economy in which the firm operates.

SQ2 March 03: Equity valuation

a) Dividend per share1 = EPS1 · π = USD 1 million/0.5 million · 0.3 = USD 0.6 per share Dividend per share2 = USD 0.6 · 1.1 USD = USD 0.66 per share b) kE = rf + β · (risk premium) = 5% + 1.2 · 6 = 12.2% Using the constant growth model, the value of the stock is determined as follows:

27.271.0122.0

60.010 =

−=

−=

gk

DivP

Since the resulting value is greater than the current stock price, we conclude that the stock is underpriced and she should buy the stock (2 points). However, the difference is small, and a slight change in the value of the parameters could change the decision. (2 points)


c) The current P/E ratio is 12.5 (= 25/2). The expected EPS is 2.2 for year 2. Therefore, the expected stock price at the beginning of next year is 5.272.25.12 =⋅ . A simpler way of finding this is to multiply the current price (25) by one plus the growth rate (10%): 25 · 1.1 = 27.5. The return is: ((27.5 + 0.6)/25) - 1 = 12.4%. Yes, this return can be expressed as 0.6/25 + 10% = 2.4% + 10% = 12.4% Yes, if the P/E declines for instance, the return will drop (and vice versa). The same explanation applies with the growth rate. d) The dividend of the first year is 0.8, that of the second year = 0.8 · 1.1 = 0.88, and that of the third year = 0.88 · 1.05 = 0.924. The earnings of the third year = 0.924/0.3 = 3.08. The selling price at the end of the second year will be 3.08 · 8 = 24.64. The cash flow at t=0 is –25, that at t=1 is 0.8, and that at t=2 is 0.88 + 24.64 = 25.52. The IRR amounts to 2.65%.


a) Sustainable growth rate = return on equity � earnings retention rate

= %9.126.021536.0))750'35

300'14(1()

000'166

750'35( =⋅=−⋅

or = (net profit – dividend)/equity = (35’750 – 14’300)/166’000 = 12.9% b)

68095.0000'21

300'14

Shares gOutstandin

DividendsCash DPS0 ===

DPS1 = DPS0 � 1.12 = 0.76267 DPS2 = DPS1 � 1.12 = 0.85419 DPS3 = DPS2 � 1.12 = 0.95669 DPS4 = DPS3 � 1.06 = 1.01409 Terminal value = 28.97

Value per share = 3

e

e

4

3e

32

e

2

e

1

)k1(

)gk(

DPS

)k1(

DPS

)k1(

DPS

)k1(

DPS

+−

++

++

++

Estimated value per share = =−+++332 095.1

)06.0095.0(

01409.1

095.1

95669.0

095.1

85419.0

095.1

76267.024.21

c) Your colleague is right because the value of equity is primarily determined by the cash generated by the assets. The FCFF approach is more appropriate when doing scenarios concerning operating activities as well as debt policies.


d) Tax rate = 19'250/55'000 = 35% NOPAT = 75'000 x (1- 0.35) = 48'750 Operating cash flow = 48'750 + 75'000 = 123'750 FCFF = 123'750 – 50'000 + 10'000 = 83'750 e) No, because this ratio is very dependent upon the industry. Capital intensive companies will appear on the top of the rankings, though they may not be very profitable. Across industries, the ratio EBIT/Sales is a better measure, even though depreciation is not necessarily a good proxy for required investments. In any case, a ranking is always much better if it is based on returns rather than margins.


a) Cost of equity = 5% + 1.2 · 6.5 = 12.8% Debt and equity weights (based on market values): Equity: 35 · AUD 251m = AUD 8’785m Since the firm’s debt is trading at par value, the market value is equal to the book value: AUD 3’453m Weight of equity = 8785/(8785 + 3453) = 71.8% Weight of debt = 1 - 71.8% = 28.2% WACC computation: 0.718 · 12.8% + 0.282 · 8% · (1 - 0.34) = 10.7% The assumption is that the short term liabilities are non-financial debt. Even if short-term liabilities include bank accounts, these are usually also discarded as the leverage policy is best assessed by long-term debt. b) EBIT = 1’331 + 440 = 1’771 NOPLAT = EBIT · (1-t) = 1’771 · (1 - 0.361) = 1’131.7 After tax operating cash flow = NOPLAT + Depreciation = 1’131.7 + 420 = 1’551.7 Change in net working capital = Est. NWC2004 – NWC2003 = (4’645 - 3’300) - (4’400 - 3’121) = 1’345 - 1’279 = 66 Capital Expenditures (CAPEX) = change in fixed assets + depreciation = (6’100 - 6’001) + 420 = 519 Free cash flow to firm = 1551.7 – 66 – 519 = 966.7


c) c1) 1’000/1.13 = 884.96 1’050/1.132 = 822.30 1’080/1.133 = 748.49 [(1’080 · 1.08)/(0.13 - 0.08)]/1.133 = 23’328/1.133 = 16’167.47 Therefore, 884.96 + 822.30 + 748.49 + 16’167.47 = 18’623 c2) The amount of financial assets should have been added to the above figure. This is because when computing the present value of free cash flows, we only consider operating items. c3) 16’000 - (long-term debt 2003 = 3’453)/251 = 12’547/251 = 49.99 We only consider long-term debt because we assume that there is no interest-bearing item in the current liabilities. Note to correctors: also consider that the answer is correct if total liabilities are subtracted (the share price is then 37.55, which is very close to the current price of 35). 49.99 is higher than the current share price of 35 therefore the stock is undervalued.


