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John Gregg, Associate Principal & Head Emerging Markets
*Normalized book value, assuming 8 percent equity as 'normal.' Source: SNL Securities, 2002 (Pricing as of 3/25/2002). Summary of 21 comparable banking companies with similar assets, capital and profitability characteristics.
Note the ratios used to value banks are equity based – the Market
value to Book Value and the P/E ratio related to various earnings
measures
Comparison with all Acquisitions Since 2001
All Asian Banking Acquisitions with a total deal value over $200m
SOV-Waypoint Deals in 2004 Deals since 2003 Deals since 2002 Deals since 2001
# of Deals 1 7 16 20 28
Median 238.5 256.1 238.7 238.7
Mean 241.0 249.6 240.8 244.6
Median 304.7 299.2 290.4 299.2
Mean 319.3 309.6 301.4 307.3
Median 20.7 20.4 20.3 20.3
Mean 20.9 20.3 19.9 20.2
Median 29.9 30.4 30.1 30.2
Mean 31.4 32.8 32.1 31.4
238.5
251.8
22.0
32.1
Price/Book
Price/Tangible Book
Price/LTM Earnings
Price/Deposits
Adjustments to Multiples
• Process
Find multiples from similar public companies
Adjust multiples for
Liquidity
Size
Control premium
Developing country discount
Apply adjusted multiples to book value, earnings, and EBITDA
• There is often more money in dispute in determining the discounts and premiums in a
business valuation than in arriving at the pre-discount valuation itself. Discounts and
premiums affect not only the value of the company, but also play a crucial role in
determining the risk involved, control issues, marketability, contingent liability, and a
host of other factors.
• If the entity were closely held with no (or little) active market for the
shares or interest in the company, then a non-marketability discount
would be subtracted from the value.
• Non-marketabiliy Discounts – ranges from 10% to 30%
• …represents the reduction in value from a marketable interest level
of value to compensate an investor for illiquidity of the security, all
else equal.
• The size of the discount varies base on:
relative liquidity (such as the size of the shareholder base);
the dividend yield, expected growth in value and holding period;
and firm specific issues such as imminent or pending initial public
offering (IPO) of stock to be freely traded on a public market.
Adjustments to Multiples – Marketability and
Liquidity Discount
Studies of Liquidity Discount
• Private and public transactions
Attempt to compute EV/EBITDA in public and private transactions
Adjust so that the transactions are comparable
Compute the ratio in pubic and private transactions
Discount of 20 to 28 percent for US firms
Discount of 44 to 54 percent for non-US firms
• Other studies
Value in IPO versus value of private trades before IPO
High liquidity in 40-50% range, but selection bias
Theory involves control by public board
P/E Analysis – Use of P/E Ratio in Valuation
• J.P. Morgan performed an analysis comparing 's price to earnings multiples with Mobil's
price to earnings multiples for the past five years.
• The source for these price to earnings multiples was the one and two year prospective
price to earnings multiple estimates by I/B/E/S International Inc. and First Call,
organizations which compile brokers' earnings estimates on public companies. Such
analysis indicated that Mobil has been trading in the recent past at an 8% to 15%
discount to Exxon.
• J.P. Morgan's analysis indicated that if Mobil were to be valued at price to
earnings multiples comparable to those of Exxon, there would be an enhancement
of value to its shareholders of approximately $11 billion.
• Finally, this analysis suggested that the combined company might enjoy an overall
increase in its price to earnings multiple due to the potential for improved capital
productivity and the expected strategic benefits of the merger. According to J.P.
Morgan's analysis, a price to earnings multiple increase of 1 for Exxon Mobil would
result in an enhancement of value to shareholders of approximately $10 billion.
Price Earnings Ratio
• The price earnings ratio is obviously very important in stock evaluation.
Therefore, I describe some background related to the ratio and some theory
with regards to the P/E ratio. Subjects related to the P/E ratio include:
Dividend growth Model
Theory of price earnings ratio and growth
P/E ratio and the EV/EBITDA ratio
The PE ratio depends more on accounting
The PE is affected by leverage
The EV/EBITDA ignores depreciation and capital expenditure
Case exercise on P/E and EV/EBITDA
P/E Ratio versus EV/EBITDA
• Use the EV/EBITDA when the funding does not make much difference in
valuation
Many companies in an industry with different levels of gearing and
companies do not attempt to maximize leverage
Very high levels of gearing and wildly fluctuating earnings
When the earnings are affected by accounting policy and account
adjustments
• Use the P/E ratio when cost of funding clearly affects valuation and/or
when the level of gearing is stable and similar for different companies
Debt capacity can provide essential information on valuation
EBITDA does not account for taxes, capital expenditures to replace
existing assets, depreciation and other accounting factors that can
affect value.
