Transcript Issues in Valuation - Yale School of Management

Issues in Valuation
E-Business Valuation
AGENDA
1. DCF Method and Forecasting
2. Valuation of Dot.coms
– Introduction
– DCF Method
– McKinsey Method: DCF starting from the
future
– The PEG ratio
– The Price-to-Sales Ratio
– Other multiples
Consistency
(or 2 out of 3 ain’t bad)
• To conduct a DCF there are three layers of
assumptions that you need to make:
– Growth in revenues
– Investment Rates
– Financing
• You only need to determine two of these.
The third one is then given.
Example 1
• If a firm has a target capital structure.
– Financing then determines the investment
policy. You just need to forecast how well the
firm will invest (NOPLAT → g) to complete
your valuation model.
– Examples include firms in emerging markets,
which are financially constrained.
Example 2
• Suppose the investment policy is
constrained by competition.
– In mature industries such as tobacco and
steel growth opportunities are not available.
– This fixes growth in revenues and investment
rates.
• Only need to determine the firm’s financial
policy (dividends, repurchases, equity &
debt issues).
Paper and Pencil
Back of the Envelope Forecasting
Year 2000
Forecast 2001
Assumptions
Income Statement
Sales
Description
1000 % of Sales (t-1)
COGS
% of Sales (t)
Gross Profit
Arithmetic
Interest
% of Debt (t)
Taxable Income
Arithmetic
Taxes
% of Taxable
Income
Net Income
Arithmetic
Dividends
% of Net Income
Retained Earnings
Arithmetic
Value
1+0.07
0.7
0.1
0.53
0.6
Paper and Pencil Continued
Balance Sheet
Current Assets
% of Sales (t)
0.15
Fixed Assets
% of Sales (t)
0.7
Total Assets
Arithmetic
Current Liabilities
% of Sales (t)
0.07
Debt (PLUG)
Equity
Stock
400 Constant
Accumulated Earnings
100 Arithmetic
Total Liabilities
Arithmetic
400
Pro Forma
Assumptions
Sales growth
Initial sales
FA_Sales
CA_Sales
CL_Sales
COGS_Sales
Interest
Dividend Payout
Tax rate
7%
1,000
70%
15%
7%
70%
10%
60%
53%
Forecasts
Year
0
1
2
3
4
5
1,070
1,145
1,225
1,311
1,403
COGS
749
801
858
918
982
Gross Profit
321
343
368
393
421
28
28
28
28
27
Taxable Income
293
316
340
366
393
Taxes
155
167
180
194
209
Net Income
138
148
160
172
185
Dividends
83
89
96
103
111
Retained Earnings
55
59
64
69
74
Income Statement
Sales
Interest
Forecasts Continued
Year
0
1
2
3
4
5
Current Assets
161
172
184
197
210
Fixed Assets
749
801
858
918
982
910
973
1,041
1,114
1,192
75
80
86
92
98
280
279
277
275
273
Balance Sheet
Total Assets
Current Liabilities
Debt (PLUG)
Equity
Stock
400
400
400
400
400
400
Accumulated
Earnings
100
155
214
278
347
421
910
973
1,041
1,114
1,192
Total Liabilities
Valuation of Dot.coms
• Valuation of Internet companies has been
a hotly discussed topic.
• Most Internet companies have a limited
history and have been losing money.
• Yet, share prices of Internet companies
are (still) extremely high compared to their
financial performance.
Relative Values
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Then: December 2000
AOL (TWX) $132B > Procter & Gamble (PG) $122B
Schwab (SCH) $43B > Merrill Lynch (MER) $29B
Yahoo (YHOO) $40B > New York Times (NYT) $6B
eBay (EBAY) $23B > Sotheby’s (BID) $2B
Priceline.com (PCLN) $23B > US Airways (UAIR) $5B
Amazon (AMZN) $22B > Barnes & Noble (BKS) $2B
And Now: August 2004
AOL (TWX) $77B < Procter & Gamble (PG) $139B
Schwab (SCH) $12B < Merrill Lynch (MER) $47B
Yahoo (YHOO) $38B > New York Times (NYT) $6B
eBay (EBAY) $50B > Sotheby’s (BID) $1B
Priceline.com (PCLN) $.7B > US Airways (UAIR) $.16B
Amazon (AMZN) $15B > Barnes & Noble (BKS) $2B
.Com Values – Give Up Now?
• There are several features of internet firms that make
their valuation a very, very difficult task.
– Is it still worth trying?
– No choice, every day the market has to take its best guess as to
each firm’s value. Just learn to deal with it.
