Applied Midterm 2
introduction chapter 4
-The firm's weighted average cost of capital (WACC) is the weighted average of the expected after-tax rates of return of the firm's various sources of capital. •It is the discount rate that should be used to discount the firm's expected free cash flows to estimate firm value. •It can be viewed as its opportunity cost of capital. The weighted average cost of capital (WACC) is a weighted average of the after-tax costs of the various sources of invested capital raised by the firm to finance its operations and investments. We define the firm's invested capital as capital raised through the issuance of interest-bearing debt and equity (both preferred and common). Opportunity cost of capital is the expected rate of return that its investors forgo from alternative investment opportunities with equivalent risk.
scenario analysis
-Typical scenarios: •Base case •Best case •Worst case -Others: •Beat to market •Economic recession •Industry disruption
sources of error in using CAPM or APT models:
1. Model uncertainty - Is the model correct? 2. Input uncertainty - Are the equity risk premium or factor risk premiums and risk-free ratecorrect? 3. Uncertainty about current values of stock beta or factor sensitivities **Ke is the most difficult estimate;
Which of the following could be considered "influence costs"? (Check all that apply.)
1. The impact to morale done by allowing some project champions to "get away with" justifying lower discount rates for their project. 2. The bias associated with a manager who has financial incentive to estimate a higher value for the project, either through optimistic cash flow forecasts or understated risks. 3. The bias associated with a manager who has financial incentive to estimate a lower value for the project, either through pessimistic cash flow forecasts or overstated risks.
Why Use EBITDA Multiples Rather than Free Cash Flow Multiples?
Although EBITDA provides a crude estimate of a firm's cash flows, it does provide a relatively good measure of the before-tax cash flows that are generated by the firm's existing assets •EBITDA provides a good measure of the before-tax cash flows that are generated by the firm's existing assets. -If we assume that the firm will not be paying taxes and will not be investing and growing and it will not experience any changes in working capital; FCF will be equal to EBITDA -Disadvantage: EBITDA measures only the earnings of the firm's assets already in place, it ignores the value of the firm's new investments (okay if they're comparable) -Advantage: FCF Multiple is too volatile since it reflects discretionary expenditures for capital investments and working capital that can change dramatically from year to year
EBITDA vs. Free Cash Flow
EBITDA is not always a good estimate of free cash flow. •EBITDA is a before-tax measure and does not include expenditures for new capital equipment (CAPEX) and does not account for changes in working capital (NWC). •FCF is often more volatile than EBITDA because it includes consideration for new investments in CAPEX and NWC, which are discretionary to varying degrees and vary over the business cycle. •In years when large capital investments are being made, EBITDA significantly overstates the firm's free cash flow, and vice versa.
Which of the following statements is true about the use of a single, firm-wide cost of capital for evaluating all of a firm's investment projects?
Firms operating in a single, narrow line of business are most likely to appropriately use one cost of capital for all projects.
Sustainable Growth
If a firm: •does not want to sell new equity, and •cannot change its profit margin or capital intensity, and •does not want to change its dividend policy, and •cannot or does not want to change its capital structure - Then there is only one possible maximum growth rate.
valuing the tax shield
If we ignore signaling effects, and further assume that the firm is not meaningfully increasing distress risk with a particular amount of new debt, then the value added by this type of recapitalization would be due to the tax shield We receive this tax benefit not once, but indefinitely (presuming we hold the new debt level), so we value the cash flows as a level perpetuity
real estate example
Most common application of this method is the valuation of commercial and residential real estate. •Collect the ratio of prices from recent sales in the neighborhood -Multiply the price per square foot "comp" number by the number of square feet in your house to get an estimate of what the home should sell for. •Analysis should include differences in value from distinctive features of the real estate and intangibles. -Apply a "premium" or "discount" for location, size of property, view, amenities and specialty finishes, swimming pool, etc. •Commercial real estate analysis includes evaluation of cash flow ratios as well as prices per sq. ft. and features.
Sensitivity Analysis: Chart
NPV Sensitivity Analysis can also be presented in a graph for a single value driver that graphically shows the base case, breakeven value, and minimum and maximum values all together The advantage here is that with a glance, the analyst or decision maker can easily see where the critical value lies in relation to its minimum and maximum
evaluating new investment opportunities: 2 phases
Phase I •Analyst tries to envision the possible outcomes from an investment •Analyst prepares estimates and forecast -Analysis forms the basis for estimating an expected value for the investment along with NPV, IRR, and other measures of investment worth Phase II •Analyst details underlying sources of risk. -Identify value drivers and uncertainty •Analyst seeks ways to mitigate risks and monitors throughout the life of the project
sensitivity analysis: tornado diagram
Sensitivity analysis is often presented in a tornado diagram, as seen here. The table below the diagram repeats the previous analysis (using different values); the diagram itself gives a graphical representation of the results. The assumptions that have the greatest impact on the forecast variable are placed at the top of the diagram, followed by the assumptions that have the next largest impact.