P/E Ratio
• If you use the P/E ratio for valuation, the ratio implies that only this year or
last years earnings matter
• Cash matters to investors in the end, not earnings (different lifetime of
earnings)
• When earnings reflect cash flow, P/E is reasonable for valuation
• High P/E causes treadmill and does not necessary imply that companies
are performing well
• Earnings can be managed and manipulated
P/E Ratio, Growth and Reconciliation to Cash Flow
• P/E = (1-g/r)/(k-g)
g -- long term growth rate in earnings and cash flow
r -- rate of return earned on new investment
k -- discount rate
• (k-g) = (1-g/r)/(P/E)
• k = (1-g/r)/(P/E) + g
• Example: if r = k than the formula boils down to 1/(k)
• If the g = 0, the formula is P/E = 1/k
• P = E/(k-g) x (1-g/r)
If, for some reason, g = r, then the Gordon model could be applied to
compute k.
PE Ratio Formula when k = r – There is no economic
profit on new investments
• P/E = (1-g/r)/(k-g)
If k = r
P/E = (1-g/k)/(k-g)
P/E = (k/k-g/k)/(k-g)
P/E = ((k-g)/k)/(k-g)
P/E = 1/k
• PEG Ratio P/E divided by g
If the g and the r were the same, the ratio would be a benchmark
Should consider the r and the k
Use of P/E Ratio Formula to Compute the Required
Return on Equity Capital
• It will become apparent later that one cannot get away from estimating the
cost of equity capital and the CAPM technique is inadequate from a theoretical
and a practical standpoint.
• The following example illustrates how the formula can be used in practice:
k = (1-g/r)/(P/E) + g
•
P/E Notes
• High ROE does not mean high PE – Hence the existence of high ROE
stocks with low PEs
• Growth and value are not always positively correlated
• Growth from improvement will always be value enhancing whereas growth
from reinvestment depends upon the return against the benchmark return
• Reinvestment should also include “ Cash hoarding”
• PB is better at differentiating ROE differences than PE
Relationship Between Multiples
• The P/E, EV/EBITDA and Cash Flow Multiples should be consistent and you should understand why one multiple gives you a different answer than another multiple.
• Each of the multiples is affected by
The discount rate – the risk of the cash flow
The ability of the company to earn more than its cost of capital
The growth rate in cash flow or earnings
• Differences in the ratios are a function of
Leverage, Depreciation Rates, Taxes, Capital Expenditures relative to cash flow
Relationship Between Multiples
• Enterprise Value = NOPLAT x (1-g/ROIC)/(WACC – g)
• NOPLAT = Investment x ROIC
• NOPLAT = EBIT x (1-t)
• EBITDA = EBIT + Depreciation
EV/EBITDA
• EBT = EBIT – Interest
• NI = EBT x (1-t)
NI/Market Cap
• Market Cap = EV – Debt
MB = Market Cap/Equity
Relationship Between Multiples - Illustration
• Assume
Value = NOPLAT x (1-g/ROIC)/(WACC –g)
This is the EVA Formula
• Assume
No Taxes
No Leverage
No Depreciation
No Growth Rate
ROIC = 10%
Comparative Multiples
With the simple assumptions, each of the multiples is the same as
shown belowExercise: Data table with alternative
parameters to investigate P/E and
EV/EBITA
Comparative Multiples
Once taxes, leverage and depreciation are added, the multiples diverge as shown on
the table below:
Problems in Applying Multiples
• If you assume that the company has been growing at a high rate
and apply the P/E ratio will be overstated in valuation.
• When comparing companies, the operating leverage and financial
risks should be similar and there should be an understanding of
why P/E ratios are different.
• In applying multiples for comparable transactions, if synergy
values are added, there is double counting
• If industry has cycles, must be careful in application
Market and sector PE ratios – The danger of averages
This chart illustrates issues associate with computing averages. In practice,
the number of comparable firms is small and choosing the median is
advisable.
