AF 4107 Financial Statement Analysis Seminars 11 Chapters 7, 8, 10 & 11: Forecasting & Valuation

Forecasting & Valuation

Reading: Forecasting: Chapters 7 & 8 (page 143 to 191) Valuation: Chapters 10 & 11 (page 205 to 242) of Lundholm Book Case: Kohl in above Chapters
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3. Discounted Cash Flow (DCF) Method

Indirect Approach, Free Cash Flows Determine terminal value of FCF Advantages & Disadvantages of the Model

Seminar 11: Valuation

4. The Comparables Method

5. Investment prospect
Putting P/E and P/B together P/B0 = ROE0 x P/E0
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3. Valuation: Discounted Cash Flow (DCF) Indirect Approach: Free Cash Flows

Discounted Cash Flow (DCF) Valuation

Direct approach: Dividend Discount Model Indirect approach: Free Cash Flow Model Free cash flows to all investors or Free cash flows to common equity holders
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Discounted Cash Flow (DCF) Valuation

Implementing FCF Valuation 1. Estimating FCF 2. Estimating FCF growth rate at the end of forecasting horizon 3. Estimating the discount rate used WACC for FCF to All investors Cost of equity for FCF to common equity
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Discounted Cash Flow (DCF) Valuation

Steps in valuing shares using FCF model
1. A forecast of free cash flows over a time period of 5 to 10 years 2. Determine appropriate discount rate: use WACC for valuing the firm, use cost of equity for valuing shares

Discounted Cash Flow (DCF) Valuation

Steps in valuing shares using FCF model 3. Determine terminal value of free cash flows using a zero or constant growth model 4. Compute present value of the cash flows and terminal value using the discount rate 5. After getting the entity value, subtract this value by the value of other claims (i.e. debts and preference shares) to derive the total value of shares
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3 ways to compute Free Cash Flow to All investors

1. NOI DNOA is easy 2. from the Statement of Cash Flow, note that
CFO + CFI + CFF = Dcash (CFI and CFF usually negative) compute FCF = CFO + CFI Dcash + Net Interest payment * (1-tax rate). compute FCF = CFF + Net Interest payment * (1-tax rate). See Cash Flow Analysis sheet in eVal.

3. OR use the traditional approach

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 this assumes that all cash is operating. If want to think of it as financing, then it is negative debt, so an increase in the cash balance is like a reduction in debt.

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Forecast financial statements

0 NOA0 -L0 CE0 for the period ending 1 2 T-1 T T+1 T+2 NOA1 NOA2 NOAT-1 NOAT NOAT(1+g) NOAT(1+g)2 -L 1 -L 2 -L T-1 -L T -L T(1+g) -L T(1+g)2 CE 1 NOI1 -I1 NI1 CE 2 CE T-1 CE T CE T(1+g) CE T(1+g)2 NOIT(1+g) NOIT(1+g)2 -IT(1+g) -IT(1+g)2 NIT(1+g) NIT(1+g)2

NOI2 NOIT-1 NOIT -I2 -IT-1 -IT NI2 NIT-1 NIT

L=Interest bearing liabilities, CE= Common Equity, NOI=Net Operating Income after tax, I=Net interest expense after tax, NI= Net income after tax. Value is determined by your forecasts!
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 So where do we get the Dt values for inputs into the model? From forecasted financial statements! Observations: 1) we dont need anymore detailed financial statements that this (although the net of tax bit in NOI and I really requires tax expense as well). 2) note the distinction between the finite horizon and the infinite thereafter. this is how we will always handle the infinite future it is really quite flexible because g can be between 1 and r. g=-1 implies T+1 is the last flow; g approaching r implies almost infinite value. 3)Armed with forecasted financial statements forever into the future, value is determined, we 12 just need to discover what it is.

FCF to All Investors

1. Free Cash Flow to All Investors can be computed from

Income statement and Balance sheet

Ct = NOIt (NOAt NOAt-1).

Ct = FCFt

2. Free Cash Flow to All Investors can also be computed from Statement of cash flow

Ct = Dt + It(1-txt) - DLt + PDt - DPSt.

