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Valuation Project Damodaran

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The objective of this project is to use different tools and valuation methodologies to value companies in different industries and markets, determining whether they are currently under or overvalued and giving a recommendation about their stocks.

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Valuation Project Damodaran

  1. 1. December 12th, 2012Valuation Final ProjectCompany Ticker AnalystHipermarcas BOV:HYPE3 Paula W. NestrovskiKarsten BOV:CTKA4 Leonardo BoguszewskiLinkedIn NYSE:LNKD Andre Botelho BastosTesoro Corporation NYSE: TSO Henrique MorsolettoValuation, Fall 2012Prof. Aswath Damodaran
  2. 2. Table of Contents1. Summary...............................................................................................................................................42. Hypermarcas .......................................................................................................................................52.1. Company Overview ..............................................................................................................................52.2. DCF Valuation......................................................................................................................................52.2.1. Cost of Equity .......................................................................................................................52.2.2. Cost of Debt ..........................................................................................................................62.2.3. Cost of Capital ......................................................................................................................62.2.4. Model....................................................................................................................................62.3. Relative Valuation ................................................................................................................................92.3.1. Multiple.................................................................................................................................92.3.2. Sector Regression..................................................................................................................92.3.3. Market-Wide Regression: Emerging Markets ....................................................................102.4. Conclusion ..........................................................................................................................................103. Karsten...............................................................................................................................................113.1. Company Overview ............................................................................................................................113.2. DCF Valuation....................................................................................................................................123.2.1. Cost of Equity .....................................................................................................................123.2.2. Cost of Debt ........................................................................................................................133.2.3. Cost of Capital ....................................................................................................................133.2.4. Model..................................................................................................................................143.3. Relative Valuation ..............................................................................................................................163.3.1. Multiple...............................................................................................................................163.3.2. Sector Regression................................................................................................................163.3.3. Market-Wide Regression: Emerging Markets ....................................................................173.4. Option Valuation.................................................................................................................................173.5. Conclusion ..........................................................................................................................................184. LinkedIn.............................................................................................................................................194.1. Company Overview ............................................................................................................................194.2. DCF Valuation....................................................................................................................................214.2.1. Cost of Equity .....................................................................................................................214.2.2. Cost of Debt ........................................................................................................................22
  3. 3. 4.2.3. Cost of Capital ....................................................................................................................224.2.4. Model..................................................................................................................................234.3. Relative Valuation ..............................................................................................................................254.3.1. Multiple...............................................................................................................................254.3.2. Sector Regression................................................................................................................254.3.3. Market-Wide Regression: United States.............................................................................264.4. Conclusion ..........................................................................................................................................275. Tesoro.................................................................................................................................................285.1. Company Overview ............................................................................................................................285.2. DCF Valuation....................................................................................................................................295.2.1. Cost of Equity .....................................................................................................................295.2.2. Cost of Debt ........................................................................................................................305.2.3. Cost of Capital ....................................................................................................................305.2.4. Model..................................................................................................................................305.3. Relative Valuation ..............................................................................................................................325.3.1. Multiple...............................................................................................................................325.3.2. Sector Regression................................................................................................................335.3.3. Market-Wide Regression: United States.............................................................................345.4. Conclusion ..........................................................................................................................................34
