Notater: MAN 8998 Bedriftsøkonomisk Analyse. What Valuation is About. 5. modul, 2. dag. Valuation: Some Basics. Outline of the Session

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1 MAN 8998 Bedrifsøkonomisk Analyse 5. modul, 2. dag Valuaion: Some Basics Norwegian School of Managemen Spring 2003 Tor Tangenes Wha Valuaion is Abou? Ouline of he Session Groups of Models The Dividend-, RI-, and Free Cash Flow Model xample A: The Relaion Beween Inellecual Capial and RI Noaer: xample B: The Free Cash Flow Mehod 2 Wha Valuaion is Abou 3

2 Before We Sar Up - Why Boher? Why no simply look a marke prices? Wha economic facors deermine he value of equiy? Wha abou marke efficiency? Is he firm s hisory of relevance? Wha can be said abou he firm s fuure? 4 When valuae? Valuaion is he pricing of economic aciviy Valuaion can be grouped according o objec of valuaion Capial budgeing: Valuaion of projecs inside a firm Firm valuaion: Valuaion of he enire firm, equiy and deb Securiy valuaion: Valuaion of claims on he firm s cash flow Noaer: When When securiy markes are inefficien When securiies are issued When firms are resrucured 5 Differen invesor behavior Inuiive invesor: Passive invesor: Sock screeners: Fundamenal invesor: Rely on heir own insinc Trus he marke efficiency Trade on a rule of humb Relies on fundamenal analysis 6 2

3 The Process of Fundamenal Analysis Knowing he Business Analyzing Informaion Forecasing Payoffs Convering Payoffs o Valuaion Forecasing is a he hear of fundamenal analysis 7 Marke fficiency Marke efficiency is a simple applicaion of he heory of compeiion In compeiive markes here is no room for excess reurn If informaion is cosless, you should expec no reurn from using i Invesmens posiions based on cosless informaion should only yield normal reurn for such posiions. Noaer: An anomaly is a predicable abnormal reurn Valuaion implies ha he marke is no fully efficien If for example he P/B-meric conains informaion abou a sock s fuure profiabiliy ha is no refleced in he sock price, he phenomenon is consisen wih an inefficien marke. WHY? 8 2 Groups of Models 9 3

4 Models Based on Balance Shee Values () Balance Shee Going concern Break-up Value Liquidaion Value Wha is he basic problem aached o balance shee models? Wha is he relaion o inellecual capial? 0 Fixed Asses FIA Inangible asses 2 Propery, plans and equipmen quiy Minoriy ineress Long erm accruals (no ineres bearing) Pension obligaions Deferred ax liabiliy Oher accruals 9 0 quiy BV Minoriy M Long Term Accruals LTA 3 Long erm invesmens Long erm deb (ineres bearing) 2 Long Term Deb Curren Asses 4 Noaer: 5 6 Invenories Accouns receivable Shor-erm invesmens Shor-erm financial liabiliies (ineres bearing) 3 D CA 7 8 xcess cash and cash equivalens Operaing cash cash equivalens Shor-erm operaing liabiliies (no ineres bearing) 4 Curren Liabiliies CL When Consider Balance Shee Based Models? Low reurn on asses vs. Inrinsic Values The earnings are hard o predic The asses are easily used for differen purposes The differen operaions can be divided and sold separaely 2 4

5 Models based on Profi Numbers or Cash-Flows Fuure Sreams Dividends Div model Cash-Flows FCF model APV model arnings Muliples Normal arnings 3 The Income Saemen The firm s income saemen for any fuure year () + Revenues + R - Operaing xpenses - OpX - Depreciaion - DepX = Operaing Profi = OP (arnings Before Ineres and Taxes) (BIT) - Ineres xpense - IX = i * D- + Tax - IT= τ (OP IX) Noaer: = Ne Profi = NP arnings per share (PS ) = NP / # of shares 4 The Cash Flow Saemen The firm s ne cash flow for any fuure year () + Ne Profi + NP - Dividends paid - Div + Depreciaion - DepX - Increase in working Capial = WC - Increase in Ne Plan, Propery & quipmen - PP + Increase in Ineres-bearing deb + D + New issued equiy capial + NC = Ne cash flow = NCF 5 5

6 Models Based on Boh Sock and Flow Presen equiy and fuure flows The The RI RI --model model (Abnormal earning) Presen book book equiy equiy and and fuure fuure RI RI The VA model (conomic Value Added) Based on RI, bu adjused figures 6 Wha is Residual Income (abnormal earnings)? RI is defined as NP beyond he cos of equiy capial RI = NP, BV The residual income valuaion model saes ha he fundamenal value of equiy equals BV (book value of equiy) plus NPV of fuure residual income. T Noaer: FV BV + RIτ = τ s= τ + ( + k, τ ) = BV + NVP ( RIτ ) 7 Problem: Growh firms Fra id il annen kan vi høre følgende usagn: Veksaksjer er mer verd enn aksjer uen veks. Forklar kor i lys av kjen eori hva som menes med dee usagne. 8 6

