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J. K. Dietrich - FBE 532 – Spring 2006

Finance Theories, Case Analysis, and Valuation

January 12, 2006


FBE 532 Objectives

Analyze and communicate implications of financial theory using cases

Understand finance careers and functions Refine and expand specific financial

analytical skills Responsibility for learning is with you Requirements are clear: review, prepare, and

participate


Cases and Case Preparation

Cases attempt to present real-life corporate financial decision-making environments

Problems are not always clearly stated The goal is to apply theoretical concepts to

refine important questions and form recommendations– Use “13 points’ as a guide– Focus on key points and data– Feel free to discuss before writing up


Financial Functions

All finance is concerned with value Corporate decision-making

– Investments, including mergers and acquisitions and divestitures (disinvestment)

– Growth and financing needs – Management of working capital

Chief financial officer is responsible for these decisions– Requires project analysts, treasury assistants


Objectives Understand how practitioners value firms

– Liquidation or adjusted-asset value– Public comparables (multiples approach)– Discounted-cash-flow methods

» WACC (entity) approach

» Flow to equity (fundamental analysis) methods

» Adjusted present value

Compare and contrast these methods and understand advantages and limitations of each


Liquidation or Adjusted-Assets Value of equity in firm is simply:

Equity = Assets – Liabilities A crude estimate of value is the book value

of equity and is used as a reference (times book)

Adjust assets for market value rather than accounting values

An adjusted estimate of equity value is:Equity = Adjusted Assets - Liabilities


Comparables using Public Firms

Using comparables of publicly traded firms is very widely used by analysts (both buy and sell side)

Often called multiples approach Uses a combination of accounting and

market numbers to value companies. Most common multiples are:– Price/earnings– Asset/sales– Market/book


Example of Comparables Method

Greens Health Inc., a privately owned Supermarket chain has expected earnings of $20 million per year on sales of $205 million with total assets of $80 million.

In a proposed IPO, Greens will issue 10 million shares so forecast EPS is $2 per share; the firm is all equity.

Using data on suitable comparables, compute a valuation matrix


Valuation Matrix: P/E Ratios

Vons 18

Safeway 19

PE RatioComparables Implied Stock Price

36

38

Average 18.5 37

Using an average stock price of $37, firm value is estimated to be $37 10m = $370 million

Source: Compustat (Wharton) Raios for 1995


Valuation: Price/Sales Ratios

Vons .24

Safeway .38

P/S RatioComparables Implied Firm Value

49.2

77.9

Average .31 63.6

Firm value is estimated to be $63.6 million


Valuation: Market/Book Ratios

Vons 2.0

Safeway 6.9

M/B RatioComparables Implied Firm Value

160.0

552.0

Average 1.3 356.0

Firm value is estimated to be $356.0 million


Compare Results

Range of values is $63 to $360 million Wide differences in Vons and Safeways ratios What are differences in firms and how do they

affect comparability of valuations?– Vons has debt-to-asset ratio of .66

– Safeway’s debt-to-asset ratio is .82

– Both firms are highly leveraged

P-E and P/B valuations are closer than P/S approach


Pitfalls in Comparables: I

Remember when using P/E ratios that the estimated value is the value of equity, not firm value.

Example: – Suppose Greens carried $114 million of debt.

With equity of $250 million and debt of $114, firm value is now V = E + D = $364 million.

– How does this affect value using P/S ratios?


Pitfalls in Comparables: II

Are the comparables really comparable? Firms differ in many significant dimensions including– Growth rates– Cash flows– Risk (most obviously capital structure; note that

Greens equity value was unchanged by the fact that it carried debt. Is this realistic?


Pitfalls in Comparables: III

Suppose the unobserved true relation between stock price and earnings is

Price = $9.00 + 12EPS

For Vons, say EPS =$1.50, so Price = $27 and P/E =18

For Greens, we have value = $9.00 +12 x 2 = $33

The multiples approach misprices by $4.00 or twelve percent of firm value -- other relations could be off more.


