FBE 421 Final Exam

EBITDA

- Widely used proxy for operating Cash Flow Operating income + DA Independent of capital structure and tax regime

DCF WACC method (adjusted cost of capital)

- incorporates the value of financing by the discount rate and values (both together)

Debt/ Debt equivalents

- interest bearing debt - leases - minority interest - prefferred

DCF

- long forecast - grows at constant rate - reinvests at constant rate - constant rate of return on new - capital invested

P/E or Equity Value/ NI

- most widely recognized - how much investors are willing to pay for a dollar of company's current or future earnings - Impacted by capital structure and tax regime

What to think about with comps

- operations, lifecycle, size, risk and growth

Market comps/ relative valuation

- practioners prefer market comps

EV/Sales

young firms and startups that do not have an established history of earnings Estimated EV = sales (firm) * EV to sales ratio(industry)

Mergers discussed

- more vertical integration - economies of scale - position for larger scale and strength

Cost of Capital

- see problems in ppt & blackboard - know which to use in various DCF models

Liquidity discount

20-30% for privately held firms Often sell at a discount to their publicly traded counterparts since they cannot be sold easily Privately held companies are generally less liquid

Control Premium

25-35%+ control premium for strategic acquisition Incentivize the target company to give up control When there are benefits (synergies) from control Amount depends on strength of bargaining positions of the buyer

Fully Dilluted shares outstanding

= basic shares outstanding + in the money options and warrants + in the money convertible securities

APV

APV method values unlevered assets and interest tax shield separately No matter how you slice up the claims on a company's assets its value is not going to change

Stock deals

Best to do stock deals when stock is trading at a high multiple or is considered overvalued

Historical or predicted Beta for company

Best used when capital structure is developed and no major changes are expected Estimated by regressing the firm's excess stock returns on the excess returns of a market portfolio Problem is does this method reflect risk and return for future times

Market risk not diverisable (systematic)

Beta represents market risk or undiversifiable risk

Hybrid claims

Convertible debt Preferred stock Employee stock options Non controlling interest

Problems with CAPM

Cost of equity estimates are based on historical returns when market conditions are changing and survivor bias is skewed Not a lot of evidence that the relationship between beta estimates and future rates of return is strong Market cap and book to market ratios provide better predictions of future returns Multifactor risk models are more comprehensive

DISNEY PIXAR M&A

Does it move the needle? - size and scale of transactions will have meaningful impact to acquirerer Strategic Fit - must strengthen one of their 3 corporate Pillars (creativity, new tech, increase international presence) Structural Attractiveness: - IS it a profitable sector whose dynamics are likely to keep unforseen competitors at bay Willingness to play a premium - is there an identifiable and quantifiable synergy? - Approach to M&A intergration

High to low probability of cost synergies

Duplicated functions Operating activities shared (less people) Shared facilities Sell assets

Applying a size premium with traditional CAPM WACC model is the same as performing first 2 factors of Farma French

EXPLAIN

Equity Value multiples

Equity Value = Market Cap Equity Value = Share price * fully dilluted shares outstanding - denominator must be a financial statistic that floows only to equity holders like NI or diluted EPS

Debt that is not publicly traded

Estimate Kd using comparables approach Look at bonds with similar credit ratings and maturity

Historical Returns: Survivorship Bias

Historical data is skewed in overall returns since companies still operating are the only ones included in the analysis and ones that went bankrupt are not Recommended equity risk premium is 5.5% Recommended risk free rate is 3.5%

Benchmarking

Includes measures of size, profitability, growth, returns, and credit strength Establish relative positioning Goes beyond quantitative comparison of comparables' financial metrics

3 Factors

It attempts to capture the determinants of equity returns using three risk premiums: - The equity risk premium of the CAPM: RMRF - return on equity index minus 30 day T-bills, (Rm - Rf) is the market's equity risk premium (ERP=MRP) - A size risk premium: SMB (small minus big) - return on small cap portfolio minus return on large cap portfolio first two parts are just CAPM, ke= Rf + bp + size premium - A risk premium related to the relative value of the firm when compared to its book value (historical cost-based value): HML (high minus low) is the difference in returns from portfolios of high and low book-to-market stocks for month t (i.e., HMLP) (won't ask t calculate)

Gross profit

Key indicator of operational efficiency and pricing power, expressed as % of sales

Cost of preferred equity

Kps = Divps/Pps Rearrange this equation depending on info given

Enterprise Value Market Comps

Market Value of Equity (diluted shares outstanding x stock price) + Net Debt (value of int. bearing debt - cash and marketable securities) + Preferred Stock + Minority Interest (non controlling interest) = EV

