Finance Theories, Case Analysis, and Valuation

1. Finance Theories, Case Analysis, and Valuation January 12, 2006

2. FBE 532 Objectives • Analyze and communicate implications of financial theory using cases • Understand finance careers and functions • Refine and expand specific financial analytical skills • Responsibility for learning is with you • Requirements are clear: review, prepare, and participate

3. Cases and Case Preparation • Cases attempt to present real-life corporate financial decision-making environments • Problems are not always clearly stated • The goal is to apply theoretical concepts to refine important questions and form recommendations • Use “13 points’ as a guide • Focus on key points and data • Feel free to discuss before writing up

4. Financial Functions • All finance is concerned with value • Corporate decision-making • Investments, including mergers and acquisitions and divestitures (disinvestment) • Growth and financing needs • Management of working capital • Chief financial officer is responsible for these decisions • Requires project analysts, treasury assistants

5. Objectives • Understand how practitioners value firms • Liquidation or adjusted-asset value • Public comparables (multiples approach) • Discounted-cash-flow methods • WACC (entity) approach • Flow to equity (fundamental analysis) methods • Adjusted present value • Compare and contrast these methods and understand advantages and limitations of each

6. Liquidation or Adjusted-Assets • Value of equity in firm is simply:Equity = Assets – Liabilities • A crude estimate of value is the book value of equity and is used as a reference (times book) • Adjust assets for market value rather than accounting values • An adjusted estimate of equity value is:Equity = Adjusted Assets - Liabilities

7. Comparables using Public Firms • Using comparables of publicly traded firms is very widely used by analysts (both buy and sell side) • Often called multiples approach • Uses a combination of accounting and market numbers to value companies. Most common multiples are: • Price/earnings • Asset/sales • Market/book

8. Example of Comparables Method • Greens Health Inc., a privately owned Supermarket chain has expected earnings of $20 million per year on sales of $205 million with total assets of $80 million. • In a proposed IPO, Greens will issue 10 million shares so forecast EPS is $2 per share; the firm is all equity. • Using data on suitable comparables, compute a valuation matrix

9. Valuation Matrix: P/E Ratios Comparables PE Ratio Implied Stock Price Vons 18 Safeway 19 36 38 Average 18.5 37 Source: Compustat (Wharton) Raios for 1995 Using an average stock price of $37, firm value is estimated to be $37  10m = $370 million

10. Valuation: Price/Sales Ratios Comparables P/S Ratio Implied Firm Value Vons .24 Safeway .38 49.2 77.9 Average .31 63.6 Firm value is estimated to be $63.6 million

11. Valuation: Market/Book Ratios Comparables M/B Ratio Implied Firm Value Vons 2.0 Safeway 6.9 160.0 552.0 Average 1.3 356.0 Firm value is estimated to be $356.0 million

12. Compare Results • Range of values is $63 to $360 million • Wide differences in Vons and Safeways ratios • What are differences in firms and how do they affect comparability of valuations? • Vons has debt-to-asset ratio of .66 • Safeway’s debt-to-asset ratio is .82 • Both firms are highly leveraged • P-E and P/B valuations are closer than P/S approach

13. Remember when using P/E ratios that the estimated value is the value of equity, not firm value. Example: Suppose Greens carried $114 million of debt. With equity of $250 million and debt of $114, firm value is now V = E + D = $364 million. How does this affect value using P/S ratios? Pitfalls in Comparables: I

14. Are the comparables really comparable? Firms differ in many significant dimensions including Growth rates Cash flows Risk (most obviously capital structure; note that Greens equity value was unchanged by the fact that it carried debt. Is this realistic? Pitfalls in Comparables: II

15. Pitfalls in Comparables: III Suppose the unobserved true relation between stock price and earnings is Price = $9.00 + 12EPS For Vons, say EPS =$1.50, so Price = $27 and P/E =18 For Greens, we have value = $9.00 +12 x 2 = $33 The multiples approach misprices by $4.00 or twelve percent of firm value -- other relations could be off more.