  4. 4. 1. SummaryThe objective of this project is to use different tools and valuation methodologies to valuecompanies in different industries and markets, determining whether they are currently under orovervalued and giving a recommendation about their stocks.The following is a summary table with the companies analyzed, the values obtained according toeach method applied and the analysts’ recommendations:1Since Karsten has different classes of shares, the values for the company represent value of equity (R$ mm) rather than valueper share.Company Price Option RecommendationModel Used Value Multiple Used Value ValuationLinkedIn 111.74$ HiGrowth 78.90$ VS 27.23$ SellHypermarcas 15.62R$ FCFF2 10.88R$ PE 21.39R$ SellKarsten 143.97R$ FCFF2 58.09R$ PBV 32.46R$ 83.74R$ BuyTesoro Corporation 38.62$ FCFF2 62.69$ PE 76.63$ BuyDCF Valuation Relative Valuation
  5. 5. 2. Hypermarcas2.1. Company OverviewHypermarcas is one of the largest consumer goods companies in Brazil and has the mostdiversified portfolio of brands in the country, including predominantly leading brands in theirrespective segments. The company operates in two business lines: Drugs and Personal Care,developing, producing and selling products that are part of an entire portfolio of brands.Since its foundation in 2001, Hypermarcas’ growth strategy has been defined by a combinationof organic growth and acquisitions, having made 28 acquisitions so far, taking advantage of theincreased credit available in Brazil during these years and the funds raised in its IPO. It openedcapital in 2008 and trades in Bovespa with the ticker HYPE3, bellow is the LTM performance ofthe stock:2.2. DCF Valuation2.2.1. Cost of EquityIn order to calculate the cost of equity we used a beta from the weighted average of the sectorsDrug and Toiletries/Cosmetics. Since Hypermarcas is based in Brazil and all its sales are withinthe country, the Brazilian Equity Risk Premium was used. Also, it is important to note that wefirst used the parameters in US$ and then calculated the Cost of Equity in R$ using the inflationdifferential. Below the detailed calculation:
  6. 6. 2.2.2. Cost of DebtThe majority of the company’s debt is denominated in the local currency; according to the3Q2012 Earnings Release, the cost of debt is CDI (a money market interest rate in Brazil) minus0.2 basis points, current leading to an average of 7.05%.2.2.3. Cost of CapitalThe company’s Cost of Capital is calculated based on the weighted average of the Cost of Equityand Cost of Debt described above. Below are the details:2.2.4. ModelHypermarcas growth strategy required intense working capital and capex investments. Besidesacquisitions, the company used commercial policy (extending terms to clients) to drive salesgrowth. This patterned changed in 2011 when a slowing demand from Brazilian consumers andhigh leverage forced the company to review its commercial policy.Since then Hypermarcas’ investments shifted to optimize organic growth and profitability in itsoperations; recently invested in order to consolidate pharma production in the Brazilian state ofGoias (Project Matrix). Future plans include consolidating the personal care production (ProjectMagnum) in the same state. The change in commercial terms has been reflected in 3Q2012results; free cash flow from operation increased 248% when compared to the same period lastyear.Business Revenues EV/SalesEstimatedValueUnleveredBetaDrug 1,958.53 2.9 5,586.05 1.1Toiletries/Cosmetics 1,730.16 1.5 2,566.98 1.2Company 3,688.69 8,153.03 1.1MV EquityShares Outstanding 627.4Current Price per Share 15.69,799.93Cost of EquityUS 10y T 1.63%Equity RP 8.63%LeveredBeta 1.43Cost of Equity USD 13.97%Inflation US 2%Inflation BR 4.50%Cost of Equity BRL 16.76%Equity Debt CapitalMarket Value 9799.9 4211.5 14011.5Weight in Cost of Capital 70% 30% 100%Cost 16.8% 7% 13.8%
  7. 7. In order to be consistent with this new strategy our CAPEX projections include only the PP&Eportion (maintenance and the projects above mentioned), from historical average of 2.00%(2008-2010), this figure increased to 5.6% in 2011. Our projection starts with 2.6% in 2012 andgradually decreases to 2.5% in 2017.Gross margin has been improving historically, however we believe it might be reaching its limit:consolidation of production should be beneficial however the increase in sales of genericmedicines (that have low margins) should offset gains. In our model we consider this margin toslightly improve: 60.3% (2011), 62.4% (2012 – 3Q2012 margin), 63% (2013) and stable fromthen on.Consolidation of operations should benefit SG&A more than costs, therefore we forecast thatEBITDA margins will improve more than the Gross one. From the historical average of 22%(2008-2010), 16% in 2011 (a bad year, reasons already mentioned) back to the previous levels of22% (reported on 3Q2012), we foresee this margin gradually evolving to 23% in 2017Brazilian Tax Law allows goodwill to be deducted for tax purposes, however becauseHypermarcas presents its statements in IFRS (and therefore shows tax expenses), in our modelwe used the standard Brazilian tax rate. In order to be fair, the present value of the goodwill taxbenefit was added back to the company value. Bellow a summary of Hypermarcas amortizationschedule:The Brazilian personal care and pharmaceutical market grew substantially within the past years;Hypermarcas was able to capture this growth (as show in the table below). The mix betweenPharma and PC was influenced by the types of companies acquired. Looking forward, mainlybecause of the generic medicines, we foresee the revenue mix reaching 60% Pharma, 40% PC.2008 2009 2010 2011Net Sales 1,333 1,967 2,792 3,325Working Capital (226) (297) (601) 52WC % of Sales 17% 15% 22% -2%Capex (411) (407) (712) (782)Capex % of Sales 31% 21% 25% 24%Goodwill Amort. Schedule(BRL mm)3Q122012 231.72013 926.82014 774.32015 747.22016 657.12017 607.52018+ 882.5Total 4,827.1
