CORPORATE FINANCE: SPRING Aswath Damodaran

Transcription

1 CORPORATE FINANCE: SPRING 2017 Aswath Damodaran

2 Ponderous Thoughts, or maybe not 1. There are few facts and lots of opinions. a. Even the givens (cash & risk free rate) are not. b. With accounting and market numbers, all bets are off. 2. The real world is a messy place. a. Money making firms can become money losers b. Companies can be restructured/ given facelifts 3. Models don t compute values and optimal paths. You do. 4. Change is the only constant. Everything changes all the time. 2

3 The most analyzed companies this semester were.. 1. Apple, Facebook, Intel, Nordstrom, Pfizer (5 each) 2. Underarmour (6) 3. Nike (6) 4. Netflix (8) 5. Electronic Arts (9) 6. Lululemon (9) 3

4 And here s why you can do the same company.. Company Beta Jensen's Alpha ROC - WACC Current Debt ratio Optimal Debt Ratio Dividends FCFE Value/share Price/Share Electronic Arts % 6.59% 3.62% 30.00% $ $(673.40) $53.46 $94.69 Electronic Arts % 8.29% 3.90% 30.00% $- $2, $86.56 $93.97 Electronic Arts % 5.50% 10.00% 10.00% $- $ $40.31 $64.24 Electronic Arts % 9.21% 3.51% 30.00% $ $23.00 $39.35 $94.82 Electronic Arts % 10.77% 10.22% 20.00% $ $ $58.02 $95.74 Electronic Arts % 10.67% 4.12% 30.00% $- $7, $95.74 $95.74 Electronic Arts % 20.72% 3.98% 20.00% $- $1, $42.93 $95.74 Electronic Arts % 8.87% 4.11% 30.00% $- $ $59.27 $89.27 Electronic Arts % 4.15% 11.68% 60.00% $- $1, $48.28 $

5 The Breakdown in the Classical Objective Function STOCKHOLDERS Have little control over managers Managers put their interests above stockholders BONDHOLDERS Lend Money Bondholders can get ripped off Managers Delay bad news or provide misleading information Markets make mistakes and can over react Significant Social Costs SOCIETY Some costs cannot be traced to firm FINANCIAL MARKETS 5

6 I. Where does the power lie? Where the power lies: Spring % 1% 33% 55% Shareholders have no power Shareholders has some power Shareholders have high power Other 6

7 II. Who is your marginal investor? From Spring % The Marginal Investor 80% 70% 60% 50% 40% 30% 20% 10% 0% Small Large US Europe Emerging Markets Institutional Individual Insider 7

8 III. Risk Profiles and Costs of Equity Cost of Equity Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows + Beta - Measures market risk Type of Business Operating Leverage X Financial Leverage Risk Premium - Premium for average risk investment Base Equity Premium Country Risk Premium 8

9 Beta: The Standard Approach Beta of Equity Rj Top-Down Slope = Beta R 2 : Proportion of risk that is not diversifiable Intercept - Rf (1-Beta) = Jensen!s Alpha Bottom-up 1. Identify businesses that firm is in. 2. Take weighted average of the unlevered betas of other firms in the business 3. Compute the levered beta using the firm!s current debt to equity ratio:!l =!u [1 + (1-tax rate) (Debt/Equity)] Rm 9

10 Your choice on beta approach Beta Approach 1% 7% Bottom up Regression Other 92% Typical reasons 1. My company is unique. I cannot find comparable firms. 2. My company is in only one line of business 3. My bottom-up beta is too different from my regression beta 10

11 Beta Distribution 80. Betas across your companies To To To To To To To To 2 2 and over 11

12 Jensen s Alpha Distribution 80 Jensen's Alpha <-20% -10% to -20% 0 to-10% <2% 2-5% 5-10% 10-20% 20-30% 30-40% 40-50% >50% 12

13 R Squared R Squared Distribution R Squared Average 24.95% Median 20.90% To To To To To To and over 13

14 Cost of Capital Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E)) Cost of Equity Cost of Debt = Riskfree Rate + Default Spread Market-value Weights of Debt & Equity Actual Rating Rating Synthetic Rating Equity includes Options Debt includes all fixed commitments 14

15 Distribution of Current Market Value Debt Ratios Current Debt Ratio Median = 18.01% <10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% 15

