Transcript Training - Chris Argyrople's Web Site

Introduction to Equity
Valuation
Chris Argyrople, CFA
Concentric LLC
Enterprise Valuation &
Cash Flow Analysis
1
Today in the Financial Markets
(1998)
• Hollywood Entertainment had a tender
offer for $11 / share that fell through.
• Not enough investors wanted to sell at the
$11 price
• What happened ???
• The stock fell 20% to close at $8.8125 !!
• DOES THIS MAKE SENSE ?? ARBs
Unwinding ??
2
Today in the Markets, 9/15/98
• Dow rose above 8,000 again, nobody
knows where it will go next.
• Port Mgr: Likes Rainforest Café (RAIN)
• Stock closed at $6 5/16
• He says $3 net cash
• 98 EPS estimate is $0.75
• Is it a screaming buy???
• Feb 1, 1999 Price $ 5 7/8
• STOCK ULTIMATELY FELL TO $1
3
M&M’s Theory
• The Value of An Asset is Independent of
How it is Financed
• Example: Buy a $300,000 house. At
closing, the seller just wants a certified
check for $300,000. He doesn’t care
whether the money came out of your
passbook account or whether you wrote a
mortgage.
• This logic holds for all assets
4
Modigliani & Miller (M&M)
• M&M Postulated that, “Capital Structure
Does Not Matter”
• Do you Agree?? Why or Why not?
My View:
• At any instant, CS DOESN’T MATTER
• But, as time horizon lengthens, CS DOES
Matter.
• Debate??
5
P/E Ratio can be Misleading
Company A & B
are Identical
Company
A
Income Statement
Revenue
COGS
SG&A
Depreciation
Operating Income
Identical:
Expense/Inc.
Assets, CashFlow,Interest
PBT
Taxes
Growth Rates
NI
P/E’s:
A = 15.0 , B =8.5
Memo:
Debt
Stock Market Value
Enterprise Value
P/E Ratio
B
250.5
(133.7)
(26.0)
(34.1)
56.7
250.5
(133.7)
(26.0)
(34.1)
56.7
(1.0)
(45.0)
55.7
(22.3)
33.4
11.7
(4.7)
7.0
10
500
510
450
60
510
15.0
6
8.5
Why P/E is Misleading
• Why is P/E Misleading? Comments?
• Why doesn’t Interest Expense properly
account for associated cost of the debt?
– Capitalized Interest
– Yield Curve: ST Debt vs. LT Debt
• This is part of it, but:
• Cost of Debt NOT = Cost of Equity
– You can’t compare Apples & Oranges
7
So, is B Cheaper than A?
• Which firm’s stock is cheaper, B or A?
• My answer: B is cheaper (lower P/E), but A
is probably a better equity investment.
• A is less risky, throws off more free cash
flow, and has less constraints (less debt)
• B’s debt constrains its choices, and if
something goes wrong, B gets hammered
• Debt can make managements either: Very
Aggressive OR Very Risk Averse
8
Enterprise Value
• Total Enterprise Value (TEV) = Firm Value
• TEV = Debt + Equity - Cash
– Use Market Values, NOT Book Values, but, it
is ok to use Book Debt as a Proxy for Market
Debt (usually)
– Measures the value of the entire company,
independent of capital structure.
– This is the right way to do it. Any
arguments??
9
Why Subtract Cash from TEV?
• Cash is not really part of the business, it is
portable & fungible
• It can be used to pay down debt (same as
subtracting off cash from TEV)
• It can be dividended to equityholders
(same as subtracting cash from TEV)
• IMAGINE A SHELL COMPANY WITH
ONLY CASH, WHAT IS THE COMPANY
WORTH? This is why you subtract cash.
10
More Sophisticated TEV
TEV = Debt + Equity - Working Capital
• If there is extra working capital, it may
make sense to subtract off the WC
• This technique is difficult to implement
because companies require a certain
amount of WC to sustain operations, so it
is difficult to ascertain how much to
subtract. Subtracting WC is sophistic.
11
TEV Trick
• Subtract Working Capital when it is
Negative
• Why? Because negative Working Capital
usually requires additional funding, thus
diluting current stockholders (somehow)
• Subtracting a negative is equivalent to
adding the Working Capital to TEV
• When WC < 0, it would be kind of
erroneous to subtract cash (wrong way)
12
Valuation: Operating Cash Flow
• How do we value a company using TEV?
Answer:
• Compare Enterprise Value to Operating
Cash Flow
• EBITDA = Earnings Before Interest Taxes
Depreciation & Amortization
• EBITDA = Operating Cash Flow
• EBITDA = Operating Income + NonCash
Charges 13
What is EBITDA?
• EBITDA is the Cash Flow thrown off by the
underlying business
• Because it is before Financing Charges,
Taxes, and Accounting Choices it is more
difficult for management to “game.”
• Obviously, EBITDA is still subject to
Revenue Recognition and Inventory
Accounting issues
14
Why EBITDA is Better
• EBITDA is not Subject to acceleration of
Depreciation or Amortization
• EBITDA is not affected by Capitalized
Interest
• EBITDA is not altered by Capital Structure
• EBITDA is not subject to Tax tricks
• It is a cash flow measure, and businesses
are propelled by cash
15
Valuation: TEV & EBITDA
• Use TEV / EBITDA as one of your primary
metrics.