Which of the following is a legitimate reason for firms to use a hurdle rate rather than an estimated WACC to evaluate projects?
To more closely represent true opportunity costs for a firm that has to reject positive-NPV projects due to financial constraints. To provide a safety margin in case of estimation error in the WACC.
When calculating a divisional cost of capital, what is the usual way of estimating the cost of debt for the division?
Using the parent firm's cost of debt, as risk to creditors is more firm-specific than industry-specific.
True or false: the estimated project discount rate using the project debt capacity approach depends on the estimated debt load of the project (i.e., how much debt vs. equity the firm uses to finance the project to begin with).
false
You are performing a simulation for risk analysis. One value driver you are particularly concerned about is the first-year sales figure. You discuss these concerns with someone in market research. They report that while they originally gave you a figure of $10,000,000 for first-year sales, that was simply the mean of likely values. In reality, they consider it just as likely that the firm sees first-year sales of any number between $5 million and $15 million. Which of the following distributions would make the most sense in your simulation?
uniform
Rationale for Liquidity Discount
•20-30% liquidity discount for privately held firms: -Recommended adjustment if market-based EBITDA multiples (taken from a sample of publicly held firms) were used in the target company valuation. •Private companies often sell at a discount to their publicly traded counterparts since they cannot be sold as easily. -Discount is typically attributed to the fact that the shares of privately held firms are less liquid (i.e., harder to sell) than those of public firms.
Rationale for Control Premium
•30%+ control premium for strategic acquisition -When there are benefits (or synergies) from control valuations often feature control premiums, which can enhance the value of an acquisition target by 30% or more. •The amount of any control premium paid will depend upon the relative strength of the bargaining positions of the buyer and seller. •Mergerstat® is one source that publishes premium data from past merger and acquisition transactions for controlling and minority equity interests. -Data is broken down by dollar value/transaction size, and industry classification.
summary
•A firm's weighted average cost of capital (WACC) provides the rate that is used to discount a firm's future cash flows and determine how it is likely to be valued in the financial marketplace. The estimation of a firm's WACC involves three fundamental activities: evaluating the composition of the firm's capital structure, estimating the opportunity cost of each source of capital, and calculating a weighted average of the after-tax cost of each source of capital. •Our main focus is on how firms evaluate investment opportunities. In this regard, the WACC plays a key role. -When firms evaluate opportunities to acquire other firms, they calculate the WACC of the acquisition candidate. We will be discussing this in more detail in Chapter 9. When firms evaluate an investment project, they need a discount rate that we will refer to as the project WACC. A discussion of the project WACC is the focus of Chapter 5.
Multiple Discount Rates May Result in Influence Costs
•A manager who benefits personally from a project being accepted has incentives to put the investment proposal in the most favorable light possible. -Optimistic cash flow forecasts -Understated risk •Extra time and effort is spent -Project advocate: justifying a lower discount rate -Managers evaluating the project: determining extent of the bias •Using a single discount rate for all projects may increase perception of fairness, improve employee morale, and improve one source of influence cost.
P/E Ratios for Stable-Growth Firms
•A stable-growth firm is one that is expected to grow indefinitely at a constant rate. •The P/E multiple of such a firm is determined by its constant rate of growth, and can be calculated by solving the Gordon growth model applied to the valuation of a firm's equity •Firms are able to grow their earnings by reinvesting retained earnings in positive NPV projects. -Assume these investments earn a rate of return (r) that exceeds the firm's required rate of return (k). •Well-positioned firms with competitive advantages, intellectual property, patents, and managerial expertise are able togenerate both higher rates of return on new investment, as well as opportunities to reinvest more of their earnings. -It is the combination of the amount by which r exceeds k, and the fraction of firm earnings that can be profitably reinvested each year (1 - b) that determines the firm's P/E ratio. -Under these assumptions, we can express a firm's dividend growth rate as the product of its retention rate, b, and the rate of return it can provide on newly invested capital, r.
problems with CAPM
•Academic research has failed to find a significant cross-sectional relation between the beta estimates of stocks and their future rates of return. •Firm characteristics, like market capitalization and book-to-market ratios, provide much better predictions of future returns than do betas. •Proposed modifications of CAPM - i.e. size premium •Ibbotson Associates, divides firms into discrete groups based on the total market value of their equity (the following is based on the 2013 Ibbotson NYSE Decile-Size Premium Data): -Large-cap: firms with market value of equity above $7.687B - no size premium. -Mid-cap: firms with market value of equity between $7.687B and $1.912B - apply size premium of 1.12%. -Low-cap: firms with market value of equity between $1.912B and $5141M - apply size premium of 1.85% -Micro-cap: firms with market value of equity below $514M - apply size premium of 3.81%.
