Equity Valuation - NYUigiddy/val-short.pdfIan H. Giddy Valuation -11 Equity Valuation: Application to M&A Prof. Ian Giddy New York University Equity Valuation: Application to M&A Prof

Ian H. Giddy Valuation-1

Prof. Ian GiddyNew York University

Equity Valuation

Copyright ©2001 Ian H. Giddy Valuation 2

Valuing a Firm with DCF: An Illustration

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)



The 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 andCapital cost of debt; weights based upon market value.

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


Valuation: The Key Inputs

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

l 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)Nt =1

t =N∑



Stable Growth and Terminal Value

l When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as:Value = Expected Cash Flow Next Period / (r - g)where,

r = Discount rate (Cost of Equity or Cost of Capital)g = Expected growth rate

l This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates.

l While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point intime.

l When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.


Growth Patterns

l A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. Ingeneral, we can make one of three assumptions:u there is no high growth, in which case the firm is already in

stable growthu there will be high growth for a period, at the end of which the

growth rate will drop to the stable growth rate (2-stage)u there will be high growth for a period, at the end of which the

growth rate will decline gradually to a stable growth rate(3-stage)

l The assumption of how long high growth will continue will dependupon several factors including:u the size of the firm (larger firm -> shorter high growth periods)u current growth rate (if high -> longer high growth period)u barriers to entry and differential advantages (if high -> longer

growth period)



Length of High Growth Period

l Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is EarthlinkNetwork, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a bio-technology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period?

o Earthlink Networko Biogeno Both are well managed and should have the same high

growth period


Choosing a Growth Pattern: Examples

Company Valuation in Growth Period Stable GrowthDisney Nominal U.S. $ 10 years 5%(long term

Firm (3-stage) nominal growth rate in the U.S. economy

Aracruz Real BR 5 years 5%: based upon Equity: FCFE (2-stage) expected long term

real growth rate for Brazilian economy

Deutsche Bank Nominal DM 0 years 5%: set equal to Equity: Dividends nominal growth rate

in the world economy



The Building Blocks of Valuation

Choose aCash Flow Dividends

Expected Dividends to

Stockholders

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 Capital

WACC = 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

g

Stable Growth

g

Two-Stage Growth

|High Growth Stable

g

Three-Stage Growth

|High Growth StableTransition


Dividend Discount Models:General Model

VD

ko

t

tt

=+=

∞

∑( )11

lV0 = Value of StocklDt = Dividendlk = required return



Specified Holding Period Model

01

12

2

1 1 1V D

kD

kD P

kN N

N= + +

+

+ + +( ) ( ) ( )...

l PN = the expected sales price for the stock at time N

l N = the specified number of years the stock is expected to be held


No Growth Model

VD

ko =

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

l Preferred Stock



No Growth Model: Example

E1 = D1 = $5.00k = .15

V0 = $5.00 / .15 = $33.33

VD

ko =

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

n The required return that shareholders expect is 15%

n The earnings are not expected to grow but remain steady indefinitely

n What’s a BPL share worth?

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


n The earnings are not expected to grow but remain steady indefinitely

n What’s a BPL share worth?


Constant Growth Model

VoD g

k g

o=

+−

( )1

lg = constant perpetual growth rate



Constant Growth Model: Example

VoD g

k g

o=

+−

( )1

E1 = $5.00 b = 40% k = 15%(1-b) = 60% D1 = $3.00 g = 8%V0 = 3.00 / (.15 - .08) = $42.86

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


n The earnings are expected to grow at 8% per annum

n What’s an M6 share worth?

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


n The earnings are expected to grow at 8% per annum

n What’s an M6 share worth?

Plowback rate


Estimating Dividend Growth Rates

g ROE b= ×

l g = growth rate in dividendsl ROE = Return on Equity for the firml b = plowback or retention percentage rate

i.e.(1- dividend payout percentage rate)



Shifting Growth Rate Model

V Dg

k

D g

k g ko o

t

tt

TT

T=++

++

− +=∑( )

( )

( )

( )( )

1

1

1

1

1

1

2

2

lg1 = first growth ratelg2 = second growth ratelT = number of periods of growth at

g1


n Mindspringpays dividends $2 per share. The required return that shareholders expect is 15%

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

n What’s a Mindspringshare worth?

n Mindspringpays dividends $2 per share. The required return that shareholders expect is 15%

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

n What’s a Mindspringshare 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



Ratios Do Have Meaning

l Gordon Growth Model:l Dividing both sides by the earnings,

l Dividing both sides by the book value of equity,

l If the return on equity is written in terms of the retention ratio and the expected growth rate

l Dividing by the Sales per share,

P 0 =DPS1

r − gn

P 0

EPS 0

= PE = Payout Ratio * (1 + g n )

r-gn

P 0

BV 0

= PBV = ROE - gn

r-gn

P 0

BV 0= PBV =

ROE * Payout Ratio * (1 + g n )

r-g n

P 0

Sales 0= PS =

Profit Margin * Payout Ratio * (1 + g n )

r-gn

Equity Valuation:Spreadsheet Application



Equity Valuation:Application to M&A


Equity Valuation:Application to M&A


OptikaSchirnding



How Much Should We Pay?