  8. 8. In our projection, we assume for 2012 a 20% sales growth based on 3Q2012 earnings release.From then on growth gradually slows reaching 6% in 2017. Brazil’s consumer purchasing powerhas been upward sloping due to good economic performances and Pharma and personal caredirectly benefit from that. We understand that once the company reaches a steady state, growthrate should not exceed the Brazilian risk free rate, leading to a rate of 4% growth in perpetuity.In order to capture Hypermarcas’ new strategy of consolidation, we decided to value thecompany using a free cash flow to the firm that allowed progressive margins adjustments.Bellow our model:Therefore, trading at R$15.62 the stock is currently overpriced even in our best case scenario.2008 2009 2010 2011 2012 3QNet Sales Growth 1,333 1,967 2,792 3,325Change % 48% 42% 19%Pharma % 54% 56% 48% 49% 44%Personal Care % 46% 44% 52% 51% 56%Operations 2010 2011 2012 2013E 2014E 2015E 2016E 2017EEBIT 569 421 844 1,022 1,140 1,246 1,321 1,400Tax (193) (143) (287) (347) (388) (424) (449) (476)+ D&A 49 113 99 114 128 144 144 144- Capex (712) (782) (222) (140) (129) (146) (146) (146)- Working Capital (601) 52 22 (84) (64) (63) (93) (98)FCFF (888) (338) 455 565 687 758 778 82511.8% 12.8% 13.8% 14.8% 15.8%NPV Explicit 2,564 2,498 2,434 2,373 2,314NPV Perpetuity 8,007 6,781 5,822 5,053 4,427Total EV 10,572 9,280 8,256 7,427 6,741- Net Debt 2,659 2,659 2,659 2,659 2,659Equity Value 7,913 6,621 5,597 4,768 4,082Valeu per Share 12.61 10.55 8.92 7.60 6.51Value taxshield 2.08 2.02 1.96 1.90 1.85Total Value per Share 14.69 12.57 10.88 9.50 8.36WACC SensitivityTerminal ValueWACC 13.80%ROC 13.80%Revenue Growth 4.11%Terminal Value 11,131.53
  9. 9. 2.3. Relative Valuation2.3.1. MultipleWe analyze Hypermarcas using a P/E (LTM) ratio and, looking across Pharmaceuticals andPersonal Care industries, our sample had 41 companies. We selected this ratio because it is agood indicator of market perception towards growth prospects.Hypermarcas has a tax benefit (already mentioned) and non-cash FX variation that is not implicitin its earnings reported. In order to better compare with the other companies in the sample, wemade the following adjustment:Hypermarcas is below average but above median. Based on these metrics, the value per share ofthe company should be respectively R$21.39 and R$15.58.2.3.2. Sector RegressionIn our regression model we estimate the P/E ratio using total revenue 1yr growth LTM, payoutratio and a Market Capitalization Dummy – 1 if market cap > 6,000 $mm and 0 if market cap <6,000 $mm. P/E can be predicted by the following equation:P/E = 8.63 + 0.405 Rev 1yr Growth + 0.129 Payout Ratio + 8.41 Dummy: Market CapPlugging Hypermarcas’ numbers: 20% year growth rate, 33.5% payout ratio and zero for thedummy (current market cap is approximately $4,700mm), we arrive at a projected P/E of 21.05and an estimated price per share equal to R$15.58.2011 2012EPS (0.09) 0.63Net Income Adj (BRL mm) (31.94) 625.21EPS Adj (0.05) 1.00EPS Adj LTM 0.74P/EPS LTM 21.21Median 21.05Average 28.90Predictor Coef SE Coef T PConstant 8.626 2.501 3.45 0.001Total Rev 1Yr Growth LTM 0.40484 0.08586 4.71 0.000Payout Ratio LTM 0.12912 0.02451 5.27 0.000Dummy 8.412 3.028 2.78 0.009S = 8.43791 R-Sq = 57.0% R-Sq(adj) = 53.6%
  10. 10. 2.3.3. Market-Wide Regression: Emerging MarketsBecause we have analyzed PE ratio so far, we decided to continue our market wide comparisonwith the same multiple.P/E = 15.48 + 9.03 ROE - 2.77 Beta + 2.91 PayoutPlugging Hypermarcas’ numbers: ROE of 9%, Beta of 1.43 and Payout of 33.5%, we arrive at aprojected P/E of 13.31 and an estimated value per share of R$9.85, implying that the company isovervalued.2.4. ConclusionSince its beginning Hypermarcas has led a positive growth trajectory; 2011 was exceptional badyear for the company and made management rethink its growth strategy. According to our DCFvaluation the market already priced in too many positive expectations, implying it is overvalued.Our relative valuation points to different directions, with a multiple below market average andvery close to the market median, while our regression estimates a value per share lower than theone currently observed.Overall we believe that the DCF valuation raises some important points: difficulties faced in2011 are not long behind (company needs to demonstrate a strong organic growth rate withcontrol of working capital) and even with a positive margin scenario, there is not much equityvalue. The multiples comparison shows that a lot of the normalization of results has been pricedby the market. The risk/reward does not look compelling: we recommend SELL Hypermarcas.Methodology Fair Value per Share (R$)DCF Valuation 10.88Median P/E of the Sector 15.58Average P/E of the Sector 21.39Sector Regression 15.58Market Regression 9.85Current Value per Share (R$) 15.62Recommendation Sell
  11. 11. 3. Karsten3.1. Company OverviewKarsten is a Brazilian manufacturing company with 130 years of history. It operates in the textileindustry selling bed and bath linens in both internal and external markets. The company, whichsells its products primarily to large retail chains, accommodates different budget levels byoffering different brands:Recognized as the most innovative brand in Brazil, Karstenrepresents the company’s most complete line of products, focusedon mid-income customers.Casa In represents an excellent cost-benefit relation to low-income customers, offering the company’s traditional qualitystandards by more affordable prices.Recognized as one of the most premium brands in the bed andbath sector in Brazil, Trussardi offers high quality products tohigh-income customers.The company’s recent performance has been negatively impacted by two main events. The firstoccurred in the second semester of 2008, when the firm posted more than R$ 50 million ofcurrency-derivatives losses as a result of speculative positions, which should had been used onlyto hedge the company’s revenues from exports, betting on the appreciation of the Braziliancurrency against the dollar.The second negative event happened in 2011, when Karsten decided to build a strategicinventory of cotton after a sudden spike in the commodity price. The goal was to avoid ashortage of the raw material if the prices continued to go up. However, the cotton prices quicklydeclined after that, leaving the company with more inventory than necessary and resulting innegative operating margins, since the firm could not pass on the price increase to retailers.The consequences of these events are reflected in the valuation of the firm, whose capitalstructure is currently highly leveraged and whose margins are still returning to normal levels. Inthe following pages, based on all public information available about the company, the value ofits equity is calculated using different methodologies, such as discounted cash flow, relativevaluation, and option pricing. The most recent financial statements used in the analyses are fromthe third quarter of 2012. Below is the LTM performance of the stock:
  12. 12. 3.2. DCF Valuation3.2.1. Cost of EquityThe company’s Cost of Equity is calculated in US$, using the ten-year Treasury bond yield,currently equal to 1.62%, as a proxy for the Risk Free Rate.The Unlevered Beta, equal to 0.54, represents the median Levered Beta for textile companies inBrazil, unlevered by their median Debt-to-Equity ratio. This number, levered based on thecompany’s current capital structure, represents Karsten’s Levered Beta, currently equal to 2.10.The Equity Risk Premium takes into account the company’s revenue composition. Based on thelatest financial statements, 92% of its revenues are generated in Brazil, while 8% come fromother countries, primarily United States. As a result, the Equity Risk Premium used in thevaluation, which represents a weighted average of these countries’ equity risk premiums, is equalto 8.41%,Therefore, the company’s Cost of Equity in US$ is equal to 19.31%, as detailed below:Risk Free Rate 1.62%Levered Beta 2.17Equity Risk Premium 8.41%Cost of Equity in US$ 19.91%