a) If two companies are in the same business risk class, the volatility of their operating earnings is the same and their asset betas will be identical. Given that our two companies are in the same business risk class, their asset beta should be the same. As Merlot is all-equity financed, its equity beta will equal its asset beta. Hence, Merlot's equity beta can be estimated with Cabernet’s asset beta. We have: βMerlot equity = βCabernet assets = 0 x 1/4 + 1.6 · 3/4 = 1.2 (Note that a D/E ratio of 1/3 is equivalent to a D/V of 1/4. Indeed, one can write: (D/E) + 1 = 1/3 + 1, which gives V/E = 4/3. Therefore E/V = 3/4 and D/V = 1/4). b) For Cabernet, the cost of debt is 10% and the cost of equity, using the CAPM formula, is equal to 10% + 6% x 1.6 = 19.6%. Therefore, we have: WACC = 19.6% x 0.75 + 10% x 0.25 = 17.2% For Merlot, the WACC is equal to the cost of equity, as the firm is all-equity financed. We have: KE = 10% + 6% x 1.2 = 17.2% = WACC This result is the one we would expect in the Modigliani and Miller's capital structure framework with no tax: firms in the same business risk class have the same weighted average cost of capital.


c) For information: the financial analyst correctly obtained the theoretical price of USD 872.09 = USD 150 / 0.172, where 17.2% is the cost of equity calculated above in question b). In the Modigliani and Miller's capital structure framework, there is a disequilibrium that should lead to an arbitrage. In our case, the shareholder will realise a gain by selling his Merlot's shares and buying Cabernet's shares with the proceeds of the sale. The arbitrage can be achieved as follows:

(i) Sell Merlot's shares for USD 1,000 per share.

(ii) Use the proceeds of the sale to buy debt and equity of Cabernet in the same proportion as Cabernet’s own debt/equity ratio of 1/3. Thus, per share sold, the investor should purchase for USD 250 of Cabernet' debt and for USD 750 of Cabernet's equity. This would have the effect of maintaining the same average cost of capital. The annual income after the arbitrage will be: USD 250 x 0.10 = USD 25 USD 750 x 0.196 = USD 147 USD 172/year

Thus, the investor's gain is USD 172 – USD 150 = USD 22/year, with no change in risk.


a) r = rf + β · premium = 8.5% + 1.1 · 4.0% = 12.9% b)

EPS1 = (EBIT - Interest Expenses) · (1 - Tax Rate) = (160 - 80) · (1 - 0.28) = UAH 57.6 billion. ROE = EPS1/BV = 57.6/400 = 14.4%. P/BV = (ROE - g)/(r - g) = (0.144 - 0.05)/(0.129 - 0.05) = 1.19. VEq = BVEq · (P/BV) = 400 · 1.19 = UAH 476 billion. c) Advantages: 1. Incorporates some concept of asset values. 2. Easy to compute even for companies with negative (volatile) earnings. 3. Easy to compare with market and specific industries. Disadvantages: 1. Book value may be poor guide to actual asset values. 2. Subject to differing accounting rules. 3. Affected by non-recurring items. 4. Subject to historical costs. 5. Ignores future earnings perspectives as well as growth potential.


d) The price-to-book value ratio is an increasing function of the return on equity. The larger the return on equity relative to the required rate of return, the greater the price-to-book value ratio. e) The statement is correct. The market value will deviate from the book value when the earning power of company’s assets has increased or declined significantly since their acquisition.


a) (All figures in USD million)

Year 0 1 2 3 4 5 Sales 25.00 30.00 36.00 43.20 51.84 62.21 Net operating profit margin 3.00 3.60 4.32 5.18 6.22 - Taxes 1.05 1.26 1.51 1.81 2.18 + Non cash relevant expenses 0.75 0.75 0.75 0.75 0.75 - Non cash relevant income 0 0 0 0 0 Gross cash flow 2.70 3.09 3.56 4.12 4.79

b) Gross cash flow 2.70 3.09 3.56 4.12 4.79 - Changes in NWC -0.25 -0.30 -0.36 -0.43 -0.52 - Capex -0.50 -0.60 -0.72 -0.86 -1.04 Free cash flow 1.95 2.19 2.48 2.83 3.23

c) Applying CAPM we get %4.12%)4%11(2.1%4)RR(Rk fmfe =−⋅+=−⋅β+=

d) The colleague of yours is right. Indeed, your are implicitly making two strong hypotheses in using the cost of capital found above: 1) the cost of equity stays at the same level, which implies, other things being equal, that the beta remains at 1.2; 2) the company will have no debt for infinity, which is quite a strong hypothesis. In addition "others things" are not equal.


