443_4 - Applied Equity Analysis and Por3olio ...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 4 The Valua=on Process Using Enterprise DCF Valua%on is an itera%ve process… 6. Calculate and Interpret Results Once the model is complete, examine valuation results to ensure your findings are technically correct, your assumptions are realistic, and your interpretations are plausible. 1. Analyze Historical Performance By thoroughly analyzing the past, we can document whether the company has created value, whether it has grown, and how it compares with its competitors. 5. Enterprise Value to Equity Value To convert enterprise value into equity value, subtract any nonequity claims, such as debt, unfunded retirement liabilities, capitalized operating leases, and outstanding employee options. 4. Compute the Cost of Capital To value the enterprise, free cash flow is discounted by the weighted average cost of capital. The cost of capital is the blended rate of return for all sources of capital, specifically debt and equity. 2. Forecast Financials and Cash Flows Project financials over the short and medium term. Short-term forecasts should be consistent with announced operating plans. Medium-term forecasts should focus on operating drivers, such as margins, and on capital turnover. 3. Estimate a Continuing Value To forecast cash flows in the long-term future, use a perpetuity that focuses on the company’s key value drivers, specifically ROIC and growth. Valuing the Enterprise versus Financial Claims •  To value a company, you can either value the cash flows generated by the company’s economic assets or value each financial claim separately (debt equity, other financial claims, etc.). Enterprise Valuation of a Single-Business Company $ million 427.5 After- tax c ash flow to debt holders 427.5 Debt value 1 110 Free c ash flow To value operations, discount free cash flow by the weighted average cost of capital. 70 20 180 110 140 100 65 200.0 15 120 Cash flow to e quity holders Equity value 227.5 90 Discount free cash flow by t he weighted average cost of capital. 70 85 55 70 Enterprise value 1 Debt value e quals discounted a fter- tax cash flow to debt holders plus the present value of i nterest tax s hield . To value equity directly, discount equity cash flow by the cost of equity. Alternatively, value operations and subtract the value of debt. Defining Enterprise Value versus Equity Value A company’s equity value can be computed indirectly by calculating enterprise value first and then subtracting any nonequity claims, such as debt. Enterprise value equals the value of operations (core businesses) and nonoperating assets, such as excess cash. Enterprise Valuation of a Multibusiness Company $ million 225 560 30 520 40 200 360 125 200 Unit A Unit B Value of opera=ng units Unit C Corporate center Value of Nonopera%ng Enterprise opera%ons assets value assets Value of debt Equity value Enterprise DCF •  Value the company’s opera=ng assets by discoun=ng free cash flow from opera=ons at the weighted average cost of capital. Free cash flow is net opera=ng profit less adjusted taxes, NOPLAT, minus net investment. Net investment is the amount of new capital required each year and thus represents the growth in invested capital. The investment rate is the rate of NOPLAT that the firm decides to invest in new capital. • Value non- opera=ng assets, such as excess marketable securi=es, equity investments, and nonconsolidated subsidiaries. Combining the value of opera=ng assets and non- opera=ng assets leads to enterprise value. • Iden=fy and value all non- equity financial claims against the company’s assets. Non- equity financial claims include fixed and floa=ng rate debt, pension shor3alls, employee op=ons, and preferred stock, among others. • Subtract non- equity financial claims from enterprise value to determine the value of common stock. To determine share price, divide equity value by the number of shares outstanding. Analyze Historical Performance: Analyzing ROIC Analyze Historical Performance •  Before projecting