  13. 13. 3.2.2. Cost of DebtThe company’s Cost of Debt is calculated in US$. Since Karsten does not have a bond ratingavailable, the analysis considers the firm’s interest coverage ratio to determine an estimated bondrating and an estimated default spread, to be added to the Risk Free Rate.The company’s current interest coverage ratio is equal to 0.16, justifying a high default spread of12%. As a result, the company’s Pre-Tax Cost of Debt in US$ is equal to 13.62%. Overall, thisnumber can be considered a conservative assumption because, according to the company’sfinancial statements, it usually has access to cheaper sources of money, either with banks orgovernment agencies.The company’s Tax Rate, in turn, is equal to 34%. Therefore, as detailed below, Karsten’s After-Tax Cost of Debt in US$ is equal to 8.99%:3.2.3. Cost of CapitalThe company’s Cost of Capital, calculated in US$ based on the weighted average of the Cost ofEquity and Cost of Debt described above, is converted to R$ using the inflation differentialbetween United States and Brazil. Currently, Karsten’s Cost of Capital is equal to 10.59% inUS$ and 13.30% in R$.The details are described below. In this sense, important to note that, given that the company hastwo different classes of shares, its current Market Value of Equity is calculated taking intoaccount their different prices.Interest Coverage Ratio 0.16Estimated Bond Rating DEstimated Default Spread 12.00%Pre-TaxCost of Debt in US$ 13.62%TaxRate 34.00%After-TaxCost of Debt in US$ 8.99%Market Value of Equity (R$ mm) 43.97Market Value of Debt (R$ mm) 255.25Debt-to-Capital Ratio 85.31%Cost of Capital in US$ 10.59%Inflation in R$ 4.50%Inflation in US$ 2.00%Cost of Capital in R$ 13.30%
  14. 14. 3.2.4. ModelThe operating model used in the analysis is based on conservative assumptions about thecompany’s prospects for the future. The textile sector in which the firm operates represents amature industry with a reasonably stable growth. For instance, the revenues’ compound averagegrowth rates in the last 3, 5 and 10 years are equal to, respectively, 3.63%, 3.57% and 3.84%. Inthe model, the growth rate is assumed to be 3.48% in the next 5 years, increasing thereafter untilreach 4.11% in perpetuity, when the growth rate is assumed to be equal to the Risk Free Rate inR$.Given the severe increase in its cost of goods sold in the last year, the firm observed negativeoperating margins. However, the most recent financial statements have already shown slightlypositive operating margins in the last twelve months, showing that the company gradually returnsto the normal levels observed before. For instance, the median operating margin in the last threeyears is equal to 8.68%. In the model, we assume the company reaches this margin next year andgradually increases its profitability to achieve an operating margin of 10% in the terminal year.The firm’s reinvestment rate is calculated based on its sales to capital ratio, equal to 1.29 in thelast twelve months. Therefore, given the increase in its margins, Karsten observes an increasingReturn on Capital over the projected period. The first two years are the only exception, when thegradual reduction of tax benefits provided by net operating losses decreases its Return onCapital. The model assumes that the current net operating losses will be completely used aftertwo years.The Cost of Capital of 13.30% in R$ calculated above is used to discount the Free Cash Flows tothe Firm in the next five years. After that, the model assumes that the Cost of Capital graduallydecreases until reach 8.72% in perpetuity, when the discount rate is expected to be similar to thatof mature companies, equal to the Risk Free Rate plus 4.5%. The model also assumes that theReturn on Capital will be equal to the Cost of Capital in perpetuity.To conclude, given the firm’s highly leveraged capital structure, the model takes into account therisk that it will go out of business at some point in the future. In this sense, since the companydoes not have a publicly traded bond based on which we could back out the probability ofdefault, the model assumes a chance of distress of 70%, close to the one implied in the optionvaluation detailed in the next pages.The proceeds if the firm fails are estimated as the book value of capital. Since it is currentlylower than the estimated fair value for the firm based on our assumptions, we believe that thisrepresents a fair estimate for the company’s liquidation value.Therefore, according to our model, the fair value of equity of the company is equal to R$ 58.09million, which represents an upside of 32.13% relative to the current market value of R$ 43.97million. In this sense, important to note that, since the company has two classes of shares with
  15. 15. different liquidity and trading at different prices, this analysis will focus on the total market valueof equity rather than on an estimated value per share.Below, we can see the details of the discounted cash flow valuation and a sensitivity analysisconsidering different probabilities of failures and different percentages of book capital as distressproceeds if the firm fails at some point.R$ mm Base 1 2 3 4 5 6 7 8 9 10 TerminalRevenue growth rate 3.48% 3.48% 3.48% 3.48% 3.48% 3.60% 3.73% 3.86% 3.98% 4.11% 4.11%Revenues 348.79 360.91 373.45 386.43 399.86 413.76 428.66 444.65 461.80 480.20 499.94 520.49EBIT margin 1.79% 8.68% 8.83% 8.98% 9.12% 9.27% 9.42% 9.56% 9.71% 9.85% 10.00% 10.00%EBIT 6.25 31.34 32.98 34.69 36.48 38.35 40.36 42.52 44.83 47.32 49.99 52.05Tax rate 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00% 34.00%EBIT(1-t) 4.13 31.34 30.22 22.89 24.08 25.31 26.64 28.06 29.59 31.23 33.00 34.35- Reinvestment 2.76 2.86 2.96 3.06 3.16 3.68 4.23 4.83 5.47 6.16 6.38FCFF 28.58 27.36 19.94 21.02 22.15 22.96 23.83 24.76 25.76 26.84 27.97NOL 56.20 24.86 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00Cost of capital 13.30% 13.30% 13.30% 13.30% 13.30% 12.39% 11.47% 10.55% 9.64% 8.72% 8.72%Cumulated discount factor 0.88 0.78 0.69 0.61 0.54 0.48 0.43 0.39 0.35 0.32PV(FCFF) 25.23 21.31 13.71 12.75 11.86 10.94 10.18 9.57 9.09 8.71Terminal cash flow 27.97Terminal cost of capital 8.72%Terminal value 606.70PV (Terminal value) 196.80PV (CF over next 10 years) 133.35Sum of PV 330.14Probability of failure 70.00%Proceeds if firm fails 278.85Value of operating assets 294.24- Debt 245.58- Minority interests 0.00+ Cash 9.43+ Non-operating assets 0.00Value of equity 58.09- Value of options 0.00Value of equity in common stock 58.09Current market value of equity 43.97Upside 32.13%0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%0% 93.99 93.99 93.99 93.99 93.99 93.99 93.99 93.99 93.99 93.99 93.9910% 60.98 63.77 66.56 69.35 72.13 74.92 77.71 80.50 83.29 86.08 88.8720% 27.97 33.54 39.12 44.70 50.27 55.85 61.43 67.01 72.58 78.16 83.7430% 0.00 3.32 11.68 20.05 28.41 36.78 45.15 53.51 61.88 70.24 78.6140% 0.00 0.00 0.00 0.00 6.55 17.71 28.86 40.02 51.17 62.32 73.4850% 0.00 0.00 0.00 0.00 0.00 0.00 12.58 26.52 40.46 54.41 68.3560% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 13.03 29.76 46.49 63.2270% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 19.05 38.57 58.0980% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 8.35 30.65 52.9690% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 22.74 47.83100% 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 14.82 42.70Distress proceedsProbabilityoffailureValue of Equity (R$ mm)
