Valuation in FED	
2013/5/19(Sun)	
1
自己紹介&Ice	
  Break	
•  名前	
  
•  所属	
•  勉強会に参加したきっかけ	
  
	
  
2
3
Contents	
•  Part1 Foundations of Value	
•  Part2 Core Valuation Techniques	
•  Part3 Intrinsic Value and the Stock Mark...
4
Part2	
6. Framework for Valuation	
7. Reorganizing the Financial Statements	
8. Analysand Performance and Competitive Po...
5
Part2	
6. Framework for Valuation	
7. Reorganizing the Financial Statements	
8. Analysand Performance and Competitive Po...
6
Growth and ROIC:Drives of Value	
Return on 	
investment capital	
Revenue growth	
Cash flow	
Cost of of Capital	
Value
7
Home Depot:

Enterprise DCF	
Forcaset year
Free cash flow
($ million)
Discount factor
(@ 8.5%)
Present value of
FCF
(& m...
Can	
  you	
  predict	
  the	
  market	
  which	
  you	
  
belong	
  to	
  in	
  business?	
  
Let’s	
  predict	
  5	
  ye...
9
Determine length and detail of the forecast	
•  A detailed five-year to seven-year forecast,which develops
complete bala...
10
Steady State	
•  The Company grows at a constant rate by
reinvesting a constant propotion of its operating
profits into...
11
Non financial Companies

:ROIC Decay Analysis	
companies'rates of ROIC generally remain fairly stable over time.	
(P77)...
12
Revenue growth decay analysis	
Growth decays very quickly;high is not sustainable for the typical company.	
Exhibit5.10...
Five	
  forces	
13
Threat of
new entry	
Bargaining
power of
suppliers	
The degree of
rivalry among
existing
competitors
Pr...
Can	
  companies	
  keep	
  their	
  
	
  compeDDve	
  advantages	
  over	
  Dme?	
  	
14
The image of traditional sustain...
15
Future Cash Flow of steady state	
revenue	
growth	
margins	
capital turnover	
Value Driver	
Past	
and	
Future	
	
P/L	
B...
16
Growth and ROIC:Drives of Value	
Return on 	
investment capital	
Revenue growth	
Cash flow	
Cost of of Capital	
Value
DCF approach to valuation	
Value=
FCFt=1
WACC-g
FCF=NOPLAT-Net Investment
=NOPLAT-(NOPLAT× IR)
=NOPLAT×(1-IR)
17
g=ROIC× I...
18
Company's earnings multiple	
Value
NOPLATt=1
=
1-
g
ROIC
!
"
#
$
%
&
WACC-g
NOPLAT=Invested Capital× ROIC
Value=
Invest...
19
Components of a good model	
i.  Raw historical data	
ii.  Integrated financial statements	
iii. Historical analysis and...
20
Mechanics of forecasting	
1. Prepare and analyse historical financials	
2. Build the revenue forecast	
3. Forecast the ...
21
Mechanics of forecasting	
1. Prepare and analyze historical financials	
2. Build the revenue forecast	
3. Forecast the ...
22
Step1

Prepare and analyze historical financials	
•  Collecting raw date on a separate worksheet	
•  Building the integ...
23
Step1

Prepare and analyze historical financials	
2007	
 2008	
Balance Sheet	
Accounts payable and other liabilities	
 ...
24
Mechanics of forecasting	
1. Prepare and analyze historical financials	
2. Build the revenue forecast	
3. Forecast the ...
25
Step2

Build the revenue forecast	
Using the company's own forecasts
of demand from existing
customers,customers turnov...
26
Mechanics of forecasting	
1. Prepare and analyze historical financials	
2. Build the revenue forecast	
3. Forecast the ...
27
Step3

Forecast the income state	
1st	
2nd	
3rd	
Decide
what economic relationship drive line
item.	
Estimate	
the fore...
Partial Forecast of Income Statement	
28
Exhibit9.3 (P195)
29
Typical forecast drivers 

for the income statement	
Line item	
Typical 	
forecast driver	
Typical forecast ratio	
Oper...
30
Completed Forecast of

the Income Statement	
Forecast	
 Forecast	
percent 2009	
 2010	
 $million 2009	
 2010	
Revenue g...
31
Mechanics of forecasting	
1. Prepare and analyze historical financials	
2. Build the revenue forecast	
3. Forecast the ...
Stock versus flow example	
32
Year1	
 Year2	
 Year3	
 Year4	
Revenue(dollars)	
  	
