Transcript Valuation - University of Iceland

Company Valuation
Presentation to Háskóli Íslands
Haraldur Yngvi Pétursson, Equity Research - Iceland
31 March 2008
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Introduction
Multiples / Comparables
Discounted Cash Flow (FCFF)
Introduction
Haraldur's Personal Introduction
 Academic:
― University of Iceland – Cand. Oecon
 Professional
― Deloitte – Accounting – 3 years
– Preparations of financial accounts
– Auditing of financial accounts
― Kaupthing Bank – Equity Research – Since October 2004
– Began focusing on operating companies (e.g. OSSR – ACT)
– Now focus on Banks and Financials
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Goal of Presentation
 Discuss company valuation generally and main obstacles
 Review in some detail the main currently employed valuation methods
 Don't worry if you don't fully understand everything said
― To most ordinary humans this is entirely foreign material
― Valuation and Equity Research is very much "on site training"
 Hopefully you'll enjoy picking up some of the terminology
and the next valuation presentation you sit through should be slightly more bearable
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Kaupthing's Research
 Covers over 400 equities
― UK, Iceland, Sweden, Denmark, Norway, Finland
 Focusing on Nordic and UK market
 Contributes to profits through various ways, e.g. market activity
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Company Valuation?
 Icex-15 last 3 years
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Reasons for Valuing Companies
 Key to successful trading in (and managing) corporations
― Ability to estimate their value
― Understanding the sources of their value
 Investors do not buy corporations for aesthetic or emotional reasons –
but for their expected future cashflows
― Inherent value of a company based on forward-looking estimates and judgements
 Valuation is fundamental for any decision & negotiations relating to e.g.
― Company investments
― Mergers
― IPO / rights issues
― Management project evaluation
― Portfolio valuation
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Valuation – Basics

Valuation a science or an art? A bit of both
Science:
Certain methods are based on solid mathematical pillars. Has (and is) being researched by entire
university departments, thousand's of professors/PhD's/market practitioners
Foundation of the world's financial system
Art:
Modelling and forecasting of the future (?!?)
– management/key employees, tastes/fashion/sentiment, disruptive technologies…
Material role of fickle (and difficult to model) behavioural issues and biases
– overconfidence, overreaction, loss aversion, herding, regret, misestimating of probabilities..
Fact remains – companies need to be valued and the following
methods are the best tools currently available
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Valuation - Reservations
 Assumptions and inputs into the models are of paramount importance
― Garbage in -> Garbage out
 Several "difficult-to-model" factors hugely important
― Is it for sale? Is there a buyer? Sale under distressed circumstances? is funding available?
― Output from valuation models ≠ current price
 Additionally some types of companies are tremendously difficult to value analytically
― Start-ups
― Biotech/pharmaceutical research
― Highly cyclical companies
― Companies with large "real options"
– Rights to unexplored oil-fields / mining
– Online companies (social networking, search engine..)
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Valuation Methodologies
 Discounted Cash-flow (DCF)
― Free Cash Flow to Firm (FCFF), FCF to Equity, Adjusted Present Value (APV)
 Multiples / Comparables
― P/E, EV/EBITDA, EV/Sales etc.
 Other methods
― Invested capital, VC Capital Method, Option Pricing, Last round of financing,
Break-up value and Dividend Models
 ..and then the more "sketchy" methods
― e.g. Technical Analysis
 Balance between model relevance, complexity and number of assumptions
 Usually at least two methods used in any valuation exercise
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Valuation Method:
Multiples / Comparables
Multiples / Comparables (comps) - Introduction
 The idea is to approximate a company's value by comparing it to companies with known value
 Source of figures
― Comparable public company multiples
― Recent private company transactions
 Important to only compare relative value of similar companies (apples with apples)
― Similar Industry Scope
― Similar Growth
― Similar Risk
― Similar Results (ROE)
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Multiples / Comparables (comps) - Introduction
 Many benchmarks can be used (usually industry specific)
― Enterprise Value / EBITDA
― Enterprise Value / Sales
― Price / Earnings (I: V/H)
― Price / Book (I: Q-hlutfall)
― Price / Net Asset Value (NAV)
― Monthly Rent Multiple
― Funds under management
― # subscribers, # patents, # employees, #website hits / Enterprise Value
― etc.
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Multiples / Comparables (comps) – Introduction cont.
 Positives
― Quicker and easier than analytical methods (DCF)
― Reflects current market conditions (investor sentiment, bargaining power..)
― Helpful in "reality-checking" DCF valuations
 Disadvantages
― Are the comparable companies similar enough?
– E.g. public vs. private, future prospects, sector, management quality, market position,
capital structure, tax-scheme…
― Doesn't capture value of different scenarios/"what-ifs"
– E.g. post acquisition cost-cutting is successful, synergies are achieved, pending lawsuit
goes one way or the other..
― Disconnect between a multiple and inherent firm value. Hence does not capture systemic
under-/overvaluation of companies by the market
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Enterprise Value / EBITDA (1/5)
Enterprise Value
EBITDA

