Chapter 6 – Prospective Analysis:



Chapter 7 – Prospective Analysis: Valuation Theory Basics

Problems: 7-2, 7-3, 7-7, 7-8, 7-9, Complete Auto Industry Valuation Sheet

Key Learning Outcomes

• Developing a broad set of valuation measures

• The ability to estimate the appropriate cost of capital

• Working with growth rates and terminal values (equilibrium)

• Valuation with Multiples (screening methods)

• Theory based valuation models

• Understanding the residual income and abnormal earnings valuation models

• Matching costs of capital with financial statement data and forecasts

• The ability to understand and measure Abnormal Earnings and Growth for terminal values

• Assessing the implied cost of capital given the current market price (value)

Earnings Multiples Valuation

(Method of Comparables)

1992 1993

Company EPS BPS DPS PPS EPS BPS DPS PPS

Chrysler 2.21 25.5 0.60 32.25 -7.62 19.3 0.65 53.25

Daimler-Benz Not Traded in US 0.74 21.7 8.01 48.63

Federal Signal 1.00 5.23 0.42 21.25 1.15 5.81 0.48 28.00

Ford Motor, Canada -35 64.2 0.00 85.5 -22.5 39.9 0.00 95.50

Ford Motor, US -15.6 30.1 1.60 42.88 4.55 31.2 1.60 64.50

General Motors, US -38.3 8.47 1.40 32.25 2.13 7.77 0.80 54.88

Honda Motor, Ltd. 0.67 18.31 0.24 25.50 0.47 19.3 0.27 32.38

Navistar, Intl. -0.95 0.37 0.00 1.88 -15.5 7.10 0.00 27.25

Paccar, Inc. 1.93 30.7 1.30 57.25 4.21 32.8 0.00 61.25

Required:

a. Calculate estimated prices in 1992 and 1993 for Chrysler using averages multiples of earnings, book values and dividends of the other firms in the industry. Which valuation comes closest to the actual price?

b. List and explain the reservations (problems) you identify in using the multiples.

c. All else being equal, would you expect the price of a firm with a high dividend payout ratio to be higher or lower than that of comparison firms? Explain.

Method of Comparables (Mechanics and Logic) – Screening Tool

A. Determine Relevant Valuation Multiples

1. Take relevant industry averages (excluding firm to be analyzed)

a. Omit negative values and (possibly) large outliers

2. Possible measure to use:

a. P/E (trailing)

b. P/E (forecast)

c. P/B

d. D/P

e. P.E.G. (Price/Earnings) / (1-Year ahead Earnings Growth Rate)

f. P/EBITDA (un-levered measure)

g. P/(FCF per share)

• FCF = CFFO + CFFI (physical assets) +/- CFFF (Change in Debt)

h. (Enterprise Value)/(EBITDA) or (Enterprise Value)/(FCF)

• Enterprise Value = EV

• EV = Market Value of Equity + Value Liabilities – (Cash and Financial Investments)

• Compute Industry Average EV/FCF or EV/EBITDA and then value your firm

B. Compute Value based on Average Multiple (comparable) and forecast metric

1. Example for P/E (forecast)

[pic]

C. Examine Price (PPS) assessment across all multiples.

1. Commonly, there exist a wide range of values

2. No “theory” to state which valuation multiple is “best”

3. Keep in mind you are not doing an “intrinsic” valuation

a. Industry average benchmarks are determined by market consensus

D. Workshop on PEG, P/EBITDA; P/FCF; EV/FCF.

1. Sample Companies (Broad-Line Semi-Conductors)

Mkt Cap

• STMICROELECTRONICS [STM] $17.3 B

• ANALOG DEVICES [ADI] $12.3 B

• MAXIM INTEGRATED [MXIM] $10.5 B

• NATL SEMICONDUCTOR [NSM] $8.8 B

• ADV MICRO DEVICES [AMD] $7.5 B

2. Value Maxim Integrated (MXIM) Using Valuation Multiples

Data from Yahoo Finance

Which cost of Capital? (Matching with financial statements)

1. Weighted Average Cost of Capital (WACC) (after tax)

[pic]

2. Capital Asset Pricing Model (CAPM)

• Formula

• What about Leverage??

3. Discounted Earnings or Cash Flow?

• Free Cash Flow?

Intrinsic Valuation Methods

A. Intrinsic Valuation

1. Involves Detailed Forecasts and Analysis

2. Requires substantial professional judgment and estimates

3. Is the analyst’s “opinion” (assessment) of firm value (not consensus)

4. Can help identify under-valued; over-valued; and “reasonably” valued firms

5. Severe differences between Intrinsic and Market values should be examined

6. Utilizes present values

B. Popular Valuation Methods Available

1. Discounted Dividends

2. Discounted Free-Cash Flows

3. The Residual Income Method (accounting based)

4. Abnormal Earnings Approach (accounting based)

5. Residual Income Perpetuity

C. Discounted Dividends Valuation

1. The Model

[pic]

or (in perpetuity)

[pic]

2. Examine data requirements and estimates

3. Empirical considerations

D. Residual Income Valuation

1. Foundations: Consistent with Modigliani and Miller Model (and intuition)

a. Finance Model (Market Value Based)

V F = V D + V E (Market Values)

b. Balance Sheet (Accounting Value Based)

A = L + E (Accounting Values)

2. Residual Income (RI) Valuation Model

[pic]

a. Examine data requirements and estimates

b. Empirical considerations

E. Discounted Free Cash Flows

[pic]

1. Examine data requirements and estimates

2. Empirical considerations

4. Difference between accounting earnings and free cash flow (conceptual)

5. How do we handle taxes

• After or before tax cash flows?

• After or Before Tax WACC?

• Why does it matter?

F. Residual Income Perpetuity Model

1. Short-Cut Version of Traditional Residual Income Model.

2. Basic Residual Income (RI) Valuation Model

[pic]

a. Examine data requirements and estimates

• Detailed forecasts and analysis required

b. Empirical considerations

2. Residual Income (RI) Perpetuity Valuation Model

a. Conceptually similar to moving from Detailed Discounted Dividends Model to simplified Gordon’s Growth Model.

[pic]

b. Data is easy and summarized. Good initial analysis tool

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