 1,000	
 1,100	
 1,200	
 1,300	
Account...
33
Typical forecast drivers 

for the balance sheet	
Line item	
 Typical forecast driver	
 Typical forecast ratio	
Operati...
34
Typical forecast drivers 

for the balance sheet	
•  Nonoperating assets	
•  Operating working capital	
–  estimating m...
35
Forecast balance sheet Sources of financing	
(P206 exhibit 9.12)	
Assets 2008	
 2009	
 2010	
 2010	
Operating cash 	
 5...
Forcast Balance Sheet:Sources of Financing	
Step1	
•  Determine retained earnings using the clean surplus
relationship,for...
37
Mechanics of forecasting	
1. Prepare and analyze historical financials	
2. Build the revenue forecast	
3. Forecast the ...
38
Calculate ROIC and FCF 	
•  Once you have completed your income statement
and balance sheet forecasts,calculate ROIC an...
Additonal Issues	
39
Nonfinancial
Operating
Drivers	
Fixed versus
Variiables
Costs	
In industries where prices are changin...
40
Part2	
6. Framework for Valuation	
7. Reorganizing the Financial Statements	
8. Analysand Performance and Competitive P...
41
Mechanics of forecasting	
1. Prepare and analyse historical financials	
2. Build the revenue forecast	
3. Forecast the ...
42
Home Depot:

Enterprise DCF	
Forcaset year
Free cash flow
($ million)
Discount factor
(@ 8.5%)
Present value of
FCF
(& ...
43
Defining company's value	
Value=	
Present Value of
Cash Flow during
Explicit Forecast
Period	
Present Value of
Cash Flo...
44
Continuing Value
as a Percentage of total value
• Continuing value accounts for 56% to 125% of total value.	
• These la...
45
Continuing value by using the value 

driver formula in Chapter2	
•  NOPLAT_t+1=net operating profit less adjusted taxe...
DCF approach to valuation	
Value=
FCFt=1
WACC-g
FCF=NOPLAT-Net Investment
=NOPLAT-(NOPLAT× IR)
=NOPLAT×(1-IR)
46
g=ROIC× I...
47
CV =
50
1.11
+
53
1.11( )
2
+
56
1.11( )
3
++
50(1.06)149
(1.11)150
CV = 999
000,1CV
%6%11
50
CV
=
−
=
000,1CV
%6%11
%...
48
Tehnical considerations	
NOPLAT	
RONIC	
Growth rate	
WACC	
The level of NOPLAT should be based on a
normalized level of...
49
Economic Profit approach	
	
( )
WACC
WACCRONIC
RONIC
NOPLAT
)ProfitscPV(Economi
such that
gWACC
)
2t
ProfitscsPV(Econom...
50
Comparison of Total-value

Estimates using different forecast horizons	
Years 1-5	
 Years 6+	
Growth	
 9	
 6	
RONIC	
 1...
185
358 364
1050
877
104
767
Free Cash flow model Business components approach Economic profit approach
51
Comparison of C...
52
Common Piatfalls	
•  Naive Base year extrapolation	
•  Naive Overconservatism	
•  Purposeful Overconservatism
53
Evaluating other approaches

to continuing value	
•  Other DCF Approaches	
–  convergence formula	
•  Non Cash flow App...
54
Technique	
 Assumptions	
 Continuing value	
Book value	
 Per accounting records	
 268	
Liquidation value	
 80% of worki...
55
Part2	
6. Framework for Valuation	
7. Reorganizing the Financial Statements	
8. Analysand Performance and Competitive P...
56
Growth and ROIC:Drives of Value	
Return on 	
investment capital	
Revenue growth	
Cash flow	
Cost of of Capital	
Value
57
Mechanics of forecasting	
1. Prepare and analyse historical financials	
2. Build the revenue forecast	
3. Forecast the ...
58
Weighted Average Capital Cost	
The opportunity cost that investors face for investing
their funds in one particular bus...
59
Criteria of cost of capital	
•  It must include the opportunity costs of all investors-debt,equity,and so
on-since free...
60
Weighted Average Capital Cost	
=
=
=
=
=
+−=
m
e
d
emd
T
k
k
VE
VD
k
K
E
Tk
V
D
WACC
/
/
)1(
target level of debt to en...
61
Weighted Average Capital Cost	
Components	
 Methodology	
 Data requirements	
Cost of equity	
 CAPM	
Risk Free	
Use a lo...
62
Source of
capital	
Proportion of
total capital	
Cost of
capital	
Marginal tax
rate	
After-tax
opportunity
cost	
Contrib...
63
Estimating the cost of equity	
•  Capital Asset Pricing model	
•  Fama-French three factor model	
•  The arbitrage pric...
64
Estimating the cost of equity	
•  Capital Asset Pricing model	
•  Fama-French three factor model	
•  The arbitrage pric...
65
Capital Asset Pricing model	
[ ]fmifi rRErRE −+= )()( β
markettheofreturnexpected)(
themarkety tosensitivitsstock'
rate...
66
General conclusion regarding CAPM	
•  To estimate the risk-free rate in developed economies,use
highly liquid,long term...
67
[CAPM]Estimating the risk free rate	
•  Ideally,each cash flow should be discounted using a
government bond with the sa...
68
[CAPM]Estimating the market risk premium	
•  Estimating the future risk premium by measuring and
extrapolating historic...
69
[CAPM]Estimating beta	
εβα ++= mRRi
• In the market model, the stock's return(Ri) ,not, price
regressed against the mar...
70
Estimating the cost of equity	
•  Capital Asset Pricing model	
•  Fama-French three factor model	
•  The arbitrage pric...
71
Fama-French Three factor model	
•  Given the strength of Fama French's empirical
results,the academic community now mea...
72
Home Depot:
Weighted Average Cost of Capital
Factor	
Average monthly
premium (percent)	
Average
annual
premium
(percent...
73
Estimating the cost of equity	
•  Capital Asset Pricing model	
•  Fama-French three factor model	
•  The arbitrage pric...
74
Arbitrage Pricing Theory	
•  In the APT,a security's actual returns are generated by k
factors and random noise.	
•  On...
75
Estimating the after tax cost of debt	
•  To estimatet,the cost of debt for investment-grade
companies,use the yeild to...
76
Adjusted present value model(APV)	
Adjusted 	
Present Value	
	
