Modelling and Valuation of real sector companies

Transcription

1 Modelling and Valuation of real sector companies Pitfalls and best practices Konstantin Fastovets

2 Main topics 1. General thoughts on valuation & forecasting 2. Modelling structure 3. Modelling detail 4. The valuation method 5. Other common pitfalls 6. Relative valuation 2

3 General thoughts on valuation & forecasting Valuation offers a method or a tool rather than a number Any output is conditional on a number of assumptions It is how those assumptions If you disagree with the market try to have an explanation for why the market is wrong Other participants are lacking the information that you have Other participants do not have resources dedicated to the same kind of analysis 3

4 Modelling structure Separate operations, financials, valuation, and, definitely, assumptions into a different sheet each Try to match columns (years) Color code, use comments To determine a proper structure start off by looking at the operating segments. Pay special attention to divisions that generate the bulk of the EBITDA 4

5 Modelling structure Remember EBITDA is generated by total sales, not only external ones 5

6 Modelling structure Treat each operating segment as a separate business This way you do not need to keep track of whether one segment sold enough raw materials to a different one (where your model can unbalance) Internal and external sales can alternate from year to year Unlike revenues or costs, EBITDA is additive 6

7 Modelling detail How detailed should your model be? 7

8 Modelling detail How detailed should your model be? Pros of detailed models: They reflect business processes more closely Assumptions are broken down into more pieces (COGS as a whole vs each component) They give the impression of being more correct, because they took longer to build Cons of detailed models: They are hard to update Valuation drivers can get lost in the detail The extra detail is not always impactful or can be projected in a meaningful manner The answer: ideally, it should contain all useful and impactful detail on which opinions can be formed Example modelling farming costs 8

9 Modelling detail If you adopt a 20/80 approach you only really care about operating segments that generate a meaningful amount of EBITDA In this example 79% of EBITDA has been generated by the coal and power generation division 9

10 Modelling detail Working with limited information Examples are abundant in Ukraine Usually you have a problem with costs and breaking them down Information on sales volumes and prices is often available 10

11 Modelling detail Working with limited information Examples are abundant in Ukraine Usually you have a problem with costs and breaking them down Information on sales volumes and prices is often available The answer use margins on per operating segment basis Margins allow you to estimate costs. In absence of a better approach bulking everything together actually works quite well Costs/t=Price/t EBITDA/t In the short term costs are fixed this is an excellent way to forecast near term earnings You can adjust costs based on information that is available to you (example iron ore into steel) 11

12 Modelling detail One remarkable characteristic of margins is that in the absence of structural changes on the market they tend to be mean reverting. This also works in absolute terms MHP farming EBITDA/ha, $ MHP poultry EBITDA/kg, $ Ferrexpo pellets, EBITDA/t Metinvest steel EBITDA/t, $

13 Modelling detail When you ve got structural changes, profits will reflect that and the price/cost spread will adjust accordingly. You can think of profits driving prices and costs rather than vice versa Kernel bulk oil, $/t Kernel grain trading, $/t new players entering new players entering

14 The modelling method Is there any difference between the discounted FCF and FCE approaches? What is the meaning of WACC? Errors are introduced when the WACC is used incorrectly 14

15 The modelling method deriving the WACC Start off with: E E ECF 1 Ke ECF 1 Ke 1 Ke ECF 1 Ke ECF 1 Ke 1 Ke E 1 Ke ECF E Therefore: The same logic goes for: [1] [2] Intertemporal form Derive what the discount rate for FCF needs to be for the following to hold EV 1 Ke EV 1 WACC FCF Since where FCF ECF D D D Kd 1 T EV E D We are proving: Combine [1], [2], and [5]: [4] Subtracting the tax shield from FCF is mostly a convention [5] where CFd D Kd D D [3] 15 Source: WACC: Definitions, Misconceptions, and Errors by Pablo Fernandez

16 The modelling method deriving the WACC Now plug in FCF and CFd definitions ([3] and [4]) to get: Which simplifies to: Solving for WACC: 16

