Company Valuation Presentation to Háskóli Íslands 22 October 2008Haraldur Yngvi Pétursson, Equity Research - Iceland

Company Valuation

Presentation to Háskóli Íslands

22 October 2008Haraldur Yngvi Pétursson, Equity Research - Iceland

23

Introduction

Multiples / Comparables

Discounted Cash Flow (FCFF)

1

4 Bank valuation

Introduction

Valuation 22 October 2008 5

Haraldur's Personal Introduction

Academic:

― University of Iceland – Cand. Oecon

Professional

― Deloitte – Accounting – 3 years

– Preparations of financial accounts

– Auditing of financial accounts

― Kaupthing Bank – Equity Research – Since October 2004

– Began focusing on operating companies (e.g. OSSR – ACT)

– Now focus on Banks and Financials


Goal of Presentation

Discuss company valuation generally and main obstacles

Review in some detail the main currently employed valuation methods

Don't worry if you don't fully understand everything said

― To most ordinary humans this is entirely foreign material

― Valuation and Equity Research is very much "on site training"

Hopefully you'll enjoy picking up some of the terminology

and the next valuation presentation you sit through should be slightly more bearable


Kaupthing's Research

Covers over 400 equities

― UK, Iceland, Sweden, Denmark, Norway, Finland

Focusing on Nordic and UK market

Contributes to profits through various ways, e.g. market activity


Reasons for Valuing Companies

Key to successful trading in (and managing) corporations

― Ability to estimate their value

― Understanding the sources of their value

Investors do not buy corporations for aesthetic or emotional reasons – but for their expected future cashflows

― Inherent value of a company based on forward-looking estimates and judgements

Valuation is fundamental for any decision & negotiations relating to e.g.

― Company investments

― Mergers

― IPO / rights issues

― Management project evaluation

― Portfolio valuation0

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Valuation – Basics

Valuation a science or an art? A bit of both

Science:

Certain methods are based on solid mathematical pillars. Has (and is) being researched by entire

university departments, thousand's of professors/PhD's/market practitioners

Foundation of the world's financial system

Art:

Modelling and forecasting of the future (?!?)

– management/key employees, tastes/fashion/sentiment, disruptive technologies…

Material role of fickle (and difficult to model) behavioural issues and biases

– overconfidence, overreaction, loss aversion, herding, regret, misestimating of probabilities..

Fact remains – companies need to be valued and the following

methods are the best tools currently available


Valuation - Reservations

Assumptions and inputs into the models are of paramount importance

― Garbage in -> Garbage out

Several "difficult-to-model" factors hugely important

― Is it for sale? Is there a buyer? Sale under distressed circumstances? is funding available?

― Output from valuation models ≠ current price

Additionally some types of companies are tremendously difficult to value analytically

― Start-ups

― Biotech/pharmaceutical research

― Highly cyclical companies

― Companies with large "real options"

– Rights to unexplored oil-fields / mining

– Online companies (social networking, search engine..)


Valuation Methodologies

Discounted Cash-flow (DCF)

― Free Cash Flow to Firm (FCFF), FCF to Equity, Adjusted Present Value (APV)


― P/E, EV/EBITDA, EV/Sales etc.

Other methods

― Invested capital, VC Capital Method, Option Pricing, Last round of financing, Break-up value and Dividend Models

..and then the more "sketchy" methods

― e.g. Technical Analysis

Balance between model relevance, complexity and number of assumptions

Usually at least two methods used in any valuation exercise

Valuation Method:



Multiples / Comparables (comps) - Introduction

The idea is to approximate a company's value by comparing it to companies with known value

Source of figures

― Comparable public company multiples

― Recent private company transactions

Important to only compare relative value of similar companies (apples with apples)

― Similar Industry Scope

― Similar Growth

― Similar Risk

― Similar Results (ROE)


Multiples / Comparables (comps) - Introduction

Many benchmarks can be used (usually industry specific)

― Enterprise Value / EBITDA

― Enterprise Value / Sales

― Price / Earnings (I: V/H)

― Price / Book (I: Q-hlutfall)

― Price / Net Asset Value (NAV)

― Monthly Rent Multiple

― Funds under management

― # subscribers, # patents, # employees, #website hits / Enterprise Value

― etc.