Normalizing EBITDA
•Any given year's EBITDA may be influenced by idiosyncratic effects that need to be accounted for when using the EBITDA valuation model. •Nonrecurring special events -Onetime transaction with a customer, which contributed to EBITDA but is not likely to be repeated in future years - make a downward adjustment to EBITDA -Extraordinary write-offs - make an upward adjustment
Benefits to Use of a Single Discount Rate
•Approximately 6 out of 10 firms use a single, companywide discount rate to evaluate investment projects. -Works well for firms engaging in a narrow spectrum of activities. -Using multiple discount rates can be difficult and can pose administrative costs.
Possible Nonrecurring Items
•Asset write-downs •Restructuring charges •Start-up costs expensed •Profits & losses from asset sales •Change in accounting estimates or principles •Gain (loss) from discontinued operations •Strikes •LIFO liquidations •Catastrophes such as natural disasters or accidents Product recalls
Example: Valuing a Privately Held Firm
•Because it is privately owned, a potential acquirer cannot observe its market value. However, the acquirer can use similar firms that are publicly traded to infer a value for Helix by using the appropriate EBITDA valuation ratio. -We are assuming that Helix's EBITDA for the year just ended is known. This would be the case if Helix and Airgas had entered into negotiations.
limitations to breakeven sensitivity analysis
•Considers only one value driver at a time, while holding all others constant. -This can produce misleading results if two or more of the critical value drivers are correlated with one another. •We don't have any idea about the probabilities associated with exceeding or dropping below the breakeven value drivers. •No formal way of incorporating consideration for interrelationships among the variables. •Sensitivity analysis always considers only one value driver at a time, while holding all others equal to their expected values. •Breakeven sensitivity analysis analyzes the percentage change between the expected value of a value driver and its critical value, but this is not the only type of sensitivity analysis. •Alternatively, the analyst can choose a likely minimum and maximum value for the value driver. -This has the benefit of incorporating the probability of extreme values into the analysis.
summary chapter 5
•DCF valuation requires 2 important inputs. -Estimates of future cash flows -Discount rates •This chapter examined the appropriate discount rate that firms should use to value individual investment projects. -Theory suggests that firms should evaluate each investment project with individual discount rates that reflect both the debt capacity and the unique risks of the investment. -In practice, firms often use their companywide WACC to evaluate their investments.
Practical Issues with Normalizing EBITDA
•Determining nonrecurring items are difficult. -Requiring judgment, there is no "bright-line" separating recurring from nonrecurring income. •What management says is nonrecurring may not be. -Management's labeling of large losses as nonrecurring is affected by timing and other factors. •Adjust/allocate nonrecurring losses over past years -Although a given event may be nonrecurring, on average some such event may occur every few years.
rationale for using multiple discount rates
•Discount rates should reflect the opportunity cost of capital/the risk of the investment. •Investment project expected returns should be judged in comparison to returns that could be generated from investments in publicly traded stocks and bonds with equivalent risk. -Less risky investments (cash flows resembling the cash flows of a portfolio of bonds) will have an opportunity cost of capital that is lower than more risky investments (cash flows resembling the cash flows of a portfolio of stocks).
introduction chapter 5
•Discount rates used to evaluate individual investment projects are not necessarily the same as WACC •Firms are faced with a variety of investment opportunities with different risks and financing alternatives -Investment projects that are less risky should require a lower discount rate •Technical and political issues arise within a firm's organization that complicates the process of estimating project rates of return -More than 50% of the surveyed firms (2001) used a single, companywide discount rate to evaluate all investment proposals.1 -Firms can realize substantial gains through the use of project-specific discount rates.
Choosing a Project Discount RateMethod #1
•Divisional WACC -Isolates costs of capital for each business unit or division •Divisions defined either by geographical regions or industry lines of business -Only one cost of capital estimate per division (as opposed to per project) •Advantages: -Discount rates reflect differences in the systematic risk within each division -Minimizes time and effort -Limits managerial latitude and influence costs
EBITDA Multiple: Key Points
•EBITDA multiples provide a good valuation tool for businesses in which most of the value comes from a firm's existing assets. •We see EBITDA multiples being used primarily for the valuation of stable, mature businesses. •EBITDA multiples are much less useful for evaluating businesses whose values come mainly from future growth opportunities.
