UNIVERSITY OF SOUTHERN CALIFORNIA



UNIVERSITY OF SOUTHERN CALIFORNIA

Marshall School of Business

Spring 2010

FBE 529 Tuesday, Thursday Class; JKP 210

Financial Analysis and Valuation

Instructor: Lloyd Levitin

Time: 11:00 am – 12:20 pm

Office: Accounting 301E

Office Hours: T, Th, 10-10:45 A.M.; W 5-6 P.M., and by appointment

Office Phone (USC): 213-740-6524

Office Phone (Home): 310-858-0260

Email Address: levitin@marshall.usc.edu (preferred method of communication)

Teaching Assistant: Mark Schwartzman(mark.schwartzman.2010@marshall.usc.edu)

Office hours TBA

Course Website: On Blackboard

COURSE OBJECTIVE

Understanding what determines the value of a firm and how to estimate that value is a prerequisite for making rational business decisions. Entire industries (investment banking, securities analysis, and consulting) have grown prosperous providing valuation skills to investors and managers. The objective of this course is to give a general grounding in the valuation approaches used by successful practitioners. We cover discounted cash flow models, market multiple models, as well as specialized models used for M&A transactions and LBOs. We focus on valuation of businesses at the divisional and corporate levels. The course emphasizes practical and “real world” applications of valuation methodologies. The course is of interest to those contemplating careers in investment banking, security analysis, consulting, private equity, and corporate finance. And it will also help with personal investing. The course will be in the form of lectures, discussions, and group projects.

By the end of the course, students should be able to:

• Determine the valuation for any public or private company whether for purchase or sale, investment of a minority interest, going public in an IPO, implementing a LBO, or a restructuring.

• See clearly how industry fundamentals and competitive forces directly impact financial results and, in the process, drive stock valuation.

• Assess whether a company is creating value for its shareholders.

• Pull apart the financial statements to get at the relevant information for valuing equities.

• To identify “red flags” that indicate manipulation of financial statements and/or an impending liquidity crisis.

VALUATION REQUIRES A SKILL SET THAT COMBINES BOTH ART AND SCIENCE

Various valuation models and formulae will be taught in this class. Learning how to plug numbers into models and formulae to produce a valuation answer is the easy part. The quality that separates winners from losers in the world of valuation is the ability to decide which information to use under the circumstances and what assumptions to make that become inputs to the models and formulae. In other words, one has to exercise good judgment to be a winner. This course will sharpen your skills in making these judgments.

Walter Wriston, former Chairman of Citibank, said “Judgment comes from experience – and experience comes from bad judgment.” The instructor will provide cases from his business career and his knowledge of valuation successes and failures of others to help students sharpen their ability to improve decision making. In the financial world, judgment is the quality that can make the difference between success and failure in one’s career.

REQUIRED COURSE MATERIALS

1. Instructor’s Corporate Valuation Handbook to be posted to “Blackboard”.

2. Textbook: Investment Banking: Valuation, Leveraged Buyouts and Mergers and Acquisitions, by Joshua Rosenbaum, Joshua Pearl, 2009, John Wiley & Sons, Inc.

3. Financial calculator capable of performing discounted cash flows (please bring calculator to each class).

INSTRUCTOR’S CORPORATE VALUATION HANDBOOK

Chapters from the Valuation Handbook will be posted as they are available.

List of Chapters

1. Valuation Approaches

2. How Value Is Created

3. Understanding The Business

4. Evaluating A Firm’s Historical Financial Performance

5. Cost of Capital

6. Valuation Using Enterprise DCF Model

7. Other DCF Models

8. Market Multiples

9. M&A Transactions

10. LBO Transactions

11. Restructuring Transactions

12. Valuation Summary

INSTRUCTOR’S VALUATION WORKBOOK

The Workbook contains exercises and problems to help you master financial valuation. These exercises and problems are organized to follow each of the chapters in the corporate valuation handbook. Solutions are also provided. These problems, with solutions, will be an excellent resource for exams. Most of these problems are from past exams.

