Example: Nelson Paper Products

1. Example: Nelson Paper Products • What is the problem of this case? • Mr Guzman, VP of NPP, needs to present an evaluation of Northwestern Pacific Lumber CO, and a recommendation to buy it or not. • The asking price for NWP is $95m in cash or stock. • Directors of NPP also asked for a plan to finance it (not done in this case) • NPP was committed to more investments and projects than what they could finance from internally generated resources. • The acquisition of NWP would mean a lot of expending and the first venture outside of paper-making for NPP.

2. Example: Nelson Paper Products • How does the company look? And in comparison to the industry? • Diversified from cardboard boxes into a diversified paper producer with sales of $900m in t-1 • For 10 years, revenues increased at 10% a year, with great stability despite the bad trend for the paper industry as a whole. • Mostly growth through internal expansion.

6. Example: Nelson Paper Products • Is NPP facing any challenges? • Until recently, it acquired pulp and wood from timber-logging firms, so it did not need to ↑ its control over wood sources • But the new laws of curtailment of logging made this change as ↑ prices of wood • They had a project of “mini-mills” which required $135 m, so they had external financial needs for almost $226 m for 1995 alone

8. EXHIBIT 5

9. Example: Nelson Paper Products • Who is Northwestern Pacific Lumber Co.? • Its business was the manufacture and sale of lumber and other forest products processed from timber obtained from private landowners and the federal government. • NWP was formed as a conglomeration of small independent lumber mills • The firm had rapid growth for 20 years via internal expansion and acquisition of small lumbering outlets. • The expected gains from joining independent lumber mills never came because as NWP was acquiring them, the owners remained as managers and retained their style. • In 1990, market conditions softened: • NI per share decreased from $23 to $2 in 1990 • Cost of sales increased from 81% to 91% in 1992 • Dividend policy very choppy: from $0.36 to $0 in 1991 and 1992 • The sales, although large, were very volatile and unpredictable • It sold to new construction, home improvements, and industrial markets in the US. • It sold most of its wood chips to NPP representing 16% of its total sales.

11. Example: Nelson Paper Products • And in comparison to the industry? • The hardest ↓of all 4 firms (↓EPS to 1/10th while the others only ↓½ or 1/5) • DPS of all other firms have remained constant, while NWP brought it to $0.0 • Revenues are there, but NI↓, so it must be that ↑Costs a lot

13. Example: Nelson Paper Products • Why is NWP for sale? How much can they expect to raise? • The minority shareholders (the owners of small mills) all wanted to sell to retire. • The trustees of NWP sought to sell the firm • NWP was for sale and already had a bid for $65 m on the table (book value), but this number may be only a floor if the firm is expected to do better. • What does the future look like for NWP? • But the firm was coming back at the beginning of 1993 and the outlook was better • NI↑ to $7.3 m • Dividends were ↑ to 10c and even 30c by 1996.

15. Example: Nelson Paper Products • The decision: Should NPP acquire NWP? And if so, how much should it pay for it?

16. Example: Nelson Paper Products • What elements should NPP’s management consider in evaluating NWP? • Guzman thought that better management at NWP could reduce costs of sales to 85% (average of other wood products firms). • Guzman also planned to eliminate administrative overhead of NWP’s individual mills, so as to \SG&A costs to $7.5 m by 1995 • NPP knew NWP well because of its business relation and geographical proximity • NWP’s main impediment -- the mill-manager minority shareholders-- were near retirement and wanted liquidity for their shares. • Other benefits for NPP of acquiring NWP” • opportunity to expand NPP’s small wood products operation • secure a large, captive supplier of wood chips

17. Valuation Methodologies Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

18. 1. Net Asset Approach (1) • This is a good starting point. • We are looking for the underlying value of the assets of the business. This approach focuses on the balance sheet and posits that the company is worth the sum of the value of its net assets. • A first approximation of Net Asset Value (NAV) can be calculated by simply subtracting the debt from the total assets of the firm, which provides book value for the firm. • The net asset approach is generally relevant when the company is experiencing financial difficulty and investors prefer valuing it as a portfolio of assets rather than a going-concern. • Net Asset Value is also useful to provide a floor to the value of a company since owners of the company will likely be reluctant to sell at less than NAV.

19. 1. Net Asset Approach (2) • Book Value – Northwestern Pacific (Nelson Paper Products example)

20. 1. Net Asset Approach (3) • Limitations: • This accounts-based approach is fraught with problems since accounting-based values are often very different from market values: • Land, buildings and equipment are usually shown at their original purchase price less accumulated depreciation, an amount which can be arbitrary. • Stock values can be significantly under-estimated because they are usually reported at the lower of cost or net realizable value. • Other limitations have to do with the treatment of asset accounts such as R&D costs, patents, and organization expenses.

