Connor Haley 02.09.

12

The Art of Valuation

Goals of this presentation Keep you interested Valuation is FUN Explain the weaknesses inherent in any DCF Introduce a three-layered approach to valuation

DCF Valuation
What is it?
Shortcomings Inaccurate information (distant cash flows) is added to accurate information (near-term cash flows), which produces inaccurate information Leads to false sense of security

Example
Consider the Terminal Value in a DCF
Comprises the majority of the value in most valuations If we are wrong by 1% in either direction, range of TV

is greater than 3-1!

Term. Cost of Capital 8% 7%

Term. Growth Rate Multiple 4% 5% 1/(8%-4%) = 25 1/(7%-5%)= 50

9%

3%

1/(9%-3%) = 16.6

A Better System
1) Asset Value- How much are the companys assets on

the books worth TODAY 2) Earnings Power Value- How much is the current earnings power worth (assuming zero growth) 3) DCF How much (if anything) is growth worth?

Asset Value
Any valuation start with a decision about the

competitive position of the firm Is industry..

Economically viable?

Value at Reproduction Costs Value at Liquidation Value (Scrap)

In Terminal Decline?

Even with this approach, we separate good and bad

information (as we move down BS)

Earnings Power Value

Estimates the current earnings powerif it were to continue indefinitely into the future with zero growth.

Adjusted earnings include Rectifying accounting misrepresentations (one-time charges Resolving discrepancies between depreciation and amortization and actual amount of investment by the company Take into account the current position in the business cycle EPV has the advantage of being based entirely on currently

available information and is uncontaminated by more uncertain conjectures about the future

Earnings Power Value Formula=

EBIT Taxes = NOPAT (net operating profit after tax) + Depreciation and amortization - Maintenance capital expenditures (only maintenance, not total capex) = Adjusted Operating Cash Flow

(Adjusted OCF/ Cost of capital) + Net Cash = Earnings Power Value / Shares outstanding
= EPV/share

DCF Value the Growth

Most difficult to estimate, must be confident in

competitive advantages
Realize not all growth is valuablefor companies w/o

competitive advantages, growth can actually DESTROY value By employing three-stage valuation, an investor has a far better idea of what he/she is betting on than an investor just starting with DCF

Reverse DCF can often be more useful in evaluating

the sanity of the current market price

Example: Skechers (SKX)

Shoe company founded in 1992, competes with Adidas,

Nike, New Balance Over $1 B sales since 2005 Shape-Ups Boosted earnings 40% in 2010
Company too aggressive with growth plans (fad) Forced to liquidate inventory at huge write-downs Will likely have to pay large fine ($60 mm) for false

advertising claims to FTC Stock price fallen from high of $23 to low of $11 to current price of $14

1: Asset Value
Current Stock Price= ~$14
$18 TBV/share (28% upside) Excludes value of int. assets Need to further adjust for further inventory write-downs ($35 mm), $60 mm FTC liability Adjusted TBV= ~$16 (14% upside) NCAV: $9.25- 9.72/share (~30% downside) Most conservative estimate of Asset Value

Earnings Power Value

Two Scenarios modeled for run-rate
2007 operating results as a proxy for what the company

could look like without the Shape-up revenue 2005 operating results, which are 30% lower than 2007

2- Earnings Power Value

2005 Results EBIT Taxes NOPAT Maintenance Capex D&A Adj. Cash Flow EPV Net Cash Total EPV EPV/Share $77.2 mm $30.88 $46.32 $18.50 $32 $60 $600 $63.7 $663.7 $13.26 (5% overvalued) 2007 Results $112.9 mm $45.16 $67.74 $18.50 $32 $81 $810 $63.7 $873.7 $17.47 (24% undervalued)

Value of Growth
Assumes 2007 starting point for FCF ($70.2 mm)
Average 5% growth next ten years, 2% TG 11% Discount Rate, constant margins

IV/Share = $21, (50% undervalued)

Valuation Summary
Asset Value: Low: $9.25 High: $16 EPV Low: $13.26 (5% DS) High: $17.47 (24% US) DCF Base: $21 EPV > Asset Value =

company has competitive adv. in marketplace My competitive analysis suggests SKX is likely to maintain market position (but not necc. Increase) Stock likely worth between EPV values

Summary
Relying on DCF alone is dangerous It lumps together estimates based on good information with those based on very uncertain assumptions producing poor information It relies on making accurate estimates of events that are far in the future The 3-Stage Valuation model I have proposed emphasizes

current information and a knowledge about fundament competitive conditions It depends on specific knowledge about particular industries and assets, and it places less faith in projections of rosy futures unless substantiated by current hard date This is the discipline of value investing in the Graham and Dodd Tradition