16 IV. The Quality of Investments: The Firm View After-tax Operating Income Capital Invested in Assets in Place Return on Capital = After-tax Operating Income/ Capital Invested in Assets in Place Return Spread = ROC - WACC EVA = (ROC - WACC) (Capital Invested) Cost of Capital = Cost of Equiity (E/(D+E)) + After-tax cost of debt (D/(D+E)) Net Income Equity Invested in Assets in Place Return on Equity= Net Income/ Equity Invested in Assets in Place Return Spread = ROE - COE Equity EVA = (ROE - COE) (Equity Invested) Cost of Equiity 16

17 Return Spreads Excess Returns across Companies ROE -COE ROC - WACC Average 25.33% 15.98% Median 10.24% 6.76% <-10% -5% to -10% -2.5% to -5% 0 tp -2.5% 0 to 2.5% 2.5%- 5% 5%-10% 10%-20% 20-30% 30-40% 40-50% >50% ROE - COE ROC - WACC 17

18 VI. The Optimal Financing Mix Actual and Optimal Debt Ratios Optimal debt ratio Average 51.91% Median 40.00% High Low 90.00% 12 firms 0.00% 17 firms <10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% >90% Actual Optimal 18

19 Under versus Over Levered Firms Under and Over Levered firms Under or over levered Average % Median % Low % High +68% Underlevered > 40% Underlevered 30-40% Underlevered 20-30% Underlevered 10-20% Underlevered less than 10% Overlevered less than 10% Overlevered 10-20% Overlevered 20- Overlevered 30 30% to 40% Overlevered more than 40% 19

20 VIII. The Right Kind of Financing Sensitivity of Firm Value to Changes in Interest Rates Sensitivity of Firm Value to Changes in GDP Sensitivity of Firm Value to Changes in Inflation Sensitivity of Firm Value to Changes in Exchange Rates Duration of Assets Cyclicality of Firm Pricing Power Foreign Currency Exposure Duration of Debt Margin for Error Fixed versus Floating Rate Domestic versus Foreign Currency Debt 20

21 IX. Measuring Potential Dividends Begin with the net income (which is after interest expenses and taxes) Add back the non-cash charges such as depreciation & amortization Subtract out reinvestment needs - Capital expenditures - Investments in Non-cash Working Capital (Change) Subtract out payments to non-equity investors - Principal Repayments - Preferred Stock Dividends Add any cash inflows from new debt - New Debt Issues To get to the Cash that is available for return to Owners 21

22 Dividends versus FCFE 180 Dividends+ Buybacks versus FCFE FCFE/Dividends Average 151% Median 51% % 0-10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% % >100% 22

23 X. Valuation: Match up cashflows and discount rates Financing Weights Debt Ratio = DR EQUITY VALUATION WITH FCFE Cashflow to Equity Net Income - (Cap Ex - Depr) (1- DR) - Change in WC (!-DR) = FCFE Expected Growth Retention Ratio * Return on Equity Firm is in stable growth: Grows at constant rate forever Value of Equity Terminal Value= FCFE n+1/(ke-gn) FCFE1 FCFE2 FCFE3 FCFE4 FCFE5 FCFEn... Forever Discount at Cost of Equity DISCOUNTED CASHFLOW VALUATION Cashflow to Firm EBIT (1-t) - (Cap Ex - Depr) - Change in WC = FCFF Expected Growth Reinvestment Rate * Return on Capital Firm is in stable growth: Grows at constant rate forever Firm Value - Value of Debt = Value of Equity FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn... Terminal Value= FCFF n+1/(r-gn) Forever Discount at Cost of Capital (WACC) = Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) 23

24 Getting to equity value per share Approach used Discount dividends per share at the cost of equity Discount aggregate FCFE at the cost of equity Discount aggregate FCFF at the cost of capital To get to equity value per share Present value is value of equity per share Present value is value of aggregate equity. Subtract the value of equity options given to managers and divide by number of shares. PV = Value of operating assets + Cash & Near Cash investments + Value of minority cross holdings -Debt outstanding = Value of equity -Value of equity options =Value of equity in common stock / Number of shares 24