Enterprise Value	
as if company was 	
All-equity-Finance...
77
Process of AVP in detail	
1.  Valuing free cash flow at unlevered cost of capital	
2.  Determining the unlevered cost o...
78
Bond Ratings and Yield to Maturity	
N
)YTM1(
CouponFace
)YTM1(
Coupon
)YTM1(
Coupon
Price 2
+
+
+
+
+
+
= ・・・
•  To sol...
79
Trade time	
 Trade volume ($thousand)	
 Bond Price (dollars)	
 Yield (percemt)	
16:15:51	
 29	
 78.75	
 7.75	
16:15:51	...
80
Maturity(years)	
Rating	
 1	
 2	
 3	
 5	
 7	
 10	
 30	
Aaa/AAA	
 36	
 59	
 55	
 69	
 82	
 58	
 139	
Aa2/AA	
 154	
 140	...
81
Using target weights to determine 

the cost of capital	
•  Estimate the company's current market-value-based capital
s...
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20130519 第3回valuation勉強会

  1. 1. Valuation in FED 2013/5/19(Sun) 1
  2. 2. 自己紹介&Ice  Break •  名前   •  所属 •  勉強会に参加したきっかけ     2
  3. 3. 3 Contents •  Part1 Foundations of Value •  Part2 Core Valuation Techniques •  Part3 Intrinsic Value and the Stock Market •  Part4 Managing for Value •  Part5 Advanced Valuations Issues •  Part6 Special Situations
  4. 4. 4 Part2 6. Framework for Valuation 7. Reorganizing the Financial Statements 8. Analysand Performance and Competitive Position 9. Forecasting Performance 10. Estimating Continuing Value 11. Estimating the Cost of Capital 12. Moving from Enterprise Value to per Share 13. Calculating and Interpreting Results 14. Using Multiple
  5. 5. 5 Part2 6. Framework for Valuation 7. Reorganizing the Financial Statements 8. Analysand Performance and Competitive Position 9. Forecasting Performance 10. Estimating Continuing Value 11. Estimating the Cost of Capital 12. Moving from Enterprise Value to per Share 13. Calculating and Interpreting Results 14. Using Multiple
  6. 6. 6 Growth and ROIC:Drives of Value Return on investment capital Revenue growth Cash flow Cost of of Capital Value
  7. 7. 7 Home Depot:
 Enterprise DCF Forcaset year Free cash flow ($ million) Discount factor (@ 8.5%) Present value of FCF (& million) 2009 5,909 0.922 5,448 2010 2,368 0.850 2,013 2011 1,921 0.784 1,506 2012 2,261 0.723 1,634 2013 2,854 0.666 1,902 2014 3,074 0.614 1,889 2015 3,308 0.567 1,874 2016 3,544 0.522 1,852 2017 3,783 0.482 1,822 2018 4,022 0.444 1,787 Continuing value 92,239 0.444 40,966 Present value of cash flow 62,694 Midyear adjustment factor 1.041 Value of operations 65,291 Value of excess cash - Value of long-term investments 361 Value of tax loss carry-forwards 112 Enterprise value 65,764 Less:Value of debt (11,434) Less:Value of capitalized operating leases (8,298) Equity value 46,032 Number of shares outstanding(December 2008) 1.7 Equity value per share 27.1 Forecasting performance
  8. 8. Can  you  predict  the  market  which  you   belong  to  in  business?   Let’s  predict  5  years  a?er  in  your  market.
  9. 9. 9 Determine length and detail of the forecast •  A detailed five-year to seven-year forecast,which develops complete balance sheets and income statements with as many links to real variables(e.g, unit volumes,cost per unit) as possible. •  A simplified forecast for the remaining years,focusing on a few important variables,such as revenue growth,margins,and capital turnover. (P188)
  10. 10. 10 Steady State •  The Company grows at a constant rate by reinvesting a constant propotion of its operating profits into the business each year •  The company earns a constant rate of return on both exsting capital and new capital invested. (P188)
  11. 11. 11 Non financial Companies
 :ROIC Decay Analysis companies'rates of ROIC generally remain fairly stable over time. (P77) Exhibit4.8 (P77)
  12. 12. 12 Revenue growth decay analysis Growth decays very quickly;high is not sustainable for the typical company. Exhibit5.10 (P97)
  13. 13. Five  forces 13 Threat of new entry Bargaining power of suppliers The degree of rivalry among existing competitors Pressure from substitute products Bargaining power of buyers Because the five forces differ by industry and because companies within the same industry can pursue different strategies, there can be significant variation in ROIC across and within industries.
  14. 14. Can  companies  keep  their    compeDDve  advantages  over  Dme?   14 The image of traditional sustainable competitive advantage The image of a succession of temporal competitive advantage 入山章栄(2012)『世界の経営学者はいま何を考えているのか』英治出版 P71
  15. 15. 15 Future Cash Flow of steady state revenue growth margins capital turnover Value Driver Past and Future P/L B/S Finacials A simplified forecast for the remaining years
  16. 16. 16 Growth and ROIC:Drives of Value Return on investment capital Revenue growth Cash flow Cost of of Capital Value
  17. 17. DCF approach to valuation Value= FCFt=1 WACC-g FCF=NOPLAT-Net Investment =NOPLAT-(NOPLAT× IR) =NOPLAT×(1-IR) 17 g=ROIC× IR IR= g ROIC FCF=NOPLAT(1- g ROIC ) Value= NOPLATt=1 1- g ROIC " # $ % & ' WACC-g
