Cornell University 2013 United Fresh Produce Executive Development Program. Valuation. March 11th, Copyright 2013 by Rich Curtis

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2 Valuation Topics A. What Do We Want to Value? B. What is Value? C. Examples of Valuation Methods for Common Stock D. Do Markets Always Correctly Value Assets? E. Common Stock Valuation Based on Multiples of Financial Variables For Comparable Companies F. The Ultimate Source of Value for Financial Assets G. Common Stock Valuation Based on Cash Flows H. Common Stock Valuation Dividend Discount Models I. Dividend Discount Models What Defines Growth? J. Is Growth Always Good? Capital Budgeting Meets Dividend Policy K. Conclusions: How Can You Increase Value For Stockholders? 2

3 A. What Do We Want to Value? Financial Assets Physical Assets Projects Brands 3

There are 2 ways we could estimate the value of

Balance Sheet Liabilities Assets Preferred

4 There are 2 ways we could estimate the value of all the firm s common stock (i.e. its Market capitalization or Market Cap ) Balance Sheet Liabilities Assets Preferred Stock Common Stock 1. Value the Stock Directly, or 2. Value the Firm and Subtract the Value of Debt and Preferred Stock 4

5 Then divide the estimated market capitalization by the number of common shares to get the price per share. 5

6 Let s Talk About Valuing the Common Stock Directly 6

7 B. What is Value? Oscar Wilde: A cynic is a man who knows the price of everything but the value of nothing. Warren Buffett: Price is what you pay, value is what you get. Value Picks -- Stocks, Wine, Restaurants, NFL Draft Picks 7

8 C. Examples of Valuation Methods for Common Stock 1. Based on Comparable Firms Relative Valuation a. Based on a multiple of earnings b. Based on a multiple of book value c. Based on a multiple of Free Cash Flow 2. Based on Cash Flows Intrinsic Valuation a. Based on Dividends (Dividend Discount Models) b. Based on Free Cash Flow 8

9 3. Based on the estimated breakup value of the firm (the market price of the firm if it is sold off in pieces) 4. Based on the estimated value of the firm after financial restructuring 5. Based on the value of the firm as a takeover candidate 6. Based on the replacement value of the firm s assets 7. Based on Castles In The Air The Greater Fool Theory 9

10 D. Do Markets Always Correctly Value Assets? Valuation is tricky and imprecise a science, but also an art. Reasonable people can disagree. Just because something goes down in price doesn t mean it was overvalued, and just because something goes up in price doesn t mean it was undervalued. 10

11 Shortly after its initial public offering in 1999, etoys stock value was $8 billion, exceeding the $6 billion value of the long-established brick and mortar retailer Toys R Us. And yet in fiscal 1998 etoys sales were $30 million, while Toys R Us sales were $11.2 billion, almost 400 times larger. And etoys profits were a negative $28.6 million, while Toys R Us profits were a positive $376 million. From Irrational Exuberance by Robert J. Shiller (P. 176) 11

12 Amazon - In April 1999, after increasing 4,800% in < 2 yrs., it has a market value over $30 billion - $30 billion was almost 10 times the combined market values of Borders and Barnes & Noble (with 1,000 stores apiece) - Amazon never had a profit to that point and lost $600 million that year Priceline - In October 1999, it had a peak market value that was more than half the equity of the entire U.S. airline industry From P. 73 of Jeremy Siegel s The Future for Investors 12

13 The takeaway? Valuation of many financial assets is a very difficult, imprecise exercise. 13

14 E. Common Stock Valuation Based on Multiples of Financial Variables For Comparable Companies Analogy: My height is 69 inches. What s my weight? Some data (from guys): Weight (lbs.) Height (in.) Weight/Height (lbs./in.) Student # Student # Student # Student # Student # Mean = 2.60 Median = lbs./in. x 69 in. = lbs., or 2.57 lbs./in. x 69 in. = lbs. 14