TEXTBOOK

The textbook, Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions, is a step-by-step approach to performing the primary valuation models complete with very useful model templates. The group projects will utilize these templates. The text also provides a comprehensive overview of the fundamentals of LBOs and an organized M&A sales process.

GRADING

30% of your grade will be based on a Valuation Project done by groups.

15% of your grade will be based on your class participation.

20% of your grade will be based on the Midterm.

25% of your grade will be based on the Final.

10% of your grade will be based upon an evaluation of your peers on your

contribution to the work done in teams

GROUP VALUATION PROJECT (30% of your grade)

The purpose of this project is for you to apply what you have learned in class, including how to analyze the financial performance of a company, and how to value it applying the valuation techniques presented in the course. In addition, you will gain a deep understanding of the company that you have decided to do your project on and its industry. I do not care whether you give the stock a buy, hold, or sell recommendation. I will be grading your project based on the quality of your analysis, how well you support your assumptions and apply the valuation models, the judgment you exercise, and on the professionalism of your presentations. My goal is for you to create an analyst report that you are proud of and would be comfortable sharing with a potential employer. In order to encourage you to work on this assignment throughout the semester, this project is broken down into 7 modules, each one due at a different date. Modules 2-7 will be graded on a 1-5 point basis. Thus, the entire project is worth 30% of your grade (6 models x 5%) each. The material to be included in each module, and the due date is indicated in the attached Topics, Readings, and Assignments. The due dates are scheduled to provide class time and readings prior to the work. The project is to be done in groups.

Students are to organize themselves into groups of 4-8 students by the second day of class and elect a team leader who in turn notifies the teaching assistant by January 15 of the names of group members. The team leader is responsible to equitably allocate the required work for a given module, and draw together each participant’s work to hand in when due. If you have problems finding a group, you must let the teaching assistant know by January 15, and he will assign you to groups already formed, and notify the welcoming group. Groups, once formed, cannot be changed without unanimous written consent of all members. Grades on group projects will be posted to Blackboard. You have 2 weeks from the time of posting to inform the Instructor of any error in posting.

CLASS PARTICIPATION (15% of your grade)

Class participation counts 15% of your grade. Of this, two-thirds (10% of your grade) will be based on oral reports on your Valuation Project. On each due date for Modules #2-7, one or two groups will be called upon to present their analysis. You should use PowerPoint slides and/or handouts to facilitate your presentation. You should expect your group to be called upon twice (for two of seven modules), and the dates you are scheduled will be posted on Blackboard at least one week before due date.

The remainder of your class participation grade (5% of your grade) will be based on classroom attendance, volunteering to answer questions posed to the class, and displaying your name card.

You are expected to attend every class. If, for extenuating reasons, you are not able to attend class on a particular day, I will assume that it is for an important reason. Therefore, I do not need to be told the reason.

MIDTERM (20% of your grade)

The midterm will be closed-book, closed notes. However, a formula sheet will be attached to the exam. Laptops or any hand-held device with email capabilities cannot be used in an exam. You should bring a calculator to perform calculations. If you are unable to take a midterm, the following rules apply:

1) If you fail to inform me in writing before the midterm begins, you will receive a zero grade, even if you have a valid excuse. An exception will be made if you have a note from your doctor that you were unable to communicate your excuse.

2) If you inform me in writing before the midterm begins, and you have an acceptable excuse, then at my discretion, either a make-up exam will be given, or the final exam will count 45% of your grade.

FINAL EXAM (25% of your grade)

A final examination will be held in the regularly-scheduled final exam period for this class. The exam will be closed-book, closed-notes. However, a formula sheet will be attached to the exam. The final exam is cumulative from the beginning of the course. Laptops or any hand-held device with email capabilities cannot be used. You should bring a calculator to perform calculations.

PEER EVALUATION (10% of your grade)

Study groups provide a valuable learning experience – how to work effectively and efficiently in groups (a common practice in Corporate America), learning from others, and sharpening a student’s ability to communicate to others. However, human nature being what it is, some students are tempted to relax and let others carry their load. In order to provide an incentive for all students to make maximum contributions to the study group, students will be asked to grade each team member’s contributions on a 0 to 10 point scale. This evaluation is to be submitted by email to the Instructor before the last day of classes. Any team member who does not email his (her) evaluation of team members will be deemed to have given a 10 point score to each member of the team.