Drawbacks to the P/E ratio
•EPS can be negative. The P/E ratio does not make economic sense with a negative denominator. •The components of earnings that are on-going or recurrent are most important for this method. -Earnings often have volatile, transient components, making application of this method difficult. •Management can "manage earnings" and distort earnings per share. -Distortions can affect the comparability of P/E ratios across companies.
Enterprise Value vs. Firm Value
•Enterprise value of a firm is defined as the sum of the values of the firm's interest-bearing debt and its equity minus the firm's cash balance on the date of the valuation.
enterprise value overview
•Enterprise value represents the present value of future cash flows in two segments -Planning period (finite number of years) -Terminal period (all years thereafter) Note: Terminal value often represents more than 50% of enterprise value
Equity Valuation using the price-to-earnings (P/E) Ratio
•Equity analysts tend to focus their attention on estimating the earnings of the firms they evaluate, and then use the price-to-earnings (P/E) ratio to evaluate the price of the common stock. •Earning power is a chief driver of investment value. Earnings per share (EPS), the denominator of the P/E ratio, is chief focus of most security analysts. -In the first edition of Security Analysis, Benjamin Graham and David L. Dodd (1934) described common stock valuation based on P/E ratios as the standard method of that era. •The P/E ratio is widely recognized and used by investors and is the most familiar valuation measure used today.
the equity beta
•Factors favoring historical company beta -Using current capital structure in developing weights -No change expected in business mix •Factors favoring historical industry beta -Change in business mix expected -Firm in Chapter 11 -Firm betas vary substantially by source -Firm not publicly-traded •Factors favoring forecasted beta -Using future weights, not historical weights to estimate WACC Projecting change in business mix
effects of recapitalization pt 1
•First, the repurchase itself has a signalingeffect: firm management signals that it believes its shares are undervalued, and (importantly) is willing to buy shares at their current market price. •If investors assume firm management knows more than they do about the stock (i.e., there is asymmetric information), they may interpret this as a positive signal and invest more heavily in the stock, or be willing to pay more.
Mutually Exclusive Projects
•For firms that have constraints limiting the number of projects that can be accepted, the opportunity cost of capital reflects the return on alternative investments that may have to be passed up. -The opportunity cost of capital must reflect the rate of return foregone on the next best project that must be rejected if the evaluated project is accepted.
project debt capacity
•How much debt will the project support? •The amount of additional debt the firm can take on as a result of undertaking the project, without lowering the firm's credit rating.
Hybrid Approach to Enterprise Valuation
•Hybrid valuation combines DCF analysis with relative valuation -The present value of planning period cash flows are discounted using the traditional DCF approach -Terminal value is calculated using an EBITDA multiple and end-of-planning period EBITDA -The present value of the terminal value is added to the present value of planning period cash flows to estimate enterprise value •Using EBITDA to calculate terminal value is beneficial because it ties the analysis of distant cash flows back to recent market transactions involving similar firms •Used in establishing the enterprise value for IPOs, LBOs, spin-offs, carve-outs, and equity valuation for investment purposes •EBITDA multiple and Gordon growth model should generate very similar terminal value estimates when there are no extraordinary capital expenditures or investments in net working capital
key points
•Identification of appropriate comps is paramount. •The initial estimate must be tailored to the investment's specific attributes. •The specific metric used as the basis for the valuation can vary from one application to another. •Investments that look very similar on the surface can generate cash flows with very different risks and growth rates, and should thus sell for different multiples. -Operating leverage is an important determinant of value and must be accounted for in comp selection, andadjusted in analysis. •Exercise care and using creative ways to properly apply the method of market comparables. -Valuation using market comparables requires the same diligence and care as discounted cash flow analysis.
Divisional WACC—Estimation Issues and Limitations
•Implementation using industry-based comparison has a number of potential shortcomings: -Poor sample of comparable firms in a given industry •Sample size may be either too small - or too large -- causing subjectivity in selection -Capital structure - differences in use of leverage -Differences in project risks for investments within a division -Good "comps" for a particular division may be difficult to find
Hurdle Rates & Cost of Capital
•In practice firms tend to discount cash flow using discount rates, often referred to as hurdle rates, which exceed the appropriate cost of capital for the project being evaluated. -It's not unusual to see corporate hurdle rates as high as 15% for firms with WACCs, as well as project WACCs, as low as 10%. •Firms generally require that accepted projects have a substantial NPV cushion, or margin of safety. -Most managers would consider an NPV cushion of 0.2% of the project's initial expenditure to be too small. -For example, most managers are unwilling to invest in a project with an initial expenditure of $100 million if the project's NPV is only $200,000. This is a positive-NPV project that will add $200,000 to the firm's value.
