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J. K. Dietrich - FBE 532 – Spring 2006
Finance Theories, Case Analysis, and Valuation
January 12, 2006
J. K. Dietrich - FBE 532 – Spring 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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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?
J. K. Dietrich - FBE 532 – Spring 2006
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?
J. K. Dietrich - FBE 532 – Spring 2006
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.
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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)
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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.
J. K. Dietrich - FBE 532 – Spring 2006
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%
J. K. Dietrich - FBE 532 – Spring 2006
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 ( )
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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”
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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
J. K. Dietrich - FBE 532 – Spring 2006
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