  18. 18. 18 Company's earnings multiple Value NOPLATt=1 = 1- g ROIC ! " # $ % & WACC-g NOPLAT=Invested Capital× ROIC Value= Invested Capital× ROIC× 1- g ROIC ! " # $ % & WACC-g Value Invested Capital =ROIC 1- g ROIC WACC-g ! " # # # $ % & & & Company‘s earnings multiple is driven by both its expected growth and its return on invested capital.
  19. 19. 19 Components of a good model i.  Raw historical data ii.  Integrated financial statements iii. Historical analysis and forecast ratios iv. Market data and weighted average cost of capital v.  Reorganized financial statements vi. ROIC and FCF vii. Valuation summary (P190)
  20. 20. 20 Mechanics of forecasting 1. Prepare and analyse historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  21. 21. 21 Mechanics of forecasting 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  22. 22. 22 Step1
 Prepare and analyze historical financials •  Collecting raw date on a separate worksheet •  Building the integrated financials,and deciding wether to aggregate immaterial line items. •  Making sure never to combine operating and nonoperating accounts into a single category.
  23. 23. 23 Step1
 Prepare and analyze historical financials 2007 2008 Balance Sheet Accounts payable and other liabilities 16,676 17,587 Advances in excess of related costs 13,847 12,737 Income taxes payable 253 41 Short-term debt and current portion of long-term debt 762 560 Current liability 31,538 30,925 From note11:Liabilities,commitments,and contingencies Accounts payable 5,714 5,871 Accrued compensation and employee benefit costs 4,996 4,479 Product warranty liabilities 962 959 Environmental remediation 679 731 Forward loss recognition 607 1458 Other liabilities 3,718 4,089 Accounts payable and other liabilities 16,676 17,587 (P192 exhibit 9.2) ■Boeing Company: Current liabilities in Balance Sheet
  24. 24. 24 Mechanics of forecasting 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  25. 25. 25 Step2
 Build the revenue forecast Using the company's own forecasts of demand from existing customers,customers turnover,and the potential bounds for the forecast. Estimating revenues by sizing total market,determining market share,and forecasting prices. bottom up approach Top down forecast
  26. 26. 26 Mechanics of forecasting 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  27. 27. 27 Step3
 Forecast the income state 1st 2nd 3rd Decide what economic relationship drive line item. Estimate the forecast ratio Multiply the forecast ratio by an estimate of its driver
  28. 28. Partial Forecast of Income Statement 28 Exhibit9.3 (P195)
  29. 29. 29 Typical forecast drivers 
 for the income statement Line item Typical forecast driver Typical forecast ratio Operating Costs of goods and sold(COGS) Revenue COGS/revenue Selling,general,and administrative(SG&A) Revenue SG&A/revenue Depreciation Prior-year net PP&E Depreciation_t/net PP&E_t-1 Nonoperating Nonoperating income Appropriate nonoperating asset,if any Nonoperating income/ nonoperating asset or growth in nonoperating income interest expense Prior-year total debt Interest expense_t/total debt_t-1 interest income Prior-year excess cash Interest income_t/excess cash_t-1 (P196 exhibit 9.4)
  30. 30. 30 Completed Forecast of
 the Income Statement Forecast Forecast percent 2009 2010 $million 2009 2010 Revenue growth 20 20 Revenues 240 288 COGS/revenues 37.5 37.5 COGS -90 -108 S&GE/revenues 18.8 18.8 S&GE -45 -54 Depreciation_t/net PP&E_t-1 9.5 9.5 Depreciation -19 -24 EBITA/revenue 35.8 35.8 EBITA 86 102 Interest rate Interest expense -23 -22.2 Interest expense 7.6 7.6 Interest income 5 3.0 Interest income 5 5 Nonoperating income 4 5.3 Earnings before taxes 72 88.2 Nonoperating items Nonoperating income growth 33.3 33.3 Provision for income taxes -24 -29.7 Net income 48 58.8 Taxes Operating tax rate 34.4 34.4 Statutory tax rate 40 40 Average tax rate 33.3 33.6 (P197 exhibit9.5)
  31. 31. 31 Mechanics of forecasting 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  32. 32. Stock versus flow example 32 Year1 Year2 Year3 Year4 Revenue(dollars)   1,000 1,100 1,200 1,300 Accounts receivable(dollars) 100 105 117 135 Stock method Accounts receivable as % of revenues(%) 10 9.5 9.8 10.4 Flow method Change in accounts receivable as % of the change in revenues(%) - 5 12 18 Exhibit9.8 P201 •  When you forecast the balance sheet, one of the first issues you face is whether to forecast the line items in the balance sheet directly(in stocks) or indirectly by forecasting changes(in flows) •  The relationship between the balance sheet accounts and revenues is more stable than that between balance sheet changes and changes in revenues.
  33. 33. 33 Typical forecast drivers 
