Valuation

Today Valuation

Discounted cash flow models DDM FCFE

Relative valuation over time across assets at a given time relative to comparables relative to the market

Today Getting started with S&P’s research

insight. A powerful tool for getting financial

information and producing reports Maybe too powerful – if you use numbers

generated by S&P analysts, you must understand how they are derived!

Available on library computers. You can use RIWeb to compute the financial

ratios you need for next class.

Today Getting started with S&P’s research

insight. A powerful tool for getting financial

information and producing reports Maybe too powerful – if you use numbers

generated by S&P analysts, you must understand how they are derived!

Available on library computers. You can use RIWeb to compute the financial

ratios you need for next class.

Today

First of three accounting statements Income statement first Balance sheet Cash Flows Interrelationships can reveal important

facts and trends Settle group and sector assignments

General Thoughts on Valuation We will be using quantitative models.

But one size does not fit all. Obviously, a DDM won’t work for a company that

doesn’t pay dividends. Estimating growth for a cyclical company is problematic. Sometimes, it’s easier to compare ratios with

comparables. But this comparison should be both across comparables

and across time.

Use more than one valuation metric The more metrics that produce the same answer, the

better. Sensitivity analysis is vital.

Valuation Models Discounted Cash Flow

DDM FCFE

Relative Valuation P/E P/B Other ratios (some predict better than

others for different industries.

Valuation Methods Valuation Versus Own History

Is it relatively cheap now? Valuation Versus Peer Group

Is it undervalues relative to peers now? How has that relationship evolved over time?

If a company always sells at a discount, there’s probably a reason.

Valuation Versus Market Is it undervalued relative to the market now? How has that relationship evolved over time?

Absolute Valuation

What you may find Companies that look cheap, and always

have. Firms that look good in industries that look

bad. That is, the industry currently looks expensive

but the firm is the cheapest thing in the industry.

Industries that look good with firms that are average for the industry.

How can you tell?

DCF DDM’s FCFE

The holy grail: the numerator should be the cash flows that can be distributed to shareholders while retaining enough cash to support the assumed growth rate

The holy grail 2: your discount rate should match your numerator type

Basic Dividend Discount Model

P= D1

(r-g)

Two Stage DDM

Pо=∑ D1_____+ ___Pn___

(1+Khg)† (1+Khg)ⁿ

Where Pn=DPSn+1

(Kst-Gn)

Citigroup: Gordon Growth DDM

Citigroup Dividend Discount Model $47.00Dividend 1.6 1.6 1.6 1.6 1.6R 9.00% 9.00% 9.00% 9.00% 9.00%growth 4.00% 5.00% 6.00% 7.00% 8.00%P=D/(R-g) 32.00$ 40.00$ 53.33$ 80.00$ 160.00$

Dividend 1.60$ 1.60$ 1.60$ 1.60$ 1.60$ R 10.00% 10.00% 10.00% 10.00% 10.00%growth 5.00% 6.00% 7.00% 8.00% 9.00%P=D/(R-g) 32.00$ 40.00$ 53.33$ 80.00$ 160.00$

DDM Challenges

Certainty and Growth Rate of Dividends

Appropriate Discount Rates Length of Growth Period(s) Normal growth is what??? Small Changes in Assumptions Lead to

Widely Disparate Values Outliers Most likely to be Misspecified

Growth Failure: Companies Maintaining 20% Growth

0123456789

10

%

5 Years 10 Years 15 Years

% Companiesw/ 20% Growth

Discount Model Applications Testing of Assumptions: Solve for Implied

Values. Take P as given, pick R and solve for g.

Must have Stable Growth and Leverage Companies

Cross Sectional, Time Series Analysis DDM may produce low values for a particular industry.

Prefers Low PE/High Dividend Payers over High PE Cash Retainers

The high P/E cash retainers can perhaps be better valued by FCF.

FCF is often a good Alternative to Dividends

Free Cash Flow Valuation

Simple Definition: FCF=

Operating Earnings+Depreciation-Capital Expenditure-∆Working Capital

You may be able to do better, but this is useful for forecasting.