Multiples / Comparables (comps) – Introduction cont.

Positives

― Quicker and easier than analytical methods (DCF)

― Reflects current market conditions (investor sentiment, bargaining power..)

― Helpful in "reality-checking" DCF valuations

Disadvantages

― Are the comparable companies similar enough?

– E.g. public vs. private, future prospects, sector, management quality, market position, capital structure, tax-scheme…

― Doesn't capture value of different scenarios/"what-ifs"

– E.g. post acquisition cost-cutting is successful, synergies are achieved, pending lawsuit goes one way or the other..

― Disconnect between a multiple and inherent firm value. Hence does not capture systemic under-/overvaluation of companies by the market


Enterprise Value / EBITDA (1/5)

Currently the most common "valuation" method for several industries

Typically in the range of 5-15x depending on

― Company type

― CAPEX requirements

― Prospects

― Market conditions

"EBITDA" = Earnings before interest, taxes, depreciation and amortization

Proper to use Forecasted EBITDA (the future is what you're paying for)

― Trailing 12 month / 4 Quarter EBITDA is commonly used

― EBITDA is adjusted for one-off items (e.g. merger costs)

EBITDA

Value Enterprise

Sales

- Cost of Goods Sold

- Administrative Costs

+ Depreciation & Amortization

= EBITDA



Enterprise Value (EV)

― A measure of company's entire value

― Vehicle & Apartment prices are quoted as enterprise value i.e. without any reference to current debt structure (the price assumes no debt is included)

― Imagine how cumbersome it would be to hunt for a flat if prices referred to the value of equity in the flat

Flat's quoted price: 10 million (50 (its value) – 40 (debt included) )

Company share price refers to equity value -> very reasonable to calculate and work with company's EV

Share Price x Number of Shares

EV = Equity Value + Net Debt*

Borrowing – Cash

* and + Minority Interest– Associates+ Operating lease commitment + Unfunded pension liabilities



Multiple in some ways better indicator of value than other measures

― Helpful in comparing companies with different capital structures (w/o interest on debt)

― Depreciation and amortization schedules vary between companies

― Easier to approximate how much debt the company can support

Has several weaknesses

― Capital Expenditure (CAPEX) requirements between companies vastly different

― Some companies capitalize significant amounts of cost (e.g. R&D) and thus raise their EBITDA figure

― Does not include different interests expenses, tax rate and required rate of return

EBITDA

Value Enterprise



Example Question:

(1) Value the company (EV and Equity Value)

(2) Approximate its share price

Figures for Caveat Emptor Ltd.

EBITDA=1.000

Net Debt = 2.000

#Shares outstanding=300

Similar companies are trading at average EV/EBITDA multiples of 8.0x



Solution to Example Question

EBITDA 1.000

* EV/EBITDAx 8.0x

= Enterprise Value 8.000

- Net Debt 2.000

= Equity Value (Market Cap)

6.000

/ Number of Shares 300

Share Price 20


Valuation

Intentionally blank slide


Price / Earnings (PER or P/E)

Price Earnings (I: V/H) ratio shows how much accounting profit its owners are entitled to

Example: Stock price = 20, EPS= 2 => PER= 20/2 = 10

Compared to companies similar in risk and prospects PER is an indicator of whether a particular stock is under or overpriced

Several variants

― Trailing PER or forward PER (using forecasted earnings)

― Primary shares outstanding or diluted number of shares

― Average price over period

Generally:

― High PER (>16) indicates that the market believes significant growth is on horizon

― Low PER (<8) indicates that the market believes current profit levels are unsustainable

IncomeNet

ValueEquity

Shareper Earnings

Price ShareEarnings Price


Price/Book (P/B) and Net Asset Value (NAV)

Price / Book = Value of Equity / Book Value of Equity (I: Q-hlutfall)

Purpose of ratio is to show the market premium to the accounting equity

P/B is used for valuing investments whose value is derived primarily from the underlying value of their tangible assets

― Holding companies

― Real estate companies

― Banks

― Companies up for liquidation (solvency value)

Net Asset Value (NAV) is a significantly better measure than book equity

― Calculated by correcting the value of assets & liabilities in the accounts

– Book value of associates

– Book value of fishing quota

– Goodwill justified?