  16. 16. 3.3. Relative Valuation3.3.1. MultipleWe opted to analyze Karsten based on a PBV ratio. We believe that it is the most appropriatemultiple for the company because Karsten is operating in an industry with a reasonably stablegrowth. Also, since the firm currently presents a capital structure with 85% of debt, multiplesbased on enterprise value are less effective to reflect the value of the equity in the company.Nowadays, there are only a few public companies in Brazil operating in the textile sector. As aresult, given the current dynamics of this industry, with significant competition amongcompanies from different countries, we created a sample with textile companies from emergingmarkets, focusing specifically on those operating in the bed and bath segment.Therefore, we analyzed a sample of 35 public and operating companies. From this perspective,taking into account the company’s different classes of shares, the value of its equity is currentlyovervalued. Based on the average and the median of the sector, the company’s value of equityshould be equal respectively to R$ 32.46 million and R$ 20.63 million. The statistics are shownbelow:3.3.2. Sector RegressionWe also ran a regression to identify how the PBV ratios in the sector have reflected thecompanies’ fundamentals. To do so, we used the Return on Equity as a proxy of quality ofgrowth and a dummy variable as a proxy of risk, considering 1 if the company has a marketcapitalization lower than US$ 100 million and 0 if not.As shown below, all variables are statistically significant at a p-value of 0.05. Also, theircoefficients are in the expected direction, with a higher Return on Equity resulting in a higherPBV and small market capitalizations translating into lower multiples. Overall, the resultingmodel explains 40.5% of the PBV ratio:Market Value of Equity (R$ mm) 43.97Book Value of Equity (R$ mm) 33.27PBV(x) 1.32Average of the Sector (x) 0.98Median of the Sector (x) 0.62
  17. 17. Regression Analysis: PBV versus ROE, Dummy: Market CapitalizationPBV = 1.16 + 3.76 ROE - 0.898 Dummy: Market CapitalizationPredictor Coef SE Coef T PConstant 1.1635 0.2406 4.84 0.000ROE 3.763 1.678 2.24 0.032Dummy: Market Capitalization -0.8978 0.2374 -3.78 0.001S = 0.689589 R-Sq = 40.5% R-Sq(adj) = 36.8%Analysis of VarianceSource DF SS MS F PRegression 2 10.3619 5.1810 10.90 0.000Residual Error 32 15.2171 0.4755Total 34 25.5790Source DF Seq SSROE 1 3.5606Dummy: Market Capitalization 1 6.8014Based on this regression, using the most recent information available, the company should tradeat a PBV ratio of 0.58, with a market value of equity of R$ 19.18 million. Consequently, it is alsoovervalued from this perspective.3.3.3. Market-Wide Regression: Emerging MarketsFor the market regression, as shown below, we analyzed the company based on the PBVregression for emerging markets:PBV = 0.77 - 0.17 Beta + 1.16 Payout + 5.78 ROEBased on this regression, using the company’s Beta in the last five years and the most recentfinancial information available, the company should trade at a PBV ratio of 1.19, with a marketvalue of equity of R$ 39.67 million. As a result, Karsten is currently slightly overvalued fromthis perspective.3.4. Option ValuationGiven the company’s capital structure, with significant debt obligations, we also calculated thevalue of its equity as an option on the firm. To do so, we used the following variables as inputs tothe option pricing model:
  18. 18. Stock Price: book value of capitalStrike Price: book value of debt plus interest paymentsExpiration: weighted average maturity of debtRisk Free Rate: Treasury bond yield adjusted by the inflation differentialVariance: bottom-up estimate for the variance in firm value for the Retail (soft lines) sectorFrom this perspective, Karsten is significantly undervalued. The details are shown below:3.5. ConclusionThe following are the overall results of our analysis of Karsten:Given the impact of different prices for different classes of shares on the relative valuation, alsofocused on the company’s weak past numbers, we believe that it does not represent the bestestimate of the fair value of equity in the company. Therefore, we believe that investors shouldbuy the stock given the significant upside presented by the intrinsic value calculated in the DCFvaluation – view also supported by the option valuation methodology, which points to an evenhigher upside.Stock Price (R$ mm) 278.85 Value of Debt (R$ mm) 195.11Strike Price (R$ mm) 311.96 Value of Equity (R$ mm) 83.74Expiration (y) 2 Current Value of Equity (R$ mm) 43.97Risk Free Rate 2.69% Upside 90.47%Variance 34.02%d1 0.34 Fair Interest Rate 26.45%N(d1) 0.63 Probability of Default 68.56%d2 -0.48N(d2) 0.31Methodology Fair Value of Equity (R$)DCF Valuation 58.09Average PBVof the Sector 32.46Median PBVof the Sector 20.63Sector Regression 19.18Market Regression 39.67Option Valuation 83.74Current Value of Equity (R$) 43.97Recommendation Buy
  19. 19. 4. LinkedIn4.1. Company OverviewLinkedIn is the largest social network of professionals on the web with 187 million members and110 million unique visitors in Q3’2012. Company’s members are able to create, manage andshare their professional identities online, build and engage with their professional networks,access shared knowledge and insights, and find business opportunities, enabling them to be moreproductive and successful. The second player in this segment – Viadeo – has 45 millionprofessionals as members and has more users than LinkedIn in high-growth countries such asChina.Main lines of revenues (million) are:
  20. 20. Talent Solutions – Revenue is derived primarily from the sale of LinkedIn Corporate Solutionsand LinkedIn Jobs products. In this segment it competes with established online recruitingcompanies, such as Monster, CareerBuilder, and Indeed.com, talent management companies andlarger companies that are focusing on talent management and human resources services, such asOracle (through its acquisition of Taleo), SAP (through its acquisition of SuccessFactors) andIBM (through its acquisition of Kenexa), and traditional recruiting firms. Additionally, othercompanies, including newcomers to the recruiting industry, may partner with Internet companies,including social networking companies, to provide services that compete with LinkedIn’ssolutions, either on their own or as third party applications, such as BranchOut that partneredwith FaceBook.Marketing Solutions – Revenues is derived primarily from fees received from marketers,mainly advertising agencies and direct advertisers, for display and text ads on the website.Community members are the most influential, affluent and highly educated audiences on theInternet. The graph bellow shows the strong tendence for digital content revenues.Premium Subscription - Revenue is derived primarily from online sales of Business, BusinessPlus and Executive subscription products. It’s offered monthly or annual subscriptions. In thegraph bellow we can see the importance of social network for Americans and how they areexpending more time on it than portals.