– You get points not for being 100% right, just being right over 50%
of the time!
• Three years ago, everybody expected the internet
consulting business to surge.
– 2000 year-end forecasts estimated the demand for internet
consulting to grow a 50-60% per year, resulting in a market for
these services at 60-70 billion in the year 2003!
– Good example of forecasts gone wild.
Forecasts with Negative Earnings
• Current earnings growth rates cannot be used in valuation. What do
you do now?
• Use analyst estimates of future earnings. But how did they get their
estimates?
• Use your own judgment regarding future costs, and revenues.
– Dot com firms typically have large fixed costs and relative to traditional
firms lower marginal costs.
– A typical forecast will keep the fixed and marginal costs fairly constant
from year to year.
– To get the future earnings you now only need to project out sales
growth. Not easy, but at least you now have a baseline to work with.
• The Going Concern Assumption
– Many Dot.coms have failed in the last several years.
– Before you assume a terminal value with an infinite life, ask yourself
whether or not you believe the probability that the firm will survive is
one? If not remember to adjust you expected cash flows for the
probability the firm will go out of business.
Other Hurdles
• Absence of Historical Data
– Cannot estimate betas based on historical information
about stock prices.
– I would use an asset beta of one. On average it
should be right!
• Absence of Comparable Firms
– Cannot value the company based on multiples.
– But, you can get a handle on things by looking at a
related industry. For example Priceline is a travel
company. What is the beta for firms in the overall
travel and tourism industry?
Amazon.com
Comparison Data
Profitability
Company Industry1 Market2
Gross Profit
23.69%
54.25% 49.37%
Margin
Pre-Tax Profit
4.61%
1.17%
8.79%
Margin
4.61%
-1.92%
5.59%
Net Profit Margin
--- 11.20%
Return on Equity
14.60%
-1.30%
1.90%
Return on Assets
Return on
28.40%
-1.80%
5.50%
Invested Capital
Amazon.com
Valuation
Price/Sales
Ratio
Price/Earnings
Ratio
Price/Book
Ratio
Price/Cash
Flow Ratio
Company Industry1
Market2
2.62
4.81
1.23
58.45
--
40.67
--
5.73
2.47
55.11
91.42
10.82
Amazon.com
Operations
Days of Sales
Outstanding
Inventory
Turnover
Days Cost of
Goods Sold in
Inventory
Asset Turnover
Net Receivables
Turnover Flow
Effective Tax
Rate
Company Industry1 Market2
7.54
38.78
49.12
19.8
25.3
8.4
18
3.4
14
0.7
43
0.4
57.1
10.5
8.2
0.00%
--
33.60%
Amazon.com
Financial
Current Ratio
Quick Ratio
Leverage Ratio
Total Debt/Equity
Interest
Coverage
Company Industry1 Market2
1.7
2.42
1.41
1.4
2.2
1
---
1.73
0.24
5.87
1.38
3.4
2
2.7
Amazon.com
Per Share Data ($)
Company
Industry1 Market2
14.74
3.61
21.85
0.66
-0.13
0.66
Dividends Per Share
0
0.01
0.33
Cash Flow Per Share
0.7
0.19
2.48
Working Capital Per Share
1.59
1.59
-0.18
Long-Term Debt Per Share
4.33
0.67
11.33
Book Value Per Share
-1.94
3.03
10.87
Total Assets Per Share
4.64
5.24
63.82
Revenue Per Share
Fully Diluted Earnings Per Share
from Total Operations
Amazon.com
Company
Industry1
Market2
34.40%
20.60%
15.90%
12-Mo. Net Income Growth
--
--
201.90%
12-Mo. EPS Growth
--
--
61.00%
12-Mo. Dividend Growth
--
-83.30%
-25.00%
36-Mo. Revenue Growth
22.60%
-2.40%
4.40%
36-Mo. Net Income Growth
--
--
11.40%
36-Mo. EPS Growth
--
--
-8.40%
36-Mo. Dividend Growth
--
--
-9.10%
Growth
12-Mo. Revenue Growth
1Industry:
Internet Software & Svcs
Public companies trading on the New York Stock Exchange, the
American Stock Exchange, and the NASDAQ National Market.
2
Data from Hoover’s Online.
DCF Applied to Internet Firms
• At the time of the valuation we might expect an Internet firm to lose
money for at least 5-10 years.
– Will it run out of cash first?
• Since this is close to the forecast horizon in the DCF method, all the
value creation takes place in the continuation period.
• In this sense, DCF is not different from multiples valuation.