Applying the discounted cash flow approach, we need to know:

1.The incremental cash flows to be generated from the acquisition, adjusted for debt servicing and taxes

2.The rate at which to discount the cash flows (required rate of return)

3.The deadweight costs of making the acquisition (investment banks' fees, etc)


Application

l Fakawi Navigation plans to acquire Feng-ShuiCompass Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields.Fakawi expects to divest the target in year 6 for $100 million. The Treasury note rate is 6%, and the S&P return is 16%. Fakawi's advisors estimate that Feng-Shui has a beta of 1.3. For this advice they are charging 2% of the acquisition price.

l What is the maximum price that Fakawi should offer for Feng-Shui?



Framework for Assessing RetructuringOpportunities

RestructuringFramework

1

2

CurrentMarketValue

3

Totalrestructuredvalue

Potentialvalue withinternal+ externalimprovements

Potentialvalue withinternalimprovements

Company’sDCF value

Maximumrestructuringopportunity

Financialstructureimprovements

4

Disposal/Acquisitionopportunities

Operatingimprovements

Current marketoverpricing orunderpricng

5

(Eg Increase D/E)


Equity Valuation in Practice

l Estimating discount rate

l Estimating cash flowsl Application to Optika

l Application in M&A: Schirnding-Optika



Estimating Future Cash Flows

n Dividends?n Free cash

flows to equity?

n Free cash flows to firm?


Optika OptikaGrowth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt spread 1.5%Market risk premium 5.50%

T+1Revenues 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187-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 2278

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 = 2278-250 = 2028



Optika & SchirndingSchirnding-Optika

Optika Schirnding CombinedGrowth 5% 5% 5%Tax rate 35% 35% 35%Initial Revenues 3125 4400 7525COGS 89% 87.50%WC 10% 10% 10%Equity Market Value 1300 2000 3300Debt Market Value 250 160 410Beta 1 1 1Treasury bond rate 7% 7% 7%Debt spread 1.5% 1.5% 1.5%Market risk premium 5.50% 5.50% 5.50%

T+1 T+1Revenues 3281 4620 7901-COGS 2920 4043 6963-Depreciation 74 200 274=EBIT 287 378 664EBIT(1-Tax) 187 245 432-Change in WC 16 22 38=Free Cash Flow to Firm 171 223 394Cost of Equity (from CAPM) 12.50% 12.50% 12.50%Cost of Debt (after tax) 5.53% 5.53% 5.53%WACC 11.38% 11.98% 11.73%

Firm Value 2278 3199 5859


Optika-Schirnding with SynergySchirnding-Optika

Optika Schirnding Combined SynergyGrowth 5% 5% 5% 5%Tax rate 35% 35% 35% 35%Initial Revenues 3125 4400 7525 7525COGS 89% 87.50% 86.00%WC 10% 10% 10% 10%Equity Market Value 1300 2000 3300 3300Debt Market Value 250 160 410 410Beta 1 1 1 1Treasury bond rate 7% 7% 7% 7%Debt spread 1.5% 1.5% 1.5% 1.5%Market risk premium 5.50% 5.50% 5.50% 5.50%

T+1 T+1 T+1Revenues 3281 4620 7901 7901-COGS 2920 4043 6963 6795-Depreciation 74 200 274 274=EBIT 287 378 664 832EBIT(1-Tax) 187 245 432 541-Change in WC 16 22 38 38=Free Cash Flow to Firm 171 223 394 503Cost of Equity (from CAPM) 12.50% 12.50% 12.50% 12.50%Cost of Debt (after tax) 5.53% 5.53% 5.53% 5.53%WACC 11.38% 11.98% 11.73% 11.73%

Firm Value 2278 3199 5859 7479Increase 1620

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Equity Valuation - NYUigiddy/val-short.pdfIan H. Giddy Valuation -11 Equity Valuation: Application to M&A Prof. Ian Giddy New York University Equity Valuation: Application to M&A Prof