valuation puzzles

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Fundamental Puzzles in ValuationOklahoma CFA SocietyApril 25, 2012Travis Harms, CFA, CPA/ABV

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Market or Income?

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Introduction

» Image of a statue

Valuation approaches are ultimately different windows (or lenses) through which we “see” the real value of the business, which exists independently of the selected window or lens. In other words, all valuation approaches – whether fundamental or relative - essentially describe rather than define.

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At Issue» When you think of the

value of a company, where do you start – discounted cash flow or comparable company analysis? (i.e., what window do you most frequently look through, or are most comfortable looking through?)

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Income Approach

» Consciously or unconsciously, some of us believe that the income approach is the mother of all valuation approaches After all, everything has to

convert to a stream of cash flows and some kind of pricing of those cash flows

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“The DCF is ALWAYS right”

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Income Approach» What do our friends in the art community

think of the income approach?

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Income Approach

Only two things can be wrong with a DCF…

The “D”or the “CF”

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Income Approach

Source of discount rates for income approaches – lots of data, but is it information?

Equity risk premium? Beta? Size premium? Et al.

The “D”

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Income Approach

» Management’s “objective” inputs?» Analyst inputs – how much do you

REALLY know about revenue growth and margin over the next five to ten years?

The “CF”

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» Income approach requires inputs

» Garbage In > Garbage Out

» Prevalence of – and susceptibility to – cognitive biases

Income Approach

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Market ApproachThe market approach satisfies a very basic human need for a reference.

Think about how people love quotes. If someone else said it, it must be true.

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Market Approach» To be OBJECTIVE – adjective

4. being the object or goal of one's efforts or actions.

5. not influenced by personal feelings, interpretations, or prejudice; based on facts; unbiased: an objective opinion.

6. intent upon or dealing with things external to the mind rather than with thoughts or feelings, as a person or a book.

7. being the object of perception or thought; belonging to the object of thought rather than to the thinking subject (opposed to subjective).

8. of or pertaining to something that can be known, or to something that is an object or a part of an object; existing independent of thought or an observer as part of reality.

(Source: www.dictionary.com)

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Market Approach

“One must be a wise reader to quote wisely and quote well.”

Amos Bronson Alcott

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Market Approach» Is it true that something’s only worth what

somebody’s willing to pay for it? In the event of a liquidity crisis, does the absence

of trading activity in an asset imply that the asset is worthless?

Example: the subprime debacle…» Market Intelligence > Consensus Opinion > Herd

Mentality > Lemmings headed over the Cliff

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What good is the market approach when the market turns out to be wrong?

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Market Approach

» Was Socrates right?

“The only true wisdom is in knowing you know nothing.”

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Epistemology matters» Price = f(required return, expectations)» How do you decide if Value ≠ Price?

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The Equity Risk Premium

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What is Risk?“More things can happen than will happen”

Elroy DimsonVia Peter Bernstein

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Measuring the ERP

» Historical Realized Returns» Consensus Estimate of Market Participants» Demand Side: What Returns Should Investors Rationally

Charge?» Supply Side: What Returns Can Firms Realistically Supply?» Valuation: What Does Current Market Pricing Suggest?

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Consensus is Elusive

Source: Rethinking the Equity Risk Premium, © 2011 The Research Foundation of CFA Institute

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Valuation PerspectiveMarket Data for S&P 500 (Ex. Financials) at December 2011

Source: Professor Robert J. Shiller, www.econ.yale.edu/~shiller/data/ie_data.xls

EV toSales EBITDA Historical 5-Yr Growth Enterprise Forward($Mil) Margin Revenue EPS Value EBITDA

1st QUINTILE MEDIAN 46,514 13.3% 5.1% 5.2% 55,105 6.8

2nd QUINTILE MEDIAN 14,658 20.6% 4.2% 5.4% 26,169 7.1

3rd QUINTILE MEDIAN 7,882 19.6% 5.2% 9.7% 13,651 7.6

4th QUINTILE MEDIAN 4,466 22.9% 4.0% 7.7% 9,578 8.2

5th QUINTILE MEDIAN 2,153 33.5% 6.5% 11.7% 8,406 9.7

OVERALL MEDIAN 7,886 21.8% 4.9% 7.2% 14,306 7.6

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Valuation Perspective

EV = MVequity + Debt

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Enterprise Balance Sheet

Source: Bloomberg, LP

Aggregate Balance Sheet - December 31, 2011 ($Billions)