ABOUT YOUR INSTRUCTOR

Lloyd Levitin is a Professor of Clinical Finance and Business Economics at Marshall. He was Executive Vice President and CFO of Pacific Enterprises from 1982-1995 (now Sempra Energy), and was actively involved in the firm’s diversification program which included numerous acquisitions. He testified as an expert on utility diversification to the Senate Finance Committee of the U.S. Congress and has been a consultant for JurEcon, Inc., a nationwide consulting and research firm for management and counsel. He has a MBA from Wharton and a JD from University of San Francisco. He practiced as a CPA after receiving his MBA, and as an attorney after receiving his JD.

WHAT DO I EXPECT OF YOU?

1. Be prepared for class. I will be. We will all benefit from this and we will be able to cover more ground.

2. Turn in group projects on time. If they are turned in late (after start of class on day it is due) you will be penalized.

3. Ask questions. There are no “dumb” questions and we all benefit from clarification.

4. Do not wait until the last minute to do the required module of the Valuation Project. You just can’t do a good job in a crammed time period.

5. Be on time! Don’t leave early!

6. If you are having a problem, let me know. I cannot help you if I do not know of your problem.

7. Laptops are not to be opened in class.

UNCLAIMED PAPERWORK

Returned assignments unclaimed by a student will be discarded after two weeks, and hence, will not be available should a grade appeal be pursued by a student following receipt of his/her course grade.

EXTRA-CREDIT ASSIGNMENTS

In fairness to other students, there will be no extra-credit assignments. Requests for extra-credit assignments to make up poor performance on a test will not be granted.

ACADEMIC INTEGRITY

The use of unauthorized material, communication with fellow students during an examination, attempting to benefit from the work of another student, and similar behavior that defeats the intent of an examination or other class work, is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions accompanying examinations. Where a clear

violation has occurred, however, the Instructor may disqualify the student’s work as unacceptable and assign a failing mark on the paper.

STUDENT DISABILITY

Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to be as early in the semester as possible. DSP is located in STU 301 and is open 8:30 AM to 5:00 PM, Monday through Friday. The phone number for DSP is (213) 740-0776.

TOPICS, READINGS AND ASSIGNMENTS

| | | |Valuation Group |

|Date |Class Topics |Reading Assignments |Project Due* |

|Jan. 12 |Valuation Approaches |Valuation Handbook (VH) – Chapter 1 | |

|Jan. 14 |How Value Is Created |VH – Chapter 2 | |

|Jan. 19 |How Value Is Created - continued | |Module #1 |

|Jan. 21 |Understanding the Business |VH – Chapter 3 | |

|Jan. 26 |Evaluation of a Firm’s Historical Financial |VH- Chapter 4 | |

| |Performance | | |

|Jan. 28 |Evaluation of a Firm’s Historical Financial | |Module #2 |

| |Performance – continued | | |

|Feb. 2 |Evaluation of Firm’s Historical Financial | | |

| |Performance – continued | | |

|Feb. 4 |Evaluation of Firm’s Historical Financial | | |

| |Performance – continued | | |

|Feb. 9 |Cost of capital |VH – Chapter 5 | |

|Feb. 11 |Enterprise DCF Model |VH – Chapter 6 |Module #3 |

|Feb. 16 |Enterprise DCF Model – continued |Text – pages 6-8 | |

|Feb. 18 |Enterprise DCF Model – continued |Text – Chapter 3: pages 109-131 | |

|Feb. 23 |Enterprise DCF Model – continued |Text – Chapter 3: pages 131-157 |Module #4 |

|Feb. 25 |Review | | |

|Mar. 2 |MIDTERM | | |

|Mar. 4 |Other DCF Models |VH – Chapter 7 | |

|Mar. 9 |Other DCF Models - continued | | |

|Mar. 11 |Market Multiples |VH – Chapter 8 | |

|Mar. 23 |Market Multiples – continued |Text – Chapter 1: pages 11-47 | |

|Mar. 25 |Market Multiples – continued |Text – Chapter 1: pages 48-70 |Module #5 |