Relative Valuation for IPOs

Market comparables approach is important for pricing of IPOs Determines an initial estimate of a range of values for the issuer's share, typically result of comparables valuation analysis Underwriters like to price the IPO at a discount (10-25%) to the price the shares are likely to trade on the market to help generate good aftermarket support

FF Model: Risk of a stock is based on three risk premiums

1) Equity risk premium of CAPM 2) Size risk premium (SMBP) 3) Risk premium associated with the value of firm to book value HMLP = difference in returns from portfolios of high and low book to market stocks for month Equation Ke = Krf + b x Equity risk premium + s x (SMPB) + h x HMLP

ONWC (or invested capital) OA-OL (change from year to year) & CAPEX & Invested Capital

OA: working cash, AR, inventory, prepaid expenses OL: non interest bearing liabilities, AP, accrued salaries, deferred recenue, income taxes payable (sometimes include goodwill, acquired intangibles, capitalized software) CAPEX= PP&E(t)- PP&E (t-1) + depreciation Invested Capital: OA-OL

Systematic risk

Only type or risk ACCOUNTED for in CAPM model

EBIT

Operating income Independent of capital structure or tax regime

Debt Equivalents

Operating leases Securitized receivables Unfunded pension liabilities Long-term operating provisions Nonoperating provisions Contingent liabilities

How to get to equity value

PV of operatioons + non operating assets = ENTERPRISE VALUE - non equity claims = EQUITY VALUE

Two factors that influence default premium

Probability and timing of default (variable is Pb) Potential recovery amount from bondholders in event of default (variable is Re)

Vertical Integration

Seeks to provide a company with cost efficiencies and potential growth opportunities by affording control over key components of the supply chain

Ent. Value/ EBITDA or EV/ EBIT

Serves as valuation standard for most sectors Independent of capital structure and taxes EV/EBITDA more common due to differences in DA among companies

Why do LBO analysis for M&A

Sets the max purchase price a financial buyer could pay, therefore good for determining price of competitors

Cost of Normal Equity Ke CAPM MODEL

States a stock's expected return is driven by how sensitive its returns are to the market portfolio E(R) = Rf + (Beta * MRP)

Historical or Industry beta

Best to be used when a change in business mix is happening Firm is distressed Firm is not publicly-traded

Revenue synergies

Broader offerings attract more customers Increases in innovations with more human capital Increase in revenue due to cross-marketing of related goods and services These synergies demand a higher discount rate due to the difficulty of realizing them

Kp

DIVp/Pps

3 Steps to WACC

Estimate capital structure and determine weights Estimate cost of each source of financing Calculate the WACC using the weights of capital structure

Non operating assets

Excess cash and marketable securities Excess real estate Nonconsolidated subsidiaries Financial subsidiary Tax loss carryforwards Discontinued operations

Industry with largest transaction value and largest number of transactions

Health care - value Tech - number

In WACC cost of debt capital

Kd(1-t)

FF model, calculate the cost of equity with coefficents and premia data given

Ke= Krf + b(ERP) +s (SMBP) +h(HMLP) - use CAPM model - then adjust for h(HMLP)

Required Rate of Return based on holding period

Longer holding period of investment high required rates of return

M&A trends

M&A activity typically peaks near economic bubbles, returning to all time high

Cost Synergies

Overall Easily and quickly realized Reduction in combined overhead through headcount reductions and salary cuts Reduction in COGS by combining plants

Small Cap Trap

When low numbers of shares are being traded on small cap stocks appears to be less volatility and understated Beta Realistically these low betas aren't a result of less movement with the market but less liquidity

Fama French 3 factor model: - Understand the parts the FF model

a stock's excess returns are regressed on three factors: - excess market returns, the excess returns of small stocks over big stocks (SMB) - the excess returns of high book-to market stocks over low book-to-market stocks (HML). The Fama-French three-factor model defines risk as a stock's sensitivity to three portfolios: - the stock market - a portfolio based on firm size - portfolio based on book-to-market ratios. Dont support CAPM Capital Asset Pricing Model that average stock returns are positively related to market betas Found: • Equity returns are inversely related to the size of a company (as measured by market capitalization). • Equity returns are positively related to the ratio of the book value to market value of the company's equity

Terminal Value Con of DCF

almost 3/4 of a value can be based on the terminal value - doesn't provide flexibility to change a capital structure

Relative Valuation should be used to...

complement DCF

WACC assumed

constant capital structure

Non-equity Claims

debt pensions/ leases pref. stock minority interest

Enterprise value =

equity value + total debt + pref. stock + noncontrolling interest - cash and cash equivalents Assume all cash is excess cash as shortcut