a)

sharesordinaryofnumberaverageweighted

rsshareholdeordinarytoleattributabincomenetEPSBasic =

2005 2004 Net income 68.5 29.9 Outstanding shares 27.8 27.3 Basic EPS 2.46 1.095


sharesordinarypotentialdilutiveallofconversionthefromresultingshares

ordinaryofnumberdingtanoutssharesaverageWeighted

sharesordinarypotentialdilutiveonerestinttaxAfter

rsshareholdeordinarytoleattributabincomeNet

EPSDiluted+

+

=

2005 Options exercisable (million) 1.71 Exercise price (in USD) 15.00 Shares outstanding (million) 27.8 Average stock price (in USD) 21.62 1. Proceeds from the exercise of options (in USD million) 1.71 · 15 = 25.65 2. Assumed share purchases (million) 25.65/21.62 = 1.19 3. Dilutive effect (theoretical number of options exercised at an exercise price of zero, in million)

1.71 – 1.19 = 0.52

4. Change in the numerator (no interest, so no change) 0 5. Denominator for calculating diluted EPS 27.8 + 0.52 = 28.32 6. Diluted EPS 2.42

b) Four drawbacks of EPS for valuation of firms are: • It does not take into account the possibility of some conversions not taking place.

Similarly the adjustment for options is also not realistic. • It contradicts the Modigliani-Miller hypothesis about indifference between retained

earnings and dividends as well as indifference to debt-equity ratios. • It does not take into account multiple classes of common stock. • There may be graded rights and claims for preferred share holders under which case this

method may not be applicable. To compare companies across industries, the cash flow per share is not a good criterion. Indeed, for a given ROA, capital-intensive companies (in capital intensive industries) will necessarily show higher cash flow per share, i.e. a higher cash flow to sales ratio, than companies in labor intensives industries. We cannot conclude they are “better”. c) The cost of equity for SE Company is 15%. Using the formula %150735.036.105.0)RR(Rk fmfe =⋅+=−⋅β+=

Year EPS Div 0.00 2.46 - 1.00 3.08 - 2.00 3.84 - 3.00 4.80 - 4.00 6.01 - 5.00 7.51 - 6.00 8.26 2.48 7.00 9.08 2.73 8.00 9.99 3.00 9.00 10.99 3.30


As the payout ratio is 0% for the first 5 years, there are no dividends. Dividends start from the

6th year onwards. The PV at the end of the 5th year is 56.5410.015.0

)10.01(48.2 =−+⋅

Share price of SE Company’s stock = 13.27)15.1(

56.545

=


a)

g is calculated by solving ( ) 16g112 3 =+⋅ , i.e. 100642.0g = b)

As ( ) 118.004.01.03.104.0k =−⋅+= the price is 53.0141100642.0118.0

100642.1160 =

−⋅=P

c) The link between the discount rate k and the price/earning ratio can be seen by applying the Gordon and Shapiro model:

( )( )

gk

πg1

EPSgk

πg1EPS

EPS

P

0

0

0

0

−⋅+=−

⋅+⋅

=

As k increases (i.e. the company becomes riskier) the price/earnings ratio, ceteris paribus, decreases. d) d1) Growth (g): the acquisition of a slower growth company reduces company ABC’s long-term growth rate Dividend (Div1): the new bond issue and related higher interest expenses may reduce the chance that the dividend will be increased next year. On the hand, as the acquired firm has less growth, maybe less risk consequently in the short term, and will increase the financial leverage, more profit per share can be distributed. (either answer) Cost of equity (ke): higher leverage will increase the risk for company ABC and therefore the required rate of return for the shareholders. d2) - If there are no synergies, the P/E ratio should decrease if we do not consider the effect of

financial leverage. Indeed, the new P/E should be somewhere between the P/E of ABC before the acquisition and the P/E of the acquired company.

- Synergies (reducing costs, economies of scale,…) and higher leverage will have a positive effect on the P/E.


- Other possible considerations that could have a positive effect on the P/E: higher sales potential due to reduced competition and bundled forces; market considers leverage as optimised if combined; riskiness could be considered lower for the combined company than for company ABC alone


a) a1) Assume earnings and dividends grow at a constant rate of growth of 7.8%. We get

2006 2007 2008 2009 Earnings per share 187.57 202.20 217.97 Dividend per share 45.28 48.81 Purchase price –2058 Selling price (SP) SP Implied cash flow –2058 45.28 48.81+SP

At a discount rate of 10% we obtain 2058 = 45.28 / 1.1 + 48.81 / (1.1)2 + SP / (1.1)2 SP = 2391.55 (required selling price in May 1994) a2) In mid-May 2006, we observe P0 / E0 = 2058 / 174 = 11.82 P0 / E1 = 2058 / 187.57 = 10.97 In mid-May 2008, the calculations are as follows P0 / E0 = 2391.55 / 202.2 = 11.82 P0 / E1 = 2391.55 / 217.97 = 10.97 Therefore, if earnings and dividends grow at a constant rate of 7.8%, share prices will grow at this rate as well. Check:

2391 55

20581

. − = 7.8%

Obviously, to get the total return on the investment, we have to add the dividend yield:

Dividend yield = 4528

2058

. = 2.2%

Taken together, we get a total return of 7.8% + 2.2% = 10% b) Constant dividend growth model

Current share price = 0 75 11

015 01

0 825

0 05

. .

