443_8 - Applied Equity Analysis and Por3olio ...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 8 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 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 The Length and Detail of the Forecast •  Before you begin forecasting individual line items, determine how many years to explicitly forecast and how detailed your forecast should be. A good forecast model is broken into three time periods: Today Years 1−5 Build a detailed five- to sevenyear forecast that develops complete balance sheets and income statements with as many links to real variables (e.g., unit volumes, cost per unit) as possible. Years 6−15 Use a simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover. Years 16+ Value the remaining years by using a perpetuity-based formula, such as the key value driver formula. The Length and Detail of the Forecast •  The explicit forecast period must be long enough for the company to reach a steady state, defined by the following characteristics: •  The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year. •  The company earns a constant rate of return on new capital invested. •  The company earns a constant return on its base level of invested capital. •  In general, we recommend using an explicit forecast period of 10 to 15 years—perhaps longer for cyclical companies or those experiencing very rapid growth. •  Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires heroic long-term growth assumptions in the continuing value. Overview of the Forecas<ng Process Although the future is unknowable, careful analysis can yield insights into how a company may develop. We break the forecasting process into six steps: 1.  Prepare and analyze historical financials. Before forecasting future financials, you must build and analyze historical financials. In many cases, reported financials are overly simplistic. When this occurs, you have to rebuild financial statements with the right balance of detail. 2.  Build the revenue forecast. Almost every line item will rely directly or indirectly on revenue. You can estimate future revenue by using either a top-down (market-based) or a bottom-up (customer-based) approach. Forecasts should be consistent with historical evidence on growth. 3.  Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, depreciation, interest income, interest expense, and reported taxes. Overview of the Forecas<ng Process We break the forecasting process into six steps: 4.  Forecast the balance sheet: invested capital and nonoperating assets. On the balance sheet, forecast operating working capital; net property, plant, and equipment (PP&E); goodwill; and nonoperating assets. 5.  Forecast the balance sheet: investor funds. Complete the balance sheet by computing retained earnings and forecasting other equity accounts. Use cash and/or debt accounts to balance the cash flows and balance sheet. 6. Calculate ROIC and FCF. Calculate ROIC to ensure forecasts are consistent with economic principles, industry dynamics, and the company’s competitive advantage. To complete the forecast, calculate free cash flow as the basis for valuation. Future FCF should be calculated the same way as historical FCF. Let’s examine each step in detail… Other Issues in Forecas<ng 1.  Nonfinancial operating drivers. In industries where prices or technologies are changing dramatically, your forecast should incorporate operating drivers like volume and productivity. 2.  Fixed versus variable costs. The distinction between fixed and variable costs at the company level is usually unimportant because most costs are variable. For individual production facilities or retail stores, this is not the case; most of their costs are fixed. 3.  Inflation. Often, the cost of capital is estimated using nominal terms. If this is the case, forecast in nominal terms. Be careful, however, as high inflation will distort historical analyses. Income Statement Forecast Line item Operating •  Cost of goods sold (COGS) •  Selling, general, and administrative (SG&A) •  Depreciation Non operating •  Nonoperating income Recommended forecast driver •  Revenue •  Revenue Recommended forecast ratio •  COGS/revenue •  SG&A/revenue •  Prior year net property, •  Depreciation/net plant, and equipment (PP&E) •  Appropriate nonoperating asset, if any •  Interest expense •  Prior year total debt •  Interest income •  Prior year excess cash PP&E •  Nonoperating income/ nonoperating asset