BEYONDINPUTS:CHOOSINGANDUSINGTHERIGHTMODEL

Choosingtherightmodel

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SummarizingtheInputs

¨ Insummary,atthisstageintheprocess,weshouldhaveanestimateofthe¤ thecurrentcashflowsontheinvestment,eithertoequityinvestors(dividendsorfreecashflowstoequity)ortothefirm(cashflowtothefirm)

¤ thecurrentcostofequityand/orcapitalontheinvestment¤ theexpectedgrowthrateinearnings,baseduponhistoricalgrowth,analystsforecastsand/orfundamentals

¨ Thenextstepintheprocessisdeciding¤ whichcashflowtodiscount,whichshouldindicate¤ whichdiscountrateneedstobeestimatedand¤ whatpatternwewillassumegrowthtofollow

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WhichcashflowshouldIdiscount?

¨ UseEquityValuation(a)forfirmswhichhavestableleverage,whetherhighornot,and(b)ifequity(stock)isbeingvalued

¨ UseFirmValuation(a)forfirmswhichhaveleveragewhichistoohighortoolow,andexpecttochangetheleverageovertime,becausedebtpaymentsandissuesdonothavetobefactoredinthecashflowsandthediscountrate(costofcapital)doesnotchangedramaticallyovertime.(b)forfirmsforwhichyouhavepartialinformationonleverage(eg:interestexpensesaremissing..)(c)inallothercases,whereyouaremoreinterestedinvaluingthefirmthantheequity.(ValueConsulting?)

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Givencashflowstoequity,shouldIdiscountdividendsorFCFE?

¨ UsetheDividendDiscountModel(a)Forfirmswhichpaydividends(andrepurchasestock)whichareclosetotheFreeCashFlowtoEquity(overaextendedperiod)(b)ForfirmswhereFCFEaredifficulttoestimate(Example:BanksandFinancialServicecompanies)

¨ UsetheFCFEModel(a)ForfirmswhichpaydividendswhicharesignificantlyhigherorlowerthantheFreeCashFlowtoEquity.(Whatissignificant?...Asaruleofthumb,ifdividendsarelessthan80%ofFCFEordividendsaregreaterthan110%ofFCFEovera5-yearperiod,usetheFCFEmodel)(b)Forfirmswheredividendsarenotavailable(Example:PrivateCompanies,IPOs)

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WhatdiscountrateshouldIuse?

¨ CostofEquityversusCostofCapital¤ Ifdiscountingcashflowstoequity ->CostofEquity¤ Ifdiscountingcashflowstothefirm ->CostofCapital

¨ Whatcurrencyshouldthediscountrate(riskfreerate)bein?¤ Matchthecurrencyinwhichyouestimatetheriskfreeratetothecurrencyofyourcashflows

¨ ShouldIuserealornominalcashflows?¤ Ifdiscountingrealcashflows ->realcostofcapital¤ Ifnominalcashflows ->nominalcostofcapital¤ Ifinflationislow(<10%),stickwithnominalcashflowssincetaxesarebaseduponnominalincome

¤ Ifinflationishigh(>10%)switchtorealcashflows

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WhichGrowthPatternShouldIuse?

¨ Ifyourfirmis¤ largeandgrowingatarateclosetoorlessthangrowthrateoftheeconomy,or¤ constrainedbyregulationfromgrowingatratefasterthantheeconomy¤ hasthecharacteristicsofastablefirm(averagerisk&reinvestmentrates)

UseaStableGrowthModel¨ Ifyourfirm

¤ islarge&growingatamoderaterate(≤Overallgrowthrate+10%)or¤ hasasingleproduct&barrierstoentrywithafinitelife(e.g.patents)

Usea2-StageGrowthModel¨ Ifyourfirm

¤ issmallandgrowingataveryhighrate(>Overallgrowthrate+10%)or¤ hassignificantbarrierstoentryintothebusiness¤ hasfirmcharacteristicsthatareverydifferentfromthenorm

Usea3-Stageorn-stageModel

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TheBuildingBlocksofValuation

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Choose aCash Flow Dividends

Expected Dividends toStockholders

Cashflows to Equity

Net Income- (1- δ) (Capital Exp. - Deprec’n)

- (1- δ) Change in Work. Capital= Free Cash flow to Equity (FCFE)[δ = Debt Ratio]

Cashflows to Firm

EBIT (1- tax rate)- (Capital Exp. - Deprec’n)- Change in Work. Capital= Free Cash flow to Firm (FCFF)

& A Discount Rate Cost of Equity• Basis: The riskier the investment, the greater is the cost of equity.• Models:

CAPM: Riskfree Rate + Beta (Risk Premium)APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors

Cost of CapitalWACC = ke ( E/ (D+E))

+ kd ( D/(D+E))

kd = Current Borrowing Rate (1-t)E,D: Mkt Val of Equity and Debt

& a growth pattern

t

gStable Growth

gTwo-Stage Growth

|High Growth Stable

gThree-Stage Growth

|High Growth StableTransition

TYINGUPLOOSEENDS

Thetroublestartsafteryoutellmeyouaredone..