PEG = P/(E/growth rate in EPS)

firms that face stable prospects for future growth in EPS as well as similar capital structures and similar industry risk attributes Estimated stock price = (growth rate in EPS/EPS)(firm) * (PEG ratio)(industry)

EV/EBITDA

firms that have significant noncash expenses such as DA (healthcare, oil/gas, telecom, equipment services) Estimated EV = EBITDA(firm) * EV/EBITDA ratio (industry)

Non operating assets

excess cash marketable securities illiquid investments unconsolidated subsidiaries (non controlling equity stake)

EV/Cash Flow per Share

firms with stable growth and thus predictable CapEx such as chemicals, paper, forestry Estimated EV = FCF (firm) * EV to FCF ratio (industry)

DCF APV method

preferred when capital structure is not contstant - value unlevered assets and interest tax shields separately - discounts FCF by unlevered cost of equity - Interest tax shields: discounts by unlevered cost of equity or pre-tax cost of debt

Unsystematic Risk

- business tisk Variability that does not contribute to the risk of a diversified portfolio (ex: lawsuits are one off events) These risks HAVE no impact on required rate of returns as they are diversified out

Enterprise Value multiples

- denominator must be financial stat that flows to both equity and debt holders

Farma-French three factor- Discovered

- equity returns are inversely related to size of the firm - equity returns are positively related to the ratio of BV to MV of a companys equity

P/E

- established positive earnings - no significant non cash expenditures Stock Prices = EPS (firm) * p/e (industry)

Nonoperating assets

- excess cash - marketable securities - illiquid investments - unconsolidated subsidiaries

CHOOSING THE RIGHT MULTIPLE

- firms with an established record of positive earnings that do not have significant noncash expenditures Estimated stock price = EPS(firm) * P/E (industry)

Nestle Digorno Pizza savings Cost synergies

- had to execute on cost synergies to compensate for compeition - Reduce truck routes - Reduce Admin Costs - Cut warehouse costs of dignornio

Comparing a financial profile: Market valuation: of equity value or enterprise value

Sales Gross Profit Ebitda Ebit NI Does company Size matter?

Sales

Sales levels and trends are key factor in determining company's relative positioning among peers

Beta estimated on comparable firms

Using beta estimated on the beta for comparable firms Usually have to adjust for capital structure by levering and unlevering

DCF WACC

The WACC method incorporates the value of financing by lowering the overall discount rate

Does company size matter?

- Controlling for size of the comparable companies is popular in practice - No theoretical model that includes size as a determinant of market multiples - Research is mixed on whether or not controlling for size is helpful for choosing comparable companies after controlling for industry and other factors - Size is correlated with some value relevant aspects of a company such as stock returns

Calculating the Cost of debt

- Have to calculate the YTM on publicly traded debt - YTM will be the risk free rate plus a default spread given the type of debt

Market Multiple valuation options

- Multiples from publicly traded companies - multiples from comparable transactions

Nestle Digorno Pizza savings

- Nestle acquires Kraft frozen Pizza division (Digorni) for 3.7B

Four components we need for cost of capital

After-tax cost of debt Cost of preferred equity Cost of equity Capital Structure

M&A Market multiples

An alternative numerator to firm value or EV is price or value at which a transaction occurred Typically higher than market multiples based on prices of public companies because the price or value at which an acquisition occurs is typically higher than the immediately preceding market value (EV or firm value)

Market value of equity/ book value of equity

Firms whose balance sheets are reasonable reflections of the market values of their assets (financial institutions) Estimated equity value = book value of equity(firm) * market to book ratio (industry)

Horizontal Integration

Purchase of business that expands the acquirer's geographic reach, product lines, services, or distribution channels Synergies are gained from leveraging respective company's distribution network, customer base, and technologies

3 ways to acquire a firm

Q) merger or consolidation 2) Acquisition of stock 3) acquisition of an asset

Regressions analysis or returns for at least 60 data points

Regression needs to be based on monthly returns to avoid systematic biases Regression must take place against value-weighted diversified portfolio

EV/Sales

Relevant for companies with little or no earnings Less pertinent than other multiples Sanity check on earnings-based multiples

Beta

Represents the sensitivity of its equity returns to variations in the rates of return on the overall market portfolio

NI

Residual profit after company's expenses have been netted out Wall St views NI on per share basis (EPS)

What is WACC?

The opportunity cost that investors face for investing their funds in one business instead of others with similar risk

Unlevering and Relevering Beta

Unlevering Beta (also known as the equity beta)