or growth in nonoperating income •  Interest expense (t)/ total debt (t-1) •  Interest income (t)/ excess cash (t-1) Balance Sheet Forecast Typical forecast driver Typical forecast ratio •  Accounts receivable •  Inventories •  Accounts payable •  Accrued expenses •  Net PP&E •  Goodwill •  Revenue •  Cost of goods sold •  Cost of goods sold •  Revenue •  Revenue •  Acquired revenues •  Accounts receivable/ revenue •  Inventories/COGS •  Accounts payable/COGS •  Accrued expenses/revenue •  Net PP&E/revenue •  Goodwill/acquired revenue Nonoperating line items •  Nonoperating assets •  Pension assets or liabilities •  Deferred taxes •  None •  None •  Adjusted taxes •  Growth in nonoperating assets •  Trend towards zero •  Change in deferred taxes/ Operating line items adjusted taxes Con<nuing Value •  To estimate a company’s value, we separate a company’s expected cash flow into two periods and define the company’s value as follows: Home Depot: Estimated Free Cash Flow 12,000 Present Value of Cash Flow 10,000 during Explicit Forecast Period + Present Value of Cash Flow $ million Value = 8,000 6,000 4,000 after Explicit Forecast Period 2,000 •  The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period. 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Explicit Forecast Period Continuing Value Con<nuing Value Methods Common Con<nuing Value Forecast Errors •  A common error is that the length of the explicit forecast affects the company’s value •  Confusion concerning the rela<onship of con<nuing value to the length of <me a company is forecast to earn returns on invested capital greater than its cost of capital—its compe<<ve advantage period •  Some analysts incorrectly infer that a large con<nuing value rela<ve to the company’s total value implies that value crea<on occurs primarily aXer the explicit forecast period Key Value Driver Formula •  Although many continuing-value models exist, we prefer the key value driver (KVD) model. The key value driver formula is superior to alternative methodologies because it is cash flow based and links cash flow to growth and ROIC. After-tax operating profit in the base year RONIC equals return on invested capital for new investment. ROIC on existing investment is captured by NOPLATt+1 g ⎞ྏ ⎛ྎ NOPLATt +1 ⎜ྎ1 − ⎟ྏ RONIC ⎠ྏ ⎝ྎ Continuing Value t = WACC − g Weighted average cost of capital, based on long-run target capital structure Expected long-term growth rate in revenues and cash flows •  The continuing value is measured at time t (not today), and thus will need to be discounted back t years to compute its present value. The Difference between RONIC and ROIC •  Let’s say you decide to use an explicit forecast period of 10 years, followed by a continuing value estimated with the KVD formula. In the formula, you assume RONIC equals WACC. Does this mean the firm creates no value beyond year 10? •  No, RONIC equal to WACC implies new projects don’t create value. Existing projects continue to perform at their base-year level. Gradual Decline in Average ROIC According to Continuing-Value Formula 20 ROIC on base capital ROIC (percent) 16 ROIC on total capital 12 RONIC 8 4 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year Economic Profit Model •  When using the economic-profit approach, do not use the traditional key value driver formula, as the formula would double-count cash flows. •  Instead, a formula must be defined that is consistent with the economic-profit-based valuation method. The total value of a company is as follows: ! Value of operations ! ! = Invested capital at beginning of forecast ! ! + Present value of forecasted economic profit during explicit forecast period ! Present value of ! forecasted economic + profit after explicit forecast period Explicit Forecast Period Continuing value represents only longrun value creation, not total value. Economic Profit Model •  The continuing-value formula for economic-profit models has two components: CVt = ICt (ROICt +1 − WACC) PV(Economic Profit t + 2 ) + WACC WACC − g Value created on current capital, based on ROIC at end of forecast period (using a no-growth perpetuity). Value created (or destroyed) on new capital using RONIC. New capital grows at g, so a growing perpetuity is used. •  The present value of economic profit at t+2 equals EVA/WACC (i.e., no growth): New Investment Economic Spread ⎛ྎ g ⎞ྏ NOPLATt +1 ⎜ྎ ⎟ྏ (RONIC − WACC) ⎝ྎ RONIC ⎠ྏ PV(Economic Profit t + 2 ) = WACC Value Using