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Butwhatcomesnext?

Value of Operating Assets

+ Cash and Marketable Securities

+ Value of Cross Holdings

+ Value of Other Assets

Value of Firm

- Value of Debt

= Value of Equity

- Value of Equity Options

= Value of Common Stock

/ Number of shares

= Value per share

Operating versus Non-opeating cashShould cash be discounted for earning a low return?

How do you value cross holdings in other companies?What if the cross holdings are in private businesses?

What about other valuable assets?How do you consider under utlilized assets?

What should be counted in debt?Should you subtract book or market value of debt?What about other obligations (pension fund and health care?What about contingent liabilities?What about minority interests?

What equity options should be valued here (vested versus non-vested)?How do you value equity options?

Should you divide by primary or diluted shares?

Should you discount this value for opacity or complexity?How about a premium for synergy?What about a premium for intangibles (brand name)?

Should there be a premium/discount for control?Should there be a discount for distress

Should there be a discount for illiquidity/ marketability?Should there be a discount for minority interests?

Since this is a discounted cashflow valuation, should there be a real option premium?

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1.TheValueofCash

¨ Thesimplestandmostdirectwayofdealingwithcashandmarketablesecuritiesistokeepitoutofthevaluation- thecashflowsshouldbebeforeinterestincomefromcashandsecurities,andthediscountrateshouldnotbecontaminatedbytheinclusionofcash.(Usebetasoftheoperatingassetsalonetoestimatethecostofequity).

¨ Oncetheoperatingassetshavebeenvalued,youshouldaddbackthevalueofcashandmarketablesecurities.

¨ Inmanyequityvaluations,theinterestincomefromcashisincludedinthecashflows.Thediscountratehastobeadjustedthenforthepresenceofcash.(Thebetausedwillbeweighteddownbythecashholdings).Unlesscashremainsafixedpercentageofoverallvalueovertime,thesevaluationswilltendtobreakdown.

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AnExerciseinCashValuation

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CompanyA CompanyB CompanyC

EnterpriseValue $1,000.0 $1,000.0 $1,000.0

Cash $100.0 $100.0 $100.0

Returnoninvestedcapital 10% 5% 22%

Costofcapital 10% 10% 12%

Tradesin US US Argentina

In which of these companies is cash most likely to bea) A Neutral Asset (worth $100 million)b) A Wasting Asset (worth less than $100 million)c) A Potential Value Creator (worth >$100 million)

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Shouldyoueverdiscountcashforitslowreturns?

¨ Therearesomeanalystswhoarguethatcompanieswithalotofcashontheirbalancesheetsshouldbepenalizedbyhavingtheexcesscashdiscountedtoreflectthefactthatitearnsalowreturn.¤ Excesscashisusuallydefinedasholdingcashthatisgreaterthanwhatthe

firmneedsforoperations.¤ Alowreturnisdefinedasareturnlowerthanwhatthefirmearnsonits

non-cashinvestments.¨ Thisisthewrongreasonfordiscountingcash.Ifthecashisinvested

inrisklesssecurities,itshouldearnalowrateofreturn.Aslongasthereturnishighenough,giventherisklessnatureoftheinvestment,cashdoesnotdestroyvalue.

¨ Thereisarightreason,though,thatmayapplytosomecompanies…Managerscandostupidthingswithcash(overpricedacquisitions,pie-in-the-skyprojects….)andyouhavetodiscountforthispossibility.

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Cash:DiscountorPremium?

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ADetour:ClosedEndMutualFunds

¨ Assumethatyouhaveaclosed-endfundthatinvestsin‘averagerisk” stocks.Assumealsothatyouexpectthemarket(averageriskinvestments)tomake11.5%annuallyoverthelongterm.Iftheclosedendfundunderperformsthemarketby0.50%,estimatethediscountonthefund.

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TheMostFamousClosedEndFundinHistory?