future cash flow, examine the company’s historical performance. A good analysis focuses on the key drivers of value: return on invested capital (ROIC) and growth. ROIC measures a company’s ability to create value. •  Both Home Depot and Lowe’s have struggled to maintain ROIC in recent years. Home Depot no longer enjoys a performance advantage over Lowe’s. Home Depot and Lowe’s Return on Invested Capital percent 20 15 Home Depot 10 Lowe's 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 1 ROIC measured with goodwill and acquired i ntangibles. Goodwill and acquired i ntangibles do not meaningfully affect ROIC for e ither company. How do we compute ROIC? Analyze Historical Performance: Compu=ng ROIC Home Depot and Lowe's: Historical ROIC Analysis NOPLAT After-tax operating profit equals revenues minus operating costs, less any taxes that would have been paid if the firm held only core assets and was financed only with equity. Invested Capital Invested capital equals the operating assets required for core business activities (such as inventory and PP&E) less any financing provided by customers, employees, and suppliers (such as accounts payable). $ million Home Depot Lowe's 2006 90,837 (61,054) (18,348) (1,645) 441 10,231 2007 77,349 (51,352) (17,053) (1,693) 536 7,787 2008 71,288 (47,298) (17,846) (1,785) 486 4,845 Opera=ng cash taxes NOPLAT (3,986) 6,245 (3,331) 4,456 (1,811) 3,033 (2,071) 3,266 (1,973) 2,901 (1,496) 2,489 Invested Capital Opera=ng working capital Net property and equipment Capitalized opera=ng leases Other opera=ng assets, net of opera=ng liabili=es 1 Invested capital (excluding goodwill) 4,556 26,605 9,141 (1,027) 39,275 3,490 27,476 7,878 (1,635) 37,209 3,490 26,234 8,298 (2,129) 35,893 1,725 18,971 3,034 (126) 23,604 1,792 21,361 3,528 (461) 26,220 2,084 22,722 3,913 (450) 28,269 Goodwill and acquired intangibles Cumula=ve amor=za=on and unreported goodwill 1 Invested capital (including goodwill) 7,092 177 46,543 1,309 49 38,567 1,134 49 37,075 − 730 24,334 − 730 26,950 − 730 29,000 16.7% 14.5% 11.7% 10.5% 8.3% 8.0% 14.5% 14.0% 11.6% 11.3% 9.1% 8.9% Net sales Cost of merchandise sold Selling, general, and administra=ve Deprecia=on Add: Opera=ng lease interest Adjusted EBITA 1 ROIC excluding goodwill (average) 1 ROIC including goodwill (average) 1 2006 2007 2008 46,927 48,283 48,230 (30,729) (31,556) (31,729) (9,884) (10,656) (11,176) (1,162) (1,366) (1,539) 185 169 199 5,337 4,874 3,985 Goodwill includes goodwill, acquired intangibles, cumula=ve amor=za=on, and unreported goodwill. ROIC is computed by comparing after-tax operating profits to invested capital Forecast Financials: Growth and ROIC •  To compute a company’s value using enterprise DCF, future free cash flow is discounted by the weighted average cost of capital. Rather than forecast FCF directly, however, forecast the financials that drive free cash flow. Home Depot: Projected Revenue Growth and ROIC percent Revenue growth Historical Forecast 17.1 8.8 11.3 12.8 11.5 11.4 2.8 2001 2002 2003 2004 2005 2006 2007 2008 2009 − 7.8 2010 5.5 5.5 5.0 2011 2012 2013 10.5 11.3 12.0 2011 2012 2013 − 8.2 − 14.8 •  To value Home Depot, we looked to consensus analyst forecasts. Note that neither revenue growth nor ROIC is expected to return to its pre-2007 levels. ROIC 1 Historical 14.7 15.9 18.2 Forecast 18.2 14.7 14.5 10.5 8.0 2001 1 2002 2003 2004 2005 2006 ROIC measured using average invested capital 2007 . 8.3 2008 2009 9.5 2010 Forecast Financials: Digging Deeper •  During his tenure, Home Depot CEO Bob Nardelli focused the organiza=on on using economies of scale to reduce cost of merchandise. This led to a 2 percent increase in opera=ng margin. Home Depot: Operating Margin Analysis percent 100 Operating profit •  In 2007, new CEO Frank Blake stated he would make improved customer service a core strategy. As a result, profitability dropped as selling expenses increased from 20 percent to 24 percent of revenue. 