Issues with Ke estimates based on historical returns
•Limitations of cost of equity estimates based on historical returns -Historical security returns are highly variable. -Market conditions are changing. -Historical returns exhibit survivor bias.
simulation analysis
•Monte Carlo simulation can help the analyst evaluate what can happen to an investment's future cash flows and summarize the possibilities in a probability1 -Outcomes from large projects are often the result of the interaction of a number of interrelated factors (or value drivers) -Makes it difficult to determine the probability distribution of a project's cash flows
Decision Trees—Valuing Project Flexibility
•Most investment projects offer the firm some flexibility on the inputs used and final product produced -Generate greater cash flows when market demand is high; cut back on capacity when market demand is low •Options associated with investments •Decision trees are useful tools that illustrate the degree of flexibility in a project's implementation, and how future decisions can affect values. •They contains a number of nodes identified by vertical lines, circles, and boxes. -The vertical lines denote a terminal node that signals the end of the decision process. -The circles signify an event node that represents a point where nature intervenes and something happens that is subject to chance.
Enterprise Valuation Using EBITDA Multiples
•Most popular approach used by business professionals to estimate a firm's enterprise value •Uses EBITDA (earnings before interest, taxes, depreciation, and amortization). -Analysts generally view EBITDA as a crude measure of a firm's cash flow, and thus view EBITDA multiples as roughly analogous to the cash flow multiples used in real estate.
Multiple Discount Rates: Best Practices
•Multiple discount rates should be used when risk attributes of projects varies widely -Firms operating in different lines of business -Firms operating in different countries •Incentive problems that arise with managerial discretion can be mitigated -Systematic and verifiable cost of capital estimation -Discount rates tied to outside market forces
Operating Leverage and Investment Risk
•No two investments are identical -must assess the extent to which the differences are likely to have a material effect on the valuation multiples. -Impact and increased risk of operating leverage. Investments with higher operating leverage will experience more volatility in its operating income in response to changes in revenues
nonsystematic risk
•Nonsystematic risk or diversifiable risk -Variability that does not contribute to the risk of a diversified portfolio. -Examples: random firm-specific events such as lawsuits, product defects, and various technical innovations. -These sources of risk should have almost no effect on required rates of returnbecause they contribute very little to the overall variability of diversified portfolios.
other effects
•Note that the recapitalization has wide-ranging effects based solely on the recap itself and the changes in stock price and number of shares: •EPS changes, since # shares changed •PE ratio changes, since EPS changes •Beta changes as a result of the new leverage, which changes both the cost of equity and the WACC •Use of debt also changes the sustainable growth rate (see following slides)
change in price
•On announcement date, the share price goes up to reflect the additional value.
change in shares
•On the execution date, the number of shares goes down when the firm repurchases the shares. •How much? However much they are spending (the new debt issuance), divided by the price they pay. •They will pay the new stock price. Why? Because this step takes place after the announcement, and the stock price has adjusted. Also, it reflects exiting shareholders receiving fair value for their equity stake.
introduction chapter 3
•Project Risk Analysis Confronts Uncertainty •Various approaches are used to analyze risk and deal with uncertainty -Scenario analysis, breakeven sensitivity analysis, and Monte Carlo simulation •Importance of Flexibility -The role investment flexibility can have on expected cash flows -The role that decision trees can play in organizing the analysis of decision
Choosing a Project Discount RateMethod #2
•Project-Specific WACCs -Project-financing using non-recourse debt -Project is the sole source of collateral -Debt holders have no recourse to the sponsoring firm's assets in the event of default
The DuPont Identity
•ROE = Net Income / Equity •BOOK EQUITY! The market value of equity is never used in the ROE formula. If it were, you'd have NI/Market Cap, which is the same as the inverse of the PE ratio. This is called "earnings yield" and is not the same as ROE. - Critically, the DuPont identity tells us that ROE derives its value from profitability (i.e., net income/sales), efficiency (sales/assets), and leverage (assets/equity). - The other implication is that the difference between ROA and ROE is merely leverage.
introduction chapter 8
•Relative valuation using market comparables: technique used to value businesses, business units, and other major investments. -Assumes similar assets should sell at similar prices. -The critical assumption underlying the approach is that the "comparable" assets/transactions are truly comparable to the investment being evaluated. •Relative valuation should be used to complement DCF analysis A.k.a: Price or market multiples, Direct comparison, Comparable companies, Trading or Public comparables, Relative valuation The reliability of this method of valuation depends on the ability to identify publicly traded stocks that are "comparable" to the company we are valuing. DCF models estimate the "intrinsic" value of a firm. Price multiples value a firm "relative" to how similar firms are valued by the market at the moment. An asset expensive on an intrinsic value basis may be "cheap" on a price multiple basis. •For income-producing investments, analysts consider additional ratios such as market values relative to the various earnings and cash flow numbers, sales, or the book value of recent transactions.