  21. 21. The company’s recent performance has been robust. In the 3Q’12, the company beat consensusrevenue, EBITDA and non-GAAP EPS estimates by 4%, 17% and 100%, respectively.LinkedIn’s IPO was on May 24, 2011 with a primary and secondary offering at a public price of$45.00 per share, raising approximately $248.4 million in net proceeds. On November 16, 2011the company realized a follow-on, pricing the common stock at $71.00 per share and raisingapproximately $177.4 million in net proceeds.4.2. DCF Valuation4.2.1. Cost of EquityThe company’s Cost of Equity is calculated in US$, using the ten-year Treasury bond yield,currently equal to 1.62%, as a proxy for the Risk Free Rate. The Levered Beta, calculated basedon a bottom-up methodology using a sample of Internet companies, is equal to 1.24.The Equity Risk Premium takes into account the company’s revenue composition. Based on thelatest financial statements, 64% of its revenues came from USA, 22% from EMEA (Europe, theMiddle East and Africa), 7% from APAC (Asia-Pacific), and 7% from Other Americas. As aresult, the Equity Risk Premium used in the valuation, which represents a weighted average ofthese countries’ equity risk premiums, is equal to 6.64%.% Revenues Total Risk Premium Weighted Average Risk PremiumUSA 64% 6.00% 3.84%EMEA 22% 7.73% 1.70%APAC 7% 7.05% 0.49%Other Americas 7% 8.63% 0.60%Weighted Average Risk Premium: 6.64%
  22. 22. Therefore, the company’s Cost of Equity in US$ is equal to 9.85%, as detailed below:4.2.2. Cost of DebtAlthough currently the company has no debt, the average Market D/E for the Internet segment is2.71% and for Human Resources segment is 10.31%. Considering that 55% of LinkedIn revenuecomes from Talent Solutions and that 50% of that revenue is achieved using methods similar tothe ones from the Human Resources segment, we will apply the following Weighted Average toestimate future D/E:(1) 55%*50%=28%Cost of Debt is estimated to be 7.12% considering that the company would have a Bond RatingB+. The company’s Tax Rate is equal to 37.5%.4.2.3. Cost of CapitalThe company’s Cost of Capital will consider operating leases as debt. Therefore, the initial DebtRatio is 2.88%. We will consider that in 10 years it will increase to 4.80%, as detailed above.Risk Free Rate 1.62%Levered Beta 1.24Equity Risk Premium 6.64%Cost of Equity in US$ 9.85%Market D/E % Weighted Average D/EInternet 2.71% 73% 1.96%Human Resources 10.31% 28% (1) 2.84%4.80%Interest Coverage Ratio 2.6Estimated Bond Rating B+Estimated Default Spread 5.50%Pre-Tax Cost of Debt in US$ 7.12%Tax Rate 37.50%After-Tax Cost of Debt in US$ 4.5%Market Value of Equity (US$ B) 11.41Market Value of Debt (US$ B) 0.34Debt-to-Capital Ratio 2.88%Cost of Capital in US$ 9.69%
  23. 23. 4.2.4. ModelLinkedIn has a strong cash position with $676 million in cash and short-term investments onQ3’12. Quarterly revenue growth is still very strong but it has been declining for the last fivequarters. The peak was approximately 120% YoY growth on Q3’11 and the last quarter itpresented a revenue growth of 80%. The adjusted EBITDA margin stabilized in the last fourquarter between 20% and 25%.The consequences of these events are reflected in the valuation of the firm. In the followingpages, based on all public information available about the company, the value of its equity iscalculated using discounted cash flow (high growth model) and relative valuation. The mostrecent financial statements used in the analyses are from the third quarter of 2012.The high growth model used in the analysis is based on assumptions about the company’sprospects for the future. We assume that the growth rate for the next year will continue strong,however, declining. The Compounded Annual Growth for the next 10 years considered is37.35%. With this assumption in 2022 the company will generate revenues of almost $20B,which represents 42% of the revenues Google generated in the Last Twelve Months and 4.3xrevenues FaceBook generated in the same period. The growth rate in perpetuity considered is1.62%, equal to the risk-free rate.Operating margins is expected to be 15% ten years from now following the industry average. Asit was mentioned LinkedIn operates in a market with low barriers to entry. The competition inthis segment seems to be really strong and margins probably will converge for the industryaverage.
  24. 24. The firm’s reinvestment rate is calculated based on its peer’s average sales to capital ratio, equalto 2.25. Also, it is important to note that we capitalized R&D, amortizing the expenses for 3years.Finally, we considered the effect of all options outstanding in the valuation of the company,which could represent approximately $1,008 million in market value.Therefore, according to our model, the fair value of equity of the company is equal to $78.90 pershare, which represents a downside of (29.39%) relative to the current market value of $111.74per share. The company seems to be overvalued.Below, we can see the details of the discounted cash flow valuation:Base 1 2 3 4 5 6 7 8 9 10 Terminal YearRevenue Growth Rate 65.00% 60.00% 55.00% 50.00% 50.00% 40.00% 30.00% 20.00% 10.00% 8.00% 2%Revenues $836,432 $1,380,113 $2,208,180 $3,422,680 $5,134,020 $7,701,029 $10,781,441 $14,015,874 $16,819,048 $18,500,953 $19,981,029 $20,304,722Operating Margin 24.78% 20.87% 18.52% 17.11% 16.27% 15.76% 15.46% 15.27% 15.16% 15.10% 15.06% 15.00%EBIT $207,269 $288,003 $408,974 $585,706 $835,177 $1,213,721 $1,666,412 $2,140,754 $2,550,486 $2,793,378 $3,008,970 $3,045,708Taxes $77,726 $108,001 $153,365 $219,640 $313,191 $455,145 $624,904 $802,783 $956,432 $1,047,517 $1,128,364 $1,142,141EBIT(1-t) $129,543 $180,002 $255,608 $366,066 $521,985 $758,576 $1,041,507 $1,337,971 $1,594,053 $1,745,861 $1,880,607 $1,903,568+ Depreciation $148,259 $222,389 $333,584 $467,017 $607,122 $728,546 $801,401 $865,513 $879,534 $893,783 $908,262 $922,976- Capital Expenditures $790,527 $393,346 $593,965 $848,909 $1,145,243 $1,535,728 $1,770,019 $1,882,562 $1,760,977 $1,422,648 $1,373,664 $1,086,481- Chg WC $48,422 $70,679 $107,649 $157,885 $222,474 $333,711 $400,454 $420,476 $364,413 $218,648 $192,410 $42,080FCFF -$561,147 -$61,634 -$112,422 -$173,711 -$238,610 -$382,318 -$327,564 -$99,554 $348,198 $998,348 $1,222,795 $1,697,982NOL $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0Terminal Value $21,293,378Cost of Capital CalculationsTaxRate 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50% 37.50%Debt Ratio 2.88% 2.88% 2.88% 2.88% 2.88% 2.88% 3.26% 3.36% 3.52% 3.84% 4.80% 4.80%Beta 1.24 1.24 1.24 1.24 1.24 1.24 1.24 1.24 1.24 1.24 1.24 1.24Cost of Equity 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85%Cost of Debt 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12% 7.12%After-taxcost of debt 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45% 4.45%Cost of Capital 9.70% 9.70% 9.70% 9.70% 9.70% 9.70% 9.68% 9.67% 9.66% 9.65% 9.59% 9.59%ComputedVariables (These are measures of howefficiently your firm is investing over time)Total Capital Invested 1,160,865.33$ 1,402,501$ 1,770,531$ 2,310,309$ 3,070,904$ 4,211,798$ 5,580,869$ 7,018,395$ 8,264,250$ 9,011,764$ 9,669,575$ 9,875,161$Reinvestment Rate 533.17% 134.24% 143.98% 147.45% 145.71% 150.40% 122.48% 115.50% 103.87% 80.60% 10.80% 10.80%Increase in Revenue/Increase in Capital 2.25 2.25 2.25 2.25 2.25 2.25 2.25 2.25 2.25 2.25 1.57Return on Capital 15.51% 18.23% 20.68% 22.59% 24.70% 24.73% 23.97% 22.71% 21.13% 20.87% 15.00%Present Value CalculationsCumulative WACC 1.09698144 1.203368291 1.320072686 1.448095243 1.588533612 1.742261745 1.910776178 2.095424138 2.297552644 2.517985065Present Value of FCFF (56,185)$ (93,422)$ (131,592)$ (164,775)$ (240,673)$ (188,011)$ (52,102)$ 166,171$ 434,527$ 485,624$Present Value of Terminal Value 8,456,515$The ValuationPVof FCFF during high growth phase = 159,561$PVof Terminal Value = 8,456,515$Value of Operating Assets of the firm= 8,616,076$Value of Cash & Non-operating assets= 676,645.00$Value of Firm= 9,292,721$- Value of Outstanding Debt = 338,007$Value of Equity = 8,954,714$- Value of Equity Options = 476,923$Value of Equity in Common Stock = 8,477,791$ Treasury Stock ApproachValue of Equity per share = 78.90$ 8.96$