. .

.

.

⋅−

= = 16.5 USD


For the end of the year, assuming the same payout ratio as last year, we expect: Earnings per share (EPS) ⋅ Payout ratio = Dividends per share Dividends per share = EPS ⋅ 0.25 = 0.825 USD

EPS= =0 825

0 25

.

.3.3 USD

which implies that price-earnings ratio = 1650

335

.

.=

c) In competitive capital markets, it is unlikely that Company C is overvalued. More likely, its earnings (and therefore its dividends) are expected to grow faster than those of Company B. This can be shown by the following calculation: By definition Current stock price of Company C = P/E ratio ⋅ EPS = 10 ⋅ 3.3 USD = 33 USD The constant-dividend-growth formula can be used to infer the expected EPS growth for Company C:

From: PD

k g g01 0825

0 1533=

−=

−=.

.USD

we can compute g = − = − =0150825

330 15 0 025 12 5%.

.. . . > 10%

d)

Price earnings formula: P/E ratio =1

0

EPS

P

Constant growth model formula (dividend discount model):

PD

k g

EPS

k gE E0

1 1=−

= ⋅−

Payout ratio →

P

EPS0

1

= Payout ratio

k - gE

There is a direct relationship between these formulas if you assume that the earnings of the P/E ratio are growing constantly for ever and that the firm maintains a stable payout ratio. In that case the only difference is in the question whether you look at earnings or dividends (which are directly linked to earnings). e) Yes, there is a relation when you assume that the earnings and dividends are stable (or

constantly growing): P

EPS k g kE E

=−

=−

=Payout ratio 0

120

.40

Therefore the cost of equity amounts to kE = 0.40 / 20 + 0.1 = 12%


Exercises: Solutions Level II


solutions II / page 1

S3 March 03: Equity Valuation and Analysis

a)

2000 2001

ROE = Net Incomet /Common Equityt-1

4310/19273 = 22.36%

4890/20237 = 24.16%

Retention ratio (RR) = (1 - payout ratio) = (1 - Common Dividend/Net Income)

42.60%

39.08%

Sustainable growth rate = ROE · RR

22.36 · 42.60 = 9.53%

24.16 · 39.08 = 9.44%

Actual growth rates = % change in sales from prior year -3.68% 15.74%

b) If the actual growth rate continues to exceed the sustainable growth rate, the management

can take one or more of the following actions:

1. Increase leverage: Management can increase financial leverage by issuing new debt to finance the growth. This will increase GW’s total-assets-to-common-equity ratio, and thus, its sustainable growth rate. However, increase in debt has a limit. Creditors impose a debt limit on firms by demanding increasingly higher returns for higher levels of debt. Higher debt ratio also increases the cost of equity and the WACC may also increase.

2. Reduce payout ratio

Reducing payout ratio will result in the firm retaining a larger proportion of its earnings. This will cause the sustainable growth rate to increase. Reduction in payout ratio is a good way to increase sustainable growth. However, this too has a limit. A firm can only reduce the payout ratio to zero.

3. Profitable pruning:

Profitable pruning involves selling-off either businesses that are not part of the firm’s core business or are marginal businesses. Businesses that are different than the core business of the firm divide management attention and reduce management effectiveness, and consequently, profitability. A firm can sell off marginal or otherwise low performing businesses. This would result in an increase in profit margin and sustainable growth. Profitable pruning can also be done in a single-product company by eliminating slow-paying customers or slow-moving inventory. The freed up cash can support new growth. Asset turnover will increase with fewer assets tied in low profit margin assets.


4. Merge with other firms: A firm, unable to finance its growth from internally generated funds, can look for a partner. A firm that has excess cash flows (is a cash cow) and is looking to merge with a high growth business would be an ideal merger partner. Such a firm could provide the cash flows needed to support high growth.

c) According to Miller and Modigliani, an increase in dividend payout should not have any

impact on the market value of the equity. This is especially true if the firm does not have new investment opportunities that earn a rate of return which equals (or exceeds) the required rate of return of the shareholders. In such cases, the firm should return cash to shareholders who can invest themselves at a higher rate. However, the share price may actually increase if the higher dividends signal the market of management’s optimism about GW’s prospects.

d) Required Rate of Return on Equity:

Re = rf + b(RM – rf) = 3.0 + (10.5 – 3.0) · 1.22 = 12.15% D2001 = Dividend per share in 2001 = Com.Div./# of shares = 0.7 Value of the stock: D2002 = D2001 · (1 + g) = 0.70 · (1+0.09) = 0.763 Value of the stock on 1/1/2002 = D2002 / (Re - g) = 763 / (0.1215-0.09) = USD 24.22 The market price at the beginning of 2002 (end of 2001), USD24.60, is almost equal to the theoretical price of USD 24.22. Therefore, if you feel at ease with the various hypotheses you made, you can say that the stock is fairly priced and can be purchased.