 for the balance sheet Line item Typical forecast driver Typical forecast ratio Operating line items Accounts receivable Revenues Accounts receivable/Revenues Inventories Cost of goods sold Inventories/COGS Accounts payable Cost of goods sold Accounts payable/COGS Accrued expense Revenues Accrued expense/Revenues Net PP&E Revenues Net PP&E/Revenues Goodwill and acquired intangibles Acquired revenues Goodwill and acquired intangibles/ Acquired revenues Nonoperating line items Nonoperating assets None Growth in nonoperating assets Pension assets or liabilities None Trend toward zero Deferred taxes Operating taxes or corresponding balance sheet item Change in operating deferred taxes/operating taxes, or deferred taxes/corresponding balance sheet item (P202 exhibit 9.9)
  34. 34. 34 Typical forecast drivers 
 for the balance sheet •  Nonoperating assets •  Operating working capital –  estimating most line items as a percentage of revenues or in day's sales. •  Property,plant,and equipment •  Goodwill and acquired intangibles •  Nonoperating assets,debt and equity equivalents
  35. 35. 35 Forecast balance sheet Sources of financing (P206 exhibit 9.12) Assets 2008 2009 2010 2010 Operating cash 5 5 6 6 Excess cash 100 60 35.8 Inventory 35 45 54 54 Current assets 140 110 95.8 Net PP&E 200 250 300 300 Equity investments 100 100 100 100 Total Assets 300 350 400 Liabillity Accounts payable 15 20 24 24 Short-term debt 224 213 213 213 Current liabilities 239 233 237 237 Long term debt 80 80 80 80 Newly issued debt 0 0 0 0 Common stock 65 65 65 65 Retained earnings 56 82 113.8 113.8 Total liabilities and equity 440 460 495.8 Completed
  36. 36. Forcast Balance Sheet:Sources of Financing Step1 •  Determine retained earnings using the clean surplus relationship,forecast exsiting debt using contractual terms,and keep common stock constant. Step2 •  Test which is higher,assets excluding excess cash,or liabilities and equity excluding newly issued debt. Step3 •  If assets excluding excess cash are higher,set excess cash equal to zero,and plug the difference with newly issued debt.Otherwise,plug with excess cash. 36
  37. 37. 37 Mechanics of forecasting 1. Prepare and analyze historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF
  38. 38. 38 Calculate ROIC and FCF •  Once you have completed your income statement and balance sheet forecasts,calculate ROIC and FCF. •  For companies that are creating value,futures ROICs should fit one of three general patterns: –  ROIC should either remain near current levels,trend toward an industry or economic median,or trend to the cost of capital.
  39. 39. Additonal Issues 39 Nonfinancial Operating Drivers Fixed versus Variiables Costs In industries where prices are changing or technology is advancing,forecasts should incorporate nonfinancial ratios,such as volume and productivity Inflation Since corporate valuation is about long-run profitability and growth,nearly every cost should be treated as variables. When inflation exceeds 5% annuallyhistorical analysis,historical financials should be adjusted to reflect operating performance independent of inflation.
  40. 40. 40 Part2 6. Framework for Valuation 7. Reorganizing the Financial Statements 8. Analysand Performance and Competitive Position 9. Forecasting Performance 10. Estimating Continuing Value 11. Estamting the Cost of Capital 12. Moving from Enterprise Value to per Share 13. Calculating and Interpreting Results 14. Using Multiple
  41. 41. 41 Mechanics of forecasting 1. Prepare and analyse historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF What is the reason for high PER?
  42. 42. 42 Home Depot:
 Enterprise DCF Forcaset year Free cash flow ($ million) Discount factor (@ 8.5%) Present value of FCF (& million) 2009 5,909 0.922 5,448 2010 2,368 0.850 2,013 2011 1,921 0.784 1,506 2012 2,261 0.723 1,634 2013 2,854 0.666 1,902 2014 3,074 0.614 1,889 2015 3,308 0.567 1,874 2016 3,544 0.522 1,852 2017 3,783 0.482 1,822 2018 4,022 0.444 1,787 Continuing value 92,239 0.444 40,966 Present value of cash flow 62,694 Midyear adjustment factor 1.041 Value of operations 65,291 Value of excess cash - Value of long-term investments 361 Value of tax loss carry-forwards 112 Enterprise value 65,764 Less:Value of debt (11,434) Less:Value of capitalized operating leases (8,298) Equity value 46,032 Number of shares outstanding(December 2008) 1.7 Equity value per share 27.1 Estimating Continuing Value
  43. 43. 43 Defining company's value Value= Present Value of Cash Flow during Explicit Forecast Period Present Value of Cash Flow after Explicit Forecast Period + • To estimate a company's value,separate a company's expected cash flow into two period. • A thoughtful estimate of continuing value is essential to any valuation,because continuing value often accounts for a large percentage of a continuing value.
