443_7 - Applied Equity Analysis and Por3olio...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 7 Valua;on 101 •  A company is worth the sum of the future cash flows that it is able to generate •  Investors will adjust the value or “discount” these cash flows based on risk PV of Cashflow from Opera;ons PV of Cashflow from Non Opera;ng Ac;vi;es = Enterprise Value Cash Available to Debt Equivalents Cash Available to Equity Equivalents Steps in a Valua;on •  Analyze historical performance •  Forecast short ­term performance •  Value cash flows beyond short term horizon using con;nuing value formula •  Es;mate cost of capital •  Calculate and interpret results Comparables / Mul;ples Analysis •  Comparables look at market prices for similar assets to provide a benchmark for valua;on •  Useful for valuing private companies and providing price ranges for similar assets with similar risks •  Key issue is to select a range of similar companies •  Comparables help set a trading range based on current sen;ment and current market prices Why Use Mul;ples? •  A careful multiples analysis—comparing a company’s multiples versus those of comparable companies—can be useful in improving cash flow forecasts and testing the credibility of DCF-based valuations. Multiples can assist in: 1.  Testing the plausibility of forecasted cash flows. 2.  Identifying disparities between a company’s performance and those of its competitors. 3.  Identifying which companies the market believes are strategically positioned to create more value than other industry players. Multiples analysis is useful only when performed accurately. Poorly performed multiples analysis can lead to misleading conclusions. What Are Mul;ples? •  Multiples such as the enterprise-value-to-revenue ratio and the enterprise-value-toEBITA ratio are used to compare the relative valuations of companies. Multiples normalize market values by revenues, profits, asset values, or nonfinancial statistics. Specialty Retail: Trading Multiples, December 2009 $ million Ticker AZO BBBY BBY HD LOW PETM SHW SPLS Company AutoZone Bed Bath & Beyond Best Buy Home Depot Lowe's Petsmart Sherwin ­Williams Staples Market capitaliza9on 7,915 10,368 16,953 49,601 34,814 3,386 7,029 18,054 Debt and debt equivalents 2,783 − 2,476 11,434 6,060 634 1,099 3,518 Gross enterprise value 10,698 10,368 19,429 61,035 40,874 4,019 8,128 21,572 Net enterprise value 10,535 9,477 18,525 60,510 39,960 3,867 8,044 20,938 Mean Median Devia;on (percent) 1 1 1 ­year forward mul9ples (;mes) Revenue 1.5 1.3 0.4 0.9 0.8 0.7 1.1 0.9 1.0 0.9 38.1% EBITDA 7.5 9.5 6.0 9.2 8.3 6.5 9.5 10.1 8.3 8.8 17.3% EBITA 8.5 11.3 7.4 13.0 12.2 10.4 11.4 13.2 10.9 11.4 18.2% Devia;on = Standard devia;on/median. Challenges with Mul;ples •  Rela;ve valua;on models measure a company’s valua;on rela;ve to another company normalized by some measure of size •  Industry ­average mul;ples overlook the fact that companies can have dras;cally different expected growth rates, ROIC, and capital structures •  Select a range of companies of similar opera;ng and financial risk profiles •  Gather data from financial statements and market prices using systems such as Bloomberg, Thomson One Banker, First Call, I/B/E/S, EDGAR, company reports, etc. •  Calculate the market mul;ples for the selected companies •  Benchmark the companies against key financial ra;os to test for appropriateness and differences in mul;ples •  Use the calculated mul;ples to determine valua;on ranges for companies in the peer group Steps in Performing a Comparable Analysis Four Best Prac;ces for Mul;ples 1.  Choose comparable companies with similar prospects for ROIC and growth. 2.  Use mul;ples based on forward ­looking es;mates. 3.  Use enterprise ­value mul;ples based on EBITDA to mi;gate problems with capital structure and one ­;me gains and losses. 4.  