– Deferred tax liability going to be paid in the near future (Real Estate)? etc.


Misc. Industry Specific Multiples

Enterprise Value is the most common numerator

Airlines & retail businesses

― EV/EBITDAR often used (notice that Rent (R) is excluded)

― Takes into account that some companies buy their aircraft/stores while other companies rent them

Real Estate

― Rent Multiplier or Yield% is often used

EV = Monthly Rent * Multiplier (e.g. 125-250) = Monthly Rent / Yield% * 12

― Appropriate Yield% can be found in sector research and depends on factors such as country, type of building, quality of area, sub-sector vacancy and market conditions

Commodity Companies (Oil refineries, mining etc.)

EV = Number of units of the commodity in reserves (e.g. barrels of oil) * Value per commodity unit

Asset Management

EV = Assets under Management * Multiple (1%..4%)

― Multiple depends e.g. on investor type (private banking % higher than institutional %)

…and other industry specific "rules of thumbs"

Valuation Method:

Discounted Cash Flow (FCFF)


Discounted Cash Flow Valuation

DCF is the cornerstone of valuations and is the "analytically most correct" way

― In reality: several "fudge-factors" and disagreement between practitioners

Robust in valuing anything that gives cash-flow in the future given assumptions

― Bonds, derivatives, companies, etc.

Valuation of future cash that the investor will get from holding the firm. At the end of the day:

"Cash is King"

"Cash is fact – profit is an opinion"

"Earnings do not pay the bills"

Used when significant information is available on company and its prospects

Also used to select between internal projects and to price the impact of various scenarios e.g. during negotiations


Fundamentals of any Discounted Cash Flow Valuation

Expected cashflow in each period

Divided by the appropriate discount factor that reflects the riskiness of the estimated cashflows

Example: How much is an infinite stream of ISK 15 million/year worth?

Assuming a 10% discount rate:

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Expected cashflow

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Discounted Cash Flow Valuation in 4 Steps

Step 1 Compile information

― Historical accounts (last 2-3 years). Review sales, margins, CAPEX, WC ratios, notes etc.

― Research business, strategy, products, customers, markets, competition etc.

― Industry and environment forecasts (official forecasts, KB research, news etc.)

― Discuss main risk factors

― Look up information on similar companies



Step 2 Estimate the appropriate discount factor weighted average cost of capital (WACC)

Components of WACC are:

1) Cost of Debt (Kd)

― Risk Free Rate (e.g. 10 year government bond) Nominal or real – must harmonize with forecasts

― Appropriate Credit Risk Premium

2) Cost of Equity (Ke) (CAPM)

― Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most common

― Equity risk premium is an estimate of the premium investors require in excess of risk-free assets for owning equities (4-7% most typically used)

― Beta is a measurement of firm's/similar firms volatility compared to themarket (if higher than 1 company/sector is riskier than market in average). When compiling and averaging betas it is necessary to take into account different company leverage

PremiumMarket Equity *β(Beta)Rate FreeRisk Ke

%)tax1(*Premium)Risk Credit Rate FreeRisk (Kd

)ED

D(K)

ED

E(*KWACC de

)

ED

tax)(-(11

ββ levered

unlevered



Step 2 cont.

― WACC calculation example (typical Icelandic firm)

Or…

... as is very common: Present WACC as a figure (8..15%) and provide a sensitivity table



Step 3 Prepare a "visible" forecast period (5-10 years and longer for some industries)

― Forecast Sales, margins, capital expenditure, working capital requirement

― And derive Free Cash Flow to Firm



Step 3 cont.