90 Depreciation 80 Selling, general, and administrative e xpenses 70 60 50 •  A reliable es=mate of sustainable sales expenses is cri=cal for an accurate assessment of enterprise value based on future cash flow. Cost of merchandise sold 40 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Note: SG&A and operating profit adjusted for operating l eases . 10 Forecast Financials: Free Cash Flow •  Free cash flow, which is driven by revenue growth and return on invested capital, provides the basis for enterprise DCF valuation. •  The computation of FCF should be consistent with that of ROIC. Free cash flow begins with NOPLAT, adds depreciation, and subtracts investments in invested capital. Home Depot: Projected Free Cash Flow $ million Historical 2006 6,245 1,645 7,890 2007 4,456 1,693 6,149 2008 3,033 1,785 4,818 Forecast 2009 2,971 1,639 4,610 2010 3,269 1,685 4,954 2011 3,780 1,778 5,558 Change in opera=ng working capital Net capital expenditures Decrease (increase) in capitalized opera=ng leases Investments in goodwill and aquired intangibles Decrease (increase) in net long- term opera=ng assets Increase (decrease) in accumulated other comprehensive income Gross investment (936) (3,349) (1,214) (3,525) 224 (739) (3,577) 1,262 − 457 − (543) (419) 175 494 292 503 678 − (174) (73) (2,355) (212) − 54 (163) (3,151) (434) − 111 (99) (8,899) 445 (2,152) (832) (1,125) − 1,299 − (2,586) − (3,637) Free cash flow (1,009) 3,998 3,693 5,909 2,368 1,921 NOPLAT Deprecia=on Gross cash flow Gross Cash Flow Investments in Invested Capital NOPLAT plus depreciation, less investments in invested capital 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: The Key Value Driver Formula •  Although many continuing-value models exist, we prefer the key value driver model. The key value driver formula is superior to alternative methodologies because it is based on cash flow and links cash flow to growth and ROIC. g ⎞ྏ ⎛ྎ NOPLATt+1 ⎜ྎ1 − ⎟ྏ ⎝ྎ ROIC ⎠ྏ Continuing Value = WACC − g For continuing value, RONIC is the return on new investment; return on existing investment is captured in NOPLAT. 4.0% ⎞ྏ ⎛ྎ 6,122 ⎜ྎ1 − ⎟ྏ ⎝ྎ 12.2% ⎠ྏ Continuing Value = 8.5% − 4.0% Continuing Value = $91, 440 Note: Enterprise valuation based on $92,239 million; the precise calculation without rounding. The continuing value is measured as of 2018. This value must still be discounted to the present day. Weighted Average Cost of Capital •  When performing an enterprise DCF, make sure to choose the cash flows and discount factor consistently. Since free cash flows are the cash flows available to all investors, the discount factor for free cash flow must represent the risk faced by all investors. •  The weighted average cost of capital (WACC) blends the required rates of return for debt kd and equity ke based on their target market values. Target (market-based) weights on debt and equity Home Depot: Weighted Average Cost of Capital D E WACC = k d (1 − Tm ) + ke V V After-tax cost of debt After-tax cost of equity percent Source of capital Debt Equity WACC Proportion of total capital 31.5 68.5 100.0 Cost of capital 6.8 10.4 Marginal tax rate 37.6 After- tax cost of capital 4.2 10.4 Contribution to weighted average 1.3 7.1 8.5 Pujng It All Together: Enterprise DCF Valua=on Home Depot: Enterprise DCF Valuation Forecast year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Con=nuing value Present value of cash flow Free cash flow ($ million) 5,909 2,368 1,921 2,261 2,854 3,074 3,308 3,544 3,783 4,022 92,239 Discount factor (@ 8.5%) 0.922 0.850 0.784 0.723 0.666 0.614 0.567 0.522 0.482 0.444 0.444 Present value of FCF ($ million) 5,448 2,013 1,506 1,634 1,902 1,889 1,874 1,852 1,822 1,787 40,966 62,694 Midyear adjustment factor Value of opera%ons 1.041 65,291 Value of excess cash Value of long- term investments Value of tax loss carry- forwards Enterprise value − 361 112 65,764 Less: Value of debt Less: Value of capitalized opera=ng leases Equity value Number of shares outstanding (December 2008) Equity value per share (11,434) (8,298) 46,032 1.7 27.1 To determine the value of operations, discount free cash flow at the weighted average cost of capital. To determine the enterprise value, add the value of nonoperating assets, such as excess cash. To determine the equity value, subtract the value of nonequity financial claims, such as debt and capitalized operating leases. From Enterprise to Equity Value: Nonequity Financial Claims •  Equity is a residual claimant, receiving cash flows only after the company has fulfilled its other contractual claims. In today’s increasingly complex financial markets, many claimants have rights to a company’s cash flow before equity holders—and they are not always easy to spot. 1.  