Financial modeling 1

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Financial modeling 1

  1. 1. Financial Analysis &Financial Analysis & ModelingModeling
  2. 2. Fundamentals of IndustryFundamentals of Industry & Company Analysis& Company Analysis
  3. 3. Industry AnalysisIndustry Analysis  Top Down ApproachTop Down Approach • Identify the relevant variablesIdentify the relevant variables  Economic CyclesEconomic Cycles  Industry Life CycleIndustry Life Cycle  Demand Supply AnalysisDemand Supply Analysis  Pricing PowerPricing Power  Earning DriversEarning Drivers  Structure of IndustryStructure of Industry  Porter’s five forcesPorter’s five forces
  4. 4. Who says fundamentals don’tWho says fundamentals don’t work in Pakistan?work in Pakistan? 0% 2% 4% 6% 8% 10% FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 -75% -50% -25% 0% 25% 50% 75% 100% 125%GDP Growth (LHS) KSE-100 Index Return
  5. 5. Stock Market & EconomicStock Market & Economic CycleCycle Financial Stocks perform well Consumer Durables perform well Capital Goods perform well Basic Industries perform well Consumer Staples perform well These are relative performances
  6. 6. Demand Supply AnalysisDemand Supply Analysis Pakistani Cement Industry - 5 10 15 20 25 30 35 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07* 0 50 100 150 200 250 300 Supply (mt) Demand (mt) Prices (Rs/bag) D/S (mt) Price (Rs/ bag)
  7. 7. Thank you Mr. Porter!Thank you Mr. Porter! Industry Competitors Rivalry among Existing Firms Suppliers Buyers Substitutes Potential Entrants Threat of New Entrants Bargaining Power of Buyers Threat of Substitute Products or Services Bargaining Power of Suppliers
  8. 8. Company AnalysisCompany Analysis  Business PerformanceBusiness Performance • Return on AssetsReturn on Assets • Return on EquityReturn on Equity • Operating MarginOperating Margin  Earnings QualityEarnings Quality • Cash Realization RatioCash Realization Ratio • Asset Replacement RatioAsset Replacement Ratio • Debt to EquityDebt to Equity  ValuationsValuations • Price / Earning RatioPrice / Earning Ratio • Price / Book ValuePrice / Book Value • Dividend YieldDividend Yield • Sales GrowthSales Growth • Earnings GrowthEarnings Growth • Free Cash FlowFree Cash Flow • Interest Coverage RatioInterest Coverage Ratio • Tax RateTax Rate
  9. 9. Interpreting RatiosInterpreting Ratios  A quick view of what’s happening in the company/ sectorA quick view of what’s happening in the company/ sector  Look for trends over yearsLook for trends over years  Comparisons against historical trend, peers, industry averagesComparisons against historical trend, peers, industry averages  Calculation of industry averagesCalculation of industry averages • Simple average – large sample size, similar sized companiesSimple average – large sample size, similar sized companies • Weighted average – Differing company sizesWeighted average – Differing company sizes
  10. 10. Business Performance MeasuresBusiness Performance Measures  Return on AssetsReturn on Assets • Indicates profitability of the company as a wholeIndicates profitability of the company as a whole  Return on EquityReturn on Equity • Indicates profitability for the owners of the companyIndicates profitability for the owners of the company  Sales GrowthSales Growth • Usually the most important driver of valueUsually the most important driver of value  Operating MarginOperating Margin • Indicates pricing powerIndicates pricing power  Free Cash FlowFree Cash Flow • More comprehensive measure than earnings. Combines earnings &More comprehensive measure than earnings. Combines earnings & reinvestment requirementsreinvestment requirements
  11. 11. Return on EquityReturn on Equity  Net Income / Avg Shareholders’ EquityNet Income / Avg Shareholders’ Equity  Interpretation/ UseInterpretation/ Use • Sort of a subset of ROCESort of a subset of ROCE • If Cost of Debt < RoE, increasing leverage will add valueIf Cost of Debt < RoE, increasing leverage will add value • Cross check between P/BV and P/ECross check between P/BV and P/E P/BV = RoE x P/EP/BV = RoE x P/E  Du Pont Analysis:Du Pont Analysis: • helps identify potential sources of high or low ROEhelps identify potential sources of high or low ROE • Net Income =Net Income = Net IncomeNet Income xx SalesSales xx AssetsAssets SalesSales AssetsAssets EquityEquity