Perpetuity Economic Profit Approach Beginning PV Forecasted EP PV Forecasted EP Value = Invested Capital + during forecast period + after forecast period CVt = Economic Pr ofit t +1 + WACC g )( RONIC − WACC ) RONIC WACC (WACC − g) ( NOPLATt +1 )( Economic Profit = Normalized EP in the year after the end of the forecast period NOPLAT = Normalized NOPLAT in the year after the end of the forecast period g = Expected growth in NOPLAT in perpetuity RONIC = Expected ROIC on new invested capital WACC = Weighted average cost of capital Comparison of KVD and Economic Profit CV •  Consider a company with $500 in capital earning an ROIC of 20 percent. Its expected base-year NOPLAT is therefore $100. If the company has an RONIC of 12 percent, a cost of capital of 11 percent, and a growth rate of 6 percent, what is the company’s (continuing) value? •  Using the KVD formula: 6% ⎞ྏ ⎛ྎ $100 ⎜ྎ1 − ⎟ྏ 12% ⎠ྏ ⎝ྎ Continuing Valuet = = $1,000 11% − 6% •  Using the economic-profit-based KVD, we arrive at a partial value: ⎛ྎ 6% ⎞ྏ 100 ⎜ྎ ⎟ྏ (12% − 11%) ⎝ྎ 12% ⎠ྏ PV(Economic Profit t + 2 ) = = $4.54 11% CVt = Note how economic-profit CV does not equal total value. To arrive at total value, add beginning value ($500). $500(20% − 11%) $4.54 + 11% 11% − 6% CVt = 409.1 + 90.9 = 500.0 Step 1 Step 2 Length of Explicit Forecast Does Not Ma\er •  While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it affects only the distribu<on of the company’s value between the explicit forecast period and the years that follow. •  In the example below, the company value is $893, regardless of how long the forecast period is. Short forecast periods lead to higher propor<ons of con<nuing value. Comparison of Total-Value Estimates Using Different Forecast Horizons percent 100% = $893 Continuing value 79 Value of e xplicit free c ash f low 21 5 $893 $893 67 60 33 40 8 10 $893 46 54 15 Length of e xplicit forecast period (years) $893 Modeling assumptions 35 Growth 65 20 RONIC WACC Spread Years 1–5 Years 6+ 9 6 16 (12) 4 12 (12) 0 Common Pi3alls: Distor<ng the KVD Formula •  Simplifying the key value driver formula can result in distortions of continuing value. Rates of Return Implied by Alternative Continuing-Value Formulas percent 25 NOPLAT CV = WACC - g 20 Overly aggressive? Assumes RONIC equals infinity! Implied ROIC 15 CV = 10 WACC 5 0 1 2 3 4 Explicit forecast period 5 6 7 8 9 Con<nuing- value period 10 NOPLAT WACC Overly conservative? Assumes RONIC equals the weighted average cost of capital. Common Pi3alls: Overconserva<sm Naive Overconserva-sm •  The assump<on that RONIC equals WACC can be faulty, because strong brands, plants, and other human capital can generate economic profits for sustained periods of <me, as is the case for pharmaceu<cal companies, consumer products companies, and some soXware companies. Purposeful Overconserva-sm •  Many analysts err on the side of cau<on when es<ma<ng con<nuing value because of its size and uncertainty. But to offer an unbiased es<mate of value, use the best es<mate available. The risk of uncertainty will already be captured by the weighted average cost of capital. •  An effec<ve alterna<ve to revising es<mates downward is to model uncertainty with scenarios and then examine their impact on valua<on. Con<nuing Value Considera<ons •  •  •  •  The level of NOPLAT should be based on a normalized level of revenues and sustainable margin and ROIC. The normalized level of revenues should reflect the midpoint of its business cycle and cycle average profit margins. The expected rate of return on new invested capital (RONIC) should be consistent with expected compe<<ve condi<ons. Economic theory suggests that compe<<on will eventually eliminate abnormal returns, so for many companies, set RONIC equal to WACC. However, for companies with sustainable compe<<ve advantages (e.g., brands and patents), you might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period. Few companies can be expected to grow faster than the economy for long periods. The best es<mate is probably the expected long- term rate of consump<on growth for the industry’s products, plus infla<on. Sensi<vity analyses are also useful for understanding how the growth rate affects con<nuing- value es<mates. The weighted average cost of capital should incorporate a sustainable capital structure and an underlying es<mate of business risk consistent with expected industry condi<ons. ...
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