Debt. If available, use the market value of all outstanding debt. 2.  Unfunded re/rement liabili/es. Although total shor3all is not reported on the balance sheet (only a smoothed amount is transferred to the balance sheet), the stock market values unfunded re=rement liabili=es as an offset against enterprise value. 3.  Opera/ng leases. The most common form of off- balance- sheet debt is that of opera=ng leases. Under certain condi=ons, companies can avoid capitalizing leases as debt on their balance sheets (required payments must be disclosed in the footnotes). 4.  Con/ngent liabili/es. Most cases, opera=ng leases represent the largest off- balance- sheet obliga=on. Any other material off- balance- sheet con=ngencies, such as lawsuits and loan guarantees, will be reported in the footnotes. From Enterprise to Equity Value: Nonequity Financial Claims 5.  Minority interest. When a company controls a subsidiary but does not own 100 percent, the investment must be consolidated, and the funding provided by other investors is recognized on the company’s balance sheet as minority interest. 6.  Preferred stock. Although the name denotes equity, preferred stock in well- established companies more closely resembles unsecured debt. 7.  Employee op/ons. Each year, many companies offer their employees compensa=on in the form of op=ons. Since op=ons give the employee the right to buy company stock at a poten=ally discounted price, they can have great value. Economic Profit Valua=on Models Frameworks for Valuation •  The economic profit model highlights how and when the company creates value yet leads to a valuation that is identical to that of enterprise DCF. •  Economic profit can be used to measure a company’s performance in a given year. This allows you to determine when value is being created. Model Enterprise discounted cash flow Measure Discount factor Assessment Free cash flow Weighted average Works best for projects, business units, and companies cost of capital that manage their capital structure to a target l evel. Discounted economic profit Economic profit Weighted average Explicitly highlights when a company creates value. cost of capital Adjusted Free cash flow Unlevered cost of Highlights changing capital structure more e asily than present value equity WACC- based models. Capital cash flow Capital cash flow Unlevered cost of Compresses free cash flow and the i nterest tax shield equity in one number, making i t difficult to compare operating performance among companies and over time. Equity cash flow Cash flow to equity Levered cost of equity Difficult to i mplement correctly because capital structure i s e mbedded within the cash flow. Best used when valuing financial i nstitutions. Defining Economic Profit •  Economic profit translates size, return on capital, and cost of capital into a single measure. Economic profit equals the spread between the return on invested capital and the cost of capital times the amount of invested capital. Economic Profit = Invested Capital × (ROIC – WACC) •  The formula for economic profit can be rearranged and defined as after-tax operating profits less a charge for the capital used by the company: Economic Profit = NOPLAT − (Invested Capital × WACC) •  This approach shows that economic profit is similar in concept to accounting net income, but it explicitly charges a company for all its capital, not just the interest on its debt. NPV vs Economic Profit 0 WACC Tax Rate Capital Gross Cash Flow Investment Free Cash Flow Discount