15 So, Estimated Weight = Weight Height Comparables x My Height Analogously, Estimated Stock Price = Estimated Stock Price = Stock Price Earnings Stock Price Book Value Comparables Comparables x Firm' s Earnings x Firm' s Book Value Estimated Stock Price = Stock Price Free Cash Flow Per Share Comparables x Firm s Free Cash Flow Per Share Cash From Operations Minus Capital Expenditures 15

16 For General Mills (GIS, Industry = Food Major Diversified) Estimated Stock Price = Price x General Mills' Earnings Earnings Comparables = x $2.71/share = $55.31 Estimated Stock Price = Price x General Mills Book Value Book Value Comparables = 2.93 x $10.81/share = $31.67 Is there any reason to suspect that the first calculation may be high? That the second calculation may be too low? General Mills closed at $46.43 on March 6 th,

17 Does valuation based on comps give a good measure of intrinsic value? 17

18 Problem: Estimate Apple s common stock price per share given that: 1. Analysts expect Apple to earn $44.56/share for the year ending Analysts expect Apple to earn $50.51/share for the year ending , and 3. Analysts expect Apple s earnings to grow at 18.98%/year for the next 5 years. Assume that Apple has a beta of.74 so it is less risky than the market. Apple s P/E ratio based on this year s estimated earnings is 9.7 (= $432/$44.56). The S&P 500 P/E ratio based on trailing twelve months (TTM) earnings is close to 18 and historically has averaged roughly 15 (but can fluctuate greatly around that number). Apple currently has around $137 billion (or $145/share) in cash, cash equivalents, and investments. 18

19 Estimates: Somewhat Pessimistic: Apple Tax to Repatriate Funds Individual Investor Tax on Dividends P Apple Common = (10 x $40/share) + (1-.35)(1-.35)($145/share) = $400 + $61.26 = $ Somewhat Optimistic: P Apple Common = (20 x $50/share) + ($145/share) = $1,000 + $145 = $1,145 What s Apple s PEG Ratio? PEG = P/E Growth = =

20 F. The Ultimate Source of Value For Financial Assets Question: What is the ultimate source of value for financial assets? Answer: The estimated future cash flows which would go to the owner of the asset. But those future cash flows have to be discounted back to get today s worth (i.e. present value) at a rate which reflects the riskiness of those cash flows. 20

21 Valuation of Assets: Asset Cash Flows Discount Rate Bonds Interest & Principal Cost of Debt Common Cash Flows to Cost of Stock Common Stockholders (Common) Equity Firm Cash Flows to Weighted Average the Firm (All Investors) Cost of Capital (WACC) Project Project s Cash Flows Discount Rate Appropriate To The Risk of the Project 21

22 Problem 1: What is the Present Value of $1,000 received annually forever starting one year from now if the appropriate discount rate is 10%? (Try to think it through logically without using a formula. How much money would you need to invest today to give you a $1,000 cash inflow every year forever if you earned 10% per year?) $ $1,000 $ $ $1,000 $1,000 Total Present Value = $1,000/.10 = $10,000 $ $1,000 Total =?? Time

23 Problem 2: What is the Present Value of cash flows which start at $1,000 at Time 1, but grow 6% per year forever? The discount rate is still 10%. Don t try to solve this just tell me whether the answer is less than or greater than the answer in Problem 1, and why. $ $1, $ $1, $ $ $1,000 Total =?? $1,060 Total Present Value = $1,000 / ( ) = $25,000 Time

24 G. Common Stock Valuation Based on Cash Flows What Cash Flows? Today's Stock Price = (P 0 ) Cash Flow to Common at Time 1 (1+Cost of Equity) 1 + Cash Flow to Common at Time 2 (1+Cost of Equity) Stockholders Expected or Required Return 24

25 H. Common Stock Valuation -- Dividend Discount Models P 0 = Dividend at Time 1 Dividend at Time 2 Dividend at Time (1+Cost of Equity) 1 (1+Cost of Equity) 2 (1+Cost of Equity) If the dividends grow at a constant rate g (e.g. 4%) after Time 1, then the above formula becomes: Today's Stock Price = Dividend Over Next 12 Months Cost of Equity - Growth Rate This is called the Gordon Growth Model and is based on the assumption that the cash flows grow at a constant rate after Time 1. The cost of equity must be greater than the growth rate of the cash flows. 25