Why Could This Be More Effective than DDM?

Relative Valuation

Measure Comparable Assets with a Common Measure

Evaluate Price vs. Fundamental Factors (P/E, P/FCF, P/S, P/Bk, EV/EBITDA)

Look at Time Series Data

Large Capitalization Stocks Key Valuation Metrics

EnterpriseValue-to- Asset Dividend

P eriod Free Gross EBITDA Book Sales Trailing Forward Value Yield1950-1954 +5.3 % +6.5 % +6.5 % +3.0 % +3.8 % +6.1 % - - - 1955-1959 3.4 1.9 1.9 (0.5) 1.8 2.7 - - - 1960-1964 3.7 4.5 3.4 2.7 2.7 3.1 - - +1.81965-1969 3.5 2.5 3.3 2.1 2.3 3.8 - - (1.3) 1970-1974 2.9 4.0 3.4 4.6 3.0 2.3 - - 2.9 1975-1979 7.2 6.5 5.1 3.5 4.5 5.3 +2.3 % +4.5 % 1.1 1980-1984 5.6 3.1 4.4 7.4 7.5 5.7 5.3 5.8 5.0 1985-1989 2.3 1.3 2.7 (0.2) 1.6 (1.2) (1.8) (1.5) 0.9 1990-1994 5.9 5.3 2.9 3.6 0.9 3.9 6.1 4.6 1.2 1995-2000 (1.9) (2.0) (1.4) (2.1) (6.2) (0.9) (2.8) 1.7 (2.5) 2000-2003 14.4 13.8 11.4 10.7 13.5 12.4 12.9 8.0 6.8

Entire P eriod 4.5 % 4.3 % 4.0 % 3.2 % 3.2 % 3.9 % 3.6 % 3.9 % 1.8

Memo:1990-2003 5.7 % 5.2 % 3.8 % 3.6 % 2.0 % 4.6 % 4.9 % 4.5 % 1.2

Source: Empirical Research P artners Analysis.

Cash Flows-to-Enterprise Value P rice-to: P /E Ratios

Annual Relative Returns: Best Quintile by Half Decade1950 Through 2003

Large Capitalization Stocks Performance of Valuation Measure By Sector

EnterpriseValue-to- Asset Dividend

Free Gross EBITDA Book Sales Trailing Forward Value YieldCyclicalsConsumer Durables and Apparel +4.7 % +5.6 % +4.4 % +9.7 % +7.4 % +3.6 % +4.1 % +12.6 % +1.7 %Capital Equipment 10.0 10.3 8.9 9.1 8.2 7.4 7.2 14.5 2.0Commercial Services 7.0 6.7 5.8 0.2 1.3 4.0 9.7 (5.7) 0.0Industrial Commodities 3.6 6.0 5.4 7.2 5.6 4.5 (0.4) 5.7 (3.4)Transports 4.8 9.0 10.1 9.3 8.6 5.9 11.4 7.2 2.2 Average 6.0 % 7.5 % 6.9 % 7.1 % 6.2 % 5.1 % 6.4 % 6.9 % 0.5 %

Growth-OrientedTechnology ### % ### % +12.1 % +10.1 % +13.0 % +6.8 % +7.8 % +10.4 % +0.0 %Health Care: P harmaceuticals and Biotech 16.4 % 25.4 % 9.9 % 7.6 % (10.1) % 3.0 % 0.7 % 7.7 % 5.8 % Equipment and Services 15.0 17.6 11.9 8.2 10.1 6.8 12.2 11.0 1.5Retail, Media and Other Consumer Cyclicals10.7 9.6 7.3 6.8 4.5 7.7 2.5 1.8 0.0Consumer Staples 6.7 6.5 6.2 6.4 4.7 7.6 9.7 0.1 (4.6) Average 12.2 % 14.8 % 8.8 % 7.3 % 2.3 % 6.3 % 6.3 % 5.2 % 0.7 %

OtherFinancials N/A N/A +4.1 % +9.8 % N/A +5.4 % +2.6 % (0.1) % 0.0 %Energy +3.6 % +9.9 % 8.2 9.6 5.8 % 8.9 8.0 +9.7 +4.2Telecommunications 13.5 6.6 13.9 (5.5) 21.1 14.4 7.1 (5.3) 3.7Utilities N/A N/A 10.1 6.4 11.3 6.9 5.9 8.0 0.0

Source: Empirical Research P artners Analysis.

