Finance 3321 (Moore)

Chapter 7

Chapter 7 Prospective Analysis: Valuation Theory Basics

Problems: 7-2, 7-3, 7-7, 7-8, 7-9, Complete Auto Industry Valuation Sheet

Key Learning Outcomes

Developing a broad set of valuation measures The ability to estimate the appropriate cost of capital Working with growth rates and terminal values (equilibrium) Valuation with Multiples (screening methods) Theory based valuation models Understanding the residual income and abnormal earnings valuation models Matching costs of capital with financial statement data and forecasts The ability to understand and measure Abnormal Earnings and Growth for terminal values Assessing the implied cost of capital given the current market price (value)

Earnings Multiples Valuation (Method of Comparables)

1992 Company
Chrysler Daimler-Benz Federal Signal 28.00 Ford Motor, Canada Ford Motor, US General Motors, US Honda Motor, Ltd. Navistar, Intl. Paccar, Inc.

1993 PPS EPS BPS DPS PPS

EPS

BPS

DPS

2.21 25.5 0.60 32.25 -7.62 19.3 0.65 53.25 Not Traded in US 0.74 21.7 8.01 48.63 1.00 5.23 0.42 21.25 1.15 5.81 0.48 -35 -15.6 -38.3 0.67 -0.95 1.93 64.2 30.1 8.47 18.31 0.37 30.7 0.00 1.60 1.40 0.24 0.00 1.30 85.5 42.88 32.25 25.50 1.88 57.25 -22.5 4.55 2.13 0.47 -15.5 4.21 39.9 31.2 7.77 19.3 7.10 32.8 0.00 1.60 0.80 0.27 0.00 0.00 95.50 64.50 54.88 32.38 27.25 61.25

Required: a. Calculate estimated prices in 1992 and 1993 for Chrysler using averages multiples of earnings, book values and dividends of the other firms in the industry. Which valuation comes closest to the actual price? b. List and explain the reservations (problems) you identify in using the multiples. -1-

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c. All else being equal, would you expect the price of a firm with a high dividend payout ratio to be higher or lower than that of comparison firms? Explain.

Method of Comparables (Mechanics and Logic) Screening Tool

A. Determine Relevant Valuation Multiples 1. Take relevant industry averages (excluding firm to be analyzed) a. Omit negative values and (possibly) large outliers 2. Possible measure to use: a. P/E (trailing) b. P/E (forecast) c. P/B d. D/P e. P.E.G. (Price/Earnings) / (1-Year ahead Earnings Growth Rate) f. P/EBITDA (un-levered measure)

g. P/(FCF per share) FCF = CFFO + CFFI (physical assets) +/- CFFF (Change in Debt)

h. (Enterprise Value)/(EBITDA) or (Enterprise Value)/(FCF) Enterprise Value = EV EV = Market Value of Equity + Value Liabilities (Cash and Financial Investments) Compute Industry Average EV/FCF or EV/EBITDA and then value your firm

B. Compute Value based on Average Multiple (comparable) and forecast metric 1. Example for P/E (forecast)

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Chapter 7

P a s Ss

e st s e d

= E ( E,

P Pt + 1 ) S* E

v e r a

c o

p f a i r r am b s l e

C. Examine Price (PPS) assessment across all multiples. 1. Commonly, there exist a wide range of values 2. No theory to state which valuation multiple is best 3. Keep in mind you are not doing an intrinsic valuation a. Industry average benchmarks are determined by market consensus

D. Workshop on PEG, P/EBITDA; P/FCF; EV/FCF. 1. Sample Companies (Broad-Line Semi-Conductors)

Mkt Cap

STMICROELECTRONICS [STM] ANALOG DEVICES [ADI] MAXIM INTEGRATED [MXIM] NATL SEMICONDUCTOR [NSM] ADV MICRO DEVICES [AMD] $17.3 B $12.3 B $10.5 B $8.8 B $7.5 B

2. Value Maxim Integrated (MXIM) Using Valuation Multiples

Levered FCF EV MVE Shares P 0.168 16.63 17.4 0.89742 0.235 11.52 12.32 0.327 0.292 8.04 8.82 0.3103 -1.05 10.18 7.45 0.55044

PEG STM ADI NSM AMD 1.69 1.63 1.36 NA

EBITDA 2.46 0.814 0.645 0.705

19.41 Billions 37.68 28.43 13.53

MXIM

1.81

0.925

0.224

9.14

10.46

0.32007

32.7

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Chapter 7

Data from Yahoo Finance

Which cost of Capital? (Matching with financial statements)

1. Weighted Average Cost of Capital (WACC)

A =C

C Vd +V

(r

(1 T ) ) +

e e

Vd +V

re

2. Capital Asset Pricing Model (CAPM) Formula What about Leverage??

3. Discounted Earnings or Cash Flow? Free Cash Flow?

Intrinsic Valuation Methods

A. Intrinsic Valuation
1. Involves Detailed Forecasts and Analysis 2. Requires substantial professional judgment and estimates 3. Is the analysts opinion (assessment) of firm value (not consensus) 4. Can help identify under-valued; over-valued; and reasonably valued firms 5. Severe differences between Intrinsic and Market values should be examined 6. Utilizes present values

B. Popular Valuation Methods Available

1. Discounted Dividends -4-

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2. Discounted Free-Cash Flows 3. The Residual Income Method (accounting based) 4. Abnormal Earnings Approach (accounting based) 5. Residual Income Perpetuity

C. Discounted Dividends Valuation

1. The Model

P
or (in perpetuity)

P t = S

t=1

(1 + k )
e

d~ E

t+1

d~ E t+1 Pt = S r g

2. Examine data requirements and estimates

3. Empirical considerations

D. Residual Income Valuation

1. Foundations: Consistent with Modigliani and Miller Model (and intuition) a. Finance Model (Market Value Based)

VF = VD + VE
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(Market Values)

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b. Balance Sheet (Accounting Value Based)

A = L + E

(Accounting Values)

2. Residual Income (RI) Valuation Model

,t

= B

V t + E

E ( N ~ t

t+1

I) ke(B
t+1 e

t=0

(1 + k )

V t ) E

a. Examine data requirements and estimates

b. Empirical considerations

E. Discounted Free Cash Flows

VE ,0

~ Et FCFt Liabilities = MV , 0 t t =1 (1 + WACC AT ,t )

1. Examine data requirements and estimates 2. Empirical considerations 3. Difference between accounting earnings and free cash flow (conceptual)

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