  12. 12. Operating MarginOperating Margin  Operating Profit / Net SalesOperating Profit / Net Sales • Sales should be net of all allowances and discountsSales should be net of all allowances and discounts etc.etc.  Interpretation/ UseInterpretation/ Use • High margin indicates good positioning, pricingHigh margin indicates good positioning, pricing power and cost controlpower and cost control
  13. 13. EPS Growth & Free Cash FlowEPS Growth & Free Cash Flow  EPS Growth – CAGREPS Growth – CAGR  Free Cash Flow – Cash generation over and above theFree Cash Flow – Cash generation over and above the essential spendingessential spending  Interpretation/ UseInterpretation/ Use • Be wary of low base effect in EPS GrowthBe wary of low base effect in EPS Growth • Growth at any price? Usually, growth in sales & earningsGrowth at any price? Usually, growth in sales & earnings requires further investment in fixed and working capital.requires further investment in fixed and working capital. Looking at earnings growth in isolation may be misleading.Looking at earnings growth in isolation may be misleading. We must understand the incremental cost incurred by theWe must understand the incremental cost incurred by the business in order to earn the incremental profitsbusiness in order to earn the incremental profits • Shareholder value increases only when incremental earningsShareholder value increases only when incremental earnings are higher than incremental costs.are higher than incremental costs. • Free Cash Flow combines earnings and costs in a singleFree Cash Flow combines earnings and costs in a single measuremeasure
  14. 14. Cash Realization RatioCash Realization Ratio  Cash Flow from Operations / Net ProfitCash Flow from Operations / Net Profit  Interpretation/ UseInterpretation/ Use • How much are the cash earnings?How much are the cash earnings? • Higher ratio is generally betterHigher ratio is generally better • Trends are important – declining trend may meanTrends are important – declining trend may mean problemsproblems • Beware of the Low Denominator – low Net Profit isBeware of the Low Denominator – low Net Profit is never goodnever good
  15. 15. Asset Replacement RatioAsset Replacement Ratio  Capex / DepreciationCapex / Depreciation  Interpretation/ UseInterpretation/ Use • Serves as a reality check over growth expectations & FreeServes as a reality check over growth expectations & Free cash flowscash flows • Ratio of lower than 1 means, asset base is shrinkingRatio of lower than 1 means, asset base is shrinking • In normal circumstances, declining asset base will not sustainIn normal circumstances, declining asset base will not sustain profitability growthprofitability growth • Important to identify correct life of the assets, conservativeImportant to identify correct life of the assets, conservative depreciation policies will depress this ratiodepreciation policies will depress this ratio • Look at past trend in “gain on sale of asset” > conservativeLook at past trend in “gain on sale of asset” > conservative depreciation policydepreciation policy • Check remaining age of assets > high replacement ratio atCheck remaining age of assets > high replacement ratio at end of asset life will only sustain current earningsend of asset life will only sustain current earnings
  16. 16. Tax RateTax Rate  Effective Tax Rate = Tax expense / Pre Tax ProfitEffective Tax Rate = Tax expense / Pre Tax Profit  Interpretation/ UseInterpretation/ Use • Check cash vs non cashCheck cash vs non cash • Reversals and other one offsReversals and other one offs • Portion of income with different tax ratePortion of income with different tax rate • Utilization of tax lossesUtilization of tax losses • Tax exemptions do not last forever!Tax exemptions do not last forever!
