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Establishing a Foundation
FIN 591: Financial Fundamentals/Valuation
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Course Focus Valuation analysis What does the term “value” mean? Value to whom?
Where should the focus be to determine if value is created?
Any conflicts exist by focusing on value?
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Management’s Objectives What is management’s objective?
Maximize sales? Maximize profit or EPS? Maximize market share? Maximize compensation? …
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How is Shareholder Value Created?
Maximize firm value Firm value
= Market value debt
+ market value
equity Firm’s investments
& financing affect its value.
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Competitiveness Competition matters and strategy is
important Competition comes in two basic forms:
Perfect competition Imperfect competition
Don’t confuse strategy and planning Planning: Ideas to make a product or service
and sell it profitability Strategy: Plans that focus on the actions and
responses of competitors.
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Strategic Thinking About creating, protecting and
exploiting competitive advantages Perfect competition
No competitive advantage focus on costs
Tactical decisions; not strategic!!
Imperfect competition Exploit competitive advantages
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Porter’s 5 Forces
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$
Qty
Fixed costs
Variable costs
Total revenue
Breakeven AnalysisWhich cost structure is better?High fixed costs or high variable costs?
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Economies of Scale Matter
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Economies of Scale
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Experience Curve Theory
Deflated costs
Total Accumulated Qty
Unit $
As output doubles, (deflated) costs decline linearly.
Plotted in log-log scale
Unit cost = Beginning cost x (n / no)
= -.51 Experience curve has slope = 70%
For manufacturing & distribution operations, costs should follow 70% curve. If constant costs aren’t declining 70-80% each time industry volume doubles, buyers are probably paying a premium for services which may or may not be of value to them.
Source: Perspectives on Experience (Boston Consulting Group, 1972)
no = beginning units; n = later units
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Competition Demystified
Markets
Have competitive advantage Don’t have competitive advantage
Operate efficiently1 dominant firm 2+ dominant firms
Game structure/simulation
Prisoner’s dilemma entry/preemption
Cooperation/bargaining
You
Others
You exit
Manage competitive advantage
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MVA & Productivity An earlier edition of the textbook
concluded: High labor productivity create more value
than low labor productivity Companies that create more value, create
more jobs.
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Why Use Multiples P/E & price-to-sales ratios used
frequently in valuation applications Quick and convenient Relies on a scaled average price of similar
firms to estimate value Fails to specify why prices are what they
are Agnostic about what determines price
See: Reference book by Barker
Highlights shortcomings of PE ratio Valuation textbook: Chapter 12.
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Justification for P/E? Dividend growth model
Current price = Dividend next period / (r - g)Current price = Payout ratio * current EPS * (1 + g) / (r - g)
Divide both sides by “current EPS”P/E = Payout ratio * (1 + g) / (r - g)
P/E ratio depends on: Constant payout ratio Constant income growth Constant discount rate
Incorporates both business risk and financial risk.
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Playing PE Games Acquirer: PE = 25; NI = $1 mill.; shares = 1 mill. Target: PE = 10; NI = $100k; shares = 100k Exchange ratio = 1 share acquirer for 2 shares
target New EPS = ($1 mill. + $100 k) / 1.050 mill. shares
= $1.05 vs. $1 before acquisition If PE of combined firm = 25; new price = $26.25 vs.
$25 Moral:
Larger firm can offer smaller firm a significant premium and still have its EPS and stock price increase
Where’s the economic value added?
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P/S Multiplier Price / sales per share
Assumes operating characteristics have the same relation to sales for all firms
Problems: Doesn’t reflect differences in efficiencies Doesn’t reflect differences in capital
investments Doesn’t reflect differences in growth prospects
Relationship to P/E ratio Price / earnings = Price / (ROS% * sales) Price / sales = ROS% * (Price / earnings)
So what?
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A Simplified Valuation Model
Assume a firm with no growth opportunitiesMarket value of the firm
= Corporate ROIC * book value of assets Required market rate
Example:A company earns 15% rate of return on its $50 million capital. The required market rate of return is 12%. What is the firm’s value?
Answer: .15 * $50 M / .12 = $62.5 M If ROIC = 9%, value = $37.5 M.
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Present Value of Growth Opportunities
PVGO =Investment * Investment’s ROICRequired market
rate Example:
PVGO = $1000 * .15/.12
= $1250 If ROIC is 10%, value
= _______.
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Growth and Value Growth is only valuable if:
Return on invested capital (ROIC) > WACC NPV > 0
If ROIC = WACC Growth neither creates nor destroys value
NPV = 0
If ROIC < WACC Growth destroys value
NPV < 0.
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A Long-Term View True value improvement comes from
management following a long-term investment strategy
LVI = (1 - dividends for next 5 years ) * 100 Current stock price
Provides estimate of investors’ confidence in management to sustain a long-term competitive advantage in its markets
Look at Exhibit 4.9 in Valuation text Dividends have been discount, contrary to the
above formula.