* Assumptions should be reviewed for consistency with past performance and business model

* Forecasts should trend downwards to achieve long run growth rates

* Depreciation should harmonize with CAPEX & the value of property, plant and equipment (PP&E) in the long run

* COGS & SG&A include Depreciation so it needs to be subtracted (non-cash item)



Step 3 cont.

* Tax relief from debt is included in the discount factor

* Helpful to create a balance sheet and model the difference in inventories, receivables and payables between years.

* CAPEX needs to be sufficient to fund the strategy (e.g. the opening of new stores)



Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to Firm with the WACC

― Deal properly with Terminal Values

Beyond the visible cashflow period, the value of the company is captured using a terminal value calculation (using either a DCF to perpetuity or comps calculation)

YearWACC)(1

1DF

* Equity Value calculated from EV

* 0..5% often used for perpetual growth

g-WACC

g)(1*year)forecast FCF(finalTV

* 30-70% split is a

rough guide for mature companies


Discounted Cash Flow – Presenting the Results

The Ultimate Answer to the Great Question of Life, the Universe and Everything

-Hitchhiker's guide to the Galaxy

All diligent valuations are presented as sensitivity tables ― Demonstrate the link between assumptions and the final value― Allow the reader, which probably disagrees with some assumptions, to use the analysis



Other DCF methods:

Free Cash Flow to Equity (FCFE) Same as Free Cash Flow to Firm but

― Interest (and tax savings from interest) and changes in net debt (repayments) are subtracted from the FCFF. Discounted with cost of equity (not WACC)

― Has many proponents arguing (a) more intuitive measure of cashflow (b) overleveraged companies in jeopardy more obvious, etc.

Adjusted Present Value (APV) – less common

― Takes into account changing debt structure – helpful for leverage finance/private equity

1. Calculate value of firm assuming no debt

2. Calculate the present value of tax savings due to interest (discounted with kd)

3. Value the effect of borrowing on likelihood and cost of bankruptcy (difficult)



Key Drivers of Cashflow

― Sales growth rates

– Market, strategic considerations, pricing, economy, competition

― EBITDA margin

– Cost development, fixed vs. floating costs etc.

― Capital expenditure (CAPEX)

– Maintenance and investment CAPEX

― Working capital requirement

– Must support current operations and strategy (inventories, receivables & payables)

― Cash tax rate

– A specialist area (legislation, relief from previous tax loss, deferred tax)

Model also highly sensitive to

― Discount factor

― Terminal value growth

Bank valuation


Value Measures – banks equity

Book Value

― Reported value of equity, based on the prevailing accounting standards

Economic Value

― Difference between market value of assets and liabilities at a given time

Market Value

― Current share price multiplied by the number of outstanding shares

Intrinsic Value

― Discounted value of future earnings

― Analyst's most used tool

― DDM the most common valuation model

― Analysts may argue for a discount or a premium


Premiums and discounts

Discounts

― Size (or lack thereof)

― Liquidity and free float

― Asset quality

― Balance sheet structure

― Capital raising risk

― Ownership, corporate governance and transparancy

― Holding company and conglomerate discount

― Management quality

― Demand


Premiums and discounts

Premiums

― Wheight of money

– Mutual fund inflows

– Asset-class allocation

– Liquidity and free float

― Excess capital

― Index issues

― Takeove or other speculation


The dividend discount model (DDM)

Some DDM Strengths

― Communicability and basis

― Absolute valuations

― Comparability

― Simple sensitivity measures

Key assumptions

― Cost of Equity

― Return on Equity

― Long term growth



DDM has various forms

― Basic one stage model

― Multistage models

The most basic DDM

― Fair value P/B multiple =

― ROE = return on equity

― COE = cost of equity

― g = long-run growth

Book value per share * P/B multiple = Fair value per share

Fair value per share * number of shares = Total fair value

ROE - gCOE - g



Cost of Equity

― Risk free rate

– Varies by markets

– Normally 10yr government bonds are used for base

― Market risk premium

– Generally 4-5%

― The troublemaker – Beta

– Historic vs. future

– Time period and frequency

– Liquidity

– Earnings volatility

― Judgement

PremiumMarket Equity *β(Beta)Rate FreeRisk Ke



Return on Equity (Net profit / average equity)

― Earnings

– Trading profits and loss, included?