e)

2002 2003 2004 2005 2006

Growth rates of dividends 0.07 0.07 0.07 0.07 0.05 Dividends at the end of year D2002 D2003 D2004 D2005 D2006 Dt = Dt-1(1+g) 0.749 0.801 0.858 0.918 0.963 Value of the stock at the end of year 2005 V2005 = D2006/(k-g) = 0.964/(0.1215-0.05) V4=13.47 PV of future cash flows (discounted at 12.15%) 0.668 0.637 0.607 0.580 8.52 Value of the Stock = ΣPV of all CFs USD 11.01

According to the CFO’s scenario, GW stock has an intrinsic value of USD11.01. It is over- priced (market price is USD 24.60) and should not be acquired.


S4 March 04: Equity Valuation and Analysis / Corporate finance

a) Present value of synergy = EUR 1.5 million Acquisition premium = Cash paid - XYZ's market capitalization prior to acquisition = 5,000,000 - 40 · 100,000 = EUR 1,000,000 NPV of acquisition = Present value of synergy - Acquisition premium =1,500,000 – 1,000,000 = EUR 500,000

b) This is not a good method. Generally, when a company with a high price-earnings ratio issues new shares to acquire a company with a lower price-earnings ratio, its earnings per share increase after the acquisition. This happens even when there is no synergy effect from the merger/acquisition. It is therefore impossible to judge the economic merits of a merger or acquisition from the change in earnings per share.

c) If the stock offer is affected, Company ABC will have a market capitalization after the acquisition of:

ABC's market capitalization prior to the acquisition + XYZ's market capitalization prior to the acquisition + synergy effect = 25,000,000 + 4,000,000 + 1,500,000 = EUR 30,500,000

There will be 300,000 outstanding shares after the acquisition (250,000+100,000/2), 250,000 of which will be in the hands of the old ABC shareholders. The proportion of the company belonging to the former shareholders of ABC is therefore 250/300 = 0.833. Therefore, they own:

667,416,25EUR000,300

000,250000,500,30 =⋅

As the market capitalization of ABC prior to the acquisition was EUR 25 million, total profits to the old ABC shareholders are: 25,416,667 - 25,000,000 = EUR 416,667

d) There will be 300,000 outstanding shares after the acquisition, of which 50,000 will be held by the old XYZ shareholders. They therefore own 0.167 (= 50/300) of the new ABC (2 points). The value of the shares held by the old XYZ shareholders will be:

333,083,5EUR000,300

000,50000,500,30 =⋅

Therefore, the stock offer is more advantageous than receiving EUR 5 million in cash.

e) When the acquiring company uses a stock offer, it is possible that it is doing so because its shares are overvalued. If this is the perception of outside investors, the company's share price will fall after the acquisition is announced. This has to do with asymmetric information between the management of the acquiring company and outsiders.


Also, if the acquiring company suspects that the company to be acquired may have some hidden debts, a stock offer may be chosen by the acquiring company as a preferable way because shareholders of the acquired company will have to share the losses from these debts. In this case, the share price could decline if the problem does exist and comes to light after the announcement of the acquisition. This is asymmetric information between the management of the acquiring company and the management of the company to be acquired.

S2 Sept 04: Equity Valuation and Analysis

a) The yearly after-tax operating cash flows of the project can be estimated as follows:

1 2 3 4 Revenues 300,000 315,000 330,750 347,288 Less: Operating expenses 100,000 105,000 110,250 115,763 Less: Depreciation 100,000 100,000 100,000 100,000 = EBIT 100,000 110,000 120,500 131,525 EBIT(1 – t) [t = 36%] 64,000 70,400 77,120 84,176 Add: Depreciation 100,000 100,000 100,000 100,000 After-tax cash flow 164,000 170,400 177,120 184,176

One can also use the following procedure: Revenues of the first year 300,000 Less: Operating expenses of the first year 100,000 = (Revenues) – (Operating expenses) 200,000 [(Revenues) – (Operating expenses)](1-t) = (REV-OEX)(1-t) 128,000 We apply the 5% yearly rate of growth on this amount and then add the tax shield:

1 2 3 4 (REV – OEX) (1-t) 128,000 134,400 141,120 148,176 Add : (Depreciation)t 36,000 36,000 36,000 36,000 After-tax cash flow 164,000 170,400 177,120 184,176

b) The net present value of the project can be calculated as follows:

Cash Flow PV Factor (10%) Present Value 164’000 0.90909 149’090 170’400 0.82645 140’826 177’120 0.75131 133’073 184’176 + 100’000 0.68301 194’096 PV of the Cash Inflows 617’086