  17. 17. Debt to Equity & Interest CoverDebt to Equity & Interest Cover  Capital Structure and its coverageCapital Structure and its coverage  Debt / Total EquityDebt / Total Equity  Interest Cover = EBIT / Interest ExpenseInterest Cover = EBIT / Interest Expense  Interpretation/ UseInterpretation/ Use • Leverage is not essentially badLeverage is not essentially bad • It adds value as long as cost of debt is lower than RoE –It adds value as long as cost of debt is lower than RoE – check these numberscheck these numbers • Also depends on future expectationsAlso depends on future expectations • Interest cover shows ability to cover financing costInterest cover shows ability to cover financing cost • EBIT vs EBITDA in numeratorEBIT vs EBITDA in numerator
  18. 18. Valuation MeasuresValuation Measures  P / EP / E • Most intuitive and widely used valuation measureMost intuitive and widely used valuation measure • Limitation:Limitation:  Looks at only one year of earningsLooks at only one year of earnings  Sensitive to future growthSensitive to future growth  P / BVP / BV • Comparison of market vs book value of equityComparison of market vs book value of equity • Limitation:Limitation:  Sensitive to return on equitySensitive to return on equity  Dividend YieldDividend Yield • Income componentIncome component • Low dividend yield suggests higher future growth prospects butLow dividend yield suggests higher future growth prospects but increases the risk of the investor also because the expectationsincreases the risk of the investor also because the expectations regarding future growth may not materializeregarding future growth may not materialize
  19. 19. Earning Drivers of KeyEarning Drivers of Key IndustriesIndustries
  20. 20. Earning DriversEarning Drivers  Understand the business model first!Understand the business model first!  10% of items derive 90% of the value10% of items derive 90% of the value • Identify these 10% items (the Earning Drivers)Identify these 10% items (the Earning Drivers) • Focus on important issuesFocus on important issues  Nature of Earning DriversNature of Earning Drivers • Economic variablesEconomic variables • Industry Specific variablesIndustry Specific variables • Government RegulationsGovernment Regulations • Industry StructureIndustry Structure
  21. 21. Looking at Key IndustriesLooking at Key Industries  AutosAutos • Purchasing Power, Affordability, Disposable Income, InterestPurchasing Power, Affordability, Disposable Income, Interest RatesRates • Government policies > Import duties, Indigenization etcGovernment policies > Import duties, Indigenization etc • Rupee/ Yen parityRupee/ Yen parity • Steel pricesSteel prices  BankingBanking • Monetary policy, money supply, interest ratesMonetary policy, money supply, interest rates • Asset allocation – Loans vs Investments, further break downAsset allocation – Loans vs Investments, further break down of loans & inv.of loans & inv. • Asset qualityAsset quality • Cost structuresCost structures • Cost of deposits > asset allocation > return on funds >Cost of deposits > asset allocation > return on funds > spreadsspreads
  22. 22. Looking at Key IndustriesLooking at Key Industries (contd.)(contd.)  CementCement • International vs Domestic pricesInternational vs Domestic prices • PSDP, Construction activity > domestic demandPSDP, Construction activity > domestic demand • Input costs > especially energy requirementsInput costs > especially energy requirements • Financial costs (interest rates) – borrowing levels are highFinancial costs (interest rates) – borrowing levels are high  FertilizerFertilizer • Farm economics, support prices, previous crops, affordabilityFarm economics, support prices, previous crops, affordability • Input costs > gas pricesInput costs > gas prices  Gas DistributionGas Distribution • Asset base, because of fixed RoA formula, prices do notAsset base, because of fixed RoA formula, prices do not mattermatter • T&D losses or UFGT&D losses or UFG • Interest RatesInterest Rates
  23. 23. Looking at Key IndustriesLooking at Key Industries (contd.)(contd.)  Oil & Gas ExplorationOil & Gas Exploration • International oil pricesInternational oil prices • Reserve size > exploration activity > success ratio > reserveReserve size > exploration activity > success ratio > reserve replacementreplacement • Interest rates (cash balances > other income)Interest rates (cash balances > other income)  Oil RefiningOil Refining • International Oil pricesInternational Oil prices • Product mix, plant sophisticationProduct mix, plant sophistication • Government regulationGovernment regulation  Oil MarketingOil Marketing • POL consumption patternPOL consumption pattern • International oil prices > inventory gains/ lossesInternational oil prices > inventory gains/ losses • Fixed margins on regulated productFixed margins on regulated product • Product mixProduct mix