High Hurdle Rates May Provide Better Incentives for Project Sponsors
•Requiring high hurdle rates may signal that firms have good investment opportunities, which may have the side benefit of motivating project sponsors to find better projects. •High hurdle rate can help in the negotiation process.
uncertainty and investment analysis
•Risk analysis tools apply to enterprise valuation - the evaluation of acquisitions of entire firms
effects of recapitalization pt 2
•Second, if we issue new debt, that has its own effect. •Positive because of the tax deductibility of interest payments (the firm value increases because of the present value of the tax shield from interest). •Negative if the firm is introducing distress risk. •Note that Miller and Modigliani Proposition I says capital structure is irrelevant - i.e., adding debt has no effect on firm value - but that result depends on no taxes and no distress risk.
Other Practical Considerations
•Selecting Comparable Firms - typically use firms from the same industry group. -Firms within a given industry tend to utilize similar accounting conventions and tend to have similar risks and growth prospects. -Be careful...different firms in the same industry often have very different management philosophies, which lead to very different risk and growth profiles. •Valuation Ratios versus DCF Analysis -It makes sense to do both a DCF analysis as well as a valuation that employs a number of different comparables-based multiples. -Analyst still needs to apply professional judgment to arrive at a final valuation. -This judgment will depend in part on the quality of information that is available and in part on the purpose of the valuation.
reflections on the use of simulation
•Simulation models require deep consideration about the underlying sources of uncertainty that affect an investment's profits -Requires explicit assumptions -Benefits arise from the process and from the actual output of the simulation
P/E Ratios for High-Growth Firms
•Since we do not expect a firm to be able to achieve high growth forever, describing the firm's growth prospects requires two growth periods. •We assume that the firm experiences very high growth lasting for a period of n years, followed by a period of much lower but stable growth. -Earnings per share, retention ratio and the growth rate are now subscripted to reflect the fact that the firm's dividend policy and its growth prospects can be different for the two growth periods.
the downside of debt
•So does use of debt have a positive or negative effect on ability to grow? •Of course, increasing debt doesn't always have a positive effect on firm value - if it did, firms would lever up to the maximum level possible. •Increasing debt also increases risk of financial distress. •This can be difficult to measure. - To gauge the suitability of a particular debt level for a firm, we often turn to similar firms (comps) and see what the industry participants use for capitalization ratios.
steps in a WACC
•Step 1. Estimate capital structure and determine the weights of each component: wd, wp, we. •Step 2. Estimate the opportunity cost of each of the sources of financing: kd, kp, ke, and adjust for the effects of taxes where appropriate. •Step 3. Calculate WACC by computing a weighted average of the estimated after-tax costs of capital sources used by the firm.
stock dividend
•Stocks normally pay cash in dividends, although there are other methods. •One is a stock dividend: paying the shareholder with more stock.
systematic risk
•Systematic risk or nondiversifiable risk -Variability that contributes to the risk of a diversified portfolio -Examples: market factors such as changes in interest rates and energy prices that influence almost all stocks. -The logic of the CAPM suggests that stocks that are very sensitive to these sources of risk should have high required rates of return, since these stocks contribute more to the variability of diversified portfolios.
Adjusted Present Value (APV) Approach to Enterprise Valuation
•The APV approach estimates enterprise value as the sum of the present value of future unlevered equity free cash flows and the present value of interest tax savings •By unlevering cash flow, the APV approach decomposes total enterprise value into value from unlevered equity free cash flow and value from financing - The impact of financing on enterprise value becomes evident
summary chapter 8
•The DCF approach is generally emphasized by academics •Practitioners prefer to use market-based multiples based on comparable firms or transactions for valuing businesses. Advantages to this method: -It provides the analyst with a method for estimating the value of an investment without making explicit estimates of either the investment's future cash flows or the discount rate. -It makes direct use of observed market pricing information. Intuitively, it does not make sense to use rough estimates of the discount rate and future cash flows to come up withan estimate of the market value of an investment, if you can directly observe how the market values such an investment with comparable transactions. The reality is that using comparable transactions is not as easy as it might at first seem. There are two important steps to the application, and each is critical. First, the analyst must identify a set of comparable transactions for which market pricing data is available. The principal weakness of market-basedcomparablesvaluation is that we almost never have truly comparable transactions. Investments typically have unique attributes, and in most cases, the investments that are used ascomparablesare somewhat of a stretch. For thisreasonit is critical that we think carefully when determining the appropriate multiples to use. For example, we should use higher multiples when the cash flows of an investment are likely to grow faster than those of the comparable investments, and we should use lower multiples when the risk of the investment is higher. In other words, you should use the insights learned from DCF valuation to augment your implementation of the multiples approach. The second critical step in using marketcomparablesentails the selection of an appropriate valuation ratio or metric. By appropriate, we mean that the value of the investment can be thought of as simply a scaled value of the metric where the investment attribute (e.g., earnings, cash flow, square footage) is the scaling variable. For example, when the P/E ratio is used as the valuation metric, we are assuming that the value of the firm's equity is equal to firm earnings scaled by the ratio of share price to earnings. Or, if we're valuing an entire firm, we might use the enterprise value to EBITDA multiple whereby we scale the firm's EBITDA by the multiple to get an estimate of enterprise value.