  44. 44. 44 Continuing Value as a Percentage of total value • Continuing value accounts for 56% to 125% of total value. • These large percentage do not necessarily mean that most of a company's value will be created in the continuing-value period. 56 81 0 -25 44 19 100 125 Tabaco Sporting goods Skin care High tech Forecast period cash flow Continuing value
  45. 45. 45 Continuing value by using the value 
 driver formula in Chapter2 •  NOPLAT_t+1=net operating profit less adjusted taxes in the first year after the explicit forecast period •  g=expected growth rate in NOPLAT in perpetuity •  RONIC=expected rate of return on new invested capital •  WACC=weighted average cost of capital gWACC RONIC g 1NOPLAT ValueContinuing 1t − ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ − = +
  46. 46. DCF approach to valuation Value= FCFt=1 WACC-g FCF=NOPLAT-Net Investment =NOPLAT-(NOPLAT× IR) =NOPLAT×(1-IR) 46 g=ROIC× IR IR= g ROIC FCF=NOPLAT(1- g ROIC ) Value= NOPLATt=1 1- g ROIC " # $ % & ' WACC-g
  47. 47. 47 CV = 50 1.11 + 53 1.11( ) 2 + 56 1.11( ) 3 ++ 50(1.06)149 (1.11)150 CV = 999 000,1CV %6%11 50 CV = − = 000,1CV %6%11 %12 %6 1100 CV = − ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ − = Comparing the methods of computing
 continuing value Discounting a long forecast(150 years) Using the growth free cash flow(FCF) perpetuity formula Using the value driver formula
  48. 48. 48 Tehnical considerations NOPLAT RONIC Growth rate WACC The level of NOPLAT should be based on a normalized level of revenuews and sustainabel margin and ROIC. The expected rate of return on RONIC should be consistent with expected competitive conditions. Few companies can be expected to grow faseter than the economy for long periods. WACC should incorporate a sustainable capital structure.
  49. 49. 49 Economic Profit approach ( ) WACC WACCRONIC RONIC NOPLAT )ProfitscPV(Economi such that gWACC ) 2t ProfitscsPV(Economi WACC WACC)-IC(ROIC 1]Year tbeyondofitsEconomicPr1Year tinProfitsEconomicCV 1t 2t t −⎟ ⎠ ⎞ ⎜ ⎝ ⎛ = − ++= +++= + + g Value= Invested Capital at Beginning of Forecast Present Value of Forecast Economic Profit during Explicit Forecast Period + Present Value of Forecast Economic Profit after Explicit Forecast Period +
  50. 50. 50 Comparison of Total-value
 Estimates using different forecast horizons Years 1-5 Years 6+ Growth 9 6 RONIC 16 12 WACC -12 -12 Spread 4 0 Modeling assumptions As the explicit forecast horizon grows longer,value shifts from the continuing value to the explicit forecast period, but the total value always remain the same. 100% = $893 $893 $893 $893 $893 Continuing value value of exlplict free cash flow 21 33 40 54 65 79 67 60 46 35 5 8 10 15 20 Exhibit10.3 (P219)
  51. 51. 185 358 364 1050 877 104 767 Free Cash flow model Business components approach Economic profit approach 51 Comparison of Continuing value approaches (15%) Value of years 1-9 free cash flow (71%) Base businessPresent value of continuing value (85%) (29%) New product line Economic-profit continuing value (30%) Present value of years 1-9 economic profit(8%) Invested capital (62%)
  52. 52. 52 Common Piatfalls •  Naive Base year extrapolation •  Naive Overconservatism •  Purposeful Overconservatism
  53. 53. 53 Evaluating other approaches
 to continuing value •  Other DCF Approaches –  convergence formula •  Non Cash flow Approaches –  multiples,liquidation value,Replacement cost •  Advanced formulas for continuing value –  two periods with different growth and ROIC assumption
  54. 54. 54 Technique Assumptions Continuing value Book value Per accounting records 268 Liquidation value 80% of working capital 186 70% of net fixed assets Price to earnings ratio Industry average of 15× 624 Market to book ratio Industry average of 1.4× 375 Replacement cost Book value adjusted for inflation 275 Perpetuity based on final year's cash flow Normalized FCF growing at inflation rate 428 Continuing value estimates
 for a Sporting goods company
  55. 55. 55 Part2 6. Framework for Valuation 7. Reorganizing the Financial Statements 8. Analysand Performance and Competitive Position 9. Forecasting Performance 10. Estimating Continuing Value 11. Estamting the Cost of Capital 12. Moving from Enterprise Value to per Share 13. Calculating and Interpreting Results 14. Using Multiple
  56. 56. 56 Growth and ROIC:Drives of Value Return on investment capital Revenue growth Cash flow Cost of of Capital Value
  57. 57. 57 Mechanics of forecasting 1. Prepare and analyse historical financials 2. Build the revenue forecast 3. Forecast the income statement 4. Forecast the balance sheet:invested capital and nonoperating assets 5. Forecast the balance sheet:investor funds 6. Calculate ROIC and FCF How do you justify the relationship of high risk and high return?
