Sprint Nextel Valuing Firm Equity Mary Léa McAnally Inder Khurana Rebecca Shortridge CPE session #44 AAA Annual Meeting 2008 1

Sprint Nextel Valuing Firm Equity

Mary Léa McAnally

Inder Khurana

Rebecca Shortridge

CPE session #44 AAA Annual Meeting 2008

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AAA 2008 Annual MeetingCPE Session #44

Implement an income method to estimate fair value of a share of publicly traded stock (Sprint Nextel)

Understand how Level 2 and Level 3 inputs affect valuation techniques and fair-value estimates

Use Sprint Nextel case materials in your classroom Background Reading Case and financial statements Teaching note


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After this session you should be able to:

3CPE session #44 AAA Annual Meeting 2008

Estimating fair value of a share ofSprint Nextel stock

There exists a quoted price in an active market for an identical asset

SFAS 157: Use market approach, Level 1 asset

Fair value 12/31/2006: $18.79 per share

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So, why use an income approach?

1. Forge conceptual links for students between observable fair value and intrinsic value derived with other valuation technique

2. Expose students to common income-approach model (one of many)

3. Segue to next session on intangible asset impairment at Sprint Nextel

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Valuation technique: Income approach (SFAS 157.18)

General class of models: Multiperiod excess earning method (SFAS 157.18)

Specific model: Residual operating income model Forecast future net operating profit after tax with short-

term and long-term growth

Forecast future net operating assets

Weighted-average cost of capital (WACC)

Present value of lump sums and perpetuities


Building blocks of theSprint Nextel case

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The income approach converts future amounts (cash flows or earnings) to a single present amount (discounted).

Examples of income approach and SFAS 157 Shares of stock when no active market exists Restricted securities Intangible assets and impairments thereof OTC option on traded equity Etc., etc., etc.

SFAS 157 does not prioritize valuation techniques.


Valuation technique: Income approach (SFAS 157.18)

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Questions to explore with your students:

What are excess earnings?

Earnings over and above “expected” earnings

How do excess earnings arise?

Managers create firm value by making operating decisions that earn more than the company’s cost of capital

Balance sheet is missing some assets. These earn a return over and above the required return on the balance sheet assets


General class of models: Multiperiod excess earnings

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Questions to explore with your students:

What would the value of a firm be with no excess earnings?

Firm value is based on future operations earnings

With no excess earnings, firm value would be equal to its net book value


General class of models: Multiperiod excess earnings

ROPI model defines value in terms of future operating earnings (as opposed to net income)

ROPI is operating income in excess of a “charge” for the cost of operating assets such as inventory, AR, property plant and equipment etc.; net of operating liabilities such as AP, accruals, pensions etc.

Net operating assets (NOA) do not include debt and ancillary investments – these are financing decisions unrelated to managers’ day to day operating decisions


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Specific model: Residual operating income model

Residual operating income is net operating profit after-tax in excess of expected operating profit.

Calculated as:


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Defining Residual Operating Income

)NOA (WACC - After Tax Profit Operating NetROPI 1-ttt

Start-of-yearNet Operating Assets

Excludes interest expense and nonoperating

revenues and expenses

“Expected” operating profit

Operating income $2,484

Tax at 38% $ 944

Net Operating Profit After Tax $1,540


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Sprint Nextel: 2006 Net Operating Profit After Tax

NOTE: The valuation model uses projected net operating profit after tax. We calculate the amount for 2006 as an example.

Residual operating income is net operating profit after-tax in excess of expected operating profit.

Calculated as:


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Defining Residual Operating Income

)NOA (WACC - After Tax Profit Operating NetROPI 1-ttt

Start-of-yearNet Operating Assets

Excludes interest expense and nonoperating

revenues and expenses

“Expected” operating profit

Defining Net Operating AssetsTraditional Balance Sheet equation: A = L + E

Operating v. Nonoperating Balance Sheet equation: NOA = Net Debt + E

Operating assets – all of Sprint Nextel’s assets less marketable securities

Operating liabilities – all of Sprint Nextel’s liabilities except long-term debt and current portion thereof

Operating assets $97,146

Less Operating liabilities $21,876

Net Operating Assets (NOA) $75,270


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Sprint Nextel: 2006 Net Operating Assets

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AAA Annual Meeting 2008

The Residual Operating Income Valuation Model

000 DebtNOAV ROPI future all of value Present

000 DebtNOAV

4

544

33

221

r)g)(1-(r

ROPI

r)(1

ROPI

r)(1

ROPI

r)(1

ROPIr)(1

ROPI

Book value of Net

Operating Assets

Present value of Year 1 ROPI

Present value of Terminal period ROPI

Present value of Year 2 ROPI

Book value of Net Debt

Nonoperating liabilities – long-term debt and current portion thereof

Nonoperating assets – marketable securities

Nonoperating liabilities $22,154

Less Nonoperating assets $ 15

Net Operating Assets (NOA) $22,139


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Sprint Nextel: 2006 Net Nonoperating Liabilities (Debt)

Start with 2006 sales – $41,028

Assume a short-term growth rate – 20%

Use this rate to forecast sales over the short term (here, 4 years). This period is called the “forecast horizon”

Assume a long-term growth rate:g – 3%

Use this rate to forecast sales over the rest of the firm’s life. This means that Sprint Nextel will continue to operate at this rate (an equilibrium level) forever. This period is called the “terminal period”


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Forecasting ROPI for Sprint Nextel:A simplified approach


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Forecasting Sales for Sprint Nextel

2006 2007 2008 2009 2010 Terminal period

Sales $41,028 $49,234

Forecasted Sales = Prior-year sales × 1.2


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Forecasting Sales for Sprint Nextel

2007 2008 2009 2010 Terminal period

Sales $49,234 $59,080 $70,896 $85,076 $87,628

× 1.2

× 1.2

× 1.2

× 1.03

20% growth

in forecast period

3% growth in terminal

period

Use projected Sales to determine future net operating profit after tax

Assume an operating profit margin – 7.5%

Use this rate to forecast operating income over the forecast horizon and for the terminal period


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Forecasting Net Operating Profit After Tax for Sprint Nextel

NOTE: This is higher than the historical profit margin and the stock value is very sensitive to this margin.