26 Problem: If the appropriate annual discount rate (e.g. cost of equity) is 7.9%, what is the present value of DTE Energy s future dividend stream assuming that the next dividend is $2.48 at Time 1 and dividends grow at the rate of 4.61% per year after that? Note: In the stock valuation context, the discount rate is called the cost of equity. It is the return prospective stockholders require or demand in order to entice them to buy the common stock. The higher the return prospective stockholders require (perhaps because they view the stock as riskier), the lower the price they are willing to pay today. 26

27 P 0 $2.48 $2.59 $ Time P 0 = Cash Flows Over Next 12 Months Discount Rate - Growth Rate of Annual Cash Flows if the Discount Rate is greater than the Growth Rate 27

28 Answer: The estimated cash flow at Time 1 is $2.48, the estimated cash flow at Time 2 is $2.59, the estimated cash flow at Time 3 is $2.71, etc. Thus, since the discount rate (7.9%) is greater than the growth rate (4.61%): Stock Price Today = Dividend Over Next 12 Months Discount Rate - Growth Rate = $ Gordon Growth Model = $75.38 DTE closed Wednesday, March 6th, 2013 at $ If the Growth Rate = 0%, then the Present Value = $ What can managers do to potentially increase the stock price and create value for shareholders? 28

29 I. Dividend Discount Models What Defines Growth? In the context of dividend discount models, the present value of the estimated future dividends is our estimate of the current stock price. What causes the stock price to change, and are any of those variables potentially under the control of management? 1. The current dividend 2. The riskiness of the dividend, and 3. The growth rate of the dividends 29

30 If the Discount Rate is greater than the Growth Rate, then we saw that : Current Stock Price = Dividends Over Next 12 Months Discount Rate - Growth Rate of Annual Cash Flows = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Risk & Interest Rates Reinvestment Rate x Return on Equity (ROE) Net Margin x Asset Turnover x Financial Leverage If you invest in any and all positive NPV projects, (i.e. projects having a Return on Equity greater than the Discount Rate ), you should in theory maximize your stock price!!!! 30

31 Note that organic growth is given by: Earnings Growth Rate = Reinvestment Rate x Return on Equity What s the intuition? Time Reinvested Equity (50%) - $10 $11 $12.10 $13.31 Invested Equity $100 $110 $121 $ $ Return on Equity (20%) Earnings $20 $22 $24.20 $26.62 $ We see that the growth rate of earnings (.10 or 10% per year) equals the reinvestment rate (.5) times the return on those equity investments (.20).

32 1. Return on Equity = Net Income Book Value of Equity Beginning of Year Example: If E = Net Income = $10 Million and Equity Book Value = $60 Million, ROE = $10 M/$60 M =.1667 or 16.67% It s a measure of how well management is utilizing the capital that stockholders have put into the firm. 32

33 2. Du Pont Identity Return on Assets Return on Equity = Net Income S/H's Equity = Net Income Sales x Sales Assets x Assets S/H's Equity Beginning of Year Net Margin Asset Turnover Financial Leverage Does this expression suggest some strategic alternatives? Can you name companies which are high on any of the 3 measures? What are the red flags? 33

34 Return on Assets Return on Equity = Net Income S/H's Equity = Net Income Sales x Sales Assets x Assets S/H's Equity Beginning of Year Net Margin Asset Turnover Financial Leverage : WalMart.2201 = $ B $ B x $ B $ B x $ B $ B = x x : Whole Foods.1224 = $.4656 B $ B x $ B $ B x $ B $ B = x x

35 Net Asset Company Year Margin Turnover Leverage ROE Walmart % % % % % % % % Whole Foods % % % % % % % % Safeway % % % % % % % % 35

36 Net Asset Company Year Margin Turnover Leverage ROE Best Buy % % % % % % Tiffany % % % % % % Microsoft % % % % % % Coach % % % % % % 36

37 Does a high Return on Equity guarantee that stockholders will do well over every holding period of the stock? 37

Return on Equity Hershey' s, 2012 = Net Income 2012 Book Value of Equity 12-31- 11 = $660.931 M $857.317 M =.7709 or 77.