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1.84

2.272.42

1.90

2.62

1.91

1.33

1.62

1.87

1.57

1.82

1.611.52 1.52

1.80

1.07

1.54

1.37

1.211.34 1.29

1.51

1.30

0.00

0.50

1.00

1.50

2.00

2.50

3.00

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

BerkshireHathaway:TheFadingBuffettPremium

P/BVRatio MarketCap BVofEquity

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2.DealingwithHoldingsinOtherfirms

¨ Holdingsinotherfirmscanbecategorizedinto¤ Minoritypassiveholdings,inwhichcaseonlythedividendfromtheholdingsisshowninthebalancesheet

¤ Minorityactiveholdings,inwhichcasetheshareofequityincomeisshownintheincomestatements

¤ Majorityactiveholdings,inwhichcasethefinancialstatementsareconsolidated.

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AnExerciseinValuingCrossHoldings

¨ AssumethatyouhavevaluedCompanyAusingconsolidatedfinancialsfor$1billion(usingFCFFandcostofcapital)andthatthefirmhas$200millionindebt.HowmuchistheequityinCompanyAworth?

¨ NowassumethatyouaretoldthatCompanyAowns10%ofCompanyBandthattheholdingsareaccountedforaspassiveholdings.IfthemarketcapofcompanyBis$500million,howmuchistheequityinCompanyAworth?

¨ NowaddontheassumptionthatCompanyAowns60%ofCompanyCandthattheholdingsarefullyconsolidated.TheminorityinterestincompanyCisrecordedat$40millioninCompanyA’sbalancesheet.HowmuchistheequityinCompanyAworth?

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MoreonCrossHoldingValuation

¨ Buildingonthepreviousexample,assumethat¤ YouhavevaluedequityincompanyBat$250million(whichishalfthemarket’sestimateofvaluecurrently)

¤ CompanyAisasteelcompanyandthatcompanyCisachemicalcompany.Furthermore,assumethatyouhavevaluedtheequityincompanyCat$250million.

¤ EstimatethevalueofequityincompanyA.

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Ifyoureallywanttovaluecrossholdingsright….

¨ Step1:Valuetheparentcompanywithoutanycrossholdings.Thiswillrequireusingunconsolidatedfinancialstatementsratherthanconsolidatedones.

¨ Step2:Valueeachofthecrossholdingsindividually.(Ifyouusethemarketvaluesofthecrossholdings,youwillbuildinerrorsthemarketmakesinvaluingthemintoyourvaluation.

¨ Step3:ThefinalvalueoftheequityintheparentcompanywithNcrossholdingswillbe:¤ Valueofun-consolidatedparentcompany¤ – Debtofun-consolidatedparentcompany¤ +

€

% owned of Company j * (Value of Company jj=1

j=N

∑ - Debt of Company j)

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ValuingYahooasthesumofitsintrinsicpieces

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Ifyouhavetosettleforanapproximation,trythis…

¨ Formajorityholdings,withfullconsolidation,converttheminorityinterestfrombookvaluetomarketvaluebyapplyingapricetobookratio(baseduponthesectoraverageforthesubsidiary)totheminorityinterest.¤ Estimatedmarketvalueofminorityinterest=Minorityintereston

balancesheet*PricetoBookratioforsector(ofsubsidiary)¤ Subtractthisfromtheestimatedvalueoftheconsolidatedfirmtoget

tovalueoftheequityintheparentcompany.¨ Forminorityholdingsinothercompanies,convertthebook

valueoftheseholdings(whicharereportedonthebalancesheet)intomarketvaluebymultiplyingbythepricetobookratioofthesector(s).Addthisvalueontothevalueoftheoperatingassetstoarriveattotalfirmvalue.

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Yahoo:Apricinggame?

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3.OtherAssetsthathavenotbeencountedyet..

¨ Assetsthatyoushouldnotbecounting(oraddingontoDCFvalues)¤ Ifanassetiscontributingtoyourcashflows,youcannotcountthemarketvalueof

theassetinyourvalue.Thus,youshouldnotbecountingtherealestateonwhichyourofficesstand,thePP&Erepresentingyourfactoriesandotherproductiveassets,anyvaluesattachedtobrandnamesorcustomerlistsanddefinitelynonon-assets(suchasgoodwill).

¨ Assetsthatyoucancount(oraddontoyourDCFvaluation)¤ Overfundedpensionplans:Ifyouhaveadefinedbenefitplanandyourassets

exceedyourexpectedliabilities,youcouldconsidertheoverfundingwithtwocaveats:n Collectivebargainingagreementsmaypreventyoufromlayingclaimtothese

excessassets.n Therearetaxconsequences.Often,withdrawalsfrompensionplansgettaxedat

muchhigherrates.¤ Unutilizedassets:Ifyouhaveassetsorpropertythatarenotbeingutilizedto

generatecashflows(vacantland,forexample),youhavenotvaluedthemyet.Youcanassessamarketvaluefortheseassetsandaddthemontothevalueofthefirm.

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AnUncountedAsset?

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Price tag: $200 million