  58. 58. 58 Weighted Average Capital Cost The opportunity cost that investors face for investing their funds in one particular business instead of others with similar risk.
  59. 59. 59 Criteria of cost of capital •  It must include the opportunity costs of all investors-debt,equity,and so on-since free cash flow is available to all investors,who expect compenstion for the risks they take. •  It must weight each security's required return by its target marked- based weight,not by its historical book value. •  Any financing-related benefits or costs,such as interest tax shields,not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value. •  It must be computed after corporate taxes(since free cash flow is calculated in after-tax terms) •  It must be based on the same expectations of inflation as those embedded in forecasts of free cash flow. •  The duration of the securities used to estimate the cost of capital must match the duration cash flows.
  60. 60. 60 Weighted Average Capital Cost = = = = = +−= m e d emd T k k VE VD k K E Tk V D WACC / / )1( target level of debt to enterprise value using market-based(not book)values target level of equity to enterprise value using market-based values cost of debt cost of equity company's marginal income tax rate
  61. 61. 61 Weighted Average Capital Cost Components Methodology Data requirements Cost of equity CAPM Risk Free Use a long-term government rate denominated in same currency as cash flows. Market risk premium The market risk premium is difficult to measure.Various models point to risk premium between 4.5% and 5.5% Company beta To estimate beta, lever the company's industry beta to company's target debt-equity ratio. After tax cost of debt Expected return proxied by yield to maturity on long- term debt Risk Free Use a long-term government rate denominated in same currency as cash flows. Default spread Default spread is determined by company's bond rating and amount of physical collateral Marginal tax rate In most situations,use company's statutory tax rate.The marginal tax rate should match marginal tax rate used to forecast net operating profit less adjusted taxes(NOPLAT) Capital structure Proportion of debt and equity to enterprise value Measure debt and equity on a market,not book,basis. Use a forward-looking target capital structure (exhibit11.1 P237)
  62. 62. 62 Source of capital Proportion of total capital Cost of capital Marginal tax rate After-tax opportunity cost Contribution to weighted average Debt 31.5 6.8 37.6 4.2 1.3 Equity 68.5 10.4 10.4 7.1 WACC 100 8.5 Home Depot: Weighted Average Cost of Capital ・The company's cost of equity was estimated using the CAPM,which led to a cost of equity of 10.4%.
  63. 63. 63 Estimating the cost of equity •  Capital Asset Pricing model •  Fama-French three factor model •  The arbitrage pricing theory(APT)
  64. 64. 64 Estimating the cost of equity •  Capital Asset Pricing model •  Fama-French three factor model •  The arbitrage pricing theory(APT)
  65. 65. 65 Capital Asset Pricing model [ ]fmifi rRErRE −+= )()( β markettheofreturnexpected)( themarkety tosensitivitsstock' ratefreerisk securityofreturnexpected)( = = = m i f i RE r iRE =β
  66. 66. 66 General conclusion regarding CAPM •  To estimate the risk-free rate in developed economies,use highly liquid,long term government securities,such as the 10 year zero-coupon STRIPS. •  Based on historical averages and forward-looking estimates,the appropriate market risk premium is between 4.5% and 5.5%. •  To estimate a company's target capital structure.Company- specific betas vary too widely over time to be used reliable.
  67. 67. 67 [CAPM]Estimating the risk free rate •  Ideally,each cash flow should be discounted using a government bond with the same matuirty. •  In reality,few practitioners discount each cash flow using a matched maturity. •  For US based corporate valuation,the most common proxy is 10 year government STRIPS.
  68. 68. 68 [CAPM]Estimating the market risk premium •  Estimating the future risk premium by measuring and extrapolating historical returns. •  Using regression analysis to link current market variables,such as the aggregate dividend-to-price ratio,to project the expected market risk premium. •  Using DCF valuation,along with estimates of return on investment and growth,to reverse engineer the markets cost of capital.
  69. 69. 69 [CAPM]Estimating beta εβα ++= mRRi • In the market model, the stock's return(Ri) ,not, price regressed against the market's return. • The measurement period for raw regressions should include at least 60 data point. • Raw regressios should be on monthly returns. • Company stock returns should be regressed against a value- weighted,well-diversified market portfolio.