25 Disney: Inputs to Valuation High Growth Phase Transition Phase Stable Growth Phase Length of Period 5 years 5 years Forever after 10 years Tax Rate 31.02% (Effective) 36.1% (Marginal) 31.02% (Effective) 36.1% (Marginal) 31.02% (Effective) 36.1% (Marginal) Return on Capital 12.61% Declines linearly to 10% Stable ROC of 10% Reinvestment Rate 53.93% (based on normalized acquisition costs) Declines gradually to 25% 25% of after-tax operating as ROC and growth rates income. drop: Reinvestment rate = g/ ROC = 2.5/10=25% Expected Growth ROC * Reinvestment Rate = Linear decline to Stable 2.5% Rate in EBIT *.5393 =.068 or 6.8% Growth Rate of 2.5% Debt/Capital Ratio 11.5% Rises linearly to 20.0% 20% Risk Parameters Beta = , k e = 8.52%% Pre-tax Cost of Debt = 3.75% Beta changes to 1.00; Cost of debt stays at 3.75% Beta = 1.00; k e = 8.51% Cost of debt stays at 3.75% Cost of capital = 7.81% Cost of capital declines Cost of capital = 7.29% gradually to 7.29% Aswath Damodaran 25

26 Current Cashflow to Firm EBIT(1-t)= 10,032(1-.31)= 6,920 - (Cap Ex - Deprecn) 3,629 - Chg Working capital 103 = FCFF 3,188 Reinvestment Rate = 3,732/6920 =53.93% Return on capital = 12.61% Disney - November 2013 Reinvestment Rate 53.93% Expected Growth.5393*.1261=.068 or 6.8% Return on Capital 12.61% Stable Growth g = 2.75%; Beta = 1.00; Debt %= 20%; k(debt)=3.75 Cost of capital =7.29% Tax rate=36.1%; ROC= 10%; Reinvestment Rate=2.5/10=25% Op. Assets 125,477 + Cash: 3,931 + Non op inv 2,849 - Debt 15,961 - Minority Int 2,721 =Equity 113,575 -Options 972 Value/Share $ First 5 years Growth declines gradually to 2.75% EBIT/*/(1/2/tax/rate) $7,391 $7,893 $8,430 $9,003 $9,615 $10,187 $10,704 $11,156 $11,531 $11,819 /2/Reinvestment $3,985 $4,256 $4,546 $4,855 $5,185 $4,904 $4,534 $4,080 $3,550 $2,955 FCFF $3,405 $3,637 $3,884 $4,148 $4,430 $5,283 $6,170 $7,076 $7,981 $8,864 Cost of Capital (WACC) = 8.52% (0.885) % (0.115) = 7.81% Terminal Value 10 = 7,980/( ) = 165,323 Cost of capital declines gradually to 7.29% Term Yr 10,639 2,660 7,980 Cost of Equity 8.52% Cost of Debt (2.75%+1.00%)(1-.361) = 2.40% Based on actual A rating Weights E = 88.5% D = 11.5% In November 2013, Disney was trading at $67.71/share Riskfree Rate: Riskfree rate = 2.75% Beta + X ERP for operations 5.76% Unlevered Beta for Sectors: D/E=13.10% Aswath Damodaran

27 Value versus Price Valuation Results Over/Under valued 40.00% 35.00% Average Overvalued by 41.16% Median Overvalued by 11.14% 30.00% 25.00% % of Class 20.00% 15.00% 10.00% 5.00% 0.00% Spring 2008 Spring 2010 Spring 2012 Spring 2014 Spring 2017 Undervalued > 50% Undervalued 10-50% Undervalued < 10% Overvalued less than 10% Overvalued between 10-50% Overvalued % Overvalued >100% 27

28 Ways of changing value Are you investing optimally for future growth? How well do you manage your existing investments/assets? Growth from new investments Growth created by making new investments; function of amount and quality of investments Efficiency Growth Growth generated by using existing assets better Is there scope for more efficient utilization of exsting assets? Cashflows from existing assets Cashflows before debt payments, but after taxes and reinvestment to maintain exising assets Are you building on your competitive advantages? Expected Growth during high growth period Length of the high growth period Since value creating growth requires excess returns, this is a function of - Magnitude of competitive advantages - Sustainability of competitive advantages Stable growth firm, with no or very limited excess returns Are you using the right amount and kind of debt for your firm? Cost of capital to apply to discounting cashflows Determined by - Operating risk of the company - Default risk of the company - Mix of debt and equity used in financing 28