– Goodwill writedown?

– Other one-offs?

– Place in the economic cycle

– Bad debt charges

– Numerous other company specific issues

– Aim to estimate the "through the cycle" ROE



Growth – long term

― A banks earnings growth can not be higher in perpetuity than long term GDP growth

– Better to err on the side of caution

– Higher growth in developing than developed countries

– One of the reasons for a multiple stage models



Example – 3 banks2008E Bank A Bank B Bank CAssets 884.615 920.000 956.800Liabilities 839.615 867.000 896.800Equity 45.000 53.000 60.000

Net profit 7.533 7.834 8.149

Outst. Shares 5.000 5.000 5.000

Book value Per share 9,0 10,6 12,0 Equity / Outst. Shares

Earnings per share 1,51 1,57 1,63 Net profit / Outst. Shares

Return on Equity 16,7% 14,8% 13,6% Net profit / Equity

Cost of Equity 11,0% 10,0% 10,0%

Long term growth 3,5% 4,0% 3,0%

Fair value multiple 1,77 1,80 1,51

Fair value per share 15,89 19,05 18,14

Total fair value 79.440 95.233 90.700

Market price 13,0 17,0 18,0

P/E at market 8,63 10,85 11,04 Price / EPS

P/B at market 1,44 1,60 1,50 Price / BVPS

Valuation Method:

Multi stage DDM



Underlying assumption in the one stage model

― Value of equity grows at the same rate as earnings

― Dividend payout ratio therefore must be

― A bank can not payout more than this ratio in the long run as capital restrictions will eventually come into place

― The payout ratio can be higher, but that would lead to less gearing, lower ROE and actual value of discounted dividends will be lower

― Is there an excess capital?

– A war chest

– A fear factor

1 - ROE

g



Two stage models are common

― Give short term flexibility in e.g.

― Earnings estimates

― Growth

Lets look at one simple example

― COE is 10%

― Growth is 4%

― ROE (long term) is 14,8%

― Assume dividends at 5% during forecast period

― Payout ratio (POR) => = 73%1 - 14,8%

4%



Our basic assumptions

― Equity = last year + earnings – dividends

― Equity in perpetuity = Equity last forecast * (1+g)

― Earnings in perpetuity = Earnings last forecast * (1+g)

― Dividend last year (and perpetuity) according to our POR

2007A 2008E 2009E 2010E PerpetuityEquity 53.000 61.484 70.859 73.804 76.756Earnings 7.834 8.931 9.868 10.905 11.341Dividend 447 493 7.960 8.279

Earnigns growth 14,0% 10,5% 10,5% 4,0%

ROE 14,5% 13,9% 14,8% 14,8%



The valuation process is in two parts (hence two stage model)

― First we calculate the present value of dividends in the forecast period

― Discount rate = COE

― Then we calculate the PV of perpetuity

― Fair value multiple as before

― Add PV of dividends over forecast

Year 2007A 2008E 2009E 2010E Total

Dividend 447 493 7.960

Discount rate 1,10 1,21 1,33

PV of dividends 406 407 5.980 6.794

Equity in perpetuity 76.756

Fair value multiple 1,8

Fair value at end 2011 138.161

Discount factor 1,33

Present value 103.802

PV of dividends 6.794

Total present value 110.596

Number of shares 5.000

Fair value per share 22,12


Questions and Answers

Q & A

Documents

Company Valuation Presentation to Háskóli Íslands 22 October 2008Haraldur Yngvi Pétursson, Equity Research - Iceland