the determinants of growth
•The ability to sustain growth must come from one of four factors: •Dividend policy •ROE: •Profit margin •Leverage •Asset turnover (capital intensity)
cap rate vs discount rate
•The cap rate is not always the discount rate; it is less than the discount rate when cash flows are expected to grow, and it exceeds the discount rate when cash flows are expected to shrink or decline over time. •The difference between the discount rate and the capitalization rate increases with the growth rate anticipated in future cash flows.
introduction chapter 9
•The enterprise value of a company is most often determined using a two-step valuation approach •Company cash flows are forecasted for a limited number of years called the planning period and are discounted to present value •The estimated value of all remaining cash flows is called the terminal value •There are two ways to estimate terminal value: a perpetuity approach (using the Gordon growth model) or a multiples approach (using EBITDA multiples) •Enterprise valuations will vary according to the growth strategies implemented by management •WACC based approaches to enterprise value are widely used but do not take into consideration changes to capital structure over time •The adjusted present value (APV) approach provides an improvement over traditional WACC approaches because it reveals how the company's financing decisions influence enterprise value
Summing up—adjusting project WACC using project debt capacity
•The key assumption in the approach we have taken in the analysis of the project-specific WACC is that, by accounting for differences in project debt capacity, we are fully accounting for differences in project risk. -This is a reasonable assumption for projects that are in the same line of business - and are thus subject to the same risk factors - but have different cost structures and profit margins, and thus different sensitivities to these risk factors. -For example, because of improved technology, power plants built with the most recent technology are more fuel efficient and have lower operating costs per kwh than plants built using older technology. Because of this, new-technology power plants have higher profit margins, which make them less risky and give them higher debt capacities.
Relative Valuation for Initial Public Offerings
•The market comparables approach plays an important role in the pricing of IPOs. -The lead underwriter determines an initial estimate of a range of values for the issuer's shares. The estimate typically is the result of a comparables valuation analysis. -Underwriters like to price the IPO at a discount, typically 10% to 25%, to the price the shares are likely to trade on the market. Underwriters argue that this helps generate good after-market support for the offering. The underwriter will utilize several valuation ratios such as the ones discussed in this chapter. For example, the underwriter may estimate enterprise value using an EBITDA multiple and then subtract the firm's net debt (i.e., interest-bearing debt less the firm's cash reserves) to get an estimate of the issuer's equity value. The price per share then is simply equity value divided by the number of shares the firm is issuing. Given the variety of comparables and valuation ratios typically used in this analysis, this exercise will result in a range of equity prices (say $10 to $15 per share) for the new issue, not a single offering price. After setting the initial price range, the underwriters go through what is known as a "book-building" process, where they gauge the level of investor interest. Specifically, over the weeks leading up to the offering date, the lead underwriter and company executives travel around the country meeting with potential investors. These visits are known as the "road show." During these visits the underwriter's sales force collects information from potential institutional investors related to their interest in purchasing shares at various prices within the initial valuation range. This information forms the basis for the "book," which contains nonbinding expressions of interest in buying shares of the IPO at various prices, generally within the initial price range.
growth rate: sustainable growth rate
•The maximum growth rate that can be sustained while holding the capital structure of the firm unchanged
growth rate: internal growth rate
•The maximum growth rate that can be sustained without external financing of any kind •The point at which the additional assets needed equals the amount of additional income plowed back into the firm
method of comparables introduction
•The method of comparables involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued in relation to a benchmark value of the multiple. -A current measure of performance (or a single forecast of performance) is converted into a value through application of a multiple for comparable firms. •Choices for the benchmark value of a multiple include the multiple of a closely matched individual stock and the average or median value of the multiple for the stock's peer group of companies or industry. •the economic rationale underlying the method of comparables is the law of one price—the economic principle that two identical assets should sell at the same price. -The method of comparables is perhaps the most widely used approach for analysts reporting valuation judgments on the basis of price multiples. •If we find that an asset is undervalued relative to a comparison asset or group of assets, we may expect the asset to outperform the comparison asset or assets on a relative basis. -However, if the comparison asset or assets themselves are not efficiently priced, the stock may not be undervalued—it could be fairly valued or even overvalued (on an absolute basis).