Factor DCF NPV NOPAT Capital Charge EP Discounted EP Sum of EP $100 - $100 1 - $100.00 $89.54 $89.54 3 $100 $30 $20 $50 $20 $30 4 $100 $30 $20 $50 $20 $30 5 $100 $30 $20 $50 $20 $30 $80 $60 $40 $20 $0 $50 $50 $50 $50 $50 0.909090909 $45.45 $50 0.826446281 $41.32 $50 0.751314801 $37.57 $50 0.683013455 $34.15 $50 0.620921323 $31.05 $30 $10.00 $20.00 $18.18 10.00% 40.00% $100 2 $100 $30 $20 $50 $20 $30 $50 Sales Cost Deprecia=on EBIT Tax NOPAT 1 $100 $30 $20 $50 $20 $30 $30 $8.00 $22.00 $18.18 $30 $6.00 $24.00 $18.03 $30 $4.00 $26.00 $17.76 $30 $2.00 $28.00 $17.39 Economic Profit at Home Depot •  Consider both measures of economic profit for Home Depot. Since Home Depot had been earning returns greater than its cost of capital, its historical economic profit was positive. Following the financial crisis in 2008, this was no longer the case. •  Not every company has a positive economic profit. In fact, many companies earn an accounting profit (net income greater than zero), but can’t earn their cost of capital. Home Depot: Economic Profit Valuation $ million Method 1 Return on invested capital Weighted average cost of capital Economic spread × Invested capital Historical 2006 15.9% 8.4% 7.5% 2007 9.6% 8.2% 1.4% 2008 7.9% 8.3% −0.4% Forecast 2009 8.0% 8.5% −0.4% 2010 9.6% 8.5% 1.1% 2011 10.8% 8.5% 2.3% Economic profit 39,389 2,950 46,543 629 38,567 (162) 37,075 (164) 34,137 383 35,038 818 Method 2 Invested capital (beginning of year) × Weighted average cost of capital Capital charge 39,389 8.4% 3,295 46,543 8.2% 3,827 38,567 8.3% 3,195 37,075 8.5% 3,135 34,137 8.5% 2,886 35,038 8.5% 2,962 NOPLAT Capital charge Economic profit 6,245 (3,295) 2,950 4,456 (3,827) 629 3,033 (3,195) (162) 2,971 (3,135) (164) 3,269 (2,886) 383 3,780 (2,962) 818 Discounted Economic Profit Leads to Same Results as DCF •  To demonstrate how economic profit can be used to value a company—and to demonstrate its equivalence to enterprise DCF—consider a stream of growing cash flows valued using the growing perpetuity formula, Value0 = FCF 1 WACC − g •  Using a few algebraic transformations and the assumption that the company’s ROIC on new projects equals the company’s current ROIC, we can transform the cash flow perpetuity into an economic-profit-based key value driver model, Value0 = Invested Capital0 + Invested Capital0 × (ROIC − WACC) WACC − g •  Substituting the definition of economic profit, Value0 = Invested Capital0 + Economic Profit 1 WACC − g Home Depot: Economic Profit Valua=on Home Depot: Economic Profit Valuation Invested capital1 ($ million) 37,075 34,137 35,038 36,897 38,900 40,821 42,748 44,665 46,568 48,453 Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Continuing value Present value of e conomic profit ROIC1 (percent) 8.0 9.6 10.8 11.6 12.3 12.3 12.2 12.2 12.2 12.1 WACC (percent) 8.5 8.5 8.5 8.5 8.5 8.5 8.5 8.5 8.5 8.5 Economic profit ($ million) (164) 383 818 1,145 1,487 1,550 1,611 1,671 1,731 1,789 41,922 Discount factor (@ 8.5%) 0.922 0.850 0.784 0.723 0.666 0.614 0.567 0.522 0.482 0.444 0.444 Present value of economic profit ($ million) (151) 325 641 827 991 952 913 873 834 795 18,619 25,619 Invested capital i n 2008 Invested capital plus present value of e conomic profit 37,075 62,694 Midyear adjustment factor Value of operations 1.041 65,291 1Invested capital is measured at the beginning of the year. Valuation using economic profit leads to the same value as enterprise DCF! The value of operations equals: the sum of discounted economic profit + current invested capital Adjusted Present Value •  The adjusted present value (APV) model separates the value of opera=ons into two components –  Value of opera=ons as if the company was all equity financed –  Value of tax shields that arises from the choice if financing •  Useful when companies are expected to see a significant change in their capital structure going forward •  Modigliani and Miller: In a market with no taxes a company’s choice of capital structure will not affect the value of its economic assets ...
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