Valuation From Discounted Free Cash Flow
Advantages and Disadvantages of DCF
• Advantages
Theoretically Valid – value comes
from free cash flow and assessing
risk of the free cash flow.
Operating and Financial Values –
explicitly separates value from
operating the company with value
of financial obligations and value
from cash
Sensitivity – forces an
understanding of key drivers and
allows sensitivity and scenario
analysis
• Disadvantages
Assumptions: Requires WACC
assumptions and residual value
assumptions. There are major
problems with WACC estimation.
Forecasting Problems: Complex
forecasting models can easily be
manipulated
Growth: The residual value depends
on growth rates which can easily
distort value
Real Options: Discussed above
Discounted Flow
• Use the discounted cash flow when you know something more
about the company that can be obtained with a forecast
• Any cash flow forecast involves:
Value =
Cash flow during explicit forecast period +
Present of cash flow after explicit forecast period
• The second item generally involves some kind of growth
projection.
• Value of Equity = Value of Enterprise – Value of Net Debt
Discounted Cash Flow
• Why would you make a cash flow forecast of more than one year
If the company is stable and you know the stable level of earnings
and cash flow, then a cash flow forecast does not add anything to the
valuation analysis
If you do not know what the future earnings will be, then a cash flow
forecast is helpful as long as you have information to make the
forecast
If you know earnings and cash flow will fluctuate and then reach a
stable amount, then discounted cash flow will be better than multiple
analysis
Step by Step Valuation with Free Cash Flow
• Step by Step valuation using free cash flow:
Step 1: Compute projected free cash flow over the explicit forecast period and
discount the free cash flow at the WACC
Step 2: Make adjustments to free cash flow in the last forecast year
Step 3: Add terminal value to cash flow to establish enterprise value
Step 4: Make other balance sheet adjustments for balance sheet liabilities and
assets that are not in cash flow but affect value
Step 5: Subtract current value of debt net of surplus cash to establish the total
equity value.
Step 6: Divided the equity value by the current outstanding shares to establish
value per share
Assets and Liabilities that Escape DCF Valuation
• Any asset or liability that has no cash flow consequences
• Carefully Analyze the Balance Sheet::
Assets Add to Enterprise Value
Un-utilized Land
Un-utilized Equipment
Legal Claims
Liabilities Subtract From Enterprise Value
Environmental
Contract Provisions
Unrecorded unfunded Liabilities
Net Pension Liabilities not Funded
Double Counting of Assets and Obligations
• Work through simple examples to make sure that the cash flow and the
adjustments to valuation are consistent.
• Work through simple examples
• Examples minority interest
Income from minorities is included in free cash flow, then the financing of
minorities must be included in invested capital
If diluted shares are deducted in earnings than do not also include the diluted
shares when computing share value
Deferred tax treatment depends on how future deferred taxes are forecast
DCF Valuation – Length of Forecast
• Short-run
Forecast all financial statement items
Gross-margin, selling expenses, Etc.
• Further out
Individual line items more difficult
Focus on key drivers
Operating margin, tax rate, capital efficiency
• Continuing Value
When ROIC and growth stabalise
$ Explicit forecasts 8,924.43 Terminal valuation 17,811.59 Appraised Enterprise Value (AEV) 26,736.02 Plus: Listed investments 3,416.00 Plus: Other investments 4,356.00 Plus: Cash 20,316.00 Total Appraised Value 54,824.02 Less: Bank & other debt 24,282.00 Less: Minorities 78.00 Equity value 30,464.02
DCF Example to Compute Equity Value from Free Cash Flow – Net Debt is
Bank and Minority Interest minus Cash and Listed Investments
Note how investments are added
and debt is deducted in arriving
at equity value
Treatment of other
investments depend
on definition of free
cash flow. Here,
income from other
investments must not
be in free cash flow
Continuing Value
Estimating Continuing Value
• Continuing value is important aspect of valuation
• In actual valuations compiled by MONITOR, the terminal value is – 56% to
125% of valuation
• High terminal values are reasonable if cash flow in early years is offset by
outflows for capital spending that should generate higher cash flows in later
years
The terminal value should reflect cash flow and earnings that is at the middle
of the business cycle, or in the case of commodities, where prices reflect
long-run marginal production cost, or in the case of high growth companies,
when the market is saturated
• Terminal or continuing value is analogous to dividends and capital gains.
Free cash flow is dividends, residual value is capital gain.