The NPV is therefore: 617,086 - 500,000 = 117,086 and the project is acceptable. The wealth of the shareholders will increase by CU 117,086


c) The implicit assumption made is that inflation has the same impact on both revenues and expenses. This assumption does not always hold. Prices of raw materials, for instance, may increase or decrease by a different percentage than the personnel expenses, land or buildings. When calculating the net present value, the treatment of inflation should be consistent between the cash flows and the cost of capital, i.e. it should be either considered or ignored in both calculations. If cash flows are estimated using nominal values of revenues and expenses, the cost of capital should also be nominal. In most cases, the cost of capital is nominal, and for sake of simplification, the cash flows are often supposed to be constant. That solution must be avoided, as it is incoherent. d) An increase in the tax rate has an effect on the NPV at least in two ways. First, the after tax cash flows related to cash income and cash expenses will decrease. Second, the depreciation tax shield will increase. For profitable projects, the net effect will necessarily be negative. Tax may also have an effect on the residual asset values. It is difficult to forecast the effect on the cost of capital, as it will be nil if the investors consider their after-tax return. If the tax rate is 40% instead of 36%, the effect on the NPV of the depreciation tax shield will be: - PV of the tax shield with a tax rate of 36% : 100,000 x 0.36 x 3.170 = 114,120 - PV of the tax shield with a tax rate of 40% : 100,000 x 0.40 x 3.170 = 126,800 The effect will be a positive impact on the NPV of 12,680. A shorter calculation is: (100,000 x (0.40 – 0.36) x 3.170 = 12,680 e) The 90-day T-bill is not a good proxy except when the term structure of interest rates is flat. The net present value is highly sensitive to the value of the cost of capital. If the cost of capital used is not correct, the value of the NPV obtained and thus the decision to accept or reject the project may be wrong. If the cost of capital used is higher than it is supposed be, the project whose cash flows are farther in the future will have a lower NPV, and vice-versa. Indeed, the farther the cash flows are in the future, the larger the impact of an error in estimating the cost of capital.



a) Using 2003 data and the highest prices of the year, we obtain:

Alpha Beta Gamma MFG 500 Highest price 53.0 55.0 68.0 1470.0 P/CF 40.2 76.4 5.0 17.9 P/E 49.5 80.9 11.6 30.5 Dividend yield (%) 0.92 none 2.76 1.14

At the market high, base on P/E and P/CF, Beta traded with a very high premium relative to the market, and Alpha was also expensive. Obviously investors paid for expected high growth rates. Gamma is attractive on dividend yield, but as a mature company it compensates for slower growth with a higher dividend yield. Alpha has managed to generate continuously high growth rates and has paid dividends close to market average. The market premium for Alpha could be justified by the outstanding stability of growth rates over time. The very fast growing Beta Computer is expensive and pays no dividend, but this strategy is successful only if growth rates persist. b) Using the discounted cash flows, we obtain

Growth rate %

Cash Flow 2004

2005 2006 2007 2008 2009 PV of annual

CF

PV terminal

value

Total value

Alpha: CFM 14.67 1.51 1.73 1.99 2.28 2.61 2.99 8.57 39.03 47.60 Beta: CFM 36.67 0.98 1.34 1.83 2.50 3.42 4.67 9.85 60.92 70.77 Gamma: DDM 7.00 1.80 1.93 2.06 2.21 2.36 2.53 8.29 32.92 41.21 CFM 7.00 7.46 7.98 8.54 9.14 9.7810.46 34.36 136.43 170.79

Using the cash flow model, the values of the three companies' shares are within the Hi/Low range for 2004 in case of Alpha. Beta seems to be undervalued a little. However Gamma seems to be totally undervalued, but the result is due to the assumption of 7% growth rate as opposed to the actual negative growth shown in the past years. The CFM does not make sense to evaluating Gamma, which is a low growth firm. We can value Gamma using the DDM, which gives more sensible results. Discounted Cash Flow is not appropriate for low growth and high dividend companies. A DDM gives better results. c) In recession periods, growth rates become very questionable with significant implications for growth companies. Technology companies like Beta face problems because growth rates


appear to be unsustainable, and stock prices fall. Value cyclical companies like Gamma are protected by the dividend and become more attractive in recession times. Usually these companies are the first to recover in the market. In a second stage after recession investors pay for stable growth if the price is right, Alpha is an example. For aggressive growth companies, investors have to become very confident on future growth and need the confirmation for rising growth rates. They profit the most when a new period of economic recovery is confirmed. Price/Earnings ratios contract in recession times and expand in periods of long growth. A problem for all manufacturing companies in recession times are falling prices and higher marketing costs (incentives).


a) Forecast earnings per share this year = E(EPS) = (BVPS of last year) · ROE = 100 · 0.1 = 10 euros Forecast dividends per share this year = E(DPS) = E(EPS) · (Payout ratio) = 10 · 0.3 = 3 euros Sustainable growth rate = g = ROE · (1 – Payout ratio) = 0.1 · (1 - 0.3) = 0.07 Using the constant growth dividend discount model, the implied return (implied kE) of JUN’s shares is:

Implied kE gpriceShare

)DPS(E+= 1015.007.0

95

3=+=

Required rate of return under the capital asset pricing model (CAPM) = kE = Risk-free rate + Stock market risk premium · beta = 0.03 + 0.07 · 1.1 = 0.107 The implied return of 10.15% is less than the required return of 10.70% under the CAPM, so JUN's shares are at a premium. b) Forecast residual income per share this year: = E(EPS) – BVPS · RE = 10 – 100 · 0.107 = -0.7 euros Earnings per share and book value per share will grow at the sustainable growth rate of 7% from next year onwards, so the residual income per share (or in this case, residual loss) will also increase by the sustainable growth rate of 7%. Theoretical share price = (BVPS at end of last year) + (PV of residual income per share in and after this year)

euros08.8107.0107.0

7.0100 =

−

−+=


The theoretical price for JUN's shares is thus 81.08 euros, and the current price of 95 euros is at a premium. With this approach, one obtains the same result as with the constant growth dividend discount model:

Theoretical price for JUN shares gk

)DPS(E

E −= euros08.81

07.0107.0

3=

−=

c) Even if the share price is below the liquidation value, JUN's shares are still at a premium to the theoretical price calculated from forecast earnings and dividends. Therefore, JUN’shares should not be considered as an investment. d) • Assuming the balance sheet accurately reflects the company's asset values, a PBR below 1

indicates that the shares are trading for less than the company's liquidation value, which makes the company a potential take-over target. If the company becomes a take-over target, the share price is likely to rise above the liquidation value, which would make it a good investment.

• Empirical evidence suggests that in most countries stocks with low PBRs have high risk-

adjusted returns. Therefore, as a general rule a stock with a low PBR could be a promising investment.


a) Calculation of the cost of equity for Company X and Company Y by using the results of the regression analysis shown in Table 3. Let us denote Company X's cost of equity as Xr and

Company Y's cost of equity asYr . Then,

%2.9092.004.08.102.0r %,8.4048.004.07.002.0r YX ==⋅+===⋅+= Table 1 indicates dividend per stock of JPY 10 and JPY 6 for Company X and Company Y in 2006 respectively. The following relationship holds true under the constant-growth dividend discount model:

0

110

P

Divrg

gr

DivP −=⇒

−=

The stock prices of Company X and Company Y are currently JPY 500 and JPY 1000 respectively, so using the formula, Company X's dividend growth rate Xg and Company Y's

Yg are calculated as follows:

%6.8086.0)000,1/6(092.0 %,8.2028.0)500/10(048.0 ==−===−= YX gg


b) Company XY will use a stock-for-stock exchange to complete the merger, swapping 1 stock in Company Y for 2 stocks in Company X. Therefore, Company XY's total stocks issued and outstanding will be 200 + 10 x 2 = 220 million stocks. Analyst A does not think the merger will have any impact on next year's results, so net income will be the same as total net income for pre-merger Company X and Company Y, or 4,200 (= 4,000 + 200) million. Therefore, with a payout ratio of 50%, Company XY's dividends per stock will be (4,200/220) x 0.5. If the cost of equity capital is 5.2% and the stock price is JPY 540, the dividend growth rate is 3.43%, as shown by the following formula:

%43.30343.0540

5.0220/200,4052.0

P

Divrg

0

1 ==⋅

−=−=

However, Analyst A's opinion cannot be supported. Company XY's sustainable growth rate can be calculated from post-merger Company XY's net assets of 73,100 (= 71,500 + 1,600) and retained earnings ratio of 50%. The results are 4,200/73,100 x 0.5 = 0.0287 = 2.87%. Therefore, the dividend growth rate of 3.43% is unachievable unless the company engages in further equity financing. One must therefore conclude that the rise in the stock price was due to the market reflecting other factors than the dividend growth rate, for example, forecast net income, dividend amounts, or cost of equity capital. c) Table 1 indicates Company X will have sales of 135,000 in 2006; Company Y, 4,200. If after the merger sales increase by 5%, the ratio of EBIT to sales is 7.9% and the ratio of interest payments to sales is 2.5%, then EBT will be 5.4% of sales. The corporate tax rate is 40% and payout ratio 50%, so Company XY will have dividend per stock in 2006 of:

((135000 +4200) · 1.05 · 0.054 · 0.6 · 0.5)/220 = JPY 10.7627 Using the dividend discount model, Company XY's stock price XYP is calculated at:

( )14.538JPY135.538JPY

032.0052.0

7627.10PXY ≅=

−=

d) It is possible that Analyst B and Analyst C hold the following different views that would account for the under-valuation of the merger effect and the estimations of cost of equity capital. d1) Estimation of cost of equity capital Since Company X has a beta of 0.7 and Company Y a beta of 1.8, and since market capitalization at the time of merger will be JPY 10 billion for Company X and JPY 1 billion for Company Y, Company XY will have a beta of: 0.7 · (10000/11000) + 1.8 · (1000/11000) = 0.8. So Analyst B presumably estimated Company XY's cost of equity capital at: 0.02 + 0.8 · 0.04 = 0.052 = 5.2%. d2) Under-valuation of the impact of the merger on net income Analyst B postulates that after the merger the ratio of EBIT to sales will be 7.9% and the ratio of interest payments to sales will be 2.5%. This is roughly equivalent to an average (weighted by market capitalization) of the pre-merger results of Company X and Company Y for the