  70. 70. 70 Estimating the cost of equity •  Capital Asset Pricing model •  Fama-French three factor model •  The arbitrage pricing theory(APT)
  71. 71. 71 Fama-French Three factor model •  Given the strength of Fama French's empirical results,the academic community now measures risk with a model commonly known as the Fama-French three-factor model. •  With this model, a stock's excess returns are regressed on –  excess market returns(similar to the CAPM), –  the excess returns of small stocks over big stocks(SMB), –  excess returns of high book to market stocks over low book to market stocks(HML).
  72. 72. 72 Home Depot: Weighted Average Cost of Capital Factor Average monthly premium (percent) Average annual premium (percent) Regression coefficient Contribution to expected return (percent) Market portfolio 5.4 1.39 7.5 SMB portfolio 0.23 2.8 (0.09) (0.3) HML portfolio 0.4 5.0 (0.14) (0.7) Premium over risk-free rate 6.6 Risk free rate 3.9 Cost of equity 10.5 1 SMB and HML premiums based on average monthly returns date, 1926-2009. 2 Based on monthly returns date, 2002-2006. 3 Summation rounded to one decimal point.
  73. 73. 73 Estimating the cost of equity •  Capital Asset Pricing model •  Fama-French three factor model •  The arbitrage pricing theory(APT)
  74. 74. 74 Arbitrage Pricing Theory •  In the APT,a security's actual returns are generated by k factors and random noise. •  On paper,the theory is extremely powerful. •  In practice,implementation of the model has been tricky,as there is little agreement about how many factors there are,what the factors represent,or how to measure the factors. kkft rRE λβλ+・・・+βλβλβλβ +++++= 4321)(
  75. 75. 75 Estimating the after tax cost of debt •  To estimatet,the cost of debt for investment-grade companies,use the yeild to maturity of company's long- term,option-free bonds. •  Technically speaking,yield to maturity is only a proxy for expected return,because the yield is actually a promised rate of return on company's debt. •  For companies with below investment grade debt,we recommend using adjusted present value(AVP) based on the unlevered cost of equity rather than the WACC to value the company.
  76. 76. 76 Adjusted present value model(APV) Adjusted Present Value Enterprise Value as if company was All-equity-Financed Present Value of Tax Shields = + The APV valuation model follows directly from the teachings of economists Franco Modigliani and Merton Miller,who proposed that in a market with no taxes, a company choice of financial structure will not affect the value of its economic assets.
  77. 77. 77 Process of AVP in detail 1.  Valuing free cash flow at unlevered cost of capital 2.  Determining the unlevered cost of capital with market data 3.  Choosing the appropriate formula. 4.  Valuing tax shields and other capital structure effects.
  78. 78. 78 Bond Ratings and Yield to Maturity N )YTM1( CouponFace )YTM1( Coupon )YTM1( Coupon Price 2 + + + + + + = ・・・ •  To solve for yeild to maturity,reverse enginieer the discount rate required to set the present value of bond's promised cash flow equal to its price. •  To determine a company's bond rating,a rating agency will examine the company's most recent financial ratios,analyze the company's competitive environment,and interview senior management. •  Using the company's bond ratings to detemine the yield to maturity is a good alternative to calculating the yeild to maturity directly.
  79. 79. 79 Trade time Trade volume ($thousand) Bond Price (dollars) Yield (percemt) 16:15:51 29 78.75 7.75 16:15:51 29 78.75 7.75 14:48:00 5 78.00 7.83 14:03:19 110 81.85 7.43 12:08:43 2,000 80.06 7.62 12:08:00 2,000 80.06 7.62 12:08:00 2,000 80.00 7.62 12:08:00 2,000 80.06 7.62 12:06:22 2,000 80.25 7.60 Home Depot bond yield 7.62 30-year U.S. Treasury yield (4.39) Home Depot default premium 3.23 Home Depot: Trading Data on Corporate Debt
  80. 80. 80 Maturity(years) Rating 1 2 3 5 7 10 30 Aaa/AAA 36 59 55 69 82 58 139 Aa2/AA 154 140 150 160 168 139 179 A1/A+ 159 153 166 169 168 139 182 A2/A 183 178 192 193 189 152 190 A3/A- 195 194 213 210 210 177 199 Baa1/BBB+ 324 310 336 333 325 288 320 Baa2/BBB 332 315 340 338 328 292 324 Baa3/BBB- 402 408 425 433 421 380 416 Ba2/BB 559 583 586 590 578 545 577 B2/B 870 916 913 925 909 878 904 Yield Spread over U.S. Treasuries by Bond Rating, May 2009 Basis points
  81. 81. 81 Using target weights to determine 
 the cost of capital •  Estimate the company's current market-value-based capital structure. •  Review the capital structure of comparable companies. •  Review management's implicit or explicit approach to financing the business and its implications for the target capital structure. emd k K E Tk V D WACC +−= )1(

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