1 Quintile membership is determined across not within sectors.

Cash Flows-to-Enterprise Value P rice-to: P /E Ratios

Annual Relative Returns: Best - Worst Quintile1

1952 Through 2003

Relative Valuation

Commonly Used against Company Historical Range, Peers, or Market

Easy to Access, Easy to Misuse Yields Different Answers Than DCF If it Looks Too Good to be True it

Probably is…Too Good to Be True

What are Comparable Assets?

Comparable Assets

Similar Cash Flow, Growth and Risk

Generally in Similar Industries

Complicating Issues: Size, Business Mix, Leverage, Profitability

Understand Implicit Assumptions

Comparable Assets 2004? GE ($33.75) 2004 estimate $1.57 LTG estimate 9.4% PTax Margin 15.12% Mkt Cap $356bn ROE 21% Debt/Tot Cap 43.6% 2003 PE 21.4x

C ($47.00) 2004 estimate $4.01 LTG estimate

11.36% PTax Margin 27.8% Mkt Cap $243bn ROE 19.52% Debt/Tot Cap 23.3% 2004 PE 11.7x

Comparable Assets 9/03 GE ($31.79) 2003 estimate $1.56 LTG estimate 11.3% Op Margin 14.14% Mkt Cap $318bn ROE 23.8% Debt/Equity 421% 2003 PE 23x Price 9/13/04 $33.75

UTX ($79.48) 2003 estimate $4.64 LTG estimate 11.6% Op Margin 12.26% Mkt Cap $37.2bn ROE 26.6% Debt/Equity 51% 2003 PE 18x Price 9/13/04 $94.64

When to use what?

1. P/E2. P/FCF3. P/B4. P/Sales5. EV/EBITDA6. Other measures???

1. PE Ratio

Sensitive to Volatility, Growth, Profitability

P/E = 1/r + PVGO/E Affected by Accounting Issues Multiple Definitions (Operating Eps,

Historic, Forward, Pro-forma, Fully Diluted vs Basic)

Affected by leverage

2. Free Cash Flow Yield(instead of earnings)

Operating Earnings+Depreciation Expense- Cap Ex-∆Working CAP

Cash Available for Distribution to Shareholders

Strips Back Some Accounting Artifice

Incorporates Info from Balance Sheet

3. Price to Book Value

Less Meaningful Today Useful in Distressed Situations Useful in Lower Growth Industries (Energy, Utilities, Financials)

3. Price to Book Value

Useful in Financials Where Reserves can be Manipulated

Influenced by ROE and Cost of Equity Significant Accounting Issues

(Buybacks, Repurchase, Restructuring)

Can be Useful in Mean Reverting Mature Industries (Energy, Utilities)

4. Price to Sales Tougher to Manipulate Revenues Tend to be Positive! Useful in Absence of Profitability

(Highly Cyclical Situations) Enterprise Value to Sales (MV of

Equity+MV of Debt-Cash)/Sales Corrects for Companies with Different Leverage

5. Enterprise Value to Ebitda

(Market Value of Equity+Debt-Cash)/(Earnings Before Interest, Taxes, Depreciation, and Amortization) Used in the Absence of Profits Used Where EBITDA is Free Cash Corrects For Varying Leverage But Ignores Depreciation as Real

Expense

6. Alternative Measures?

PE to Growth Ratio Market Value per Subscriber Market Value per Home Passed Market Value per Member Market value per Pet HOLD ON TO YOUR WALLET!