SSE Riga Investment Fund Board 2011/2012 Elections

SSE Riga Investment Fund Board 2011/2012 Elections

23/05/2011

Agenda

Info about iFundElections’ procedureQuestions

iFund Structure

5 board membersSeveral associates from Y2~40 supporting people from Y1

iFund Structure: Board

Chairman of the BoardInvestment Game OrganizerCorporate Relations ManagerPortfolio ManagerMacroeconomist/Y1 coordinator

iFund ActivitiesFundraisingInvestment GamePortfolio managementEducational seminarsInvestment [UN]limitedGuest lecturesScholarships

Elections’ Procedure

Signing upValuation of a companyPresentationsInterviewsHandover party

Signing up

Send an email to ifund@sseriga.edu.lv expressing your wish to participateASAP

Valuation of a CompanyMain part of electionsTime - from May 23rd to June 8th More on it later tonight

Presentations & InterviewsPresentations on June 10/13th

10 minutes + time for questions

Interviews on June 14-15th

Short interviews with current board members

Handover Party

One of the most exclusive eventsTime – June 18th

Place – Laba pirtsMembers of new board announcedElections of the chairman

WHY?Managerial Experience

Something to put on your CV

NetworkingSome way to get good contacts for good internship during Year 2

Real investment opportunitiesPortfolio worth of 1500LVL

WHY (2)?There is a robust tendency that iFund ex-board members get sexy future employment positions

Barclay’s CapitalMerrill LynchCentral Banks (LV)BCG

Thank you for your attention

Questions?

Valuation Instructions

May 23, 2010

Your Task€ Prepare a DCF valuation of a company

listed on any of Baltic stock exchangesRefrain from financial and insurance companies!

€ Task has been developed by 2001/2002 board

Introduction to the Model

Your output must consist of two parts:

€ Valuation model:Excel file

€ Valuation report:Up to 10 pages of text excluding appendices

Valuation ReportGeneral company dataCompany’s market environment:

Industry outlook

Company’s market position

Products/services of the company

Evaluation and analysis of financial performanceResults of the valuation modelAdvice to investors

DCF Steps

#1: Forecast and construct future IS, BS, CF#2: Calculate Free Cash Flows (FCF)#3: Find the equity risk () and risk premium (rm-rf)

#4: Find required rate of return on equity (re)

#5: Find the discount rate (WACC)#6: Find the Terminal Value, and discount all cash flows

DCF Steps

#1: Forecast and construct future IS, BS, CF#2: Calculate Free Cash Flows (FCF)#3: Find the equity risk () and risk premium (rm-rf)

#4: Find required rate of return on equity (re)

#5: Find the discount rate (WACC)#6: Find the Terminal Value, and discount all cash flows

Forecasting Financial Statements (1)€ Choose a listed company from any of the Baltic

stock exchanges€ Create the model in MS Excel first€ Make separate sheets for:

Inputs, IS, CF, BS, (Sales, Costs, Investments, etc)For Free Cash Flows (CFC) calculations

€ Construct IS, BS, CF for the future € IS and BS of 2010 as a starting point

Do not try to re-create previous CF statements!€ Make sure the model is error-free

Fixed assets 1 500 1 520 Revenues 450 500 Cash Flows from Operations 167 Plant 1 000 1045 COGS -145 160 EBIT 135 Equipment 500 475 Gross profit 305 340 (+) Interest income 5Current assets 300 357 Operating expenses -185 -205 (-) Interest expense -30 Inventory 100 110 Salaries -50 -55 (-) Taxes paid -33 Debtors 150 135 R&D -30 -35 (+) Depreciation 80 Cash 50 112 Marketing -25 -30 Change in Working CapitalTotal assets 1 800 1 877 Depreciation -75 -80 (-/+) Increase / decrease in inventory -10

Other -5 -5 (-/+) Increase / decrease in Debtors 15EBIT 120 135 (+/-) Increase / decrease in creditors 5

Equity and reserves 1 395 1 412 Interest income 5 5 Capital 1 200 1 200 Interest expense -25 -30 Cash Flows from Investments -100 Retained earnings 125 135 Earnings before taxes 100 110 (-) Investments in f ixed assets (i.e. plant) -100 Last year profit 70 77 Taxes, 30% -30 -33 (+) Sale of f ixed assets 0Long-term liebilities 250 300 Net Income 70 77

Loan, 10% 250 300 Cash flows from Financing activities -5Short-term liabilities 155 165 proposed dividends 55 60 (-) Dividends payed -55 Creditors 100 105 (-) Shares repurchase 0 Dividends payable 55 60 (+) New shares issue 0Total liabilities 1 800 1 877 (-) Loan repayment 0