17 The modelling method WACC use example TV ECF before change in debt ECF after change in debt Tax rate 2% 3% 4% 5% 6% 7% 10% Kd (interest rate) 8% 8% 8% 8% 8% 8% 8% Debt, bop After tax interest expense Change of debt FCF Ke 20% 20% 20% 20% 20% 20% 20% Equity, bop WACC 17% 17% 18% 17% 16% 15% 14% EV (discounted FCF), bop EV (equity + debt), bop 782 Terminal FCF growth rate 0.0% Equivalent ECF growth rate 0.0% Terminal Ke 20% Terminal Kd 8% Terminal WACC 14% D/E need to be assumed fixed Implications if you want to use WACC: You will have to calculate the fair value of equity first The cost of debt has to equal the cash interest rate (i.e. fair value and balance sheet value of debt need to match!) You have to assume a fixed D/E ratio setting a terminal growth rate on FCF implies growth rate of debt, which means that the equivalent FCE growth rate is actually much higher. In this example 3.0% 17 translates into 5.5%

18 The modelling method How to determine a proper cost of equity? Does the CAPM work well? 18

19 The modelling method How to determine a proper cost of equity? Does the CAPM work well? No, it works poorly because real markets do not fulfill the assumptions under which it is derived The overall market needs to be in equilibrium this implies that everything is already priced correctly A special relationship between an asset s return and the distribution of its returns is only achieved if everyone is holding the same optimal portfolio, which includes all assets present on the market 19

20 The modelling method deriving the CAPM Since 2, In the present of a risk free rate a portfolio s expected return can be expressed as: The variance of a portfolio s return in the sum of all entries in the table: The marginal contribution of a risky asset i to the expected portfolio is thus : The sum of the entries of the i th row and the i th column is the total contribution of asset ito portfolio variance: Source: Caltech lecture notes by J. Wang ( CAPM and APT ) 20

21 The modelling method deriving the CAPM The marginal contribution of asset i to portfolio variance is thus: In an optimal portfolio the ratio of marginal return to marginal risk must be the same across all included assets (otherwise you should be rebalancing) The marginal contribution of asset i to portfolio volatility (or standard deviation) is: Since it is also true for the market portfolio itself: Rewriting: Source: Caltech lecture notes by J. Wang ( CAPM and APT ) 21

22 The modelling method Empirical evidence shows that the CAPM did not work well over the last 30 years even on the US market Source: Fischer Black, Beta and return 22

23 The modelling method So what s the solution? Change your approach. The relationship between the cost of equity and the fair equity value is the same as that of a price of a bond to its yield You can: Calculate the implied cost of equity for similar companies on the market and the decide if there should be a premium Look at the cost of debt and add a premium In the end you can only answer the question what a fair equity value (or stock price) is, given a certain cost of equity. Demonstrate different results with different cost of equity assumptions Metinvest 2021 DTEK 2024 The best you can do for bonds is look at spreads FIUB 2018 Oschadbank Ferrexpo 2019 Ukrzaliznutsya 2021 Ukreximbank 2022 MHP 2020 Oschadbank 2025 Ukreximbank 2025 Kernel 2022 MHP Corporate Eurobonds Government Eurobonds

24 Other common pitfalls Earnings that grow out of nowhere Make sure capex compensates for D&A Make sure the company s investment projects are reasonable in terms of return You can model them separately to see their net effect Check your growth rate, especially if you re using FCF you could be generating most of your value from an unknown source Using unrealistic price assumptions Its fine to just assume the current price for commodities and assigning some sort of inflation to it otherwise make sure you know why the market is wrong and you re right Forgetting about currency risks. If the company s cash flow is mixed in hard currency and the hryvnia, make sure your discount rate reflects that 24

25 Relative valuation DCF vs relative valuation which one is better? Should you take averages? Maybe weighted averages? 25

26 Relative valuation DCF vs relative valuation which one is better? Should you take averages? Maybe weighted averages? No, the two approaches should be telling you the same thing. If they are not, figure out why (maybe one of them simply fails to work correctly). The bond analogy is duration Common pitfalls: The peer group does not operate in the same industry, or environment Financial year periods do not match Earnings metrics are calculated on a different basis The inclusion of JVs into EBITDA Revaluation effects Functional vs reporting currency during sharp exchange rate changes 26

27 Relative valuation an IAS 41 case study 27

28 Relative valuation an IAS 41 case study 28

29 Q&A 29