Current vs. Forward Earnings and the P/E Ratio
•The price-earnings (P/E) ratio is a simple concept: current market price of a firm's common stock divided by the firm's annual earnings per share. -Although the current market price is an unambiguous variable, earnings are not. -The earnings variable sometimes represents earnings per share for the most recent year, this is referred to as the current P/E ratio or trailing P/E ratio. •Another commonly used definition of the P/E ratio that defines earnings per share by using analysts' forecasts of the next year's earnings is the forward P/E ratio. Although the differences in P/E are not dramatic for these sample firms, they can be dramatic in turnaround situations or in the case of firms that are facing large changes in their earnings prospects for the future. For these cases it is important for the analyst to look beyond the current or trailing P/E when trying to compare the market's current valuation of a share of stock to that of comparable firms.
Accounting for Optimistic Projections and Selection Bias
•The process used to select projects often induces an optimistic bias in the cash flow forecasts for those projects that are eventually selected. •It generally makes sense to use a high hurdle rate to offset the optimistic cash flow forecasts.
timing of recapitalization
•The recap has two events: an announcement date and an execution date •When the announcement occurs, the stock price adjusts. Why? If you were a shareholder, would you sell for the old price after you knew the value was increasing? •When the execution occurs, the number of shares outstanding changes.
Effects of Risk and Growthon EBITDA Multiples
•To reflect differences in risk characteristics and growth opportunities, EBITDA multiples should be adjusted for: -Variations in operating leverage; differences in profit margins -Differences between fixed and variable operating costs •Firms that incur higher levels of fixed operating costs but lower variable costs will experience more volatile swings in profits as their sales rise and fall over the business cycle. Differences in expected growth rates
WACC Assumptions and Problems
•Traditional WACC approaches to enterprise valuation are widely used but also require a number of implicit assumptions which may be difficult to justify in most applications, specifically: -Risks of cash flows do not change over time Company maintains a steady capital structure •Often a constant discount rate is inconsistent with projected changes to capital structure •Examples: -LBOs -Planned M&A activity -Future stock buy-back plans
summary chapter 9
•Using DCF valuation to value a firm is a straightforward extension of its use in project valuation. •The WACC approach is widely used throughout industry. -This approach requires a number ofassumptions, which may be difficult to justify in most applications. The added complexity of firm valuation comes largely from the fact that the time horizon of firm cash flows is indefinite, while project cash flows are typically finite. In most cases, analysts solve this problem by estimating the value of cash flows in what is referred to as a planning period, using standard DCF analysis, and then using the method of comparables or multiples (as introduced in Chapter 8) to calculate what is generally referred to as the terminal value of the investment. In most cases, the planning period cash flows and terminal-value estimates are discounted using the investment's weighted average cost of capital. The WACC approach that we described in the first half of this chapter is widely used throughout industry to value businesses. However, it should be emphasized that this approach requires a number of implicit assumptions, which may be difficult to justify in most applications. In particular, the analysis assumes that the risks of the cash flows do not change over time and that the firm's financial structure does not change. For this reason, we would again like to add our usual caveat that the tools that we present are imperfect and should be viewed as providing support for management and not a substitute for management judgment. The second half of the chapter considered the case where the debt ratio of the acquired business changes over time. When this is the case, the APV approach provides an improvement over the WACC approach. Although this approach is not frequently used by industry practitioners, we expect that over time it will become more popular. •When the debt ratio of the acquired business changes over time the APV approach should be applied. -Although this approach is not frequently used by industry practitioners, we expect that over time it will become more popular.
project finance WACC
•We extend our analysis of the value of the equity invested in a project to include the value of the project as a whole and the corresponding project-specific WACC, which, for the special case where project finance is used, we refer to as the project finance WACC.
Adjusting for Liquidity Discountsand Control Premiums
•What price will a buyer will be willing to pay for a company? It depends. -A purely financial buyer (a private equity investor or hedge fund) is likely to expect a liquidity discount. -A strategic buyer that can realize synergies by acquiring and controlling the investment may be willing to pay a control premium.
Using a Single Discount Rate Results in Bias Towards Risk
•When a single discount rate (firm WACC) is used, the firm will tend to take on investment projects that are relatively risky (Project B), which appear to be attractive because they generate an IRR that exceed the firm's WACC. •The firm will tend to pass up investment projects that are relatively safe (Project A), but which generate an IRR that is less than the firm's WACC. •This bias in favor of high-risk projects will make the firm riskier over time.