  24. 24. Looking at Key IndustriesLooking at Key Industries (contd.)(contd.)  Power Generation (IPPs)Power Generation (IPPs) • Power Purchase AgreementPower Purchase Agreement • For new IPPs, things might be differentFor new IPPs, things might be different  TelecomTelecom • TeledensityTeledensity • ARPUs > Avg revenue per userARPUs > Avg revenue per user • Composition of call trafficComposition of call traffic  TextilesTextiles • Cotton crop > cotton pricesCotton crop > cotton prices • Government regulations > bail out plans etcGovernment regulations > bail out plans etc • Composition of sales > local vs exportsComposition of sales > local vs exports • Exchange rateExchange rate
  25. 25. Looking at Key IndustriesLooking at Key Industries (contd.)(contd.)  Synthetics (PSF)Synthetics (PSF) • Blending ratio > international trend and local scenarioBlending ratio > international trend and local scenario • Cotton crop and cotton pricesCotton crop and cotton prices • International oil prices > input costsInternational oil prices > input costs • International demand supplyInternational demand supply  FMCGsFMCGs • Disposable income of consumerDisposable income of consumer • Brand recognition/ acceptabilityBrand recognition/ acceptability
  26. 26. Introduction to ModelIntroduction to Model ConstructionConstruction
  27. 27. Understand Company’s EconomicUnderstand Company’s Economic ModelModel  Knowing how and why a company makes moneyKnowing how and why a company makes money  How profitability will be impacted by changingHow profitability will be impacted by changing revenues, costs, capital employed, etc.revenues, costs, capital employed, etc.  Building financial models (i.e. spreadsheets isBuilding financial models (i.e. spreadsheets is difficult), but not for the reasons commonly supposed.difficult), but not for the reasons commonly supposed. • Easy part is getting all the formulae andEasy part is getting all the formulae and relationships right in a computational sense.relationships right in a computational sense. • Hard part is quantifying the assumptions regardingHard part is quantifying the assumptions regarding revenues and expenses and subjecting them torevenues and expenses and subjecting them to reality checks.reality checks.
  28. 28. Steps to analyzing company’s “economicSteps to analyzing company’s “economic model”model”  IDENTIFY REVENUE DRIVERSIDENTIFY REVENUE DRIVERS • Obvious breakdown : Revenue = Units X Price – Go deeperObvious breakdown : Revenue = Units X Price – Go deeper one levelone level • Unit Sales = a function ofUnit Sales = a function of  Competitive behaviorCompetitive behavior  Market DemandMarket Demand  Product QualityProduct Quality  Distribution EfficiencyDistribution Efficiency  Etc.Etc. • We are not looking for a magic formula and mechanicallyWe are not looking for a magic formula and mechanically pumping numbers in to itpumping numbers in to it Once you have reasonable historical estimates – ones that fit the financial statements and make intuitive sense – you are in a good position to forecast the future based on what’s changed, or likely to change.
  29. 29. Steps to analyzing company’s “economicSteps to analyzing company’s “economic model”model” FORECAST REVENUESFORECAST REVENUES • Once the drivers are understood, forecast the revenues overOnce the drivers are understood, forecast the revenues over the next 3 yrs.the next 3 yrs. • Pay close attention to the impact of higher (or lower) pricesPay close attention to the impact of higher (or lower) prices on (volumetric) demandon (volumetric) demand  CONSTRUCT A BREAK-EVEN MODELCONSTRUCT A BREAK-EVEN MODEL • The goal is to understand a company in terms of variable &The goal is to understand a company in terms of variable & fixed costsfixed costs • It enables the analyst to know the operating leverage of theIt enables the analyst to know the operating leverage of the company. This is extremely important in order to understandcompany. This is extremely important in order to understand the variation in operating margins in response to variation inthe variation in operating margins in response to variation in sales.sales.
  30. 30. Financial AnalysisFinancial Analysis  The P&L forecast:The P&L forecast:  Only a few items are really important:Only a few items are really important: • Capex assumptionsCapex assumptions should come from management. Theshould come from management. The analyst may change them based on his/her own expectationsanalyst may change them based on his/her own expectations and the track record of the company.and the track record of the company. • Depreciation/capital allowancesDepreciation/capital allowances are often tricky. Bookare often tricky. Book depreciation is more straightforward. Estimate when newdepreciation is more straightforward. Estimate when new projects will finish, use the notes to the accounts for guidanceprojects will finish, use the notes to the accounts for guidance regarding depreciation policies.regarding depreciation policies. • Interest expensesInterest expenses estimate the interest rate and the averageestimate the interest rate and the average amount of borrowing for each year of forecast and multiplyamount of borrowing for each year of forecast and multiply the two to arrive at the interest expense.the two to arrive at the interest expense. • Tax payableTax payable can be estimated by taking (PBT + accountingcan be estimated by taking (PBT + accounting depreciation – tax depreciation) X full tax rate.depreciation – tax depreciation) X full tax rate.