7 3 Some Imporan Valuaion Models 9 The Dividend Model () Basic Logic = T P0 =? Div + P - P Div2 Div3 Div4 + P4 - P4 Div4... Noaer: Ignoring ransacion coss, he value of equiy equals he presen value of all fuure cash paymens from he firm o he owners Bu wha abou dividend irrelevancy? Dividends are disribuion no creaion of wealh. 20 The Dividend Model (2) DM and GM DM: GM: FV = FV P F T s= + PV Div = k g DPS = k g { [ Div ]} + Div + Div s The Gordon Model is based on he following assumpions: Fla yield curve Consan risk premium Infinie horizon (T Infiniy) Consan reenion raio Consan growh in dividends P F : The sock s fundamenal value k : Cos of equiy g Div : Periodic consan growh in dividend DPS: Dividends per share 2 7

8 The Dividend Model (3) GM rewrien I follows from GM ha: () Div = PS ( b) (2) gdiv = b RO (3) k = RO (- b): Payou raio b : Reenion raio (RO : Reurn on book equiy) (No abnormalearnings - why?) GM: F PS+ ( b) PS P = = k RO b RO ( b) = B ( b) WHY? B : Book valueof equiy per share 22 The Dividend Model (4) Deerminans of he Growh Rae in Dividends Percenage of PS paid as dividend - payou raio (-b) Rae of reurn on invesmens financed wih reained earnings (RO) Rae of reurn on invesmens financed wih new deb. Noaer: In equilibrium RO = k and changes in RO or k do no affec he sock value. 23 The Residual Income Model () The RI model is normally based on hree assumpions: quiy value equals he ne presen value of expeced dividends in a world wih ime consan ineres raes, and homogenous beliefs. ( A) : FV = s= + PV [ ( Div )] s 24 8

9 The Residual Income Model (2) Accouning is based on a clean surplus relaion (CSR) ( A2) : BV = BV Div = BV + NP Div BV + NP RI is defined as: δbv =, δdiv δnp = 0 δdiv ( D) : RI NP BV 25 The Residual Income Model (3) Ieraive subsiuion of (A2) and (D) ino (A) provides he RI model: ( M) : FV = BV + s= + PV [ RI ] s In order o provide a connecion beween observable accouning informaion and unobservable forecass of fuure RI an informaion dynamics is proposed: Noaer: ( A3) : RI+ = v + ωri + v + ε = γv + ε 2, +, + where omega and gamma are persisence parameers, and he epsilons are zero-mean noise erms. v is a variable conaining available informaion no ye capured by he accouns. 26 The Residual Income Model (4) How should oher informaion be defined? ( D2) : [ RI ] ωri f + v Subsiuion of (A3) ino (M) provides he following soluion: ( M 2) : FV = BV + α RI + α v 2 ω α =, k ω α 2 = ( k ω)( k γ ) 27 9

10 The Residual Income Model (5) A Numerical xample Assume he following LID: [ RI+ ] = ωri + v [ v + ] = γv Moreover, assume ha he regressed persisence parameers (regression coefficiens), omega and gamma, are 0,6 and 0,4 respecively. According o he model, he expeced values for RI and oher informaion are as shown in he able. Residual income oday 0 Omega 0,6 Oher informaion oday 6 Gamma 0,3 Time xpeced xpeced Residual Income Oher Informaion 0 0,000 4,000 2,000, ,400 0, ,400 0,08 4 3,348 0, ,04 0,00 6,234 0, ,744 0,00 8 0,447 0, ,268 0, ,6 0,000 0,097 0, xample A () Residual Income and he Value of quiy Assume ha a firm s asses are assessed in he books on Jan. s o USD mill. and ha he asses are financed wih USD 0.6 mill in ineres-bearing deb and USD 0.4 mill. in equiy. For he sake of simpliciy he firm will be liquidaed in 2 years. The firm s asses consis of cash (0 mill.) and PP ( mill). No fuure capial invesmens. There is no working capial, and he deb is repaid in wo equal pars a he end of 2002 and Depreciaion on fixed asses is USD 0.5 mill for 2002 and USD 0.5 mill Ineres expenses are forecased o USD 0.05 and for each of he wo years o come. Noaer: The firm is in no ax posiion, ne profi is forecased o USD 0.2 and USD 0.3 for 2002 and 2003 respecively. Cos of equiy capial is esimaed o 20 % p.a. Free cash is paid as dividends. The fundamenal value of equiy oday is USD 0.68 mill. 29 xample A (2) From he Income Saemens 2002 Operaing Profi 250,000 Ineres xpenses 50,000 Taxes 0 Ne Profi 200, Operaing Profi 325,000 Ineres xpenses 25,000 Taxes 0 Ne Profi 300,