Dividend To common equity holders Interest and change in net debts To debt holders (net of tax shield)
Preferred dividend and change in PS To preferred 13 stockholders

 Now are are going to do the 2-step approach to valuation. First we value the entity then we subtract the value of the debt claims. To do this, we need to figure out the flows to all parties. Dont worry about the tax shield stuff for now.

Historically, this model arose from a management consulting tool (at McKinsey?).
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Free Cash Flow Generated (Used): EBIT -Taxes on EBIT +Increase in Deferred Taxes = NOPLAT +Depreciation & Amortization +Minority Interest in Earnings +Non-Operating Income (Loss) +Other Income (Loss) +Ext. Items & Disc. Ops. =Gross Cash Flow -Increase in Working Capital -Capital Expenditures -Increase in Investments -Purchases of Intangibles -Increase in Other Assets +Increase in Minority Interest +Increase in Other Liabilities +/-Clean Surplus Plug (Ignore) =Free Cash Flow to Investors

The Traditional FCF recipe for the DCF model is

NOI after tax, but before after tax net interest expense

DNOA
Both current (working capital changes) and non-current operating accruals (net investment in CAPEX and long15 term operating assets)

 Here is how FCF is computed in a traditional textbook (this is from eVal, but we took it from Copeland Valuation). Which is easier to remember?

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FCF: Traditional Calculation

Free cash flow is cash flow from operations minus cash used to make investments (i.e. net investments in non-current operating assets)
C1 C2 C3 C4 C5

Cash flow from operations (inflows)

Cash investment (outflows)

I1

I2

I3

I4

I5

Free cash flow Time, t

C1-I1

C2-I2

C3-I3

C4-I4

C5-I5

5
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Cash flow from operations (inflows)= EBIT (1-t) + depreciation Increase in net working capital

FCF Valuation
Cash flow from operations (inflows) EBITDA DA EBIT x (1- tax rate) +DA Increase in NWC EBITDA1 DA1 EBIT1 x (1- tax rate) +DA1 Inc NWC1 EBITDA2 DA2 EBIT2 x (1- tax rate) +DA2 Inc NWC2 EBITDA3 DA3 EBIT3 x (1- tax rate) +DA3 Inc NWC3 EBITDA4 EBITDA5-> DA4 DA5-> EBIT4 EBIT5-> x (1- tax rate) x (1- tax rate) +DA4 +DA5-> Inc NWC4 Inc NWC5

CFO (inflows) C1
Invest CAPEX (outflows)
I1

C2
I2

C3
I3

C4
I4

C5
I5 --->

FCF to All investors C1 I1

C2 I2

C3 I3

C4 I4

C5 I5 --->

________________________________________________ Time, t 1 2 3 4 5
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FCF Valuation
Cash flow from operations (inflows) Cash investment (outflows) C1 I1 C2 I2 C2 I2 C3 I3 C3 I3 C4 I4 C4 I4 C5 ---> I5 --->

FCF to All investors C1 I1

C5 I5 ---> --->

________________________________________________ Time, t 1 2 3 4 5

V
V0E

Equity 0

Firm 0

Debt 0

C1 I1 C2 I 2 C3 I 3 CT I T C VT Debt V 0 (1 wacc) (1 wacc) 2 (1 wacc)3 (1 wacc)T (1 wacc)T

Firm VO
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Determine terminal value of FCF

Case 1 - FCF constantly grows at g: Case 3 - FCF has zero growth:

FCF 0(1 g ) FCF1 V0 rg rg FCF 0 Formula works ONLY if r, discount rate is higher than g, growth rate of V0 FCF in perpetuity r

But which sequence does this apply to?

t0 FCF t1 FCF(1+g) t2 FCF(1+g)2 t3 t4 .(Case 1)

FCF(1+g)
FCF

FCF(1+g)2
FCF

0.. (Case 2)
FCF..(Case 3)
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How about Case 2? Zero terminal value after t2

 So now we are set. Have the numerator flows figured out, and have the discount rates figured out. But do we need an infinite # of columns in our spreadsheet? NO, because we assume that after T everything behaves in a nice way, so we can use the perpetuity formula to figure out the value from T onward. And, what is the perpetuity formula? Its the middle one! first payment is a year away AND THEN they start to grow.
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DCF Valuation: New York State Electric and Gas (Terminal V) ______________________________________________________________________________
New York State Electric and Gas Corp. (Amounts in millions of dollars except per share data) 1997
Cash from operations Cash investments Free cash flow Discount factor (1.09)t PV of cash flows Total PV of cash flows Terminal value1 PV of TV 1,795 1,355 3,578