29 Current Cashflow to Firm EBIT(1-t)= 10,032(1-.31)= 6,920 - (Cap Ex - Deprecn) 3,629 - Chg Working capital 103 = FCFF 3,188 Reinvestment Rate = 3,732/6920 =53.93% Return on capital = 12.61% Disney - November 2013 Reinvestment Rate 53.93% Expected Growth.5393*.1261=.068 or 6.8% Return on Capital 12.61% Stable Growth g = 2.75%; Beta = 1.00; Debt %= 20%; k(debt)=3.75 Cost of capital =7.29% Tax rate=36.1%; ROC= 10%; Reinvestment Rate=2.5/10=25% Op. Assets 125,477 + Cash: 3,931 + Non op inv 2,849 - Debt 15,961 - Minority Int 2,721 =Equity 113,575 -Options 972 Value/Share $ First 5 years Growth declines gradually to 2.75% EBIT/*/(1/2/tax/rate) $7,391 $7,893 $8,430 $9,003 $9,615 $10,187 $10,704 $11,156 $11,531 $11,819 /2/Reinvestment $3,985 $4,256 $4,546 $4,855 $5,185 $4,904 $4,534 $4,080 $3,550 $2,955 FCFF $3,405 $3,637 $3,884 $4,148 $4,430 $5,283 $6,170 $7,076 $7,981 $8,864 Cost of Capital (WACC) = 8.52% (0.885) % (0.115) = 7.81% Terminal Value 10 = 7,980/( ) = 165,323 Cost of capital declines gradually to 7.29% Term Yr 10,639 2,660 7,980 Cost of Equity 8.52% Cost of Debt (2.75%+1.00%)(1-.361) = 2.40% Based on actual A rating Weights E = 88.5% D = 11.5% In November 2013, Disney was trading at $67.71/share Riskfree Rate: Riskfree rate = 2.75% Beta + X ERP for operations 5.76% Unlevered Beta for Sectors: D/E=13.10% 29 Aswath Damodaran

30 Current Cashflow to Firm EBIT(1-t)= 10,032(1-.31)= 6,920 - (Cap Ex - Deprecn) 3,629 - Chg Working capital 103 = FCFF 3,188 Reinvestment Rate = 3,732/6920 =53.93% Return on capital = 12.61% Disney (Restructured)- November 2013 Reinvestment Rate 50.00% More selective acquisitions & payoff from gaming Expected Growth.50*.14 =.07 or 7% Return on Capital 14.00% Stable Growth g = 2.75%; Beta = 1.20; Debt %= 40%; k(debt)=3.75% Cost of capital =6.76% Tax rate=36.1%; ROC= 10%; Reinvestment Rate=2.5/10=25% Op. Assets 147,704 + Cash: 3,931 + Non op inv 2,849 - Debt 15,961 - Minority Int 2,721 =Equity 135,802 -Options 972 Value/Share $ First 5 years Growth declines gradually to 2.75% EBIT * (1 - tax rate) $7,404 $7,923 $8,477 $9,071 $9,706 $10,298 $10,833 $11,299 $11,683 $11,975 - Reinvestment $3,702 $3,961 $4,239 $4,535 $4,853 $4,634 $4,333 $3,955 $3,505 $2,994 Free Cashflow to Firm $3,702 $3,961 $4,239 $4,535 $4,853 $5,664 $6,500 $7,344 $8,178 $8,981 Cost of Capital (WACC) = 8.52% (0.60) %(0.40) = 7.16% Terminal Value 10 = 9,206/( ) = 216,262 Cost of capital declines gradually to 6.76% Term Yr 12,275 3,069 9,206 Cost of Equity 10.34% Riskfree Rate: Riskfree rate = 2.75% Cost of Debt (2.75%+1.00%)(1-.361) = 2.40% Based on synthetic A rating Beta + X ERP for operations 5.76% Weights E = 60% D = 40% Move to optimal debt ratio, with higher beta. In November 2013, Disney was trading at $67.71/share Unlevered Beta for Sectors: D/E=66.67% 30 Aswath Damodaran

