Intro to Valuation The Role of Relative Valuation Stuart Linde Head of U.S. Equity Research Lehman Brothers smartwomansecuritie s © 2006 Smart Woman Securities. All materials are for SWS members’ use only November 1, 2006
Jan 12, 2016
Intro to ValuationThe Role of Relative
Valuation
Stuart LindeHead of U.S. Equity Research
Lehman Brothers
smartwomansecurities
© 2006 Smart Woman Securities. All materials are for SWS
members’ use only
November 1, 2006
Topics
• The Broad Fundamental Analysis View
• Financial Statement Overview• Relative Equity Valuations• Case Study: CBS
Information is Dangerous….
Knowing How to Apply is Deadly!
The Broad Fundamental Analysis
View
Common Analyses Elements
• Revenues– Drivers Of Business Model / Stress Test Against Industry
Model– Expectation Often Predicated On Recent History Rather Than
Realism– Industry Growth, Management Strategies And Comparisons
Are Key• Profitability
– Where Rubber Hits The Road….Is Revenue Growth Creating At Least Incremental Profitability
– Easiest To Play With – “One Time” Vs. Recurring– Q To Q Volatility
• Cash Flow– Measure Of Earnings Quality– Measure Of Growth Capabilities– Risk Of Over-Investment
The Broad View
Common Analyses Elements (cont’d)
• Valuation– P/E Most Commonly Used To Benchmark Against
Market, Other Industries And Peers– Cash Flow (EV: EBITDA); – Enterprise Value (Debt, Book And Equity Measures)– Dividend Yield– Sales– The List Goes On!
• Expectations– Greatest Opportunity To Enhance Risk Taking Broadly
Is To Anticipate Expectation Embedded In Stock.
The Broad View
Uncommon Analyses Elements: How Do They Affect the Model Levers?
Key Questions to Set Stage for Valuation:– What are the Key Drivers of Growth?
– What is the Category Growth ?
– What Macro Variables Affect the Sector?
– Are There Sector and Company Specific Risks?
– What is the Geographic Scope?
– Does Scale Come into Play?
The Narrow View
Financial Statement Overview
Income Statement Analysis
• Revenues – Examine Growth Driverso Different for Every Industryo Recurring vs Non Recurring o Macro Drivers o Example Cable Networks: Subscribers, Subscriber Fees and
Advertisingo Example Hotels: Occupancy Rate, Price, RevPAR
• Gross Margin = Revenues – COGSo Impacted by Material & Labor Costs
• Operating Margin/EBIT = GM – SG&A – D&Ao Impacted by All Operating Expenses/Run the Business
• EBITDA = EBIT + D&A
Financial Statement Overview
Income Statement Analysis (cont’d)
• Below Line Itemso Interest Expense/Incomeo Minority Interestso Non Consolidated Investmentso One Time, Non Recurring Itemso Taxes
• EPSo Basico Fully Diluted – Options Includedo Operating EPS
Financial Statement Overview
Watch for Earnings Inflation
• Quality of Operating Earnings is Critical!– Analyze Earnings Release Carefully– Remove Cheerleader Behavior
• Watch for:– Depreciation and Amortization– Corporate Expense– Interest Expense– Minority Interests– Lower Share Count– Unexpected Tax Rates Changes
Financial Statement Overview
Financial Statement Overview
Balance Sheet – Understand Leverage Drivers
Liquidity = Current Assets – Current Liabilitieso Inventories, Receivables, Payables, ST Debto Burn Rates
• LT Debt Analysis – Be Cognizant of Maturity Scheduleso Credit Crunch Could Impact Bank Rateso Floating vs Fixedo Cost of Debt Could Be Impacted By Ratios, Operations and Mkt
Conditionso Interest Rates Affect EPS
Key Leverage CalculationsNet Debt/EBITDAInterest Coverage = EBITDA/Interest Expense
Financial Statement Overview
Cash Flow Statement – Direct Impact on Balance Sheet
FCF = Net Income + Depreciation/Amortization -Changes in Working Capital and Capital
Expenditures
• Capital Expenditures = Maintenance or New Investmento Recurring vs Non Recurringo Depreciation vs Capex
• The Cash Dilemma: What to Do?o Management Needs a Well Thought Out Process for Assessing
ROICo Stock Buyback is Easy Answer but is it Best? o Buyback Often Signifies Slower Growtho High Correlation Between Incremental ROIC and Multipleso Common Stock or One-Time Special Dividend
Relative Equity Valuations
Relative Equity Valuations• P/E Ratios
• EV/EBITDA
• FCF
• Sum of the Parts
• CBS: A Case Study
Equity Valuations
Growth
ROIC
Diversification
Leverage
Fundamentals
Complexity
Valuation
Equity ValuationsThings to Think About:
• Think Before You Input; Watch for Straight Line Approach
• Fundamental Analysis Key …But Do Not Forget Technicals
• Keep Emotions Out of Equation; Let Data Speak
• Fighting Tides is Often a Lost Cause; Watch Valuation Trap Find a Catalyst or Unlock the Value