Assessment

Advantages– Quick, easy to understand, and widely used

Disadvantages– Based on accounting concepts– Ignores growth opportunities and future cash

flows– Fails to account for differences in capital

structure


DCF Approaches

All DCF approaches discount cash flows by the appropriate discount rates

Ingredients– Cash flow forecasts for future periods (the past is

irrelevant)

– An associated discount rate which measures the return on investments of comparable risk

Three main approaches– WACC, APV, Flow to Equity


Value and Valuation

Finance objective function is to maximize owners’ value

Value is the present value of future cash flows at the risk-adjusted discount rate

Valuation principles are the same whether we are valuing stocks, bonds, real estate, or corporations

The challenge is to estimate the cash flows and choose a discount rate


Corporate Cash Flows

Corporate cash flows are similar to all firms’ cash flows, that is, they come from cash revenues minus cash costs

Because of tax laws and standard reporting conventions, corporate cash flows are more standardized

Value of claims on corporations can be calculated separately (e.g. stock and bond valuation) or in the aggregate (so-called entity approach)


Future Corporate Cash Flows

Since value comes from future cash flows and the future is unknown, future cash flows must be estimated

The future is usually divided into two or more parts– Forecast period and continuing value period– Rapid growth period and normal growth period

Choice of division depends on case and data available


DCF Approaches

Simplest approach is to assume first-year cash flow and perpetual growth and discount rates

More convincing approach is to use explicit cash flow projections over a forecast period and discount continuing value using simplest approach for cash flows after forecast period

gr

FlowCashPV


Computing the Discount Rate

The discount rate applied to these cash flows represents the opportunity cost of capital

It can also be thought of as the expected or required return for an investment that is equally risky


Equity Discount Rates

Unlevered Cost of Equity (rA)– What the cost of capital would be if the firm

had no leverage. – Depends on asset risk, but not not capital

structure– Equals weighted-average cost of capital

(WACC) Levered Cost of Equity (re)

– Cost of equity capital at a given leverage. Clearly depends on asset risk and also on leverage.


Discount Rates We obtain discount rates for equity using a model

of risk such as the CAPM CAPM states that the expected or required return

on an asset the sum of two components– The risk free rate

– A risk premium

The risk premium is times the market risk premium, historically about 8%


CAPM

Beta measures the sensitivity of the stock’s return to the return on the market portfolio. Note that beta depends on the firm’s leverage.

The Capital Asset Pricing Model states that the expected return on an asset is

r r r rf m f ( )


Investment Banking

Investment bankers assist corporations in their dealings with financial markets– Issuing securities

» Initial public offerings (IPOs) or secondary offerings

» Issuing debt or preferred stock to private investors (private placements) or to public markets

– Mergers and acquisitions– Advising and valuing firms

These services are corporate finance or investment banking services


Investment Banking (continued) Investment bankers also buy and sell securities

– Brokers (retail and institutional)

– Market makers

– Asset management

– Research

Investment banks are classified in a variety of ways– Full line

– Boutique

– Regional

– “Bulge bracket”


Investment Banking (continued)

Investment bankers need many types of financial skills – Analysts for research– Analytical support in doing deals– Traders – Marketing securities to retail and institutional

markets Investment banks hire junior analysts and

associates at entry level, titles vary at top


Investment Banking and Markets

Investment bankers assist corporations (and governments) in designing securities for sale to public or private markets

Traders and analysts of investment banks are usually called are said to work on the sell side of a securities firm, or are called sell side analysts or sell side traders or brokers

Investment bankers do more than deals


Specialized Investment Vehicles

Venture-capital firms provide financing to new firms, often firms in new technologies, requiring both technical and financial skills

Hedge funds are unregistered investment vehicles for wealthy investors’ or institutional funds, often using complex investment strategies requiring sophisticated financial analytical skills


Next Week – January 19

Review valuation techniques and relate to case materials

Prepare Eskimo Pie Case Form groups for group case analyses

following Eskimo Pie

marshallinside.usc.edu

Documents

owners value value

estimated value

market value

assets value of equity

greens equity value

value companies

notfirm value

percent of firm value