31 So, how do you explain the price? Its all relative.. Company Name Ticker Symbol PE Expected Growth Rate Point 360 PTSX % 2.12 Fox Entmt Group Inc FOX % 1.52 Belo Corp. 'A' BLC % 1.60 Hearst-Argyle Television Inc HTV % 2.07 Journal Communications Inc. JRN % 2.79 Saga Communic. 'A' SGA % 1.50 Viacom Inc. 'B' VIA/B % 2.18 Pixar PIXR % 1.81 Disney (Walt) DIS % 2.49 Westwood One WON % 1.67 World Wrestling Ent. WWE % 1.68 Cox Radio 'A' Inc CXR % 1.81 Beasley Broadcast Group Inc BBGI % 2.24 Entercom Comm. Corp ETM % 2.34 Liberty Corp. LC % 1.92 Ballantyne of Omaha Inc BTNE % 3.23 Regent Communications Inc RGCI % 2.55 Emmis Communications EMMS % 4.54 Cumulus Media Inc CMLS % 4.05 Univision Communic. UVN % 5.01 Salem Communications Corp SALM % 5.07 Average for sector % 2.74 PEG 31

32 Most undervalued stocks!! Company Value/share Price/Share Price/Value Burberry $82.36 $ % Fitbit $30.87 $ % Michael Kors $ $ % FitBit $20.38 $ % JBS $8.73 $ % Minerva $28.42 $ % Kroger $65.48 $ % Gilead $ $ % GameStop $51.03 $ % GameStop $50.26 $ % First Solar $70.54 $ % AMC Networks $ $ % Gilead $ $ % Home Depot $ $ % Nintendo $6, $3, % 32

33 The Triple Whammy: Underlevered, Cash Buildup and Under valued? Investment Performance Capital Structure Dividend Policy Valuation Company Power ROE - COE ROC - WACC Current Debt ratio Optimal Debt Ratio Dividends FCFE Value/share Price/Share Kroger % 5.57% 42.68% 70.00% $ $1, $65.48 $29.22 Gilead % 37.92% 23.00% 37.50% $15, $ $68.00 First Solar % 0.20% 12.90% 40.00% $ $70.54 $34.54 Gilead % 18.92% 24.28% 90.00% $2, $ $67.80 Home Depot % 16.00% 1.57% 20.00% $2, $6, $ $ First Solar % 0.10% 16.82% 30.00% $ $59.03 $34.54 Time Warner % 15.31% 25.61% 60.00% $24, $ $98.37 First Solar % -3.74% 11.47% 50.00% $ $41.14 $27.97 EA Inc % 27.73% 3.88% 30.00% $ $ $94.82 Nike % 12.78% 4.80% 30% $4, $19,573 $77.73 $53.95 Lululemon % 37.12% 6.12% 60% $0.00 $ $71.85 $51.95 Walgreens % 3.56% 31.14% 60.00% $1, $8,426 $ $82.82 Ericsson % -1.63% 18.96% 30.00% $8, $79.27 $58.45 Carnival Corporation % 4.12% 29.00% 50.00% $1, $83.21 $63.02 Sturm, Ruger & Company, Inc % 40.81% 0.04% 60.00% $55.64 $61.36 $77.57 $60.00 Lululemon Athletica Inc % 24.55% 6.69% 60.00% $ $ $64.55 $51.95 Facebook % 35.67% 0.00% 30.00% $ $ $ Intel % 7.61% 13.21% 70.00% $4, $11, $44.95 $36.82 Lululemon % 29.73% 0.00% 40.00% $ $63.16 $52.46 Northop Grumman % 6.37% 35.08% 50.00% $2, $2, $ $ Target % 8.00% 36.32% 90.00% $26, $58,384 $65.75 $55.88 Facebook % 19.58% 0.41% 30.00% $ $ $ Gilead Sciences % 23.69% 24.20% 90.00% $ $78.30 $68.00 CVS % 5.02% 38.00% 80.00% $21, $92.71 $81.13 Gap % 2.62% 37.34% 60% $1, $4,604 $29.88 $

34 First Principles 34

35 Objectives of this class If you get the big picture, the details will come (sooner or later) Tools are useful but only in the larger context of answering bigger questions. Corporate finance is not so bad!!! 35

36 And don t forget your CFEs 1. This course was mentally challenging/intellectually stimulating No-brainer! Brilliant insights! 2. This course was demanding of my time What work? Haven t slept all semester. 3. This course provided me with tools and information that I will find useful in the future Only in prison Completely relevant 4. Overall evaluation of the course Horrible! ( I want my money back) Stupendous! 5. The instructor was organized and well prepared for class Had trouble finding classroom Scarily efficient! 6. The instructor communicated his/her ideas and material well Garbled gobbledygook! Should have own TV show 7. The instructor was enthusiastic about his/her subject matter Dead man talking! I am a convert 8. Overall evaluation of the instructor Dog! Star! 36