  31. 31. Financial AnalysisFinancial Analysis  A Cash-Flow forecast is almost as important as theA Cash-Flow forecast is almost as important as the P&LP&L • Operating Cash flowOperating Cash flow • Free Cash FlowFree Cash Flow  Leverage calculations give insight in to a company’sLeverage calculations give insight in to a company’s solvencysolvency • Debt/EquityDebt/Equity • Interest CoverInterest Cover
  32. 32. Forecasting FinancialForecasting Financial StatementsStatements
  33. 33. Forecasting Income StatementForecasting Income Statement  RevenuesRevenues • Projecting volumes & prices for single product companies is relatively straightProjecting volumes & prices for single product companies is relatively straight forwardforward • Projecting volumes & prices for multi product companies can be complicated.Projecting volumes & prices for multi product companies can be complicated. Assumptions regarding overall volumetric growth and average price for theAssumptions regarding overall volumetric growth and average price for the entire product portfolio can be madeentire product portfolio can be made • For consumer related companies, an estimate of revenues can be derivedFor consumer related companies, an estimate of revenues can be derived through regression analysis against nominal GDP numbersthrough regression analysis against nominal GDP numbers  Cost of SalesCost of Sales • Know the quantitative relationship between raw materials and final productsKnow the quantitative relationship between raw materials and final products • Know the quantitative relationship between fuel & energy requirements andKnow the quantitative relationship between fuel & energy requirements and productionproduction • Project future costs of raw materials and fuel & energy based on the trendsProject future costs of raw materials and fuel & energy based on the trends and your expectationsand your expectations • For companies with large imported component in purchases, track exchangeFor companies with large imported component in purchases, track exchange rates in addition to pricesrates in addition to prices • Salaries & wages and other expenses usually grow at the rate of inflationSalaries & wages and other expenses usually grow at the rate of inflation • Raw materials, fuel & energy and salaries & wages are usually constitute aRaw materials, fuel & energy and salaries & wages are usually constitute a very large portion of the cost of sales. Other items are less important.very large portion of the cost of sales. Other items are less important.
  34. 34. Forecasting Income StatementForecasting Income Statement  Operating ExpensesOperating Expenses • Look at historical trends (may have a correlation withLook at historical trends (may have a correlation with inflation)inflation) • Use % growthUse % growth • Or as a portion of net salesOr as a portion of net sales  Other IncomeOther Income • Isolate the sources & determine whether they are recurring orIsolate the sources & determine whether they are recurring or non recurringnon recurring • Look for potential changes in investmentsLook for potential changes in investments • Dividend streams – Estimating payouts or using averageDividend streams – Estimating payouts or using average historical returnhistorical return • Capital Gains – related to market performance / projectedCapital Gains – related to market performance / projected earnings growth for the market.earnings growth for the market.