38 Return on Equity Hershey' s, 2012 = Net Income 2012 Book Value of Equity = $ M $ M =.7709 or 77.09% However, a stockholder s 2012 return based on market value was more like +19.4%: ($1.56+$72.22) - $61.78 $61.78 = or % 38

39 Hershey s Hershey s Accounting Stockholder Year Return on Equity Return % -6.2% % -16.6% % -5.7% % +6.4% % +39.2% % +37.4% % +19.4% 39

40 I. Is Growth Always Good? Capital Budgeting Meets Dividend Policy Current Stock Price = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Can we automatically manufacture a stock price increase by reinvesting less and paying out more of our earnings to common stockholders via cash dividends and share repurchases (i.e. share buybacks)? Or is there a potential downside to increasing our dividend? 40

41 Current Stock Price = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Reinvestment Rate x Return on Equity (ROE) Net Margin x Asset Turnover x Financial Leverage Answer: Reinvesting less and increasing the dividend may or may not increase our stock price! The higher dividend will tend to push up the stock price, but less reinvestment may reduce growth (assuming we have good projects) and reduced growth tends to lower the stock price. If you invest in any and all positive NPV projects, (i.e. projects having a Return on Equity greater than the Discount Rate ), you should in theory maximize your stock price!!!! 41

42 J. Conclusions: How Can You Increase Value For Stockholders? 1. Undertake Positive NPV Projects!!!! Use Risk-Adjusted Discount Rates! Same Thing 2. Invest Internally Only If You Can Earn A Return On Capital Greater Than The Project s Risk-Adjusted Cost of That Capital!! Otherwise Pay Cash Dividends or Repurchase Shares! 3. Align Management s Interests With Stockholders a. Give Management Stock Options (but not too many!!) b. Tie Bonuses & Promotions at Least Partially To a Budgeted Economic Value Added (EVA): EVA = (Return on Capital - Cost of Capital) x Capital Employed 42

43 4. Value is created for stockholders by earning a return on capital which is greater than the cost of that capital. The cost of capital reflects what the investor can earn elsewhere on investments of similar risk (their opportunity cost). This will occur if each project earns more than its risk adjusted discount rate (i.e. has positive NPV)!! 43

44 5. Organic growth in net income comes from reinvesting profits in projects generating a positive (> 0%) return. HOWEVER, growth which creates value for shareholders ONLY comes from reinvesting profits in projects earning more than the investors total risk-adjusted required return. DO NOT invest in projects earning less than their risk-adjusted hurdle rate just for the sake of increasing revenues and income. Firm Value = Invested Capital + Present Value of Future (Returns on Capital - Costs of Capital) EVA or Economic Profit Model 44

45 6. Focus on the key value drivers in your business! a. Your ability to deliver a commodity at the lowest price? b. Your reputation for service? c. Providing a unique, pleasurable experience for customers? d. Your ability to create added value at a cost less than customers are willing to pay? e. Beating competitors to the market with unique, innovative offerings? f. Your ability to build brands? g. Other things? 45

46 7. In addition, value may also be created by: a. Utilizing modest amounts of debt financing due to the deductibility of interest expense and the consequent reduction in the tax bill, and b. Making acquisitions IF the value of what you re acquiring is less than the cash or stock you re giving up to facilitate the acquisition. 46

47 Good Luck It s Been a Pleasure!!

48 The End

Cornell University 2016 United Fresh Produce Executive Development Program

Cornell University 2016 United Fresh Produce Executive Development Program Corporate Financial Strategic Policy Decisions, Firm Valuation, and How Managers Impact Their Company s Stock Price March 7th,