Module I: Investment Banking and Valuation

September 4, 2002 J. K. Dietrich - FBE 432 – Fall, 2002

Objectives

 Understand how investment bankers 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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

Valuation Matrix: P/E Ratios

Comparables Vons Safeway Average PE Ratio 18 19 Implied Stock Price 36 38 18.5

37 Source: Compustat (Wharton) Raios for 1995

Using an average stock price of $37, firm value is estimated to be $25



10m = $370 million

J. K. Dietrich - FBE 432 – Fall, 2002

Valuation: Price/Sales Ratios

Comparables Vons Safeway Average P/S Ratio .24

.38

Implied Firm Value 49.2

77.9

1.3

63.6

Firm value is estimated to be $63.6 million

J. K. Dietrich - FBE 432 – Fall, 2002

Valuation: Market/Book Ratios

Comparables Vons Safeway Average M/B Ratio Implied Firm Value 2.0

6.9

160.0

552.0

1.3

356.0

Firm value is estimated to be $356.0 million

J. K. Dietrich - FBE 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

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 432 – Fall, 2002

DCF Approaches

 Simplest approach is to assume first-year cash flow and perpetual growth and discount rates

PV



Cash r Flow



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 432 – Fall, 2002

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 432 – Fall, 2002

Equity Discount Rates

 Unlevered Cost of Equity (r A ) – 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 (r e ) – Cost of equity capital at a given leverage. Clearly depends on asset risk and also on leverage.

J. K. Dietrich - FBE 432 – Fall, 2002

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% J. K. Dietrich - FBE 432 – Fall, 2002

CAPM

The Capital Asset Pricing Model states that the expected return on an asset is

r

 

f

b (

r m



r f

) 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 432 – Fall, 2002

Next Week – September 9 and 11

 Be prepared to discuss Eskimo Pie case  Review textbook discussion of capital structure and the issues of capital structure and corporate valuation  Read

Continental Carriers Inc.

case to familiarize yourself with the issues and data available J. K. Dietrich - FBE 432 – Fall, 2002