• The following are some suggestions to cope with these difficulties:
– Lengthen the projection period from 5 to 10-15 years before assuming
constant growth.
– Use a multiple stage model and apply different growth rates and
discount rates as the return and risk profile of internet companies
change over time,
– Use techniques such as scenario analysis to reduce the risk of
assuming one outcome, which may turn to be way off.
McKinsey Approach: DCF starting
From the future
• This method consists of estimating the key value drivers
once a sustainable growth state has been reached.
• The difficult part involves a thorough analysis of the
economic environment.
– Competition
– Industry position
• The previous analysis would yield a forecast of free cash
flows for something like ten years from now.
• Next link the present to the future in a consistent way
such as linear growth.
• The discount rates may vary in different subperiods.
• Uncertainty may be resolved by means of scenario
analysis
PEG Ratio Method
• The PEG ratio (Price-to-Earnings/Growth Rate) is based
on Peter Lynch’s basic theory that a stock should trade
around the price where the P/E = g.
• Average PEG ratio should equal 1 under this theory.
• Given this theory, the PEG value is the expected
earnings per share times the expected long-term growth
rate.
P/E = g => P = g×E.
• The critical underlying assumption is that the PEG ratio
equals 1 in the long run.
– Implies current growth is a good indicator of future growth.
PEG: The Good and Bad
• The Good
– If all firms within a sector have similar growth rates and market risk, a
strategy of picking the lowest PE ratio stock in each sector will yield
undervalued stocks.
– Portfolio managers and analysts sometimes compare PE ratios to the
expected growth rate to identify under and overvalued stocks.
• Firms with PE ratios less than their expected growth rate are viewed as
undervalued.
• The Bad
– There is no general basis for believing that a firm is undervalued just
because it has a PE ratio less than expected growth.
– This relationship may be consistent with a fairly valued or even an
overvalued firm, if interest rates are high, or if a firm has a high market
risk.
– As interest rates decrease (increase), fewer (more) stocks will emerge
as undervalued using this approach.
PEG: Application
• The PEG ratio is the ratio of P/E to expected growth in earnings per
• share.
PEG = PE / Expected Growth Rate in Earnings.
• Check to make sure the earnings and growth rate used to compute
the PEG ratio are:
– From the same initial year.
– Calculated over the same period (2 years, 5 years).
– Derive from the same source (analyst projections, consensus
estimates).
• Are the earnings used to compute the PE ratio consistent with the
growth rate estimate?
– No double counting. If the estimate of growth in earnings per share is
from the current year, it would be a mistake to use forward EPS in
computing PE.
– Double counting puts the growth rate in twice. Once in the PEG and a
second time in the projected earning’s boost .
PEG and Fundamentals
• Remember that High risk companies will trade at much lower PEG
ratios than low risk companies with the same expected growth rate.
– A company that looks to be the most under valued on a PEG ratio basis
may just be the riskiest firm in the sector.
• Companies that can attain growth more efficiently by investing less
in better return projects will have higher PEG ratios than companies
that grow at the same rate less efficiently.
– Companies that look cheap on a PEG ratio basis may be companies
with high reinvestment rates and poor project returns.
• Companies with very low or very high growth rates will tend to have
higher PEG ratios than firms with average growth rates. This bias is
more pronounced for low growth stocks.
– PEG ratios do not neutralize the growth effect.
Price to Sales
• Unlike price-earnings and price-book value ratios, which can
become negative and not meaningful, the price-sales multiple is
available even for the most troubled firms.
• Unlike earnings and book value, which are heavily influenced by
accounting decisions on depreciation, inventory and extraordinary
charges, revenue is relatively difficult to manipulate.
• Price-sales multiples are not as volatile as price-earnings multiples,
and hence may be more reliable for use in valuation.
• Over time, studies have shown that companies revert to a "normal,"
or average, PSR applicable to the industry in which they operate.
– Big supermarkets, courtesy of their low margins and competitive
environment, usually trade on a PSR of about 0.5
Calculation
• The PS ratio equals the equity value divided by
the firm's sales. You can either use total values
or per share values. Either will give you the
same answer as the units cancel.
E
PS = .
S
•
•
•
•
•
For Amazon (8/6/2004):
Revenues per share $14.74
Stock Price 35.90
PS Current 2.44 = 35.90/14.74
PS Current (Industry) 4.81
Other Multiples
• Basically these are ratios based on measures of
web traffic:
– Price/Customer or User.
– Hit ratios/Click-through ratios (i.e. price/hits etc).
– Price/”growth flow” (growth flow = earnings with R&D
added back in).
Sources:
www.mediametrix.com
www.internet.com