443_9 - Applied Equity Analysis and Por3olio ...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 9 Enterprise Value and Equity Value •  Enterprise value (i.e., a company’s value to all financial stakeholders) equals the combined value of a company’s operations and the value of its nonoperating assets. •  A company’s value is shared between nonequity claims and equity holders. The equity value of a company equals enterprise value less the value of nonequity claims. PRESENT VALUE OF OPERATIONS Present value of free cash flows + Present value of continuing value + NONOPERATING ASSETS Excess cash and marketable securities + Illiquid investments and unconsolidated subsidiaries = ENTERPRISE VALUE − NONEQUITY CLAIMS = Debt + Pensions/leases + Employee options + Minority interests EQUITY VALUE The Valua=on Buildup: An Example •  When measured properly, free cash flow from operations should not include any cash flows from nonoperating assets. •  Instead, nonoperating assets should be valued separately. •  Nonoperating assets can be segmented into two groups, marketable securities (marked to market) and illiquid investments (held at cost). Given their different accounting treatments, each nonoperating asset type must be valued separately. Sample Comprehensive Valuation Buildup $ million DCF value of operations 5,000 Excess cash and marketable securities Excess real e state Nonconsolidated subsidiaries Financial subsidiary Tax l oss carry- forwards Discontinued operations Enterprise value 50 5 270 300 10 30 5,665 The Valua=on Buildup: An Example •  To calculate the value of common equity, you need to deduct the value of all nonequity claims from the enterprise value. •  Although nonequity claims include a long array of items, they can be grouped into four categories: 1.  Traditional debt 2.  Debt equivalents such as operating leases, pensions, specific types of provisions 3.  Hybrid claims such as employee stock options and convertible bonds 4.  Minority interests Sample Comprehensive Valuation Buildup Enterprise value Interest- bearing debt Bank loans Bonds Debt equivalents Opera=ng leases Securi=zed receivables Unfunded pension liabili=es Long- term opera=ng provisions Nonopera=ng provisions Con=ngent liabili=es Debt and debt equivalents Hybrid claims Conver=ble debt Preferred stock Employee stock op=ons Minority interests Equity value 5,665 (250) (550) (250) (50) (150) (50) (75) (40) (1,415) (200) (100) (50) (150) 3,750 Debt and debt equivalents Hybrid claims and minority interests Common Nonopera=ng Assets •  Nonoperating assets are assets that do not generate free cash flow (or economic profit) and, therefore, do not impact the value of operations. •  Excess cash and marketable securities. Under U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), companies must report such assets at their fair market value on the balance sheet. Therefore, use the most recent book value as a proxy for the current market value. •  Nonconsolidated subsidiaries. Nonconsolidated subsidiaries and equity investments are companies in which the parent company holds a noncontrolling equity stake. Because the parent company does not have formal control over these subsidiaries, their financials are not consolidated, so these investments must be valued separately from operations. •  Customer financing arms. Because financial subsidiaries differ greatly from manufacturing and services businesses, it is critical to separate revenues, expenses, and balance sheet accounts associated with the subsidiary from core operations. Nonconsolidated Subsidiaries: Valua=on The best approach to valuing subsidiaries depends on information available: •  Publicly Listed Subsidiary Use the market value for the companys equity stake. Verify that the market price reflects intrinsic value (i.e., that there is adequate liquidity and free float so that the trading price reflects current information). •  Privately Held Subsidiary Financial statements are available. If financial statements are available, perform separate DCF valuation. Use appropriate WACC, which may vary from parent company’s WACC. No separate financial statements are available. There are three alternatives to value a subsidiary with limited financial information: 1. Simplified cash flow to equity 2. Multiples valuation 3. Tracking portfolio Triangulate results as much as possible given the lack of precision of these three valuation approaches. Other