  35. 35. Forecasting Income StatementForecasting Income Statement  Financial ChargesFinancial Charges • Debt repayment schedule based on outstanding debtDebt repayment schedule based on outstanding debt • For cos with recurring capex, assumption needs to be madeFor cos with recurring capex, assumption needs to be made regarding capital structureregarding capital structure • Finance leases: amortization scheduleFinance leases: amortization schedule • On ST Loans, calculate interest as portion of balanceOn ST Loans, calculate interest as portion of balance outstandingoutstanding  Tax ChargeTax Charge • Accuracy of tax depreciation scheduleAccuracy of tax depreciation schedule • Differences in expenses which are deductible for accountingDifferences in expenses which are deductible for accounting purposes but not for tax purposes and vice versa (e.g.purposes but not for tax purposes and vice versa (e.g. provisions)provisions) • Current tax ratesCurrent tax rates
  36. 36. Forecasting Balance SheetForecasting Balance Sheet  Fixed AssetsFixed Assets • Fixed assets at year end = fixed assets at beginning of year +Fixed assets at year end = fixed assets at beginning of year + additions during the current year – depreciation for the yearadditions during the current year – depreciation for the year • Depreciation is not charged on work-in-processDepreciation is not charged on work-in-process • Financial charges incurred during acquisition & installation of fixedFinancial charges incurred during acquisition & installation of fixed assets are included in the cost of fixed assets and are laterassets are included in the cost of fixed assets and are later recognized as expense in the form of depreciationrecognized as expense in the form of depreciation  Other Long Term AssetsOther Long Term Assets • Depends on the type of asset e.g. equity investments will need toDepends on the type of asset e.g. equity investments will need to be adjusted for anticipated capital gainsbe adjusted for anticipated capital gains • Deferred costs & goodwill will be amortized as stated in notesDeferred costs & goodwill will be amortized as stated in notes  Current AssetsCurrent Assets • Debtors will be based on receivables turnover & revenuesDebtors will be based on receivables turnover & revenues • Stores & Spares – as a % of plant & machineryStores & Spares – as a % of plant & machinery • Other receivables & current assets: look at past trend (usually notOther receivables & current assets: look at past trend (usually not a significant amount)a significant amount) • Cash will come from the cash flow statementCash will come from the cash flow statement
  37. 37. Forecasting Balance SheetForecasting Balance Sheet  Shareholders EquityShareholders Equity • Net profit after tax is reduced by the amount of cash dividendNet profit after tax is reduced by the amount of cash dividend assumed for each year under forecastassumed for each year under forecast • This amount is added to Shareholders’ equityThis amount is added to Shareholders’ equity  Long Term LoansLong Term Loans • Ideally, every Loan requires a separate scheduleIdeally, every Loan requires a separate schedule • For companies with recurring capex, capital structure needs to beFor companies with recurring capex, capital structure needs to be assumedassumed  Short Term LiabilitiesShort Term Liabilities • For creditors, use payables turnover & estimates of purchasesFor creditors, use payables turnover & estimates of purchases • Other payables: historical trend may be useful (usually not aOther payables: historical trend may be useful (usually not a significant amount)significant amount) • Current portion of LT Loans: from schedule of repayment of longCurrent portion of LT Loans: from schedule of repayment of long term loansterm loans
  38. 38. Valuation TechniquesValuation Techniques
  39. 39. Approaches to valuationsApproaches to valuations  Two general approaches to valuationTwo general approaches to valuation • Absolute valuations – looks at the PV of future cashAbsolute valuations – looks at the PV of future cash flows/returnsflows/returns  Discounted Cash FlowDiscounted Cash Flow  Dividend Discount ModelDividend Discount Model • Relative Valuations – estimates value by looking atRelative Valuations – estimates value by looking at comparablescomparables  Price-to-EarningsPrice-to-Earnings  Price-to-BookPrice-to-Book
  40. 40. Absolute ValuationsAbsolute Valuations  Discounted Cash Flow ModelDiscounted Cash Flow Model • Enterprise DCF remains the favorite among practitionersEnterprise DCF remains the favorite among practitioners and academics because it relies solely on the flow of cash inand academics because it relies solely on the flow of cash in and out of the company rather than accounting basedand out of the company rather than accounting based profits.profits. Dividend Discount ModelDividend Discount Model • Only looks at the dividend stream. Applicable in specialOnly looks at the dividend stream. Applicable in special cases where dividend is the main driver of value.cases where dividend is the main driver of value.