latest 3 years. Therefore, the rise in the stock price in c) can be explained entirely in terms of higher sales. If it can be expected that the merger will bring reductions in the cost of sales or selling, general and administrative expenses, then the market could value it even higher. Company Y has a fairly high ratio of interest payments to sales of 6.0% (average over 3 years). It could conceivably be able to raise funds after the merger by making use of Company XY's retained earnings or issuing bonds at lower rates. When these financial benefits are taken into account, it will be possible to value Company XY higher. d3) Even if CAPM is used to estimate cost of equity capital, when the estimation is based on historical betas as in Table 3, the results will greatly depend on the size and frequency of the data's sample. It is therefore completely conceivable for Analyst C to arrive at a different estimation from Analyst B even if Analyst C was using historical betas. Or it is conceivable that Analyst C used a fundamental beta based on the corporate financial profile. Looking at the results of Table 3, CAPM has low explanatory power for Company Y, and the intercept has a significant negative value. It is therefore uncertain whether CAPM is an appropriate model for estimating cost of equity capital. In addition, the scale effects of the merger may mean that investors are happy with a lower rate of return than 5.2% from Company XY. In cases such as this, what is needed is a cost of equity capital estimation model that takes account of corporate scale, debt ratios and other aspects of the financial profile.


a) The expected market capitalization of IT Corporation at the time of an IPO 5 years hence = Projected net profits five years hence · Projected PER = EUR 20 million · 30 = EUR 600 million The value of IT’s shares after the equity finance can be calculated by discounting this value by the 50% required rate of return on IT shares:

346,012,79EUR5.1

000,000,600EUR5

=

b) The value of existing shares at the time of the equity finance is found by subtracting the amount of the capital increase from market capitalization after the equity finance: EUR 79,012,346 – EUR 5,000,000 = EUR 74,012,346 The theoretical share price at the time of the equity finance is obtained by dividing this amount by the number of issued and outstanding shares: EUR 74,012,346 ÷ 1,000,000 shares = EUR 74.01


Alternative answer: Most venture capitalists use the following calculation. The percentage ownership required by venture capitalists can be found by dividing the amount of the capital increase by market capitalization after the equity finance: Required percentage ownership = EUR 5,000,000 ÷ EUR 79,012,346 = 6.328% The number of newly issued shares and the share price can be found with the following formula: Number of newly issued shares = (Required percentage ownership/(1-Required Percentage Ownership)) · Number of existing shares = (0.06328/(1-0.06328)) · 1’000’000 shares = 67’555 shares Share price = Investment/Number of newly issued shares = EUR 5’000'000 / 67’555 shares = EUR 74.01

c) The following are conceivable reasons: • Private equity shares have low liquidity and are difficult to sell. Higher required rates of

return include a liquidity premium that reflects this liquidity risk (liquidity) • New startups have an extremely high risk of bankruptcy. Higher required rates of return

include a premium that reflects this bankruptcy risk (risk) • Unlike investments in listed companies, investments in private equities require that

venture capitalists commit to their management if they are to succeed. Higher required rates of return include the reward to the services provided by venture capitalists (services)

• The business plans and profit forecasts of new startups tend to be optimistic and often are not achieved. Higher required rates of return can be interpreted as adjustment to the overly-optimistic figures provided by management (forecast adjustments)

d) d1) Generally, when an option is purchased, its value is higher the higher the volatility in the price of the underlying asset because if the transaction does not go in one’s favor losses are limited to be option premium, while if it does go in one’s favor, capital gains are unlimited. Startup companies contain a great deal of uncertainty regarding future potential and directions and have many different options for developing the business depending on circumstances and are therefore suitable to valuation using the “real option” approach. d2) The current set of valuation and decision making tools aren't sufficient for the new business realities: - strategic investments with lots of uncertainty and huge capital requirements. - projects that must adapt to evolving conditions. - complex asset structures through partnerships, licenses, and joint ventures.

REFERENCES

BODIE Zvi, KANE Alex & MARCUS Alan J., “Investments”, Fifth edition, McGraw-Hill, New York, 2002. BREALEY Richard A. & MYERS Stewart C., “Principles of Corporate Finance”, Sixth edition, McGraw Hill, 2000. SHARPE William F., ALEXANDER Gordon J. & BAILEY Jeffery V., “Investments”, 6th edition, Prentice-Hal, Upper Saddle River, NJ 1996. SOLNIK Bruno, “International Investments”, 4th edition, Addision-Wesley, Reading, MA, 1999. LODERER Claudio, JÖRG Petra, PICHLER Karl & ZGRAGGEN Pius, “Handbuch der Bewertung”, NZZ Verlag. ROSS Stephen A., WESTERFIELD Randolph W., JAFFE Jeffrey, “Corporate Finance”, 6th edition, McGraw-Hill, 1999. MADDEN Bartley J., “CFROI Valuation”, Butterworth-Heinemann, 1999. DAMODARAN Aswath, “Investment Valuation”, 2nd edition, John Wiley & Sons, 2002. McKinsey & Company, “Valuation: Measuring and Managing the Value of Companies”, 3rd edition, John Wiley & Sons, 2000.

50267669 equity valuation and analysis manual

Documents