• A few methods of computing residual value include:
Perpetuity
EBITDA Multiple
P/E Ratio
Market to Book Ratio
Replacement Cost
NOPLAT
• Present value of residual amount to add to present value of cash flow to
establish enterprise value
Continuing Value to Add to Free Cash Flow
First, high growth firms with high net capital
expenditures are assumed to keep reinvesting at
current rates, even as growth drops off. Not
surprisingly, these firms are not valued very highly
in these models.
Second, the net capital expenditures are reduced
to zero in stable growth, even as the firm is
assumed to grow at some rate forever. Here, the
valuations tend to be too high.
Sustainable Growth and Plowback Rate
• In the P/E ratio, the sustainable growth of earnings per share is:
g = ROE x (1 – dividend payout ratio)
This depends on assumptions with respect to constant
payout and constant ROE. It also assumes that either there
are no new share issues, or if new share issues occur, the
market to book ratio is one.
• Growth in free cash flow:
g = Dep Rate x [(Cap Exp/Dep) – 1]
Capital expenditures can be greater than depreciation
because historic depreciation is low from historic accounting
or because company has opportunities for growth.
Discounted Cash Flow Example
• JPMorgan conducted a discounted cash flow analysis to determine a range of estimated equity
values per diluted share for Exelon common stock.
• JPMorgan calculated the present value of the Exelon cash flow streams from 2005 through 2009,
assuming it continued to operate as a stand-alone entity, based on financial projections for 2005
through 2007 and extensions of those projections from 2008 through 2009 in each case provided
by Exelon's management.
• JPMorgan also calculated an implied range of terminal values for Exelon at the end of 2009 by
applying a range of multiples of 8.0x to 9.0x to Exelon's 2009 EBITDA assumption.
• The cash flow streams and the range of terminal values were then discounted to present values
using a range of discount rates from 5.25% to 5.75%, which was based on Exelon's estimated
weighted average cost of capital, to determine a discounted cash flow value range.
• The value of Exelon's common stock was derived from the discounted cash flow value range by
subtracting Exelon's debt and adding Exelon's cash and cash equivalents outstanding as of
December 31, 2004.
Example of Discounted Cash Flow Analysis
• For the Exelon discounted cash flow analysis, MONITOR calculated terminal values by
applying a range of terminal multiples to assumed 2009 EBITDA of 7.72x to 8.72x. This
range was based on the firm value to 2004 estimated EBITDA multiple range derived in
the comparable companies analysis. The cash flow streams and terminal values were
discounted to present values using a range of discount rates of 5.43% to 6.43%. From this
analysis, Lehman Brothers calculated a range of implied equity values per share of Exelon
common stock.
• PSE&G: For PSEG's regulated utility subsidiary, Morgan Stanley calculated a range of
terminal values at the end of the projection period by applying a multiple to PSE&G's
projected 2009 earnings and then adding back the projected debt and preferred stock
amounts in 2009. The price to earnings multiple range used was 14.0x to 15.0x and the
weighted average cost of capital was 5.5% to 6.0%.
Discounted Cash Flow Analysis – Real World Example
• Credit Suisse First Boston estimated the present value of the stand-alone, Unlevered,
after-tax free cash flows that Texaco could produce over calendar years 2001 through
2004 and that Chevron could produce over the same period. The analysis was based on
estimates of the managements of Texaco and Chevron adjusted, as reviewed by or
discussed with Texaco management, to reflect, among other things, differing
assumptions about future oil and gas prices.
• Ranges of estimated terminal values were calculated by multiplying estimated calendar
year 2004 earnings before interest, taxes, depreciation, amortization and exploration
expense, commonly referred to as EBITDAX, by terminal EBITDAX multiples of 6.5x to
7.5x in the case of both Texaco and Chevron.
• The estimated un-levered after-tax free cash flows and estimated terminal values were
then discounted to present value using discount rates of 9.0 percent to 10.0 percent.
• That analysis indicated an implied exchange ratio reference range of 0.56x to 0.80x.
Problems with Use of Multiples in DCF
• Multiples can cause problems
Sustainable growth once stable period has been reached is
probably less than the growth used in the explicit forecast
period. This means that the multiple should be less as well.
The multiples for evaluating a merger transaction may
include synergies and other current market items. The use of
similar multiples in terminal value is highly inappropriate.