11 xample A (3) The Balance Shee Dec 3h 200 Asses,000,000 PP,000,000 Cash 0 Dec 3h 2002 Asses 500,000 PP 500,000 Cash = 0 quiy 400,000 Deb 600,000 quiy 200,000 Deb 300,000 3 xample A (4) The Balance Shee Dec 3h 2003 Asses 0 PP 0 Cash 800, ,000 = 0 Noaer: quiy 0 Deb 0 RI(2002) = 0.2-0,20*0.4 = 20,000 RI(2003) = 0,3-0,20*0.2 = 260,000 KS K (2002) = = 400,000 KS K (2003) = = 500, xample A (5) Some Conclusions Jan. s 200 FV USD 0.68 mill. (fundamenal value of equiy) BV Inellecual Capial USD 0.28 mill. NPV(KS K FV) = NPV(KS K BV) = NPV(RI)= = = = 33

12 xample A (6) Some Conclusions If he fuure RO (reurn on book equiy) is expeced o be equal o k, hen FV (fundamenal value of equiy) will be equal o BV (book value of equiy). RI = BV + NPV ( RI ) s = { +,..., T} s RI = NP BV = 0 NP = 0 BV RO = k If RO is expeced o be higher (lower) han k, hen FV will be higher (lower) han BV. 34 The Free Cash Flow Model () The FCF quiy mehod implies discouning a he ax adjused cos of equiy capial. The fundamenal value of equiy (FV) is calculaed sep-wise as follows: Forecas relevan accouning saemens Conver accouning saemens o free cash flows Noaer: Deermine arge capial srucure Compue he relevan cos of equiy capial Calculae he erminal value of FCF Discoun he free cash flows and he erminal value 35 The Free Cash Flow Model (2) Wih erminal value N Wihou e rminal value quiy FV = PV { FCFs } T quiy s= + FV = PV { FCFs } s= + quiy PV { FCFs } Some ypical problems: Wha abou excess liquidiy? How o rea financial asses? s= N

13 The Free Cash Flow Model (3) The Terminal Value In he long run we projec ha he firm s sales will grow a he long-run growh rae of he economy. The erminal value can be esimaed by means of: DCF The formula for a consan growh series, which in he case of infinie life is he Gordon Model (see Inroducion). Muliples 37 The Free Cash Flow Model (3) The Terminal Value Assume ha: I follows hen: FCF = FCF ( + g N + N FCF FVT FCFN g + = FCF ) + g + k FCF T Noaer: Infinie life In he case of infinie life (T ) he second erm is canceled ou FVT FCF N + = gfcf 38 The Free Cash Flow Model (4) The Terminal Value Terminal value a ime N+ (VT N+ ) N+0 N+20 N+30 Infiniy g = 0,05 g = 0,09 g = 0,3 Assume ha FCF N+ = and ha he WACC is 5 % p.a. 39 3

14 The Free Cash Flow Model (5) Terminal Value by Means of Muliples VT VT ( Mul.) = R Ohers Firm No based on pricing heory R is usually earnings, sales or book equiy R 40 The Free Cash Flow Model (6) Disadvanages of he DCF model Too much of he value will ofen be referred o he erminal value (60-80%) Some research show ha models based on hisoric earnings numbers beer predic fuure cash-flows han hisoric cash-flows The erminal value is very sensiive owards changes in he growh rae Noaer: ffecs of parameer uncerainy is no capured in he model, and can lead o biased value esimaes. 4 xample B () Valuaion - FCF American Casino (AC) has been in exisence for en years. AC s income (ne profi) for hese years is exhibied in he able below Year A C s ea rn in g s % change in A C s earning s % change in aggr. m arke earnings

15 xample B (2) Valuaion - FCF Moreover, assume ha AC s curren earnings of $37.2 mill. are expeced o grow a an annual rae of 5 % for he nex five years and a a rae of 6% hereafer. AC has capial expendiures of $3 mill. and depreciaion of $ 8 mill. currenly. These iems are expeced o grow a an annual rae of 8 % he nex five years and a a rae of 6 % a year hereafer. The bea is expeced o be.9 he firs five years and.0 hereafer. The relevan discoun rae is 3.6 % and 3.05 respecively for year -5 and 6 -. The presen value of AC s deb is $ 00 mill. Calculae he equiy value of AC by discouning he FCF 43 The expeced FCF, year - 5 for AC: xample B (3) Valuaion - FCF OPAT (CI DepC) Noaer: Working Cap FCF PV[FCF] Presen value of FCF year -5 : xample B (4) Valuaion - FCF [ ] PV FCF 5 = Presen value of FCF year 6 - : 67.97, [ ] = 540 PV FCF 6 = Presen value of FCF = = USD 73 mill. FV = = $ 63mill 45 5