|Mar. 30 |M&A Transactions |VH – Chapter 9 | |

|Apr. 1 |M&A Transactions – continued |Text – Chapter 2 | |

|Apr. 6 |M&A Transactions – continued | | |

| | | | |

| | | |Valuation Group |

|Date |Class Topics |Reading Assignments |Project Due |

|Apr. 8 |M&A Transactions – continued | | |

|Apr. 13 |LBO Transactions |VH – Chapter 10 |Module #6 |

|Apr. 15 |LBO Transactions – continued |Text – Chapter 4 | |

|Apr. 20 |LBO Transactions – continued |Text – Chapter 5 | |

|Apr. 22 |Restructuring |VH – Chapter 11 | |

|Apr. 27 |Restructuring – continued | |Module #7 |

|Apr. 29 |Valuation Summary |VH – Chapter 12 | |

|May 1 |FINAL EXAM | | |

| |11am – 1 pm. | | |

*Requirements for Modules #1-7 on pages 9-13.

MODULE #1 – Due January 19

SELECTING THE COMPANY TO VALUE

1. Read Standard & Poor’s industry survey for Food and Nonalcoholic Beverages. It is available in Marshall Electronic Library. Study carefully the sections on Industry Trends, How The Industry Operates, Key Industry Ratios and Statistics, and How To Analyze A Food or Beverage Company. To access the survey go to Standard & Poor’s Net Advantage in drop down menu.

2. Pick a publicly traded food and nonalcoholic beverage company to prepare your valuation report on from the Comparative Company Analysis section.

3. Each group must have a different company. Email TA your first, second and third preference by January 19. The TA will notify you of the company you are assigned based on first come, first served.

MODULE #2 – Due January 28

UNDERSTANDING THE BUSINESS

Industry Analysis

1. Discuss the economic characteristics of the Food and Nonalcoholic Beverages industry. Use Porter’s five force framework.

2. Discuss recent and long-term industry trends and the relevant impact on future industry growth and profitability. If possible, relate these trends to Porter’s five forces.

3. Based on your discussion in questions 1 and 2, what is your opinion as to future industry profitability and growth? Discuss whether you believe growth will be more than, at, or less than GDP growth and whether profitability will be more than, at, or less than the average industry profitability over the previous 5 years.

Company Analysis

4. What are the competitive advantages (if any) of your company? If your company has competitive advantages, determine if they are sustainable and how long that sustainability might last. Discuss your reasoning.

5. What is your opinion regarding your company’s future profitability? If you conclude that future returns on capital of your company will exceed future average industry returns, how long do you expect your company to enjoy this? Discuss your reasoning.

6. What are the growth prospects for your company? Discuss your answer in terms of more than, at, or less than future average industry growth. Relate your answer to the competitive advantages (if any) that your company holds.

MODULE #3 – Due February 11

EVALUATION OF HISTORICAL FINANCIAL PERFORMANCE

1. Prepare a 3-year time series analysis of your company using the template in Appendix B to Chapter 4. In case of nonrecurring items, only show adjusted ratios. Discuss possible reasons for any unusual changes. Average the 3-year data.

2. Prepare a qualitative analysis of your company covering:

a. Your assessment of the management

b. Your assessment of the risk to future company performance

3. Identify five companies in the Food and Nonalcoholic Beverages industry that are the closest match to your company in terms of business and financial characteristics. For financial characteristics, consider size, margins, growth, return on equity and credit statistics.

4. For each of the five industry peers selected in #3 above, perform the same analysis you did in question #1 for the company you are valuing. Calculate median ratios for the five industry peers. Discuss any trends for the industry your cross-sectional analysis reveals.

5. Compare your company’s ratios computed in #1 above to the industry peer median ratios computed in #4 above. Discuss how your company compares to peer performance. What does this cross-sectional analysis tell you about your company’s competitive advantages?

6. Based on your analyses, do you expect your company to have market multiples higher, lower, or about equal to the average peer?