• Low TEV / EBITDA ratios are good
• TEV / EBITDA = measures the value of
entire business vs. the operating cash flow
• Better Apples to Apples Comparison than:
P/E, P/Book, and Price/Revenue ratios
16
Key Valuation Points
• Ratios like P/E are of little value by
themselves. They must be compared to
similar firms to identify “Relative Value”
• Growth Rate drives Valuations, if this is
not the case, then you have a mis-pricing
• Estimating Growth Rates is very difficult,
Very Difficult if not Impossible.
• So, what do you do?
17
Valuation: Cash Flow Ratios
• TEV / EBITDA = Firm Value to OCF
• TEV / Revenue = Firm Value to Revenue
• EBITDA / Sales = Cash Flow Margins
• MV Equity/FCFE = “Real” P/E,
Free Cash Flow (FCFE) Mult.
• EBITDA / Interest = Interest Coverage
• Debt / EBITDA = Leverage Indicator
18
Asset Valuation
• Asset Value = PV(cash flows)
• Cash flows are independent of financing,
BUT
• Financing can dominate the Enterprise
Value of a company
• What does this Mean???
19
FREE CASH FLOW
• Above all: FREE CASH FLOW IS KING
• (if you could predict growth, then growth
would be King)
• Free Cash Flow to Equity = FCFE
• FCFE = NI + Depreciation & Amort - Capex
• NI = Net Income
• Capex = Capital Expenditures
20
How Free Cash Works
Balance Sheet
Cash
Other Assets
Total Assets
Debt
Other Liab & Eq.
Free Cash Flow
Year 1
10
400
410
65
345
30
Year 2
10
400
410
35 Debt
375 O.E.
21
Back to Company A & B
Income Statement
Year 1
A
Year 2
Year 3
Revenue
COGS
SG&A
Depreciation
250.5
(133.7)
(26.0)
(34.1)
250.5
(133.7)
(26.0)
(34.1)
250.5
(133.7)
(26.0)
(34.1)
Operating Income
Interest Expense/Inc.
56.7
(1.0)
56.7
56.7
0.5
1.6
Year 4
Year 1
B
Year 2
Year 3
250.5
(133.7)
(26.0)
(34.1)
250.5
(133.7)
(26.0)
(34.1)
250.5
(133.7)
(26.0)
(34.1)
56.7
56.7
56.7
(45.0)
(45.6)
(46.2)
PBT
Taxes
NI
55.7
(22.3)
33.4
57.2
(22.9)
34.3
58.3
(23.3)
35.0
11.7
(4.7)
7.0
11.1
(4.4)
6.7
10.5
(4.2)
6.3
Capital Expenditures
(47.0)
(47.0)
(47.0)
(47.0)
(47.0)
(47.0)
20.5
21.4
22.1
(5.9)
(6.2)
(6.6)
10.0
500.0
10.5
520.5
31.9
541.9
54.0
564.0
450.0
60.0
455.9
54.1
462.1
47.9
510.0
510.0
510.0
510.0
510.0
510.0
510.0
P/E Ratio
15.0
15.2
15.5
8.5
8.1
7.6
Stock % Return
4.1%
4.1%
4.1%
Free Cash Flow
Beginning of Year B/S:
Cash
Debt
Stock Market Value
Enterprise Value
-9.8%
-11.5%
-13.8%
Year 4
468.7
41.3
510.0
22
Free Cash Improves the
B/Sheet
• In the Example, Free Cash of 30 can be
used to:
– PAY DOWN DEBT
– INCREASE CASH
– DIVIDEND PAYMENT
– ACQUISITIONS
– SHARE BUYBACK
– UPGRADE PP&E
– NEW PROJECTS
A GOOD THING
A GOOD THING
A GOOD THING
A GOOD THING
A GOOD THING
A GOOD THING
A GOOD THING
23
If Free Cash was -30
• After dipping into cash of 10, THE
COMPANY WOULD HAVE TO COME UP
WITH THE OTHER 20 !!! HOW?
– BORROW MORE
– ISSUE EQUITY
– GO BANKRUPT
– SQUEEZE WORKING CAP.
– SELL ASSETS
– CUT DOWN CAPITAL EXP.
A BAD THING
A BAD THING
A BAD THING
A BAD THING
A BAD THING
A BAD THING
24
Argyrople Intro. Rule of Thumb
Buy Stocks: Positive Free Cash Flow
Short Stocks: Negative Free Cash Flow
You wouldn’t believe how many people don’t
understand this.
This is a simple rule that will keep you out of
some trouble.
25
Assuming No Valuation Change (TEV)
• With No Valuation Change, Free Cash
Flow is what determines the change in
stock price. This is a simple concept, but
most students don’t understand it.
• Company A & B are Identical from the
OCF line up, but due to capital structure,
A’s stock rises & B’s stock falls.
• I DON’T BELIEVE M&M EXPLAINS THIS
PROBLEM
26
M&M was Right & Wrong
• In our No-Growth example, Capital
Structure does not affect the value of the
assets (partially because the positive free
cash flow firm builds cash & does not add
to assets)
• Enterprise Value stays constant BUT
• Stock of Positive FCF firm Rises
• Stock of Negative FCF firm Falls
27
Thus, Modified M&M
• At any point in time, Capital Structure
does not matter -- Value of the Assets is
Independent of Financing
• Over time, Capital Structure does matter
for stockholders AND it is important to the
total enterprise value of the firm too
(because eventually the stock of firm B will
be wiped out) -- Cash Flow thrown off by
Assets is altered by Financing
28