Net Working Capital $885 12.5% Interest-Bearing Debt $2,939 41.6%

Net Fixed Assets $3,485 49.3% Preferred Equity $24 0.3%

Net Other Assets $2,702 38.2% Common Equity $4,109 58.1%

NET OPERATING ASSETS $7,072 100.0% TOTAL INVESTED CAPITAL $7,072 100.0%

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Enterprise Cash Flows

$813 Billion

$152 Billion

$44B

$618 Billion

Debt Equity$79B $539 Billion12.8% 87.2%

Net Operating Profit After Tax ("NOPAT")

Growth Capital Expenditures (in excess of Depreciation &

Amortization)

Incremental Working Capital Needs

Net Cash Flow

Allocation to Capital Providers


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Valuation Perspective

WACC = CF / EV + g

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The Trouble with the Valuation Perspective

» WACC = CF / EV + g Four variables, only two of which are known Can’t solve for the other two

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Certainty is Overrated“Nothing would remain stable in human society

if we determined to believe only what can be held with absolute certainty.”

Saint Augustine

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Confusing Signals» If the forward-looking ERP is as low as some suggest

(3.0% or less)… Is that bearish?

» “I will never be able to retire.”

» “Pensions are hopelessly underfunded.”

Or is it bullish?

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Valuation Perspective: Survey Says…

Equity DebtRisk-Free Rate 2.6%

+ Equity Risk Premium 3.0%Cost of Capital (After-tax) 5.6% 2.8%

Capital Structure 80% 20%

Weighted Average Cost of Capital 5.0%

Net Operating Profit After Tax ($Billions) 813

- Incremental Capital Expenditures (152)

- Incremental Working Capital Investment (44)

Net Cash Flow 618

Weighted Average Cost of Capital 5.0%

- Nominal Growth in Cash Flow 2.0%

Capitalization Rate 3.0%

Enterprise Value 20,315

- Outstanding Debt (2,939)

Market Value of Equity 17,376

Discount / Premium to Current Value 64.1%


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Equity Debt Equity DebtRisk-Free Rate 2.6% 2.6%

+ Equity Risk Premium 3.0% 4.0%Cost of Capital (After-tax) 5.6% 2.8% 6.6% 2.8%

Capital Structure 80% 20% 80% 20%

Weighted Average Cost of Capital 5.0% 5.8%

Net Operating Profit After Tax ($Billions) 813 813

- Incremental Capital Expenditures (152) (152)

- Incremental Working Capital Investment (44) (44)

Net Cash Flow 618 618

Weighted Average Cost of Capital 5.0% 5.8%

- Nominal Growth in Cash Flow 2.0% 2.0%

Capitalization Rate 3.0% 3.8%

Enterprise Value 20,315 16,082

- Outstanding Debt (2,939) (2,939)

Market Value of Equity 17,376 13,143

Discount / Premium to Current Value 64.1% 24.1%


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Equity Debt Equity Debt Equity DebtRisk-Free Rate 2.6% 2.6% 2.6%

+ Equity Risk Premium 3.0% 4.0% 5.0%Cost of Capital (After-tax) 5.6% 2.8% 6.6% 2.8% 7.6% 2.8%

Capital Structure 80% 20% 80% 20% 80% 20%

Weighted Average Cost of Capital 5.0% 5.8% 6.6%

Net Operating Profit After Tax ($Billions) 813 813 813

- Incremental Capital Expenditures (152) (152) (152)

- Incremental Working Capital Investment (44) (44) (44)

Net Cash Flow 618 618 618

Weighted Average Cost of Capital 5.0% 5.8% 6.6%

- Nominal Growth in Cash Flow 2.0% 2.0% 2.0%

Capitalization Rate 3.0% 3.8% 4.6%

Enterprise Value 20,315 16,082 13,310

- Outstanding Debt (2,939) (2,939) (2,939)

Market Value of Equity 17,376 13,143 10,371

Discount / Premium to Current Value 64.1% 24.1% -2.1%



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Travis W. Harms, CFA, CPA/[email protected] | 901.685.2120

Mercer Capital5100 Poplar Avenue, Suite 2600 | Memphis, TN 38137www.mercercapital.com | 901.685.2120 (p) | 901.685.2199 (f)

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