  25. 25. 4.3. Relative Valuation4.3.1. MultipleWe opted to analyze LinkedIn based on an Enterprise Value / Revenue ratio. We believe that it isthe most appropriate multiple for the company because many companies in the Internet segmentssometimes still have negative margins in order to achieve higher growth. Also, revenues arealways available for every company. To do so, we considered 73 Internet public companies ascomparable firms for LinkedIn.Based on the average and the median of the sector, LinkedIn’s firm value should be equalrespectively to $3.3 billion ($27.23 as value of equity per share) and $2.2 billion ($17.23 as valueof equity per share). The statistics are shown below:4.3.2. Sector RegressionWe also ran a regression to identify how the EV / Revenue ratio in the sector has reflected thecompanies’ fundamentals. To do so, we used the LTM Gross Margin % and LTM Total Revenue1 year.As shown below, except for the regression’s constant, independent variables are statisticallysignificant at a p-value of 0.05. Also, their coefficients are in the expected direction, with ahigher Revenue growth resulting in a higher EV / Revenue and a higher Gross Margin translatinginto higher multiples as well. Overall, the resulting model explains 33.5% of the EV/Revenueratio:LinkedInValue of Firm ($ mm) 10,523Revenues ($ mm LTM) 863EV / Revenue 12.19High of the Sector 33.1xLow of the Secotr 0.1xAverage of the Sector 3.8xMedian of the Sector 2.7xNASDAQ Internet Index 3.1x
  26. 26. Based on this regression, using the most recent information available, the company should tradeat an EV / Revenue of 7.39, with a firm value of $6.38 billion and a value of equity per shareconsidering the outstanding options of $54.40. Consequently, it is also undervalued from thisperspective.4.3.3. Market-Wide Regression: United StatesFor the market regression, as shown below, we analyzed the company based on the EV / Salesregression for USA:EV / Sales = 0.43 + 7.12 g + 7.69 Operating Margin – 0.4 DC – 1.87 Tax RateBased on this regression the company should trade at an EV / Sales ratio of 7.88, with a firmvalue of $6.8 billion and a value of equity per share of $58.03. As a result, LinkedIn is currentlyovervalued from this perspective as well.
  27. 27. 4.4. ConclusionThe following are the overall results of our analysis of LinkedIn:Therefore, we believe that investors should sell the stock given the significant downsidepresented by the intrinsic value calculated in the DCF valuation – view also supported by therelative valuation methodology, which points to an even higher downside.Methodology Fair Value of EquityDCF Valuation $78.90Average EV / Sales of the Sector $27.23Median EV / Sales of the Sector $17.23Sector Regression $54.40Market Regression $58.03Current Value of Equity $111.74Recommendation Sell
  28. 28. 5. Tesoro5.1. Company OverviewTesoro Corporation (NYSE:TSO) is one of the largest independent petroleum refiners andmarketers in the United States. The company has subsidiaries operating through two businesssegments: manufacture and sale of transportation fuels. The refining operating segment, whichoperates seven refineries in the western United States with a combined crude oil capacity of 665thousand barrels per day, refines crude oil and other feedstocks into transportation fuels, such asgasoline and gasoline blendstocks, jet fuel and diesel fuel, as well as other products, includingheavy fuel oils, liquefied petroleum gas, petroleum coke and asphalt. The retail operatingsegment sells transportation fuels and convenience products in 18 states through a network of1,175 retail stations, primarily under the Tesoro, Shell, and USA GasolineTM brands.Recently, the company acquired a BP integrated Southern California refining and marketingbusiness. It is still waiting regulatory approval, which is expected to close by mid-2013. Thisnew acquisition has installed capacity to produce 266 thousand barrel per day and has fullyintegrated retail marketing network of about 800 dealer operated sites.Since 2008, Tesoro has shown increase in revenues, trailing the overall improvement in theeconomy after the financial crisis.
  29. 29. Gasoline represented 51% of total refined product sales, representing 50% of total revenues. Thishigh impact in revenues implies that Tesoro’s revenue depends entirely in gasoline prices.5.2. DCF Valuation5.2.1. Cost of EquityThe cost of equity was calculated using the implied equity risk premium for the US Stock marketon December of 2012 of 6.02% (normalized cash yield). The risk free rate was chosen to be the10 year Treasury bond, currently equal to 1.62%.
  30. 30. The Unlevered Beta for the Petroleum Integrated Industry, after being corrected for cash, is equalto 1.12, while the Levered Beta for Tesoro is 1.35.5.2.2. Cost of DebtThe interest coverage ratio for the company is 6.48x, which would imply a rating of AA, butrecent bond transactions were rated as BB+. The latter was used as a proxy for the company’sdefault spread.5.2.3. Cost of CapitalThe company’s Cost of Capital is a weighted average of the Cost of Equity and Cost of Debtdescribed above.5.2.4. ModelSince the company has about 24% of debt to capital, has a fairly stable capital structure, andshows potential to growth in revenues following trend in gas prices, a DCF model based in FCFFwas chosen to value the firm.In the last couple of years, refinery utilization has been in record highs, with numbers above80%, indicating constrained supply capacity.Added to this constraint in production, gasoline inventory levels and days of demand have beendeclining since 2010. As a consequence, this could sustain increase in gasoline prices.Risk Free Rate 1.62%Levered Beta 1.35Equity Risk Premium 6.02%Cost of Equity in US$ 9.75%Interest Coverage Ratio 6.48Rating on Last Bond Issued BB+Estimated Default Spread 3.75%Pre-Tax Cost of Debt in US$ 5.37%Tax Rate 35.00%After-Tax Cost of Debt in US$ 3.5%Market Value of Equity ($ mm) 5,281.47Market Value of Debt ($ mm) 1,670.25Debt-to-Capital Ratio 24.03%Cost of Capital 8.24%
  31. 31. By analyzing the trend in gasoline prices, and assuming that the trend can be sustained due to thefacts presented about the industry, revenue growth in the DCF model was calculated to followthe rise in gasoline prices.