21. 1. Net Asset Approach (4) • Adjusted Book Value • Liquidation Value • Replacement Value

22. 1. Net Asset Approach (5) • Adjusted Book Value • One solution to the problem of historical costs is to re-value tangible assets, such as: • buildings or machinery, which have been depreciated far below its market value, • real estate and land, which has substantially appreciated above its book value (which stands at original costs) • the inventory and other items on the balance sheet using their estimated market value. • intangible assets should be reduce to 0 unless they have a market value.

23. 1. Net Asset Approach (6) • Liquidation Value: • We could go one step beyond and calculate the net cash which could be realized if the assets of the firm were disposed of in a “quick sale” and all liabilities of the firm were paid off. • This calculation also has to account for the costs of carrying out a liquidation sale. • This provides a more realistic result for the liquidation value of a company. • This value is not of importance to a buyer interested in the maintenance of the business as an on going concern, but could be used as a floor below which the seller would be unwilling to sell to the buyer.

24. 1. Net Asset Approach (7) • Replacement Value: • The current cost of reproducing the tangible assets of a business • It can be significant in that starting a new company may be an alternative means of getting into the business • Sometimes the market value for existing facilities is considerably less than the cost of building a plant and purchasing equivalent equipment from other sources.

25. Valuation Methodologies Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

26. 2. Multiples Approach (1) • Companies are often valued as a multiple of earnings, sales or book value, using historical values or industry averages. • Valuation of a firm may also be done by capitalizing earnings. This involves multiplying an earnings figure by a capitalization factor or P/E ratio. • Two questions arise: • (1) which earnings? • (2) what factor?

27. 2. Multiples Approach (2) • We can use 3 kinds of earnings: • Historical Earnings: • History can be used to predict the future. • But, this can only be a rough approximation only. • We need to make sure that random and nonrecurring items are not considered, tax carryover and carryback provisions, etc.. • Future Earnings under Present Ownership: • Earnings depend upon the policies and strategies of management. • If the new owner will fire management, this is not a good method. • Future Earnings under New Ownership: • The basis for the figures here will probably be very different from the past ones. • New investments might be needed and should be considered. • Various scenarios will help in this uncertain evaluation.

28. 2. Multiples Approach (3) • Most valuations use either: • Earnings after tax (but before extraordinary items) or • EBIT (Earnings before interest and taxes) • EBIT measures the earning power and value of the basic business, without the effect of financing • this is particularly important if the financial structure will change.

29. 2. Multiples/Relatives Approach (4) • Multiples can be segmented into two categories: • trading multiples and • transaction multiples.

30. 2.a.Trading Multiples Approach (1) • What multiple should we use? • If we consider that the investor’s primary return might result from the sale of its stock in the future, then the question is: • given the pattern of earnings, the industry, the likely state of the market, etc.. What will someone be willing to pay for my holdings? What prices are paid for stocks of similar records and histories?

31. 2.a.Trading Multiples Approach (2) • P/E Ratios • The most common trading multiple is the price/earnings (P/E) ratio. • The P/E ratio measures the relationship between a company’s current earnings per share and the price of a share of its stock. • If a company has a P/E ratio of 10x, an investor must pay ten times the company’s current earnings per share to acquire one share of its stock. • Investors must determine whether the company’s P/E ratio is a fair reflection of the company’s future profit potential. • Factors that affect the P/E ratio include projected earnings per share growth (the greater the growth rate of a company’s EPS, the higher its P/E ratio), earnings volatility, P/E ratio of the market, and the P/E ratios of comparable stocks.

32. 2.a.Trading Multiples Approach (3) • Other Earnings Multiples include: Equity Value / Sales, Equity Value / EBITDA, Equity Value / EBIT, Firm Value / Net Income • Book Value Multiples • Book value is a measure of the value of a firm based on the historical costs of its assets. • It reflects the historical purchase costs for the assets, minus accumulated depreciation, plus earnings retained by the company. • Price / Book Value Ratio = Market Price per Share / Book Value per Share

33. 2.a.Trading Multiples Approach (4) • Nelson Paper Products example

34. 2.a.Trading Multiples Approach (5) • Nelson Paper Products example Note: All three multiples in the example provide a measure of the value of the equity (per share for the P/E ratio). Some multiples, such as Firm Value / Net Income, provide the value of the firm. The numerator tells you whether you are getting firm value or equity value by applying your multiple. If you are looking for the equity value and apply the Firm Value / Net Income multiple, make sure to subtract the debt at the end (since Equity Value = Firm Value – Debt).

