Transcript Class 2 - University of Southern California

Finance Theories, Case Analysis,
and Valuation
January 12, 2006
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
Valuation Matrix: P/E Ratios
Comparables
PE Ratio
Implied Stock Price
Vons
18
36
Safeway
19
38
18.5
37
Average
Source: Compustat (Wharton) Raios for 1995
Using an average stock price of $37, firm value is
estimated to be $37  10m = $370 million
J. K. Dietrich - FBE 532 – Spring 2006
Valuation: Price/Sales Ratios
Comparables
P/S Ratio
Implied Firm Value
Vons
.24
49.2
Safeway
.38
77.9
.31
63.6
Average
Firm value is estimated to be $63.6 million
J. K. Dietrich - FBE 532 – Spring 2006
Valuation: Market/Book Ratios
Comparables
M/B Ratio Implied Firm Value
Vons
2.0
160.0
Safeway
6.9
552.0
1.3
356.0
Average
Firm value is estimated to be $356.0 million
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
Pitfalls in Comparables: I
 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?
J. K. Dietrich - FBE 532 – Spring 2006
Pitfalls in Comparables: II
 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?
J. K. Dietrich - FBE 532 – Spring 2006
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.
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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)
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
DCF Approaches
 Simplest
approach is to assume first-year cash
flow and perpetual growth and discount rates
C ashFlow
PV 
rg
 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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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.
J. K. Dietrich - FBE 532 – Spring 2006
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
risk premium is b times the market risk
premium, historically about 8%
 The
J. K. Dietrich - FBE 532 – Spring 2006
CAPM
The Capital Asset Pricing Model states that
the expected return on an asset is
r  rf  b (rm  rf )
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.
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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”
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006