  32. 32. An estimation of the future gasoline prices implies in growth of 9% for 2013 and 2014 andgrowth of 7% for 2015.To calculate the terminal value, it was considered that WACC would be equal to ROC.5.3. Relative Valuation5.3.1. MultipleThe current P/E proved to represent the best fit for the industry. The sample of comparablecompanies for Tesoro includes only public, operating companies in the Oil and Gas RefiningIndustry.FY10A FY11A FY12E FY13E FY14E FY15E FY16E FY17ERevenues 20,253.00$ 29,927.00$ 30,352.43$ 33,084.15$ 36,061.72$ 38,586.04$ 41,094.14$ 43,559.78$Growth rate 47.8% 1.4% 9.0% 9.0% 7.0% 6.5% 6.0%Cost Of Sales 18,398.00$ 27,048.00$ 27,432.50$ 29,901.43$ 32,592.56$ 34,874.04$ 37,140.85$ 39,369.30$as % of Revenue 90.8% 90.4% 90.4% 90.4% 90.4% 90.4% 90.4% 90.4%Gross Profit 1,855.00$ 2,879.00$ 2,919.93$ 3,182.72$ 3,469.16$ 3,712.01$ 3,953.29$ 4,190.48$Gross Margin 9.2% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6% 9.6%SG&A 1,716.00 1,732.00 1,756.62 1,914.72 2,087.04 2,233.13 2,378.29 2,520.99Pct of Sales 8.5% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8%EBIT 139.00$ 1,147.00$ 1,163.31$ 1,268.00$ 1,382.12$ 1,478.87$ 1,575.00$ 1,669.50$Op Margin 7.8% 11.3% 12.3% 13.3% 13.6% 14.0% 14.3% 14.3%EBIT (1-T) 90.35$ 745.55$ 756.15$ 824.20$ 898.38$ 961.27$ 1,023.75$ 1,085.17$Tax Rate 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%Chg in Working Capital (531.50) (884.50) (230.75) (661.68) (721.23) (771.72) (821.88) (871.20)YoY Chg -2.5% -3.7% -0.8% -2.0% -2.0% -2.0% -2.0% -2.0%Depreciation 422.00 417.00 424.00 495.24 575.88 654.78 738.43 797.93as % of Revenue 2.1% 1.4% 1.4% 1.5% 1.6% 1.7% 1.8% 1.8%CAPEX (295.00) (291.00) (556.00) (606.04) (660.58) (706.82) (752.77) (797.93)as % of Revenue -1.5% -1.0% -1.8% -1.8% -1.8% -1.8% -1.8% -1.8%1 2 3 4 5FCFF (314.15) (12.95) 393.40 51.72 92.44 137.50 187.53 213.98 Terminal ValuePV $47.78 $78.89 $108.41 $136.60 $9,144.37 13,375.09$ValuationEnterprise Value $9,516.06Cash $1,322.00Debt $1,670.25Equity $8,857.81Shares Out 141.30Current Price 38.62$ Up/(Down)DCF Price 62.69$ 62.32%
  33. 33. Based on the relative valuation, the market is undervaluing Tesoro, which could be assumed thatthe company paid too much for its acquisition of the BP business. If Tesoro were trading at theindustry mean, its price would be $76.63, while the industry median would imply a price of$61.84.5.3.2. Sector RegressionBy running a regression of the multiple against the Payout Ratio and the estimated annual EPSgrowth rate, the following equation was found to be a good predictor of value for companies inthe industry given their fundamentals:Regression Analysis: P/E versus LTM Payout Ratio, Est. Annual EPS Growth – 2 YearsP/E = 8.88 + 12.6 LTM Payout Ratio + 5.45 Est. Annual EPS Growth-2Yr%Predictor Coef SE Coef T PConstant 8.882 1.792 4.96 0.000LTM Payout Ratio 12.64 2.170 5.82 0.000Est. Annual EPS Growth - 2 Yr % 5.448 4.470 1.22 0.230S = 8.38939 R-Sq = 59.2% R-Sq(adj) = 57.1%Analysis of VarianceAnalysis of VarianceSource DF SS MS F PRegression 2 3982.9 1991.4 28.29 0.000Residual Error 39 2744.9 70.4Total 41 6727.8Source DF Seq SSLTM Payout Ratio 1 3878.3Est. Annual EPS Growth - 2 Yr % 1 104.6Tesoro’s current Payout Ratio is 2.87% and the estimated EPS growth is 17.90%, which wouldimply in a P/E of 10.22x when used with the regression equation. Considering Basic EPS of$4.25, the calculated P/E would imply that Tesoro’s shares should be trading at $43.42.Number of Companies in Sample 42Sample P/E Mean 18.0xSample P/E Median 14.6xCurrent P/E Tesoro 9.5xCurrent EPS Tesoro $4.25Tesoro Stock Priceimplied by the sample mean $76.63implied by the sample median $61.84
  34. 34. 5.3.3. Market-Wide Regression: United StatesThe following is the market-wide P/E regression for US companies:PE = 13.48 + 40.84 gEPS + 2.88 Payout -2.01 BetaGiven the data above and Tesoro’s 2 year Beta of 1.60, the P/E for the company can be impliedto be 17.66x, and using Basic EPS $4.25, Tesoro’s shares should be trading at $75.04.5.4. ConclusionAccording to the DCF Valuation, Market-Wide Relative Valuation and the Oil/Energy IndustryRegression Relative Valuation, Tesoro is being undervalued by the market. Based on the DCFcalculations, which take into account the effects of an increase in gas prices, the recommendationis to buy the stock.Methodology Fair Value of Share Upside/(Downside)DCF Valuation 62.69 62.3%Mean P/E of the Sector 76.63 98.4%Median P/E of the Sector 61.84 60.1%Sector Regression 43.42 12.4%Market Regression 75.04 94.3%Current Value of Share 38.62Recommendation Buy

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