Nonopera=ng Assets •  The preceding items are typically the most significant nonoperating assets. However, companies can have other forms of nonoperating assets as well: •  Tax loss carry-forwards: Create a separate account for the accumulated tax loss carry-forwards, and forecast the development of this account by adding any future losses and subtracting any future taxable profits on a year-by-year basis. Discount at the cost of debt. •  Discontinued operations: Most recent book value is a reasonable approximation since assets and liabilities associated with discontinued operations are written down to fair value and disclosed as a net asset on the balance sheet. •  Excess real estate and other unutilized assets: Identifying these assets is nearly impossible unless they are specifically disclosed in a footnote. For excess real estate, use the most recent appraisal value, an appraisal multiple such as value per square meter, or discounting of future cash flows. Overview of Nonequity Financial Claims •  To find the value of common equity, deduct the value of all nonequity financial claims from enterprise value. Although there are many forms of nonequity claims, these claims fall into four primary categories: 1.  Traditional corporate debt such as corporate bonds, short-term and longterm bank loans, and credit lines. 2.  Debt equivalents such as operating leases, unfunded pension liabilities, specific types of provisions, preferred stock, and contingent liabilities (e.g., outstanding claims from litigation). 3.  Hybrid financial claims such as employee stock options and convertible bonds. Hybrid claims have an equity component, but are not controlled by holders of common stock. 4.  Minority interests is the portion of partially owned subsidiaries owned by other companies. Valuing Corporate Debt •  Corporate debt comes in many forms: commercial paper, notes payable, fixed and floa=ng bank loans, corporate bonds and capitalized leases. •  Investment- Grade Debt—Publicly Traded If the debt is rela=vely secure and ac=vely traded, use its market value. •  Investment Grade Debt—Privately Held If the debt is not traded, discount the promised payments and principal repayment at the yield to maturity to es=mate current value. Book value is a reasonable approxima=on if interest rates and default rates have not significantly changed since issuance. •  Highly Levered Companies For distressed companies, the value of the debt will be at a significant discount to its book value and will fluctuate with the value of the enterprise. To value equity, create mul=ple performance scenarios and deduct the full value of debt under each scenario. Weight each scenario by probability of occurrence. Debt Equivalents: Opera=ng Leases •  Because operating leases are a form of secured debt, operating leases should be capitalized as part of invested capital and as a debt-equivalent liability. Leasing Example: Free Cash Flow and Equity Valuation $ million Free cash flow (unadjusted for leases) Free cash flow (adjusted for leases) Reconciliation After- tax i nterest Cash flows to debt Cash flows to e quity Reconciliation of free cash flow Discount factor Discounted cash flow Valuation Enterprise value Debt Equity value Year 1 70.2 (61.3) 8.9 Year 2 86.0 (46.4) 39.5 Year 3 101.1 477.2 578.4 5.3 (9.8) 13.3 8.9 5.8 (3.1) 36.9 39.5 5.9 131.3 441.2 578.4 1.101 8.0 1.213 32.6 1.336 433.1 473.7 (118.4) 355.3 Year 1 96.8 (120.0) (23.2) Year 2 114.8 (65.0) 49.8 Year 3 130.7 1,265.0 1,395.7 Reconciliation After- tax i nterest After- tax l ease i nterest Cash flows to debt Cash flows to l ease debt Cash flows to e quity Reconciliation of free cash flow 5.3 26.6 (9.8) (58.7) 13.3 (23.2) 5.8 28.8 (3.1) (18.6) 36.9 49.8 5.9 29.5 131.3 787.8 441.2 1,395.7 Discount factor Discounted cash flow NOPLAT (Increase) decrease i n i nvested capital Free cash flow 1.063 (21.8) 1.130 44.1 1.201 1,162.0 NOPLAT (Increase) decrease i n i nvested capital Free cash flow Valuation Enterprise value Debt Operating l eases Equity value 1,184.3 (118.4) (710.6) 355.3 If NOPLAT, invested capital, and cost of capital are adjusted for operating leases, you must deduct their value from enterprise value to determine equity value consistently. Debt Equivalents: Unfunded Pensions •  Today, under U.S. generally accepted accoun=ng principles (GAAP), U.S. companies report the market value of pension shor3alls (and excess pension assets) on the balance