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Forecasting Net Operating Profit After Tax for Sprint Nextel


Sales $49,234 $59,080 $70,896 $85,076 $87,628

Net Operating Profit After Tax $3,693 $4,431 $5,317 $6,381 $6,572

Net Operating Profit After Tax = Projected Sales × 7.5%

Start with 2006 NOA

Assume a growth rate for NOA – 5%

Use this rate to forecast net operating assets each year


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Forecasting Net Operating Assets for Sprint Nextel

NOTE: An alternate approach uses historical Total Asset Turnover ratio to forecast NOA.


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Forecasting Net Operating Assets for Sprint Nextel


NOA start of year $75,270 $79,034 $82,985 $87,134 $91,491

2006 NOA from

balance sheet

Forecasted NOA = Prior-year NOA × 1.05

Calculate expected net operating profit after tax with a weighted average cost of capital of 8.07%


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Forecasting Expected Operating Profit for Sprint Nextel

Average cost of debt from Sprint Nextel footnote 9 7.07%Tax rate 38%After tax average cost of debt: 7.07% × (1 - 38%) 4.38%

Risk free rate: 10Y Treasury 12/31/2006 4.88%Beta 12/31/2006 1.25%Equity premium 5%Cost of equity (CAPM model): 4.88% + (1.25 × 5%) 11.13%

Percent of debt in capital structure: $44,030 ÷ ($44,030 + $53,131) 45.3%

Weighted average cost of capital: (45.3% × 4.38%) + (55.7% × 11.13%) 8.07%


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Forecasting Expected Operating Profit for Sprint Nextel


NOA start of year $75,270 $79,034 $82,985 $87,134 $91,491

Expected operating income

$6,075 $6,379 $6,698 $7,033 $7,385

Expected operating income = NOA start of year × 8.07%

Classroom discussion ideas:

What happens to WACC if company becomes riskier?

How does the level of WACC affect expected income?


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Forecasting Residual Operating Profit for Sprint Nextel


Net operating profit after tax $3,693 $4,431 $5,317 $6,381 $6,572

Less Expected operating income

($6,075) ($6,379) ($6,698) ($7,033) ($7,385)

Residual operating income

-$2,383 -$1,948 -$1,381 -$652 -$813


Why are residual earnings negative for Sprint Nextel?

What does that mean conceptually?

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2007 2008 2009 2010 Terminal

Residual Operating Income -$2,383 -$1,948 -$1,381 -$652 -$813

Discount Factor WACC= 8.07% 0.92531 0.85620 0.79226 0.73309

Present Value ROPI ($2,205) ($1,668) ($1,094) ($478)

Cumulative Present Value ROPI ($5,445)

Present Value Terminal Year ($11,746)

Total Enterprise Value $58,078

Debt (net) $22,139

Value of Equity $35,939

Sprint Nextel: ROPI valuation

000 DebtNOAV

4

544

33

221

r)g)(1-(r

ROPI

r)(1

ROPI

r)(1

ROPI

r)(1

ROPIr)(1

ROPI


What happens to WACC if company becomes riskier?

How does the level of WACC affect expected income?

73309.0%3%07.8

813$


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Estimating stock price: ROPI model

Calculating Stock Price

Total shareholder value (V0) $35,939

Shares of stock outstanding 880 million

Stock price per share $12.41


12/31/2006 stock price is $18.79.

WHY is our estimate different?

Discounting expected and not contractual future amounts

Assumptions are to be those that market participants would use in pricing the asset (SFAS 157.11)

Level 2 inputs required to estimate the model:

WACC: market beta, risk-free rate, credit spread


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Sprint Nextel case:Model assumptions and inputs

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Sprint Nextel case:Model assumptions and inputs

Level 3 inputs required to estimate the model:

Short and long-term growth rates for sales and operating assets / liabilities Macro-conditions

Industry factors, trends, competition, strategy

Firm specific earnings outlook - growth

Operating profit margins

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Sprint Nextel case: Teaching Ideas

Case assumes students understand Discounting of lump sums and perpetuitiesWACC: theory and calculationsBasics of Net Operating Assets / Debt (net)

Case can be shortened by providing projected ROPI

Case can be augmented by requiring students to calculate Net Operating Assets

Excel spreadsheet projected in class, inputs changed to show sensitivity of value to input choices

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Sprint Nextel case: Teaching Materials

Case with Sprint Nextel 2006 financial statements

Background reading on Residual Operating Income valuation model

Teaching notes

Excel spreadsheet

Powerpoints


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Link to other applications:

JENNINGS McANALLY STICE

Unit of account

Individual assets:Marketable securityLoan

Firm: Group of assets and liabilities

Goodwill (impairment)

Method Market &Income

Income Market &Income

Inputs Levels 1-3 Levels 2 and 3 Levels 1-3

Data Developed From Sprint-Nextel financials

From Sprint-Nextel financials

Documents

Sprint Nextel Valuing Firm Equity Mary Léa McAnally Inder Khurana Rebecca Shortridge CPE session #44 AAA Annual Meeting 2008 1