Valuation and Evaluation

Basic Valuation

• Assets have value by virtue of being expected to produce cash flows • Cash flows to equity holders are “dividends” – including repurchases (even buyouts) – net of stock issuance (“negative dividends”) • typically assumed to be zero • The value of the firm’s equity can be expressed as the present value of expected future dividends

Dividend Discount Model

• Like any other asset, stock value is the present value of future cash flows V t = E(D t+1 )/(1+r) + E(D t+2 )/(1+r) 2 where: V t + … ≡ equity value at time t D t ≡ div. (including repurchases) E ≡ expected value operator r ≡ discount rate

• Discount rate is equity “cost of capital” – amount the firm “promises” to attract capital – amount investors could earn in alternative investments of similar risk – assumes you can borrow and lend at same rate • Dividend discount model underpins all other valuation approaches

V coke = $3,980/(1+7%)+$4,261/(1+7%) 2 +… where: dividends are 45% of forecast NI ($4,353 in ’03) repurchases are the use of excess cash ’03: Div. = 45% x $4,353 = $1,959 Repurch. = $2,021; $2,021+$1,959=$3,980 ’04: $4,261 discount rate is based on CAPM

Problems with Dividend Discount

• Dividends reflect distribution of value not creation • Dividend pay-outs are arbitrary and hard to predict • Earnings are often retained in the firm and allowed to accumulate • Much of value comes far in the future • Therefore, often focus on ability to pay dividends rather than dividends themselves

Savings Account Example

• Assume: – Invest $100 in a savings account with expected return of 10% – Cost of capital is 10% – Expect to withdraw $110 in one year • Then, V t = $110/1.1 = $100 It is worth what you put into it

• Now assume 12% expected return – e.g., mutual fund has locked in 12% one year bonds before rates fell V t = $112/1.1 = $102 • Now assume 8% expected return – e.g., mutual fund has locked in 8% one year bonds before rates rose V t = $108/1.1 = $98

Other Valuation Approaches

• The firm’s ability to pay dividends is based on its cash inflows • Therefore, other valuation approaches focus on likely cash inflows into the firm

Free Cash Flows

• Under reasonable assumptions value can be expressed in terms of expected free cash flows to the firm • Free Cash Flows = Cash from Operations + Cash from Investing • Free cash flows capture amount left over after covering investing

Practical Consideration

• Ultimately care about value of equity • One way to get at that is to directly estimate cash flows available to equity; after interest • In practice, often easier to: – estimate PV of cash flows to assets – subtract off value of debt – implies value for equity since A = L + OE

Implementation

• Assets: – Asset value is PV of free cash flows, before interest – Use free cash flows (operating minus investing) – Add back after tax interest (like ROA) • Asset values setting aside financing choices – Discount rate is technically weighted average cost of capital—more on that in finance

• Liabilities: – PV of cash flows to existing debt = book value – PV of cash flows on future debt = 0 –  forecast cash flows to assets • subtract BV of existing interest-bearing debt

V t = E(AFCF t+1 )/(1+r)+E(AFCF t+2 )/(1+r) 2 +… - Existing Debt where: AFCF is FCF adjusted for after-tax interest on existing debt existing interest-paying debt is subtracted •In the preceding example expected dividends = expected cash flows V t = $110/1.1 = $100

• E.g., you invest $100 in a mutual fund which invests for 2 years at 10% • At the end of year 1, the fund borrows $110 and pays you a dividend of $110 – dividends = $110 – free cash flows = $0

• At the end of year 2, the investment pays off $121 and the fund repays the debt – dividends = $0 – free cash flows = $121 • Dividend approach V • Free cash flow approach V t t = $110/1.1 + $0/1.21

= $0/1.1 + $121/1.21 = $100 = $100

V coke = $4,232/(1+7%)+$4,507/(1+7%) 2 +… - $5,356 where expected free cash flows are from pro forma and existing debt from balance sheet NI + Depr.

 D Working Cap. (CA-CL) - Cap. Exp.

4,353 760 -210 -950 4,556 880 -100 -1,100 + Change in Other Liab.

+113 +107 + Change in Def. Taxes + 20 + 19 + Adj. Int. (.77 x 199) +145 4,232 + 145 4,507

Problems with Free Cash Flows

• Free cash flow forecasts are generally not available • Generally must compute statement of cash flows from: – earnings forecasts – balance sheet assumptions • Much of value comes far in the future

Balance Sheet Valuation

• If estimated values of assets (& liab.) are available, they equal PV of expected cash flow • Then, can use asset and liability values to value of the firm V t = Asset Value - Liability Value

• E.g., invest in a mutual fund holding an asset returning 10% and no liabilities • Market value of the asset being held is $100 if it is expected to pay out $110 in one year • Therefore, you can rely on the market value of the asset held to value the firm

Approach

• Start with existing balance sheet • Revalue assets that are likely misvalued – E.g., Coke’s investment in bottling companies • Add assets that have been excluded – E.g., Coke’s brand • Do the same with liabilities – Typically less of an issue • Back into the equity value

V coke = (Asset book values + investment security additional values + brand values) Liability book values V coke = ($24.5B + $3.5B + $70.5B) - $12.7B

= $85.8B

Problems with Balance Sheet Method

• Many assets don’t have ascertainable values – PP&E, Intangibles, etc.

• Many assets have higher values to that firm than to other firms – Customized PP&E, Inventory, etc.

• Doesn’t work well for Coke – Too many hard-to-value assets