Adjust the enterprise ­value mul;ple for non ­opera;ng items, such as excess cash, opera;ng leases, employee stock op;ons, and pension Key Value Drivers •  As long as the spread between ROIC and WACC is posi;ve, new growth creates value. •  The value of a company, with $100 of NOPAT and 10% cost of capital, is as follows: Enterprise Values calculated using Key Value Drivers formula ROIC and Growth Drive Mul;ples Assumes EBIT of $154, Tax Rate of 35% and NOPAT of $100 Mul;ples Enterprise Value to EBITA When computing and comparing industry multiples, always start with enterprise value to EBITA. It tells more about a company’s value than any other multiple. To see why, consider the key value driver formula developed earlier: Start with the key value driver formula. Substitute EBITA(1 − T) for NOPLAT. Divide both sides by EBITA to develop the enterprise value multiple. Enterprise Value to EBITA •  Let’s use the formula to predict the enterprise-value-to-EBITA multiple for a company with the following financial characteristics: •  Consider a company growing at 5 percent per year and generating a 15 percent return on invested capital. If the company has an operating tax rate at 30 percent and a 9 percent cost of capital, what multiple of EBITA should it trade at? Distribu;on of EV to EBITA •  The majority of companies fall between 7 ;mes and 11 ;mes EBITA. If the company or industry you are examining falls outside this range, make sure to iden;fy the reason. S&P 5001: Distribution of Enterprise Value to EBITA, December 2009 Valuing The Hotel Industry Using Quick ROIC for 2009. Multiples are based on expected ROIC and Long Term Growth Rates. Source: Thomson September 28, 2010 Why EV to EBITA and Not Price to Earnings? •  A cross-company multiples analysis should highlight differences in performance, such as differences in ROIC and growth, not differences in capital structure. •  Although no multiple is completely independent of capital structure, an enterprise value multiple is less susceptible to distortions caused by the company’s debt-to-equity choice. The multiple is calculated as follows: •  Consider a company that swaps debt for equity (i.e., raises debt to repurchase equity). •  •  EBITA is computed pre-interest, so it remains unchanged as debt is swapped for equity. Swapping debt for equity will keep the numerator unchanged as well. Note, however, that EV may change due to the second-order effects of signaling, increased tax shields, or higher distress costs. Why EV to EBITA and Not Price to Earnings? •  To show how capital structure distorts the P/E, consider four companies, named A through D. Companies A and B trade at 10 ;mes enterprise value to EBITA, and Companies C and D trade at 25 ;mes enterprise value to EBITA. P/E Multiple Distorted by Capital Structure $ million Income statement EBITA Interest expense Earnings before taxes Taxes Net income Market values Debt Equity Enterprise value (EV) Mul9ples (;mes) EV to EBITA Price to earnings Company A Company B 100 100 − (20) 100 80 (40) 60 (32) 48 Company C Company D 100 100 − (25) 100 75 (40) 60 (30) 45 Since Companies A and B trade at low enterprise value multiples, the price-to-earnings ratio drops for the company with higher leverage. − 1,000 1,000 400 600 1,000 − 2,500 2,500 500 2,000 2,500 10.0 16.7 10.0 12.5 25.0 41.7 25.0 44.4 Since Companies C and D trade at high enterprise value multiples, the price-toearnings ratio increases for the company with higher leverage. Why EBITA and Not EBITDA? •  Consider three companies, named A, B, and C. Each company generates the same level of underlying operating profitability; they differ only in size. •  Since all three companies generate the same level of operating performance, they trade at identical multiples before the acquisition of B by A. •  Following the acquisition, however, amortization expense causes EBIT to drop for the combined company and the enterprise value-to-EBIT multiple to rise. Enterprise-Value-to-EBIT Multiple Distorted by Acquisition Accounting $ million Before acquisi9on EBIT Revenues Cost of sales Deprecia;on Amor;za;on EBIT Invested capital Organic capital Acquired intangibles Invested capital Enterprise value Mul9ples (;mes) EV to EBITA EV to EBIT Company A 375 (150) (75) − 150 Company B 125 (50) (25) − 50 Company C 500 (200) (100) − 200 AGer A acquires B Company A+B 500 (200) (100) (25) 175 Company C 500 (200) (100) − 200 750 − 750 1,125 250 − 250 375 1,000 − 1,000 1,500 1,000 125 1,125 1,500 1,000 − 1,000 1,500 5.0 7.5 5.0 7.5 5.0 7.5 5.0 8.6 5.0 7.5 Why EBITA and Not EBITDA? •  Many financial analysts use multiples of EBITDA, rather than EBITA, because depreciation is a noncash expense, reflecting sunk costs, not future investment. •  But EBITDA multiples have their own drawbacks. To see this, consider two companies, which differ only in outsourcing policies. Because they produce identical products at the same costs, their valuations are identical ($3,000). •  What is each companies EV-to-EBITDA multiple and why are they different? $ million Income statement Revenues Raw materials Opera;ng costs EBITDA Deprecia;on EBITA Opera;ng taxes NOPLAT Company A Company B 1,000 