sheet. •  Since only service cost is recognized in free cash flow, exis=ng shor3alls must be deducted from enterprise value to determine equity value. DuPont: Pension Note in Annual Report, Funded Status $ million Pension benefits Benefit obliga=on at end of year Fair value of plan assets at end of year Funded status 2005 22,935 19,792 (3,143) 2006 22,849 21,909 (940) Other benefits 2007 22,206 22,618 412 2005 4,089 − (4,089) 2006 4,255 − (4,255) 2007 3,796 − (3,796) 2,187 − (112) (1,663) − 412 − − (350) (4,311) − (4,661) − − (338) (3,917) − (4,255) − − (315) (3,481) − (3,796) Amounts recognized in the consolidated balance sheet Other assets Intangible assets Other accrued liabili=es Other liabili=es Accumulated other comprehensive loss Net amount recognized 3,280 28 (60) (1,750) 843 2,341 1,040 − (136) (1,844) − (940) Before SFAS 158 Source: DuPont 2007 annual report. Ader SFAS 158 Before SFAS 158 Ader SFAS 158 Present value of unfunded liabilities can be verified in footnotes. Other Debt Equivalents Other common debt equivalents: •  For long-term operating provisions and nonoperating provisions, the balance sheet value offers a reasonable approximation. •  Long-term operating provisions (e.g., plant-decommissioning costs) are typically recorded at a discounted value. •  Nonoperating provisions (e.g., restructuring charges) are generally recorded at a nondiscounted value, but are near term in nature. •  Contingent liabilities (e.g., pending litigation) should be valued by estimating the associated expected (not book) after-tax cash flows and discounted at the cost of debt. Hybrid Securi=es: Conver=ble Debt Convertible bonds differ from traditional debt in that they give the holder the additional right to convert the bonds into common stock. •  If the convertible bonds are actively traded, deduct their market value, but only if estimated stock price is near the traded stock price, as the value of convertible bonds depends on your estimate of equity value. •  If the market price differs from your estimate of share price, 1.  Option valuation approach: The value of convertible bonds can be estimated using an adjusted Black-Scholes convertible bond pricing model. 2.  Conversion value approach: This common approach assumes that all convertible bonds are immediately exchanged for equity and ignores the time value of the conversion option. The approach works well when the conversion option is deep in the money. Employee Stock Op=ons •  Employee stock options give the holder the right, but not the obligation, to buy company stock at a specified price, known as the exercise price. •  If not specifically expensed as part of NOPLAT, outstanding options must be treated as a nonequity claim: •  Option valuation models: The value of options can be estimated using optionvaluation models such as Black-Scholes or advanced binomial (lattice) models. Under U.S. GAAP and IFRS, the notes to the balance sheet report the value of all employee stock options outstanding as estimated by option-pricing models. This value is a good approximation only if your estimate of share price is close to the one underlying the option values in the footnotes. •  Exercise value approach: This common method provides only a lower bound for the value of employee options. It assumes that all options are exercised immediately and thereby ignores the time value of options. Minority Interest •  What is a minority interest? When a company controls a subsidiary without full ownership, the subsidiary’s financial position must be fully consolidated in the group accounts. The portion of third-party ownership is classified as minority interest, and this must be deducted as a nonequity claim. •  A minority interest is a claim only on a particular nonconsolidated subsidiary; its valuation is related to the subsidiary, not the company as a whole. •  If the subsidiary is publicly listed, deduct the proportional market value owned by outsiders from enterprise value to determine equity value. •  If the subsidiary is privately held, you can perform a separate valuation of the minority interest using a DCF approach, multiples, or a tracking portfolio, depending on the information available. ...
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This note was uploaded on 12/04/2011 for the course ENGL 201 taught by Professor Unknown during the Spring '07 term at Central Mich..

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