35. 2.b. Transaction Multiples Approach(1) • Transaction multiples are similar to trading multiples but are measured at the time of a transaction, to reflect the price paid for the acquisition. • They provide a good measure of how similar companies were valued by competitors and how big of a premium acquirers were willing to pay for the control of the acquired companies. • They tend to be higher than trading premiums due to the control premium.

36. 2.b. Transaction Multiples Approach(2) • Nelson Paper Products Example

37. 2.b. Transaction Multiples Approach (3) • Nelson Paper Products Example

38. 2.b. Transaction Multiples Approach (4) • Nelson Paper Products Example Note: Notice that the first set of transaction multiples provides equity value per share, while the second set generates firm (“enterprise”) values. For the second set, firm value is translated into equity value by subtracting the debt.

39. 2.b. Transaction Multiples Approach (5) • Limitations: • Multiples provide a measure of value that is consistent with comparable companies in the same industry. • However, they are limited by the fact that they are static measures that focus on the current year’s earnings not future cash flows. • The assumptions embedded in multiples valuation must be carefully considered, particularly the assumption that comparable companies have similar: • capital structures and • expected growth rates.

40. 2.c. Advantages of Relative Valuation • Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when • the objective is to sell a security at that price today (as in the case of an IPO) • With relative valuation, there will always be a significant proportion of securities that are under- valued and over-valued. • Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs • Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)

41. 2.c. Disadvantages of Relative Valuation • A portfolio that is composed of stocks which are undervalued on a relative basis may still be overvalued, even if the analysts’ judgments are right. It is just less overvalued than other securities in the market. • Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail • Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

42. 2.c. Disadvantages of Relative Valuation • Relative valuation may require less information in the way in which most analysts and portfolio managers use it. • However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). • To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

43. Valuation Methodologies Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

44. 3. Discounted Dividend Approach (1) • The Dividend Valuation Model (DVM) values the stock of a company as an infinite stream of future dividends. • The value of the company is thus the present value of this infinite dividend stream discounted by the company’s cost of capital. • If one assumes a constant growth dividend: P0 = [D0*(1+g)] / (k – g) = D1 / (k – g) Where k = required rate of return g = dividend growth rate

45. 3. Discounted Dividend Approach (2) Example 1: Consider a situation in which we are valuing a share of common stock that we plan to hold for only one year. What will be the value of the stock today if it pays a dividend of $2.00, is expected to have a price of $75 and the investor’s required rate of return is 12%? Value of Common stock = = Present Value of future cash flows = Present Value of (dividend + expected selling price) = ($2+$75) ÷ (1.12)1 = $68.75

46. 3. Discounted Dividend Approach (3) Example 2: Continue Example 1. What will be the value of common stock if you hold the stock for two years and sell it for $82? Assume the dividend payment is fixed at $2 per year. • Value of Common stock = = Present Value of future cash flows = Present Value of (dividends + expected selling price) = {($2) ÷ (1.12)1 } + {($2+$82) ÷ (1.12)2 } = $71.14

47. 3. Discounted Dividend Approach (4)Determinants of Growth Rate of Future Dividends • Firm’s growth opportunities relate to: • The rate of return the firm expects to earn when they reinvest earnings (the return on equity, ROE), and • The proportion of firm’s earnings that they reinvest. This is known as the retention ratio, b, = 1- dividend payout ratio. • The growth rate can be formally expressed as follows: • g = the expected rate of growth of dividends • D1/E1 = the dividend payout ratio • ROE = the return on equity earned when the firm reinvests a portion of its earning back into the firm.

48. 3. Discounted Dividend Approach (5) • Nelson Paper Products example / Northwestern Pacific k = firm’s cost of capital (we get it late) g = Avg 93-96 forecast=50% But unrealistic, use avg growth of sales (93-96)= 8% D1 = forecasted for 1993 Share value assume going to infinite: P0 = D/(k-g) = .10/(.146-.08)=1.52 Shares in 1992 = 2m/.32cents=NI/EPS=6.3m

50. 3. Discounted Dividend Approach (6) • Limitations: • The dividend valuation approach is extremely sensitive to the growth rate to infinity, which is difficult to estimate and can be somewhat arbitrary since theoretically a firm cannot have abnormal returns for ever. • A better approach is to estimate the growth rate over an explicit period of several years and then a growth rate to infinity once a steady state has been reached. • Other weaknesses: • It makes the unrealistic assumption that dividends will grow at a constant rate. Therefore, it cannot be used when a company pays no dividends or has an unstable dividend pattern • It cannot be used either if the firm’s cost of capital is less than the dividend growth rate (k<g) • The cost of equity (k) can be difficult to estimate. People use CAPM to do it (more on this later).