  41. 41. Discounted Cash FlowDiscounted Cash Flow  To value a company’s common stock using DCFTo value a company’s common stock using DCF • Value the company’s operation by discounting free cash-flowsValue the company’s operation by discounting free cash-flows from operations at the appropriate WACCfrom operations at the appropriate WACC • Value non-operating assets, such as excess marketableValue non-operating assets, such as excess marketable securities, non-consolidated subsidiaries and other equitysecurities, non-consolidated subsidiaries and other equity investments. Combining the value of operating assets andinvestments. Combining the value of operating assets and non-operating assets leads to enterprise valuenon-operating assets leads to enterprise value • Identify and value all non-equity financial claims against theIdentify and value all non-equity financial claims against the company’s assets. Non-equity financial claims include fixedcompany’s assets. Non-equity financial claims include fixed and floating rate debtsand floating rate debts • Subtract the value of non-equity financial claims from theSubtract the value of non-equity financial claims from the enterprise value to determine the value of common stock. Toenterprise value to determine the value of common stock. To determine share price, divide equity value by the number ofdetermine share price, divide equity value by the number of shares outstandingshares outstanding
  42. 42. Discounted Cash FlowDiscounted Cash Flow  Valuing OperationsValuing Operations • Equals the discounted value of free cash flowEquals the discounted value of free cash flow • Free Cash Flow Equals the cash flow generated by the company’sFree Cash Flow Equals the cash flow generated by the company’s operations, less any reinvestment back in to the business. It is theoperations, less any reinvestment back in to the business. It is the cash flow available to all investors and is independent of leveragecash flow available to all investors and is independent of leverage • FCF must be discounted at the Weighted Average Cost of Capital. ItFCF must be discounted at the Weighted Average Cost of Capital. It is the company’s opportunity cost of funds and represents a blendedis the company’s opportunity cost of funds and represents a blended required return by the company’s debt and equity holdersrequired return by the company’s debt and equity holders  Identifying and Valuing Non-operating assetsIdentifying and Valuing Non-operating assets • FCF should not include any cash flows from non-operatingFCF should not include any cash flows from non-operating assets; they should be valued separatelyassets; they should be valued separately  Excess Cash and Marketable SecuritiesExcess Cash and Marketable Securities  Illiquid investments such as non-consolidated subsidiariesIlliquid investments such as non-consolidated subsidiaries
  43. 43. Discounted Cash FlowDiscounted Cash Flow  Identifying and Valuing Non-Equity ClaimsIdentifying and Valuing Non-Equity Claims • Common equity is a residual claimantCommon equity is a residual claimant • Subtract any non-equity claims such as debt fromSubtract any non-equity claims such as debt from the value of the firm derived by discounting Freethe value of the firm derived by discounting Free Cash FlowCash Flow  Valuing EquityValuing Equity • Subtract non-equity claims from Enterprise ValueSubtract non-equity claims from Enterprise Value to determine equity valueto determine equity value • Divide by outstanding shares to arrive at Per ShareDivide by outstanding shares to arrive at Per Share ValueValue
  44. 44. Fundamental Principles of RelativeFundamental Principles of Relative ValuationValuation  In relative valuation, the objective is to value assets based onIn relative valuation, the objective is to value assets based on how similar assets are priced in the market.how similar assets are priced in the market.  Reasons for popularity of relation valuationsReasons for popularity of relation valuations • Can be completed with far fewer explicit assumptionsCan be completed with far fewer explicit assumptions • Easier to present to clients and customers than a DCFEasier to present to clients and customers than a DCF • More likely to reflect the current mood of the market, since it is anMore likely to reflect the current mood of the market, since it is an attempt to measure relative and not intrinsic valueattempt to measure relative and not intrinsic value  Potential pitfallsPotential pitfalls • Can result in inconsistent estimates of value where key variablesCan result in inconsistent estimates of value where key variables such as risk, growth, or cash flow potential are ignoredsuch as risk, growth, or cash flow potential are ignored • Can result in values that are too high when the market is overvaluingCan result in values that are too high when the market is overvaluing comparable firms or too low when the when it is undervaluing therecomparable firms or too low when the when it is undervaluing there firmsfirms