MODULE #4 – Due February 23

CALCULATION OF COST OF CAPITAL

1. Estimate WACC for the company you are valuing. To the extent you can, use the template for DCF Analysis, tab WACC, provided at go/investmentbanking. The password is wiley09. Note: When opening the models in Microsoft Excel, please ensure that you perform the following procedure: in the main toolbar select Tools, select Options, select the “Calculation” tab, select Manual, select Iteration, and set “Maximum Iterations:” to 1000 (also see Chapter 3, Exhibit 3.30). The model templates on the website are formatted with yellow shading and blue font to denote manual input cells. Black font denotes formula cells. In the text, however, gray shading is used to denote manual input cells, where possible.

2. You are to provide your rationale and support for each of the assumptions underlying your WACC computation including:

• Risk-free rate

• Beta

• Market risk premium

• Cost of debt

• Target debt/capital and equity/capital weights

• Tax rate

3. WACC sensitivity analysis will be done in module 5.

MODULE #5 – Due March 25

DCF VALUATION

For the company you are valuing:

1. Value the common equity using the Enterprise DCF model. To the extent that you can, use the DCF Analysis template provided at go/investmentbanking.

The password is wiley09. Use Calendar Year 2010 as the first year in your forecast. Estimate terminal value using the perpetuity growth method.

2. Justify your selection of the forecast horizon, i.e. 5 years, 10 years, etc.

3. Calculate ROIC for each year of your forecast period including the terminal year and calculate the ROIC – WACC spread. Justify your ROIC estimates in light of industry fundamentals and the company’s competitive advantage and sustainability thereof (or lack of competitive advantage).

4. Discuss your sales growth assumptions in light of prospects for industry growth and company’s competitive advantage and sustainability thereof (or lack of competitive advantage).

5. Do a sensitivity analysis that includes the following:

a) Alternate estimates of WACC using different estimates of the market risk premium and target debt/capital weight

b) Alternate estimates of TV using different growth rates and WACC.

c) Alternate estimates of Enterprise Value and Equity Value using the results of both (a) and (b) above.

6. Develop a reasonable range of DCF values using the results of your sensitivity analysis in 5 above.

7. Compare the current stock price to the range of DCF values created in 6 above. If the current stock price does not fall within your range of DCF values, adjust your key DCF assumptions as to growth, return, and WACC so that the stock price clearly falls within your DCF range. Comment on whether you believe these revised DCF assumptions are in the zone of reasonableness.

MODULE #6 – Due April 13

MARKET MULTIPLES

For the company you are valuing:

1. Value the common equity using market multiple (comparable company) analysis. To the extent that you can, use the Comparable Companies Analysis Template provided at go/investmentbanking. The password is wiley09. See Tabs: List, Benchmarking 1, Benchmarking 2, Output, Target Co., MOMP. For comparables, you may use the five companies that you identified in Module #3. Use the most current stock price and market values available for these companies.

2. If you adjusted the mean or median multiples of the comparables to reflect the fundamentals of the company you are valuing, explain your reasoning.

MODULE #7 – Due April 27

VALUATION REPORT

Prepare your valuation report including following sections:

a. Table of Contents

b. Executive Summary

i. Capsule description of the company

ii. Major recent developments

iii. Valuation summary. Prepare a chart showing the range of equity values you obtained from application of Enterprise DCF model and comparable company valuation, and the current stock price.

iv. Recommendation (buy, hold, or sell). Explain your reasoning for your recommendation.

c. Business Summary

i. Company description

ii. Industry analysis

iii. Competitive analysis

iv. Corporate strategies

v. Historical performance

d. Risks

i. Possible negative industry developments

ii. Possible negative regulatory and legal developments

iii. Possible negative company developments

iv. Risks in the forecasts

e. Valuation

i. Description of models used

ii. DCF Analysis

iii. Market Multiple Analysis

iv. Valuation Range

v. Statement of Conclusions

f. Historical and Pro Forma Exhibits

• The written report should be no longer than five pages in length. An unlimited number of attachments (exhibits) are allowed and will not be counted in the five pages.

• Font size must be 10 or higher

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