Copyright ©2003 Ian H. Giddy Valuation 1. Raising Equity Finance & Valuing a Business Prof. Ian GIDDY Stern School of Business New York University

Copyright ©2003 Ian H. Giddy Valuation 1

Raising Equity Finance & Valuing a Business

Prof. Ian GIDDYStern School of Business

New York University


Telkom South Africa

1. Why did South Africa follow its initial 30% privatization of Telkom with an initial public offering? What are the advantages and disadvantages of a public listing for a company?

2. What is an ADR? Why did Telkom use the ADR technique in conjunction with its Johannesburg IPO?

3. What does a company have to do to ensure a successful IPO? What makes shares attractive to investors?

4. Was the Telkom IPO priced correctly? How would you value a company in order to judge the price for an IPO?


Valuing a Firm with DCF

Historical financial results

Adjust for nonrecurring aspects

Gauge future growth

Adjust for noncash items

Projected sales and operating profits

Projected free cash flows to the firm (FCFF)

Year 1 FCFF

Year 2 FCFF

Year 3 FCFF

Year 4 FCFF

Terminal year FCFF

Stable growth model or P/E comparable

Present value of free cash flows

+ cash, securities & excess assets

- Market value of debt

Value of shareholders equity

…

Discount to present using weighted average cost of capital (WACC)


What’s a Company Worth?

Required returns Types of Models

Balance sheet modelsComparablesCorporate cash flow models

Estimating Growth Rates Applications Option-based models



IBM’s Financials


Equity Valuation: From the Balance Sheet

Value of AssetsBookLiquidationReplacement

Value of Liabilities

BookMarket

Value of Equity


Equity Valuation: From the Balance Sheet

Value of AssetsBookLiquidationReplacementOr what?

A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)


Relative Valuation

In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include:

• Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples,

Cash Flow multiples)

• Price/Book (P/BV) ratios and variants (Tobin's Q)

• Price/Sales ratios


Comparables

Value Indicator Earnings Cash Flow Revenues Book

Value Indicator Earnings Cash Flow Revenues Book

Average Comparable Industry Firms Deals

Average Comparable Industry Firms Deals

Target

Company

Numbers or

Projections

Target

Company

Numbers or

Projections

Estimated

Value of

Target

Estimated

Value of

Target


IBM: Comparables


Corporate Cash Flow


Discounted Cashflow Valuation: Basis for Approach

where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the

riskiness of the estimated cashflows

Value = CFt

(1+ r)tt =1

t = n


Start with theWeighted Average Cost of Capital

Choice Cost1. Equity Cost of equity

- Retained earnings - depends upon riskiness of the stock

- New stock issues - will be affected by level of interest rates

- Warrants

Cost of equity = riskless rate + beta * risk premium

2. Debt Cost of debt

- Bank borrowing - depends upon default risk of the firm

- Bond issues - will be affected by level of interest rates

- provides a tax advantage because interest is tax-deductible

Cost of debt = Borrowing rate (1 - tax rate)

Debt + equity = Cost of capital = Weighted average of cost of equity and

Capital cost of debt; weights based upon market value.

Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]


IBM’s Cost of Capital

IBM

Cost of Capital Cost Amount Weight

Debt10-year bond yield 4.95%Tax rate 29%After-tax cost 3.5% 61.9 31%

EquityRisk-free Treasury 4.50%Beta 1.47Market Risk Premium 5.50%From CAPM 12.6% 137.4 69%

Total 9.77% 199.3

Source: IBMfinancing.xls


Valuation: The Key Inputs

A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.

Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

Value = CF

t

(1+ r)tt = 1

t =

Value = CFt

(1 + r)t

Terminal Value

(1 + r)N

t = 1

t = N


Dividend Discount Models:General Model

VD

ko

t

tt

( )11

VD

ko

t

tt

( )11

V0 = Value of Stock Dt = Dividend k = required return


No Growth Model

VD

ko

Stocks that have earnings and dividends that are expected to remain constant

Preferred Stock


No Growth Model: Example

E1 = D1 = $5.00

k = .12

V0 = $5.00/0.12 = $41.67

VD

ko

Burlington Power & Light has earnings of $5 per share and pays out 100% dividend

The required return that shareholders expect is 12%

The earnings are not expected to grow but remain steady indefinitely

What’s a BPL share worth?

Burlington Power & Light has earnings of $5 per share and pays out 100% dividend


The earnings are not expected to grow but remain steady indefinitely

What’s a BPL share worth?


Constant Growth Model

VoD g

k g

o

( )1Vo

D g

k g

o

( )1

g = constant perpetual growth rate


Constant Growth Model: Example

VoD g

k g

o

( )1Vo

D g

k g

o

( )1

E1 = $5.00k = 12%

D1 = $3.00 g = 6%

V0 = 3.00 / (.12 - .06) = $50.00

Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend


The earnings are expected to grow at 6% per annum

What’s an M6 share worth?

Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend


The earnings are expected to grow at 6% per annum

What’s an M6 share worth?


Shifting Growth Rate Model

V Dg

k

D g

k g ko o

t

tt

TT

T

( )

( )

( )

( )( )

1

1

1

1

1

1

2

2V D

g

k

D g

k g ko o

t

tt

TT

T

( )

( )

( )

( )( )

1

1

1

1

1

1

2

2

g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1


Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%

The dividends are expected to grow at 20% for 3 years and 5% thereafter

What’s a Mindspring share worth?

Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%

The dividends are expected to grow at 20% for 3 years and 5% thereafter

What’s a Mindspring share worth?

Shifting Growth Rate Model: Example

D0 = $2.00 g1 = 20% g2 = 5%

k = 15% T = 3 D1 = 2.40

D2 = 2.88 D3 = 3.46 D4 = 3.63

V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3

+ D4 / (.15 - .05) ( (1.15)3

V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40


Choosing a Growth Pattern: Examples

Company Valuation in Growth Period Stable Growth

PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth

rate in the world economy

DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term

US growth rate

Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth

rate in the Europeaneconomy


Better Than Dividends:Free Cash Flows

Revenue- Expenses- Depreciation

= EBITAdjust for tax: EBIT(1-T)

+ Depreciation- Capex- Ch working capital

= Free Cash Flows to Firm

Revenue 81.20

-Expenses (67.99)

-Depreciation (4.95)

EBIT 8.26

EBIT(1-t) 5.90

+Depreciation 4.95

-CapEx (4.31)

-Change in WC (0.90)

FCFF 5.64


Deriving IBM’s Free Cash Flows

Data 4Q02ttmSales, ttm 81.20$ billionOperating costs 67.99$ billion 84%Depreciation 4.95$ billionEBIT 8.26$ billionTax 2.36$ billion 29%Cap Ex 4.31$ billionChange in WC 0.90$ billionInterest expense 0.15$ billion

Free Cash Flows $bRevenue 81.20

-Expenses (67.99)

-Depreciation (4.95)

EBIT 8.26

EBIT(1-t) 5.90

+Depreciation 4.95

-CapEx (4.31)

-Change in WC (0.90)

FCFF 5.64

Interest 0.15$

FCFE 5.49$ IBMvaluation.xls


Equity Valuation in Practice

Estimating discount rate Estimating cash flows Estimating growth Application with constant growth: Optika Application with shifting growth: IBM


Valuing a Firm with DCF: The Short Version




Free cash flows to the firm (FCFF)

Calculate weighted average cost of capital (WACC)

Estimate stable growth rate (g)




Discount to present using constant growth model

FCFF(1+g)/(WACC-g)


Optika: Facts

The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m.

Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%.

The market value of equity is €1.3b. Is this firm fairly valued in the market? What

assumptions might be changed?


Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%

T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%

Firm Value 2681

Equity Value 2431

Optika

optika.xls


Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%

T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%

Firm Value 2681

Equity Value 2431

Optika

CAPM:

7%+1(5.50%)

Debt cost

(7%+1.5%)(1-.35)

WACC:

ReE/(D+E)+RdD/(D+E)

Value:

FCFF/(WACC-growth rate)

Equity Value:

Firm Value - Debt Value

= 2681-250 = 2431

optika.xls


Valuing a Firm with DCF: The Extended Version


Adjust for nonrecurring aspects

Gauge future growth



Projected free cash flows to the firm (FCFF)

Year 1 FCFF

Year 2 FCFF

Year 3 FCFF

Year 4 FCFF

Terminal year FCFF

Stable growth model or P/E comparable


+ cash, securities & excess assets



…

Discount to present using weighted average cost of capital (WACC)


Case Study: IBM


Case Study: IBM

Constant growth model valuation:FCFF 5.64WACC 9.77%Growth rate 5.70%

Firm Value 146.51 billionless debt -61.86 billionEquity value 84.65 billion divided by 1.69 gives 50.09$ per share

2-stage growth model valuationStage 1 10%Stage 2 5.70%

End of year 2002 2003 2004 2005 2006 2007 2008Revenue 81.20 89.32 98.25 108.08 118.88 130.77 138.23-Expenses -67.99 -74.79 -82.27 -90.49 -99.54 -109.50 -115.74-Depreciation -4.95 -5.45 -5.99 -6.59 -7.25 -7.97 -6.94EBIT 8.26 9.09 9.99 10.99 12.09 13.30 15.55EBIT(1-t) 5.90 6.49 7.14 7.85 8.64 9.50 11.10+Depreciation 4.95 5.45 5.99 6.59 7.25 7.97 6.94-CapEx -4.31 -4.74 -5.22 -5.74 -6.31 -6.94 -6.94-Change in WC -0.90 -0.99 -1.09 -1.20 -1.32 -1.45 -1.53FCFF 5.64 6.20 6.82 7.51 8.26 9.08 9.57

235.25Total 6.20 6.82 7.51 8.26 244.34PV 5.65 5.66 5.68 5.69 153.32Total PV 176.00less debt -61.86 billionEquity value 114.13 billion divided by 1.69 gives 67.53$ per share

IBMvaluation.xls


Mt CameroonEcotours


Case Study: Mt Cameroon Ecotours

What alternative financing sources are available to Mount Cameroon Ecotours?

How would foreign investors assess the risks of investing in this private venture in Cameroon? What could be done to reduce the risks to foreign investors? What might be their exit plan?

What is a reasonable estimate of the company's value?

How much of the company's equity shares would have to be given up in order to raise the required EUR5 million?


Banpu

Thursday: Structured Financing

Cap des Biches

LBO

Korea Asset

Funding

Finance Co. Bhd


Documents

Copyright ©2003 Ian H. Giddy Valuation 1. Raising Equity Finance & Valuing a Business Prof. Ian GIDDY Stern School of Business New York University