Currently the most common "valuation" method for several industries

Typically in the range of 5-15x depending on
― Company type
― CAPEX requirements
― Prospects
― Market conditions
Sales
- Cost of Goods Sold

"EBITDA" = Earnings before interest, taxes, depreciation and amortization
- Administrative Costs

Proper to use Forecasted EBITDA (the future is what you're paying for)
+ Depreciation &
Amortization
― Trailing 12 month / 4 Quarter EBITDA is commonly used
― EBITDA is adjusted for one-off items (e.g. merger costs)
= EBITDA
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Enterprise Value / EBITDA (2/5)
 Enterprise Value (EV)
― A measure of company's entire value
― Vehicle & Apartment prices are quoted as enterprise value
i.e. without any reference to current debt structure (the price assumes no debt is included)
― Imagine how cumbersome it would be to hunt for a flat if prices referred to the value of
equity in the flat
Flat's quoted price: 10 million (50 (its value) – 40 (debt included) )
 Company share price refers to equity value
-> very reasonable to calculate and work with company's EV
Share Price x Number of Shares
EV = Equity Value + Net Debt*
Borrowing – Cash
* and
+ Minority Interest
– Associates
+ Operating lease
commitment
+ Unfunded pension
liabilities
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Enterprise Value / EBITDA (3/5)
Enterprise Value
EBITDA
 Multiple in some ways better indicator of value than other measures
― Helpful in comparing companies with different capital structures (w/o interest on debt)
― Depreciation and amortization schedules vary between companies
― Easier to approximate how much debt the company can support
 Has several weaknesses
― Capital Expenditure (CAPEX) requirements between companies vastly different
― Some companies capitalize significant amounts of cost (e.g. R&D) and thus raise their
EBITDA figure
― Does not include different interests expenses, tax rate and required rate of return
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Enterprise Value / EBITDA (4/5)
 Example Question:
(1) Value the company (EV and Equity Value)
(2) Approximate its share price
Figures for Caveat Emptor Ltd.
EBITDA=1.000
Net Debt = 2.000
#Shares outstanding=300
Similar companies are trading at average EV/EBITDA multiples of 8.0x
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Enterprise Value / EBITDA (5/5)
 Solution to Example Question
EBITDA
* EV/EBITDAx
1.000
8.0x
= Enterprise Value
8.000
- Net Debt
2.000
= Equity Value
(Market Cap)
6.000
/ Number of Shares
300
Share Price
20
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Valuation
 Intentionally blank slide
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Price / Earnings (PER or P/E)
 Price Earnings (I: V/H) ratio shows how much accounting profit its owners are entitled to
PriceEarnings
Share Price
Equity Value