(+) New loan 50

Total Cash flow 62

(+) Opening cash 50Closing cash 112

old assets + invest - depreciation(if investments at the beginning of the year is assumed)

dividends proposed for 2002; liability to shareholders

taxes are assumed to be paid imediately (1500+100) * 5%

(if 20 years depreciation)

Balance sheet 2001 2002 Income Statement 2001 2002 CF statement 2002

Fixed assets 1 500 1 520 Revenues 450 500 Cash Flows from Operations 167 Plant 1 000 1045 COGS -145 160 EBIT 135 Equipment 500 475 Gross profit 305 340 (+) Interest income 5Current assets 300 357 Operating expenses -185 -205 (-) Interest expense -30 Inventory 100 110 Salaries -50 -55 (-) Taxes paid -33 Debtors 150 135 R&D -30 -35 (+) Depreciation 80 Cash 50 112 Marketing -25 -30 Change in Working CapitalTotal assets 1 800 1 877 Depreciation -75 -80 (-/+) Increase / decrease in inventory -10

Other -5 -5 (-/+) Increase / decrease in Debtors 15EBIT 120 135 (+/-) Increase / decrease in creditors 5

Equity and reserves 1 395 1 412 Interest income 5 5 Capital 1 200 1 200 Interest expense -25 -30 Cash Flows from Investments -100 Retained earnings 125 135 Earnings before taxes 100 110 (-) Investments in f ixed assets (i.e. plant) -100 Last year profit 70 77 Taxes, 30% -30 -33 (+) Sale of f ixed assets 0Long-term liebilities 250 300 Net Income 70 77

Loan, 10% 250 300 Cash flows from Financing activities -5Short-term liabilities 155 165 proposed dividends 55 60 (-) Dividends payed -55 Creditors 100 105 (-) Shares repurchase 0 Dividends payable 55 60 (+) New shares issue 0Total liabilities 1 800 1 877 (-) Loan repayment 0

(+) New loan 50

Total Cash flow 62

(+) Opening cash 50

125+70-60 (dividends)

Forecasting Financial Statements (2)€ Revenues disaggregated by products or countries:

i.e. industry / market growth (%), market share (%)€ Creditors, debtors (credit days), inventories, COGS

depend on sales € Interest income and expense depend on financial

assets (cash and other), and loans€ Dividends follow earnings in the long run€ Investments depend on company’s strategy€ Check for consistency of past and future ratios

(profitability, credit days, margins, turnovers)

Forecasting Financial Statements (3)In theory, to calculate a company value, future cash flows should be forecasted as long as they lastNo sense to forecast up to infinityTwo-stage valuation:

Forecast 4 - 5 years in detail to get cash flowsCalculate company’s value (terminal value) after explicit forecast period assuming constant future growth and profitability

44

433

221

0 r)(1

P

r)(1

CF

r)(1

CF

r)(1

CF

r)(1

CFP

4

Calculating FCF

€ Which cash flows to discount?Dividends (equity value)Earnings * payout ratio (equity value)FCF (company value)

€ FCF advantage over dividends and earnings:no need to forecast how cash flows will be distributed among capital providers

€ Free Cash Flows (FCF) – cash flows to all providers of capital€ FCF is obtained by modifying Cash Flow statement

DCF Steps

#1: Forecast and construct future IS, BS, CF

#2: Calculate Free Cash Flows (FCF)#3: Find the equity risk () and risk premium (rm-rf)

#4: Find required rate of return on equity (re)

#5: Find the discount rate (WACC)#6: Find the Terminal Value, and discount all cash flows

CF statement 2002 Modified CF statement 2002

Cash Flows from Operations 167 Cash Flows from Operations 126EBIT 135 EBIT 135(+) Interest income 5 (-) Taxes on EBIT, 30% -40,5(-) Interest expense -30 NOPLAT 94,5(-) Taxes paid -33 (+) Depreciation 80(+) Depreciation 80 Change in Working CapitalChange in Working Capital (-/+) Increase / decrease in inventory -10 (-/+) Increase / decrease in inventory -10 (-/+) Increase / decrease in Debtors 15 (-/+) Increase / decrease in Debtors 15 (-/+) Increase / decrease in Cash -62 (+/-) Increase / decrease in creditors 5 (+/-) Increase / decrease in creditors 5

(+) Interest income after taxes 3,5Cash Flows from Investments -100(-) Investments in f ixed assets (i.e. plant) -100 Cash Flows from Investments -100(+) Sale of f ixed assets 0 (-) Net investments -100

Cash flows from Financing activities -5 FREE CASH FLOW 26

(-) Dividends payed -55(-) Shares repurchase 0 Cash flows from Financing activities(+) New shares issue 0 (-) Dividends payed -55(-) Loan repayment 0 (-) Shares repurchase 0(+) New loan 50 (+) New shares issue 0

(-) Loan repayment 0Total Cash flow 62 (+) New loan 50

(+) Opening cash 50 (-) Interest expense, less taxes -21Closing cash 112 Cash flows from Financing activities -26