Continuing Cash Flow from NOPLAT and ROIC
• Using a multiple of NOPLAT has a couple of advantages
It is not distorted by large of small capital expenditures
Continuing value directly relates to assumptions about ROIC
For companies with low leverage, the NOPLAT multiplier is similar to the P/E ratio
• Formulas for Computing Continuing Value with NOPLAT
Free Cash = NOPLAT – Capital Expenditure + Depreciation
Free Cash = ROIC x Investment – Capital Expenditure + Depreciation
The equation becomes:
Free Cash = (1-Real Growth/Real ROIC) x NOPLAT
In this formulation
G = ROIC x Plowback Rate
Similar to ROE x Retention Rate
Reasons for Multiplying by (1+g) in Perpetuity Method
• Assume
Company is sold on last day in the cash flow period
Valuation is determined from cash flow in the year after the residual period
This cash flow is final year x (1+g)
• Discounting
Since the value is brought back to final period, the discount factor should be the final year period
Without growth, the value is the cash flow (cf x 1+g)) divided by the discount growth
The discounting should also reflect the growth rate
• Formula
1. Cash Flow for Valuation – CF x (1+g)
2. Value at Last Day of Forecast – CF x (1+g)/(WACC –g)
3. PV of the Value -- discount rate must be at last day of forecast, not mid year
Formulas for Continuing Value
• A common method for computing cash flow is using the final cash flow in the corporate
model and assuming the company is sold at the end of the
Perpetuity Value at beginning of final year = FCF/WACC
Perpetuity Adjusted for Growth = FCF(1+g)/(WACC - g)
Perpetuity using investment returns =
NOPLAT x (1-g/ROIC)/(WACC - g)
• Once the Perpetuity Value is established for in the last year, it must be discounted to the
current value:
Current Perpetuity Value = PV(Perpetuity Value that occurs at beginning of final
year)
• NPV in excel assumes flows occur at the end of the year. Adjustments can be made to
assume that flows occur in the middle of the year.
In this case, the discounting of the residual is different from discounting of the
individual cash flows
Practical Issues and Continuing Value
• Book Value – when book value means something from an economic
standpoint
Banks
Utility Companies
• EV/EBITDA, P/E – companies without lumpy investments
Telcom
Manufacturing
• Replacement Cost – when replacement cost can be established
Oil, Gas and Mining
Airlines
•It seems foolish to assume
that current multiples will
remain constant as the
industry matures and
changes and that investors
will continue to pay high
multiples, even if the
fundamentals do not justify
them. If there is stable
growth, the P/E multiple in
the terminal value should
be lower.
Issues in Summarising DCF
• Whether to divided by diluted or non-diluted shares depends on
the treatment of employee stock options and convertible bonds
• Work through simple examples
• Three ways to model options
Deduct options from EBITDA and do not use non-diluted
shares – problem, how to handle existing options.
Ignore options and use diluted shares
Explicitly value options as a claim on cash flows and include
as debt – here would use the non-diluted shares
Example of Residual Value Analysis
Exercise on ROIC in Financial Ratio
Folder
Valuation from Projected EPS and Dividend per
Share
Valuation from Projected Earnings and Dividends
• Earnings Valuation
PV of EPS over forecast horizon discounted at the equity discount rate
Add the present value of the perpetuity EPS value reflecting the growth rate
• Dividend Valuation
PV of Dividend per share over the forecast horizon
Add present value of book value per share rather than perpetuity of earnings because book value grows when dividends are not paid
Can multiply the book value per share by market to book multiple
Price Earnings and Gordon Model
Gordon Dividend Discount Model.
P = D1/(K – G)
P = the "correct" share price
D = dividend payment for the next period (recall from discounting exercise that the next period must be used)
K = Required rate of return (based largely on market interest rates a adjusted for equity risk)
G = anticipate rate of dividend growth
The model can be used to compute the cost of capital where:
R = D/P + G
Problem: D is not EPS and G is affected by payout ratio
Illustration of EPS and DPS Valuation
• Demonstrate that incorporation of growth reduces to the formula EPS/(k-g)
• Compute present value of the EPS over the forecast horizon
• Compute free cash flow for segments of the business
• Compute EBITA by segment to evaluate the value with comparables
• Can use different residual value assumptions for different segments of the
business
Corporate Modeling and Valuation of Business Segments
Use of Relationship between Multiples and Financial Ratios
in Residual Value
The financial model projects the return on equity and the relationship between
ROE and the Market to book ratio can be used to make projections of multiples