Earningsper Share Net Income
 Example: Stock price = 20, EPS= 2 => PER= 20/2 = 10
 Compared to companies similar in risk and prospects PER is an indicator of whether a
particular stock is under or overpriced
 Several variants
― Trailing PER or forward PER (using forecasted earnings)
― Primary shares outstanding or diluted number of shares
― Average price over period
 Generally:
― High PER (>16) indicates that the market believes significant growth is on horizon
― Low PER (<8) indicates that the market believes current profit levels are unsustainable
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Price/Book (P/B) and Net Asset Value (NAV)

Price / Book = Value of Equity / Book Value of Equity (I: Q-hlutfall)

Purpose of ratio is to show the market premium to the accounting equity

P/B is used for valuing investments whose value is derived primarily from the underlying value of their
tangible assets

―
Holding companies
―
Real estate companies
―
Banks
―
Companies up for liquidation (solvency value)
Net Asset Value (NAV) is a significantly better measure than book equity
―
Calculated by correcting the value of assets & liabilities in the accounts
–
Book value of associates
–
Book value of fishing quota
–
Goodwill justified?
–
Deferred tax liability going to be paid in the near future (Real Estate)? etc.
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Misc. Industry Specific Multiples

Enterprise Value is the most common numerator

Airlines & retail businesses

―
EV/EBITDAR often used (notice that Rent (R) is excluded)
―
Takes into account that some companies buy their aircraft/stores while other companies rent them
Real Estate
―
Rent Multiplier or Yield% is often used
EV = Monthly Rent * Multiplier (e.g. 125-250) = Monthly Rent / Yield% * 12
―

Appropriate Yield% can be found in sector research and depends on factors such as country, type of
building, quality of area, sub-sector vacancy and market conditions
Commodity Companies (Oil refineries, mining etc.)
EV = Number of units of the commodity in reserves (e.g. barrels of oil) * Value per commodity unit

Asset Management
EV = Assets under Management * Multiple (1%..4%)
―

Multiple depends e.g. on investor type (private banking % higher than institutional %)
…and other industry specific "rules of thumbs"
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Icelandic Multiples
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Valuation Method:
Discounted Cash Flow (FCFF)
Discounted Cash Flow Valuation

DCF is the cornerstone of valuations and is the "analytically most correct" way
― In reality: several "fudge-factors" and disagreement between practitioners

Robust in valuing anything that gives cash-flow in the future given assumptions
― Bonds, derivatives, companies, etc.

Valuation of future cash that the investor will get from holding the firm. At the end of the day:
"Cash is King"
"Cash is fact – profit is an opinion"
"Earnings do not pay the bills"

Used when significant information is available on company and its prospects

Also used to select between internal projects and to price the impact of various scenarios e.g.
during negotiations
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Fundamentals of any Discounted Cash Flow Valuation
Expected cashflow
Value 
CF3
CF1
CF2
CF4



 ...
1
2
3
4
(1  r ) (1  r ) (1  r ) (1  r )
Year
Discount rate

Expected cashflow in each period

Divided by the appropriate discount factor that reflects the riskiness of the estimated
cashflows

Example: How much is an infinite stream of ISK 15 million/year worth?
Assuming a 10% discount rate:
Value 
15
15
15
15
15
15
15
15




...




 ...  150
1
2
3
4
(1  .1) (1  .1) (1  .1) (1  .1)
1.10 1.21 1.33 1.46
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Discounted Cash Flow Valuation in 4 Steps

Step 1 Compile information
― Historical accounts (last 2-3 years). Review sales, margins, CAPEX, WC ratios, notes etc.
― Research business, strategy, products, customers, markets, competition etc.
― Industry and environment forecasts (official forecasts, KB research, news etc.)
― Discuss main risk factors
― Look up information on similar companies
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Discounted Cash Flow Valuation