135 * 30%

if cash increased, the diference shouldbe substractedbecause it is not paidout to capital providers

5 * (1 - 0,30)

30 * (1 - 0,30)

Net Operating profitsless adjusted taxes

should be equal

DCF Steps

#1: Forecast and construct future IS, BS, CF#2: Calculate Free Cash Flows (FCF)

#3: Find the equity risk () and risk premium (rm-rf)

#4: Find required rate of return on equity (re)

#5: Find the discount rate (WACC)#6: Find the Terminal Value, and discount all cash flows

Finding Discount Rate€ For company valuation, Weighted Average

Cost of Capital (WACC) is the appropriate discount rate

Assume constant D/E ratioIt is reasonable to assume that MV(D)=BV(D)MV (Equity) – capitalization (number of shares outstanding multiplied by share price)If substantial changes in WACC inputs are expected, it should be recalculated each year

44

433

221

0 r)(1

P

r)(1

CF

r)(1

CF

r)(1

CF

r)(1

CFP

4Recall:

Discount Rate (WACC)

)D(MV MV(Equity)

MV(Equity)r)T1(

)D(MV MV(Equity)

)MV(DCODWACC

ibequityc

ib

ibib

CODib – Cost of interest bearing debt

Tc – Corporate tax rate

MV – market valuerequity – required rate of return of equity

Required Rate of Return (re) (1)

€ Cost of Debt can be calculated and estimated from IS and BS:

CODib = [Interest expense] / Dib

€ Required rate of return on equity?€ CAPM: Capital Asset Pricing Model

Finding required returns on all risky assets

Re – Required rate of return

(Rm – Rf) – Risk premium (Rm – market return)

Rf – Risk free interest rate

- Asset risk

Required Rate of Return (re) (2)€ Risk free interest rate (Rf)€ Risk premium (Rm – Rf) in mature (US) market (in

1926 – 1998) was 6.1%)€ If country of interest is not US, additional

country risk exists

€ Adjustment for Re calculations in emerging markets is offered by A. Damodaran

Risk Premium for Emerging Markets€ Re = Rf + * RPb + RPc

Rf - Risk free interest rate (Gov. bonds/interbank rate)

RPb – Base risk premium for mature market (US)

RPc – Country risk premium, calculated:

€ RPc = Ds * (Qe / Qb) Ds – country default spread http://www.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Qe – standard deviation of local equity index

Qb – standard deviation of local bond index

€ More information in A. Damodaran paper “Estimating equity risk premiums”

http://www.stern.nyu.edu/~adamodar/pdfiles/papers/riskprem.pdf

Equity Risk – Beta (1)€ Holders of a risky assets are paid only for systematic risk (health of economy, interest rates, etc) and not for company specific risk (delays in product launch, etc)€ Company specific risk can be diversified

Beta () – measurement ofsystematic risk Beta shows by how much the asset price changes

when the market risk premium increases by 1% Systematic risk

Company Specific risk

Number of companiesin portfolio

Var

Equity Risk - Beta (2)

security,market – covariance between the returns on the security and market returnsm

2 – market return varianceFor calculations daily/weekly returns can be takenTo estimate beta it is recommended to calculate industry beta by taking industry stocks portfolio (weighted according to capitalization) returns instead of stock ones.

2market

market security,

σ

σβ

Equity Risk - Beta (3)

€ Betas calculated according to emerging markets returns can be rather misleading

€ Possible way outUse already calculated relevant industry’s betas http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html

€ Try calculating both for local market and taking already calculated numbers. Use the one, which you think to be more appropriate. Discuss your choice

Terminal Value (1)€ If you have forecasted cash flows for n years,

what is the company value at the end of nth year?

€ CFn+1 – cash flow for the (n+1)th year€ g – growth rate (industry growth pace)

€ T=(CFn+1)/(r-g)€ Where, g- growth rate and r - WACC

RecapSelect forecasting horizon (4 - 5 years)Project future sales, costs, working capital, etcConstruct IS, BS, CF statementsUsing financial ratios check for consistencyFind Beta and risk premium, calculate required rate of return on equityCalculate Weighted average cost of capitalCalculate Free Cash Flows and Terminal valueDiscount using WACC

Recommendations€ V(equity) = V(company) – Net Debt€ Share price = V(equity) / number of shares€ Sensitivity analysis before making recommendations is

suggested:Check how results change if you increase / decrease by 1% or 2% WACC and growth rate (g)

€ Because future forecasts are obviously inaccurate, suggestions to buy (or sell) stock can be made only if value obtained by calculations is bigger (or smaller) than the current market price by at least 15%

Submission

Your valuations (excel file and report) should be received at ifund.sseriga@gmail.com no later than 23:59 June 8th

Good luck!