1,000 (100) (250) (400) (400) 500 350 (200) 300 (90) 210 (50) 300 (90) 210 Company A manufactures products with its own equipment. Incurs depreciation cost directly. Company B outsources manufacturing to another company. Incurs depreciation cost indirectly through an increase in the cost of raw material. Use Forward ­Looking Mul;ples •  When building mul;ples, the denominator should use a forecast of profits, rather than historical profits. –  Unlike backward ­looking mul;ples, forward ­looking mul;ples are consistent with the principles of valua;on—in par;cular, that a company’s value equals the present value of future cash flows, not sunk costs. –  Second, forward ­looking earnings are typically normalized, meaning they beter reflect long ­term cash flows by avoiding one ­;me past charges. Use Forward ­Looking Mul;ples •  •  To build a forward ­looking mul;ple, choose a forecast year for EBITA that best represents the long ­term prospects of the business. In periods of stable growth and profitability, next year’s es;mate will suffice. For companies genera;ng extraordinary earnings (either too high or too low) or for companies whose performance is expected to change, use projec;ons further out. Pharmaceuticals: Backward- and Forward-Looking Multiples, December 2007 Price/earnings 2007 net income Merck Bristol ­Myers Squibb 27 24 20 20 19 18 16 14 13 12 12 15 16 13 15 13 15 13 17 38 Enterprise value/EBITA Es;mated 2008 EBITA1 16 17 16 Es;mated 2012 EBITA1 12 12 12 12 13 13 12 12 12 12 12 11 Whereas historical P/ E ratios across pharmaceutical companies show significant variation… Abbot Eli Lilly Novar;s Pfizer Johnson & Johnson Sanofi ­Aven;s GlaxoSmithKline Wyeth AstraZeneca Schering ­Plough 1Consensus the forward-looking EV-to-EBITA multiples are nearly identical. N/A 2 2Schering-Plough analyst forecast. recorded loss in 2007, so no multiple is reported. Precedent Transac;ons •  Examine mul;ples paid for similar companies in recent transac;ons •  Useful in determining values paid in M&A deals and to value private companies that do not have trading mul;ples •  Use recent transac;on data to establish prices for comparable ra;os •  Use pricing data to calculate mul;ples similar to a comparables analysis •  Lack of informa;on availability •  Timing of historical acquisi;ons versus current market condi;ons •  Finding true comparable companies •  Pricing may include buyer synergies that are not replicable Challenges with Precedent Transac;ons 6 Key Mul;ples •  •  •  •  •  •  P/E (Price Per Share / EPS) PEG (P/E / Earnings Growth Rate) EV / Sales EV / EBITDA EV / EBIT Price / Book Comparables Source: First Call, Bloomberg Comps for Ingersoll Rand EV / Sales EV / EBITDA EV / EBIT P/E PEG EV Sales EBITDA EBIT Price EPS Growth IR 0.89 9.06 13.65 16.07 (2.68) $12,007 $13,556 $1,325 $880 $22.77 $1.42 (6.0) UTX 1.14 8.10 9.46 13.84 2.04 $61,744 $54,153 $7,619 $6,530 $56.49 $4.08 6.8 CAT 1.55 19.48 44.03 32.63 4.83 $55,150 $35,561 $2,831 $1,253 $38.57 $1.18 6.8 DE 1.81 18.17 23.85 17.77 88.83 $40,159 $22,138 $2,210 $1,684 $45.80 $2.58 0.2 ITT 0.87 7.37 8.84 13.32 (8.32) $9,406 $10,800 $1,276 $1,064 $45.82 $3.44  ­1.6 JCI Average 0.61 1.15 14.70 12.82 41.62 23.57 98.95 32.10 6.45 15.19 $17,616 $28,925 $1,198 $423 $22 $0.22 $15 As of 6/8/2009 Calculate the Mul;ple in a Consistent Manner •  There is only one approach to building an enterprise ­value ­to ­EBITA mul;ple that is theore;cally consistent. Enterprise value must include all investor capital but only the por;on of value atributable to assets that generate EBITA. Including value in the numerator without including its corresponding income in the denominator will systema;cally distort the mul;ple upward. Conversely, failing to recognize a source of investor capital, such as minority interest, will understate the numerator, biasing the mul;ple downward. If the company holds nonopera;ng assets or has claims on enterprise value other than debt and equity, these must be accounted for. •  •  Consistency: Nonopera;ng Assets •  Company A holds only core opera;ng assets and is financed by tradi;onal debt and equity. Company B operates a similar business to Company A, but it also owns $100 million in excess cash and a minority stake in a nonconsolidated subsidiary, valued at $200 million. Since excess cash and nonconsolidated subsidiaries do not contribute to EBITA, they should not be included in the numerator of an EV ­to ­EBITA mul;ple. Enterprise Value Multiples and Complex Ownership Company A Par9al income