• Keep it Simple; Do Not Over Analyze
Equity Valuations
Relative Valuation
• Define Companies in Universe
• Understand Drivers of Business Model
• Analyze Prospects for Growth
• Financial Strength/Flexibility
• Other Industry/Company Specific Dynamics Economic/Macro Product Risks Sales Concentration Risk Political Risk Management Return on Invested Capital
Equity Valuations
Understand Industry Drivers• Earnings Drivers Vary By Industry
Retail – Comp Sales, Square Footage Growth
Media – Advertising Banks – Asset Quality Energy – Commodity Prices Industrial – GDP Technology – Supply/Demand Cycle Healthcare – Regulatory
Equity ValuationsExcess Leverage Could Impact Valuation
• Bankruptcy Risk Chapter 11 and Chapter 7
• Decreases Financial Flexibility Shareholder Value M&A
• Higher Borrowing Costs Equates to Lower Net Margins
• Limits Reinvestment; Creates Asset Drain
Key RatiosNet Debt/EBITDAInterest Coverage = EBITDA/Interest ExpenseDependent on Industry Dynamics – Cyclical vs. Stable
Equity ValuationsPrice/Earnings• Absolute• Relative• PEG• TTM Versus Forward -- Must Normalize for One Time Items• Normalized Earnings• Fully Diluted
Variables• Growth – Projected and Historical• Industry/Sector• Trading Liquidity• Management• Debt• Complexity: Structure, Financing, Accting, Businesses, Control,
10k Thickness
Equity ValuationsEV/EBITDA
EV = MV of EQ + Debt – Cash – Non Consolidated Assets (Hidden Assets)
EBITDA = Earnings Before Int., Taxes and Depreciation
Variables• Debt Levels/Balance Sheet• Growth – Projected and Historical• Industry/Sector/Risks• Capital Intensity of Sector/Amount of Reinvestment• FCF• Complexity
Equity ValuationsFree Cash Flow
FCF = Net Income +Depreciation/Amortization -Changes in Working Capital and Capital
Expenditures
• FCF Used to Determine Cash on Cash Returnso Cleaner than EPS/Measures Cash Creation
Uses• Reinvestment/Acquisitions• Debt Reduction/Stock Repurchase• Dividends – One Time or Annual
Key CalculationsFCF Yield = FCFPS / Stock PriceFCF Conversion = FCF / EBITDA
Equity Valuations
Sum of the Parts
• Break Up Value of the Company
• Used in Complex Multi-Industry Situations
• Accounts for Non Consolidated Assets
• Assists in Measuring Franchise and Brand Value
Example: AOL Time Warner(US$ millions) Ownership
Interest 2002A 2003E Multiple 2003EConsolidated Operations:Cable 2,745 3,047 EBITDA 11.0x 33,516Filmed Entertainment 1,232 1,387 EBITDA 12.0x 16,648Networks 2,032 2,265 EBITDA 15.0x 33,982Music 474 465 EBITDA 8.0x 3,717Publishing 1,155 1,172 EBITDA 9.0x 10,552Corporate (332) (363) EBITDA 11.7x (4,257)Intersegment Eliminations (47) (103) EBITDA 11.7x (1,213)Total $7,260 $7,871 11.7x $92,944
Unconsolidated Operations:Time Warner Telecom 44.0% 114 114 MM shs $6.80 per share 341Court TV 50.0% 75.0 80.0 MM subs $20 per sub 800Braves, Hawks, Thrashers 100.0% $725 $783 MM value 783Viva Media 30.6% $330 $363 MM value 111Cable joint ventures (a) 50.0% 1.5 1.5 MM subs $3,200 per sub 1,634Value of NOLs 2,784 2,575 2,575Total $6,244
Total Asset Value of AOL Time Warner $99,188
Less:Net debt $23,348Comcast's Minority Interest in TWC 5,337
Value to Common Shareholders $70,503
Total shares outstanding 4,555Value per AOL/ TWX share $15.48
Equity Valuations
Case Study: CBS
Back Drop:oSpin Off From ViacomoMature AssetsoHigh Free Cash FlowoStrong Balance SheetoComplex Asset
• How to Value?
Equity Valuations
Where do we start?
• Determine Universe
• Examine Business Composition
• Analyze Growth Prospects
• Are there Company Specific Risks? Industry?
• What is the View of Management?
• Should Brand Value be Taken into Consideration?
• How Does the Economic Outlook Impact Fundamentals?
• Is there a Dividend or Other Means to Enhance Shareholder Value?
• How Does Leverage/FCF Compare to Peers?
• Complexity/Accounting Concerns
Concluding Comments
• Valuation Screens Often Precede Fundamental Analysiso More Than One Methodology Usually Required
• Relative Valuation Methods Vary by Sector
• Stocks are Sometimes Cheap for a Reasono Sector Driveno Management Track Recordo Product Pipeline
• Combining Fundamentals with Valuation Helps Minimize Risk
o Good Companies Make Great Investmentso Bad Companies Make Poor Stocks
Markets are Inefficient….
Valuation is a Key Investment Tool!
Follow-Up Reading/Courses
1. Graham & Dodd Security Analysis
– The Bible!
2. You Can Be A Stock Market Genius, Joel Greenblatt
3. Stocks for the Long Run, Jeremy Siegel
4. Investment Valuation: Tools and Techniques,
Professor Aswath Damordaran
5. Think About Taking CFA
Q&A