Step 2 Estimate the appropriate discount factor weighted average cost of capital (WACC)
WACC  K e * (
Components of WACC are:
E
D
)  Kd (
)
DE
DE
1) Cost of Debt (Kd)
Kd  (Risk Free Rate Credit Risk Premium)* (1  tax%)
―
Risk Free Rate (e.g. 10 year government bond) Nominal or real – must harmonize with forecasts
―
Appropriate Credit Risk Premium
2) Cost of Equity (Ke) (CAPM)
Ke  Risk Free Rate β(Beta)* Equity MarketPremium
―
Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most common
―
Equity risk premium is an estimate of the premium investors require in excess of risk-free assets for
owning equities (4-7% most typically used)
―
Beta is a measurement of firm's/similar firms volatility compared to the
market (if higher than 1 company/sector is riskier than market in average).
When compiling and averaging betas it is necessary to take into account
different company leverage
β unlevered 
β levered
D 

1  (1- tax)(E )
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Discounted Cash Flow Valuation

Step 2 cont.
― WACC calculation example (typical Icelandic firm)

Or…
... as is very common: Present WACC as a figure (8..15%) and provide a sensitivity table
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Discounted Cash Flow Valuation

Step 3 Prepare a "visible" forecast period (5-10 years and longer for some industries)
― Forecast Sales, margins, capital expenditure, working capital requirement
― And derive Free Cash Flow to Firm
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Discounted Cash Flow Valuation

Step 3 cont.
* Forecasts should trend downwards to
achieve long run growth rates
* Assumptions should be reviewed for
consistency with past performance and
business model
* COGS & SG&A include Depreciation so it
needs to be subtracted (non-cash item)
* Depreciation should harmonize
with CAPEX & the value of
property, plant and equipment
(PP&E) in the long run
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Discounted Cash Flow Valuation

Step 3 cont.
* Helpful to create a balance sheet and
model the difference in inventories,
receivables and payables between years.
* Tax relief from debt is
included in the discount factor
* CAPEX needs to be sufficient to
fund the strategy (e.g. the
opening of new stores)
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Discounted Cash Flow Valuation

Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to Firm with the WACC
―

Deal properly with Terminal Values
Beyond the visible cashflow period, the value of the company is captured using a terminal value calculation
(using either a DCF to perpetuity or comps calculation)
DF 
* Equity Value calculated
from EV
* 30-70% split is a
rough guide for
mature companies
1
(1 WACC)Year
TV
FCF(finalforecastyear)* (1 g)
WACC- g
* 0..5% often
used for
perpetual growth
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Discounted Cash Flow – Presenting the Results

The Ultimate Answer to the Great Question of Life, the Universe and Everything
-Hitchhiker's guide to the Galaxy

All diligent valuations are presented as sensitivity tables
― Demonstrate the link between assumptions and the final value
― Allow the reader, which probably disagrees with some assumptions, to use the analysis
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Discounted Cash Flow Valuation

Other DCF methods:

Free Cash Flow to Equity (FCFE) Same as Free Cash Flow to Firm but
― Interest (and tax savings from interest) and changes in net debt (repayments) are
subtracted from the FCFF. Discounted with cost of equity (not WACC)
― Has many proponents arguing (a) more intuitive measure of cashflow (b) overleveraged
companies in jeopardy more obvious, etc.

Adjusted Present Value (APV) – less common
― Takes into account changing debt structure – helpful for leverage finance/private equity
1. Calculate value of firm assuming no debt
2. Calculate the present value of tax savings due to interest (discounted with kd)
3. Value the effect of borrowing on likelihood and cost of bankruptcy (difficult)
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Discounted Cash Flow Valuation

Key Drivers of Cashflow
― Sales growth rates
–
Market, strategic considerations, pricing, economy, competition
― EBITDA margin
–
Cost development, fixed vs. floating costs etc.
― Capital expenditure (CAPEX)
–
Maintenance and investment CAPEX
― Working capital requirement
–
Must support current operations and strategy (inventories, receivables & payables)
― Cash tax rate
–

A specialist area (legislation, relief from previous tax loss, deferred tax)
Model also highly sensitive to
― Discount factor
― Terminal value growth
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Questions and Answers
Q&A
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