1998
602 207 395 1.090 362

1999
460 191 269 1.188 226

2000
381 211 170 1.295 131

2001
403 301 102 1.412 72

2002
379 243 136 1.539 88

2003
499 302 197 1.677 117

2004
533 216 317 1.828 173

2005
531 160 371 1.993 186

2006
534 212 322

Value of the firm (VF1997) Book value of debt and preferred stock Value of equity (VE1997) Value per share (55.733 shares)
Terminal value =

3,150

2,290

860

15.43
3,578

322/0.09 (constant @ 322 after 2005)

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Valuation All Investors Cost of Debt Cost of Equity

Kohl: Val date 18/3/2009, Cost of equity 10%, Actual : Fiscal 2001
8.00% 10.00% 9.60% (285,758)

After Tax Weighted Average Cost of Capital Value of Debt (negative means financial assets)

Free Cash Flows to All Investors (2002E) Present Value of FCF to All Investors
Entity Value (sum up PV of FCF and PV of terminal value) Less Value of Debt (or Add Value of Net financial assets) Less Value of Preferred Stock Forecast Equity Value Before Time Adj. Forecasted Equity Value as of Valuation Date (18/3/2009) Less Value of Contingent Equity Claims Value Attributable to Common Equity Common Shares Outstanding at BS Date (year end 2001A)

(153,016) (139,616)
11,772,031 285,758 0 12,057,789 21,670,861 0 21,670,861 332,167

Equivalent Shares at Valuation Date

Forecast Price/Share at 18/3/2009

332,167
$65.24
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DCF: Will it work for Wal-Mart Stores? (negative FCF)

Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.)

1988

1989

1990

1991

1992

1993

1994

1995

1996

Cash from operations

536

828

968

1,422

1,553

1,540

2,573

3,410

2,993

Cash investments

627

541

894

1,526

2,150

3,506

4,486

3,792

3,332

Free cash flow

Dividends per share

(91)

287

74

(104)

(597)

(1,966)

(1,913)

(382)

(339)

0.03

0.04

0.06

0.07

0.09

0.11

0.13

0.17

0.20

Price per share

10

16

27

32

26

25

24

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DCF: Advantages
Easy concept: Cash flows are real and easy to think about; they are not affected by accounting rules Familiarity: Is a straight application of familiar net present value techniques
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DCF: Disadvantages
Suspect concept:
FCF does NOT measure value added in the short run; value gained is not matched with value given up. FCF fails to recognize value generated that does NOT involve cash-flows FCF is partly a liquidation concept; firms increase FCF by cutting back investments

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DCF Disadvantages
Forecast horizons: Typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability
Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: Analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals. 27

4. Valuation: The Comparables Method

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The Comparables Method

Steps in valuing shares using Comparables 1. Choose a set of comparable firms 2. Compute the average multiple (s) across the comparable firms 3. Choose the most appropriate multiple for the firm being valued 4. Estimate the base for the firm being valued. For example, using P/E ratio, we need to estimate EPS for the firm being valued 5. After getting the entity value (if based on EBIT, EBITDA ratios), subtract this value by the value of other claims (i.e. debts and preference shares) to derive the total value of shares
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The Comparables Method

Value the Shares

Share Pr icefirm0 ( PEIndustry) xEPSfirm0 or1 a. P/E Method Taking the average of P/E (Price/Earnings) ratios for similar companies within the same industry. A similar company has comparable growth, risk, financial leverage and dividend payout. Higher the growth prospects expected for the firm valued, the higher the P/E ratio used. The Base calculated: EPS (earnings per share) can be on a trailing basis, i.e. using current year actual EPS or on a forward basis using forecast (or next years) EPS. Difficult to use P/E ratio to measure value of a smaller, unquoted company in the same industry
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The Comparables Method

Value the Firm (Entity value)
a. EBIT b. EBITDA

EV

firm0

( EV / EBIT )

Industry

xEBIT firm0 or1

EV

firm0

( EV / EBITDA)