16. Assessment • Advantages • Quick, easy to understand, and widely used • Disadvantages • Based on accounting concepts • Ignores growth opportunities and future cash flows • Fails to account for differences in capital structure

17. DCF Approaches • All DCF approaches discount cash flows by the appropriate discount rates • Ingredients • Cash flow forecasts for future periods (the past is irrelevant) • An associated discount rate which measures the return on investments of comparable risk • Three main approaches • WACC, APV, Flow to Equity

18. Value and Valuation • Finance objective function is to maximize owners’ value • Value is the present value of future cash flows at the risk-adjusted discount rate • Valuation principles are the same whether we are valuing stocks, bonds, real estate, or corporations • The challenge is to estimate the cash flows and choose a discount rate

19. Corporate Cash Flows • Corporate cash flows are similar to all firms’ cash flows, that is, they come from cash revenues minus cash costs • Because of tax laws and standard reporting conventions, corporate cash flows are more standardized • Value of claims on corporations can be calculated separately (e.g. stock and bond valuation) or in the aggregate (so-called entity approach)

20. Future Corporate Cash Flows • Since value comes from future cash flows and the future is unknown, future cash flows must be estimated • The future is usually divided into two or more parts • Forecast period and continuing value period • Rapid growth period and normal growth period • Choice of division depends on case and data available

21. DCF Approaches • Simplest approach is to assume first-year cash flow and perpetual growth and discount rates • More convincing approach is to use explicit cash flow projections over a forecast period and discount continuing value using simplest approach for cash flows after forecast period

22. Computing the Discount Rate • The discount rate applied to these cash flows represents the opportunity cost of capital • It can also be thought of as the expected or required return for an investment that is equally risky

23. Equity Discount Rates • Unlevered Cost of Equity (rA) • What the cost of capital would be if the firm had no leverage. • Depends on asset risk, but not not capital structure • Equals weighted-average cost of capital (WACC) • Levered Cost of Equity (re) • Cost of equity capital at a given leverage. Clearly depends on asset risk and also on leverage.

24. Discount Rates • We obtain discount rates for equity using a model of risk such as the CAPM • CAPM states that the expected or required return on an asset the sum of two components • The risk free rate • A risk premium • The risk premium is b times the market risk premium, historically about 8%

25. CAPM The Capital Asset Pricing Model states that the expected return on an asset is Beta measures the sensitivity of the stock’s return to the return on the market portfolio. Note that beta depends on the firm’s leverage.

26. Investment Banking • Investment bankers assist corporations in their dealings with financial markets • Issuing securities • Initial public offerings (IPOs) or secondary offerings • Issuing debt or preferred stock to private investors (private placements) or to public markets • Mergers and acquisitions • Advising and valuing firms • These services are corporate finance or investment banking services

27. Investment Banking (continued) • Investment bankers also buy and sell securities • Brokers (retail and institutional) • Market makers • Asset management • Research • Investment banks are classified in a variety of ways • Full line • Boutique • Regional • “Bulge bracket”

28. Investment Banking (continued) • Investment bankers need many types of financial skills • Analysts for research • Analytical support in doing deals • Traders • Marketing securities to retail and institutional markets • Investment banks hire junior analysts and associates at entry level, titles vary at top

29. Investment Banking and Markets • Investment bankers assist corporations (and governments) in designing securities for sale to public or private markets • Traders and analysts of investment banks are usually called are said to work on the sell side of a securities firm, or are called sell side analysts or sell side traders or brokers • Investment bankers do more than deals

30. Specialized Investment Vehicles • Venture-capital firms provide financing to new firms, often firms in new technologies, requiring both technical and financial skills • Hedge funds are unregistered investment vehicles for wealthy investors’ or institutional funds, often using complex investment strategies requiring sophisticated financial analytical skills

31. Next Week – January 19 • Review valuation techniques and relate to case materials • Prepare Eskimo Pie Case • Form groups for group case analyses following Eskimo Pie