statement EBITA Interest income Interest expense Earnings before taxes Gross enterprise value Value of core opera;ons Excess cash Nonconsolidated subsidiaries Gross enterprise value Debt Minority interest Market value of equity Gross enterprise value 900 − − 900 300 − 600 900 900 100 200 1,200 300 − 900 1,200 100 − (18) 82 Company B 100 4 (18) 86 •  •  Consistency: Include All Financial Claims •  •  For Company C, outside investors hold a minority stake in a consolidated subsidiary. Since the minority stake’s value is supported by EBITA, it must be included in the enterprise value calcula;on. Otherwise, the EV ­to ­EBITA mul;ple will be biased downward. The numerator should include not just debt and equity, but also minority interest, the value of unfunded pension liabili;es, and the value of employee grants outstanding. Enterprise Value Multiples and Complex Ownership Company A Par9al income statement EBITA Interest income Interest expense Earnings before taxes Gross enterprise value Value of core opera;ons Excess cash Nonconsolidated subsidiaries Gross enterprise value Debt Minority interest Market value of equity Gross enterprise value 900 − − 900 300 − 600 900 900 − − 900 300 100 500 900 100 − (18) 82 Company C 100 − (18) 82 •  Selec;ng a Robust Peer Group To create and analyze an appropriate peer group: •  Start by examining other companies in the target’s industry. But how do you define an industry? •  •  Potential resources include the annual report, the company’s Standard Industry Classification (SIC), or its Global Industry Classification (GIC). Once a preliminary screen is conducted, the real digging begins. You must answer a series of strategic questions. •  •  Why are the multiples different across the peer group? Do certain companies in the group have superior products, better access to customers, recurring revenues, or economies of scale? Expect Varia;on Even within an Industry •  As demonstrated earlier, the enterprise ­value ­to ­EBITA mul;ple is driven by growth, ROIC, the opera;ng tax rate, and the company’s cost of capital. Be careful comparing across countries. Different tax rates will drive differences in multiples. Companies with higher ROICs will need less capital to grow. This will drive higher multiples. Peers in the same industry will have similar risk profiles and consequently similar costs of capital. Since growth will vary across companies, so will their enterprise value multiples. ROIC and Growth Drive Varia;on •  The companies below fall into three performance buckets that align with different mul;ples. The companies with the lowest margins and low growth expecta;ons had mul;ples of 7×. The companies with low growth but high margins had mul;ples of 9×. Finally, the companies with high growth and high margins had mul;ples of 11× to 13×. Factors for Choosing a Peer Group Valua9on mul9ples Enterprise value/ EBITA Consensus projected financial performance Sales growth, 2010–2013 (percent) 5 3 4 3 7 8 18 24 6 21 24 EBITA margin, 2010 (percent) 12 Performance characteris9cs Low growth, low margin Low growth, high margin High growth, high margin Company A Company B Company C Company D Company E Company F 7 7 9 9 11 13 Closing Thoughts on Mul;ples A multiples analysis that is careful and well reasoned not only will provide a useful check of your discounted cash flow (DCF) forecasts but also will provide critical insights into what drives value in a given industry. A few closing thoughts about multiples: 1.  Similar to DCF, enterprise value multiples are driven by the key value drivers, return on invested capital and growth. A company with good prospects for profitability and growth should trade at a higher multiple than its peers. 2.  A well-designed multiples analysis will focus on operations, will use forecasted profits (versus historical profits), and will concentrate on a peer group with similar prospects. •  P/E ratios are problematic, as they commingle operating, nonoperating, and financing activities, which leads to misused and misapplied multiples. 3.  In limited situations, alternative multiples can provide useful insights. Common alternatives include the price-to-sales ratio, the adjusted price-earnings growth (PEG) ratio, and multiples based on nonfinancial (operational) data. ...
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This note was uploaded on 02/22/2011 for the course BMGT 443 taught by Professor Perfetti during the Spring '11 term at Maryland.

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