  45. 45. Standardized Values &Standardized Values & MultiplesMultiples  Earnings MultipleEarnings Multiple • One of the more intuitive ways to think of the value of any asset isOne of the more intuitive ways to think of the value of any asset is as a multiple of the earnings that the asset generatedas a multiple of the earnings that the asset generated • While a lower multiple is better than a higher one, these multiplesWhile a lower multiple is better than a higher one, these multiples will be affected by the growth potential and risk of business beingwill be affected by the growth potential and risk of business being acquiredacquired  Book Value or Replacement Value MultipleBook Value or Replacement Value Multiple • Investors often look at the relationship between the price they payInvestors often look at the relationship between the price they pay for a stock and the book value of equity as a measure of how over orfor a stock and the book value of equity as a measure of how over or under valued a stock isunder valued a stock is • The ratio can vary widely across industries, depending on the ReturnThe ratio can vary widely across industries, depending on the Return on Equityon Equity
  46. 46. Generalities aboutGeneralities about valuationvaluation
  47. 47. Myths about valuationsMyths about valuations  Myth # 1: Since valuation models are quantitative, valuations areMyth # 1: Since valuation models are quantitative, valuations are objectiveobjective • The models we use may be quantitative, but inputs leave plenty of room forThe models we use may be quantitative, but inputs leave plenty of room for subjective judgmentssubjective judgments • In many valuations, the price gets set first and the valuation followsIn many valuations, the price gets set first and the valuation follows • Thus, the final value that we obtain from these models is colored by the ourThus, the final value that we obtain from these models is colored by the our biasesbiases  Myth # 2: A well-researched & well-done valuation is timelessMyth # 2: A well-researched & well-done valuation is timeless • Value will change as new information is revealedValue will change as new information is revealed • Given the constant flow of information, valuation done on a firm agesGiven the constant flow of information, valuation done on a firm ages quicklyquickly  Myth # 3: A good valuation provides a precise estimate of valueMyth # 3: A good valuation provides a precise estimate of value • There will always be uncertainty about the final numbersThere will always be uncertainty about the final numbers • Give yourself a reasonable margin of error in making recommendationsGive yourself a reasonable margin of error in making recommendations • Mature firms tend to be easier to value than growth firmsMature firms tend to be easier to value than growth firms • Problems are not with valuation models, but with the difficulties weProblems are not with valuation models, but with the difficulties we encounter in making future estimatesencounter in making future estimates
  48. 48. Myths about valuationsMyths about valuations Myth # 4: The more quantitative a model, the better itsMyth # 4: The more quantitative a model, the better its valuationvaluation • As models become complex, the number of assumptions alsoAs models become complex, the number of assumptions also increaseincrease • Three important points on valuationsThree important points on valuations  Do not use more inputs than you absolutely need to value an assetDo not use more inputs than you absolutely need to value an asset  There is a trade-off between adding more inputs & estimation costs &There is a trade-off between adding more inputs & estimation costs & errorerror  Myth # 5: To make money on valuation, you have to assumeMyth # 5: To make money on valuation, you have to assume markets are inefficientmarkets are inefficient • Implicit in the act of valuation is that markets make mistakes andImplicit in the act of valuation is that markets make mistakes and that we can find these mistakesthat we can find these mistakes • Recognize that on the one hand markets make mistakes, but on theRecognize that on the one hand markets make mistakes, but on the other, finding these mistakes require a combination of skill and luck.other, finding these mistakes require a combination of skill and luck. • Conclusion:Conclusion:  If something looks too good to be true, it is probably not trueIf something looks too good to be true, it is probably not true  When the value from an analysis is significantly different from theWhen the value from an analysis is significantly different from the market, start off with the assumption that the market is correct; thenmarket, start off with the assumption that the market is correct; then convince your self that this is not the case.convince your self that this is not the case.
  49. 49. Myths about valuationsMyths about valuations  Myth # 6: The product of valuation (i.e. the value) isMyth # 6: The product of valuation (i.e. the value) is what matters; the process of valuation is notwhat matters; the process of valuation is not importantimportant • Risk of focusing exclusively on the outcome and missing someRisk of focusing exclusively on the outcome and missing some valuable insights that can be obtained from the process of thevaluable insights that can be obtained from the process of the valuationvaluation • The process of valuation can tell us a great deal about theThe process of valuation can tell us a great deal about the determinants of value and help us answer some fundamentaldeterminants of value and help us answer some fundamental questions:questions:  What is the appropriate price to pay for high growth?What is the appropriate price to pay for high growth?  What is a brand name worth?What is a brand name worth?  How important is it to improve returns on projects?How important is it to improve returns on projects?  What is the impact of profit margins on value?What is the impact of profit margins on value?
  50. 50. Thank YouThank You

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