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EXHIBIT 4.9 PRESENT VALUE OF EXPECTED DIVIDENDS* FOR SELECTED S&P 500 COMPANIES
*Assuming 7% growth in dividends during next 5 years. Cost of equity based on risk free rate of 4.3%, market risk premium of 5.0% and Bloomberg beta
Source: Bloomberg; McKinsey analysis
Present value of dividends expected over the next 5 yearsDollars
Abbott LaboratoriesBoeingCampbell SoupDow ChemicalEli LillyFord Motor CoGilletteHewlett-PackardInternational Business MachinesJohnson & JohnsonKelloggLockheed MartinMcDonald'sNew York TimesOccidental PetroleumPepsiCoRohm & HaasSears RoebuckTexas InstrumentsUnited Parcel ServiceWal-Mart Stores
Dividends as percentageof stock pricePercent
4.973.383.236.666.731.903.361.523.044.805.263.071.982.925.453.204.234.610.404.731.82
Share priceDollars
43.5942.1426.8041.5770.3316.0036.7322.9792.6851.6638.0851.4024.8347.7942.2446.6242.7145.4929.3874.5553.05
11.48.0
12.116.0
9.611.9
9.26.63.39.3
13.86.08.06.1
12.96.99.9
10.11.46.33.48.7Average
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Is the Market Price Correct?
Are financial markets efficient?
Information is reflected in prices immediately
Firms should expect to receive fair value for securities they sell
Financial managers can’t time issues of bonds and stocks
Securities markets can’t be affected by management “cooking the books”.
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Efficient Markets and the Information Set
All informationrelevant to a stock
Information setof publiclyavailableinformation
Information set ofpast prices
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Evidence
Academic studies generally supportive of weak form and semi-strong form EMH
Evidence to the contrary exists Fads in stock prices Seasonalities
January effect, day-of-the-month & week effects
Others P/E effect, moving averages
How can EMH explain October 1987 & 1997?
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EXHIBIT 4.8 MARKET REACTION TO PHARMACEUTICAL PRODUCT ANNOUNCEMENTS
Source:Datastream; Factiva; McKinsey analysis
Abnormal returns percent, 1998-2003
Lilly-Zovant
AstraZeneca-Nexium
Lilly-Evista
Wyeth-Enbrel
Wyeth-Protonix
Abbott-Humira
Pfizer-Zeldox
NovoNordisk-Ragaglitazar
Schering-AngeliqNovoNordisk-LevormeloxifeneBMS-Vanlev 2
AstraZeneca-Iressa
BMS-Vanlev 1
Developmentsuccesses(e.g., approvals)
Developmentsetbacks(e.g., withdrawals)
Announcement return -1/+1 day
Announcement return -3/+3 days
(6.4)
(12.3)
(12.6)
(15.5)
(16.4)
(19.2)
(25.5)
7.9
8.6
11.1
11.8
12.0
14.8
(1.4)
(13.7)
(10.0)
(7.7)
(18.4)
(20.3)
(24.9)
5.0
4.6
2.3
10.8
8.3
14.1
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EXHIBIT 4.10 NO CLEAR IMPACT OF U.S. GAAP RECONCILIATIONS
Source: SEC filings; Datastream; Bloomberg; McKinsey analysis
Average cumulative abnormal return (CAR) index
Positive earningsimpact (n = 16)
Negative earningsimpact (n = 34)
CARt-Stat
(0.5%)(1.54)
1.7%14.63
CARt-Stat
-1/+1
Day relative to announcement
-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30
110108
106
104
102
10098
96
94
9290
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EXHIBIT 4.11 NO CONSISTENT MARKET REACTION TO SFAS-142 GOODWILL ANNOUNCEMENT
Source: Datastream; McKinsey analysis
Abnormal return on announcement datePercent
Goodwill amortization as percent ofyear end equity market value, 2001
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Average
Time Warner
CARt-Stat
0.1%0.3
-1/+1
Day relative to announcement
EXHIBIT 4.12 MARKET REACTION AT ANNOUNCEMENT OF GOODWILL IMPAIRMENT
Source: SEC filings; Datastream; Bloomberg; McKinsey analysis
Cumulative abnormal return (CAR) index, n = 54
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Impact of option expense on pre-tax income(percent)
EXHIBIT 4.13 VOLUNTARY OPTION EXPENSING HAS NO IMPACT ON SHARE PRICE
*Defined as the absolute value of option expense divided by the pre-tax earnings before option expense
Source:SEC Filings; Datastream; Bloomberg; McKinsey analysis
Abnormal return on announcement date (percent)
Summary statisticsn = 120R2 = 0.4%Slope = 0.01t-Stat = 0.7P-value = 47.1%
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EXHIBIT 4.14 EFFECT OF INVENTORY ACCOUNTING CHANGE ON SHARE VALUE
Source: S. Sunder, “Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,” Empirical Research in Accounting: Selected Studies, 1973
Cumulative abnormal return, months from date of accounting changePercent
110 firms switching to LIFO 22 firms switching from LIFO
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0
10
20
30
40
50
60
Dec-98 Jun-99 Dec-99 Jun-2000 Dec-2000
EXHIBIT 4.15 MARKET VALUE OF 3COM COMPARED TO THE VALUE OF PALMONE OWNERSHIP BY 3COM
$ BillionFuture separation announced
5% carve-out
Full spin-off
Source: Datastream
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EXHIBIT 4.16 SHARE PRICE DISPARITY OF DUAL-LISTED COMPANIES
Relative difference in valuationPercent
Royal Dutch Petroleum NV relative to Shell T&T PLC
Unilever NV relative to Unilever PLC
-40
-30
-20
-10
0
10
20
30
40
50
Jan-73 Jan-83 Jan-93 Jan-03Source: Datastream
-40
-30
-20
-10
0
10
20
30
40
50
Jan-73 Jan-83 Jan-93 Jan-03
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Can Fundamental AnalystsBeat the Market?
Based on belief that stock market values reflect economic values
Fundamentalists also believe that there is publicly available info that allows them to form better estimates of value than contained in market prices
Price = Dividend1 / ( 1 + r) + Dividend2 / (1 + r )2
+ … Why isn’t the info reflected in the price?
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The End