Industry

xEBITDA firm0 or1

Entity value =
1. Market value of equity 2. plus book value of interest-bearing debt 3. minus cash Industry EV/EBIT (EV/EBITDA) ratio is determined by taking the average of the EV/EBIT or EV/EBITDA ratios of similar firms within the same industry.
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The Comparables Method

Value the Firm (Entity value)
a. EBIT b. EBITDA
EV
firm0

( EV / EBIT )

Industry

xEBIT firm0 or1

EV

firm0

( EV / EBITDA)

Industry

xEBITDA firm0 or1

EV/EBITDA multiple is preferred if either depreciation or amortization charges distort earnings or make comparisons difficult. EBIT or EBITDA for the firm being valued can be measured on either trailing (current) or forward basis (forecast or next years) Other multiple used: EV/Sales
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Comparison between DCF and Comparables Method

DCF
Assumptions Need assumptions about the growth rate of forecast FCF and the discount rate Assumptions are more explicit

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Comparison between DCF and Comparables Method

Comparables
Assumptions Decide whether to use average of the ratio of comparable firms (P/E, P/EBIT, P/EBITDA, P/S) or a different multiple reflecting the differences in fundamentals between the firm valued and comparable firms (need to adjust size, listed versus unlisted and stage of growth) Assumptions remain implicit, difficult to see how the multiple should be adjusted for differences (more inaccuracy)
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5. Investment prospect Putting P/E and P/B together P/B0 = ROE0 x P/E0

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P/E ratio (times)

Market price per share of common shares Earnings per share
Reciprocal of the earnings yield (EPS/Share price) is called price earning ratio (P/E). Indicates the market price of one dollar of current or future earnings. Reflect investors expectations about growth in current and forward earnings. P/E never indicates if ROE is higher/lower than cost of equity (>, < or = cost of capital), but indicates about how future ROE grows from current ROE.
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Articulation of P/E (Price/EPS)

Price in numerator of P/E is based on expected future earnings valued by the market
Earnings (EPS) in denominator is current (or forward) earnings P/E is thus based on expected growth in current or forward earnings, but not necessarily profitable

P/E denotes market perception of risk & expected growth in the stock
Higher risk, require higher rate of return ---Lower P/E Higher expected growth rate ----- Higher P/E
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Articulation of P/B
Price/Book (P/B) ratio (times)
Market price per share of common shares Book Value per share
P/B indicates expected growth in book value of common shareholders equity (focus on measuring value) P/B0 = ROE0 x P/E0 : (P in P/B and P in P/E are the same market price) P/B ratio is about profitable growth (means ROE >

cost of equity) if future ROE is high (> cost of equity), P/B will be high
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Book Value per common shares

Common Shareholde rs' equity - Preferred Equity No of common shares outstandin g
Indicates the recorded accounting amount of common shareholders equity per share of common shares outstanding.

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Investment prospect : putting P/E and P/B together

P/E
High PE, low PB, Sears

High PE & PB

Kohls Target

P/E 18.6 (industry)

Wal-Mart

Low P/E, low PB value

glamour

Low PE, high PB (stable ROE)

P/B 2.5 (industry)

P/B

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After doing the formulas

Think about P/B in terms of abn. ROE and growth Think about P/E in terms of current and future earnings Glamour stocks are high on both. (Internet Stocks) Dogs are low on both. (Steel) Harvesters have low P/E and high P/B because they have no growth but a solid, steady abn ROE. (Beer) Turnarounds (recovering dogs) have high P/E but low P/B because they have the big BV but very little earnings; expected to recover but not huge earnings growth. (firms restructuring - Winnebago went from turnaround (p/e=33, p/b=2.2 to harvester (p/e 11, p/b=3)).
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Industry P/B and P/E

26 24

based on S&P1500, as of 3/2006

Prof. Services
Information Information Technology Healthcare

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Healthcare Mining Retail Construction

Telecommunication Finance/Insurance Services Utilities M aterial s Financials

Hotel/Restaurant Manufacturing
Consumer Discretionary Consumer Staples Industrials

price-to-earnings

20 18 16 14 12 10

Utilities

Energy

0 1 2 Based on S&P1500 as of Mar 2006

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market-to-book

Summary: articulation of P/E and P/B Ratio

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