VALUATION: CLOSING THOUGHTSadamodar/pdfiles/eqnotes/val...¨ Relative valuation, where we pick a group of assets, attach the name “comparable”to them and tell a story. ¨ Contingent

VALUATION:CLOSINGTHOUGHTSFall2016“Itain’t overtillitsover”

2

Backtotheverybeginning:ApproachestoValuation

¨ DiscountedCashflowValuation,wherewetry(sometimesdesperately)toestimatetheintrinsicvalueofanassetbyusingamixoftheory,guessworkandprayer.

¨ Relativevaluation,wherewepickagroupofassets,attachthename“comparable” tothemandtellastory.

¨ Contingentclaimvaluation,wherewetakethevaluationthatwedidintheDCFvaluationanddivvyitupbetweenthepotentialthieves(equity)andthevictimsofthiscrime(lenders)

3

IntrinsicValuation:Thesetup

4

DantemeetsDCF:Ninelayersofvaluationhell..Andabonuslayer..

Base year and accounitng fixaiton

Death and taxes

High growth for how long?

Whatʼs in your disocunt rate?

The terminal value: Itʼs not an ATM

Are you paying for growth?

Debt ratios change, donʼt they?

No garnishing allowed!!

From aggregate to per share value?

The Wasserstein-Perella bonus layer

5

Layer1:BaseYearfixation….

¨ YouarevaluingExxonMobil,usingthefinancialstatementsofthefirmfrom2008.Thefollowingprovidesthekeynumbers:Revenues $477billionEBIT(1-t) $58billionNetCapEx $3billionChg WC $1billionFCFF $54billion

¨ Thecostofcapitalforthefirmis8%andyouuseaveryconservativestablegrowthrateof2%tovaluethefirm.Themarketcapforthefirmis$373billionandithas$10billionindebtoutstanding.a.Howunderorovervaluedistheequityinthefirm?b.Wouldyoubuythestockbasedonthisvaluation?Whyorwhynot?


Death and taxes









6

Layer2:TaxesandValue

¨ Assumethatyouhavebeenaskedtovalueacompanyandhavebeenprovidedwiththemostrecentyear’sfinancialstatements:

¨ EBITDA 140¨ - DA 40¨ EBIT 100¨ Interestexp 20¨ Taxableincome 80¨ Taxes 32¨ NetIncome 48¨ Assumealsothatcashflowswillbeconstantandthatthereisnogrowthinperpetuity.Whatisthe

freecashflowtothefirm?a. 88million(Netincome+Depreciation)b. 108million(EBIT– taxes+Depreciation)c. 100million(EBIT(1-taxrate)+Depreciation)d. 60million(EBIT(1- taxrate))e. 48million(NetIncome)f. 68million(EBIT– Taxes)

Free Cash flow to firmEBIT (1- tax rate)-(Cap Ex – Depreciation)- Change in non-cash WC=FCFF


Death and taxes









7

Layer3:HighGrowthforhowlong…

¨ Assumethatyouarevaluingayoung,highgrowthfirmwithgreatpotential,justafteritsinitialpublicoffering.Howlongwouldyousetyourhighgrowthperiod?

¨ <5years¨ 5years¨ 10years¨ >10years


Death and taxes









8

Layer4:TheCostofCapital

¨ ThecostofcapitalforChippewaTechnologies,aUStechnologyfirmwith20%ofitsrevenuesfromBrazil,hasbeencomputedusingthefollowinginputs:

Cost of equity = Riskfree Rate + Beta (ERP) + Small firm premium = 5% + 1.20 (5%) + 3% = 14%

Replaced current T.Bond rate of 3% with normalized rate of 5%

“Adjusted” Beta from Bloomberg

Both from Ibbotson data base, derived from 1926-2008 dataERP: Stocks - T.Bonds (Arithmetic average)Small firm: Smal stocks - Overall market

Cost of capital = Cost of equity (Equity/ (Debt + Equity)) + Cost of debt (1- tax rate) (Debt/ (Debt + Equity)= 14% (1000/2000) + 3% (1-.30) (1000/2000) = 8.05%

From above

Used market value of equity

Company is not rated and has no bonds. Used book interest rate = Int exp/ BV of debt

Used effective tax rate of 30%

To be conservative, counted all liabilities, other than equity, as debt and used book value.


Death and taxes









9

TheCorrectCostofCapitalforChippewa

10

Layer5:Thepriceofgrowth..

¨ Youarelookingattheprojectedcashflowsprovidedbythemanagementofthefirm,foruseinvaluation

¨ Whatquestionswouldyouraiseabouttheforecasts?


Death and taxes









11

Layer6:The“fixeddebtratio” assumption

¨ YouhavebeenaskedtovalueHormelFoods,afirmwhichcurrentlyhasthefollowingcostofcapital:¤ Costofcapital=7.31%(.9)+2.36%(.1)=6.8%

¨ Youbelievethatthetargetdebtratioforthisfirmshouldbe30%.Whatwillthecostofcapitalbeatthetargetdebtratio?

¨ Whichdebtratio(andcostofcapital)shouldyouuseinvaluingthiscompany?


Death and taxes









12

Layer7:TheTerminalValue

¨ Thebestwaytocomputeterminalvalueistoa. Useastablegrowthmodelandassumecashflowsgrowatafixed

rateforeverb. UseamultipleofEBITDAorrevenuesintheterminalyearc. Usetheestimatedliquidationvalueoftheassets¨ Youhavebeenaskedtovalueabusiness.Thebusinessexpectsto$

120millioninafter-taxearnings(andcashflow)nextyearandtocontinuegeneratingtheseearningsinperpetuity.Thefirmisallequityfundedandthecostofequityis10%;theriskfreerateis3%andtheERPis7%.Whatisthevalueofthebusiness?

¨ Assumenowthatyouweretoldthatthefirmcangrowearningsat2%ayearforever.Estimatethevalueofthebusiness.


Death and taxes









13

Layer8.Fromfirmvaluetoequityvalue:TheGarnishingEffect…

¨ Forafirmwithconsolidatedfinancialstatements,youhavediscountedfreecashflows tothefirmatthecostofcapitaltoarriveatafirmvalueof$100million.Thefirmhas¤ Acashbalanceof$15million¤ Debtoutstandingof$20million¤ A5%holdinginanothercompany:thebookvalueofthisholdingis$5

million.(Marketvalueofequityinthiscompanyis$200million)¤ Minorityinterestsof$10milliononthebalancesheet

¨ Whatisthevalueofequityinthisfirm?

¨ Howwouldyouranswerchangeifyouknewthatthefirmwasthetargetofalawsuititislikelytowinbutwherethepotentialpayoutcouldbe$100millionifitloses?


Death and taxes









14

Layer9.Fromequityvaluetoequityvaluepershare

¨ Youhavevaluedtheequityinafirmat$200million.Estimatethevalueofequitypershareifthereare10millionsharesoutstanding..

¨ Howwouldyouranswerchangeifyouweretoldthatthereare2millionemployeeoptionsoutstanding,withastrikepriceof$20ashareand5yearslefttoexpiration?


Death and taxes









15

Layer10.Thefinalcircleofhell…

Cost of Equity Cost of Capital

Kennecott Corp (Acquirer) 13.0% 10.5%

Carborandum (Target) 16.5% 12.5%


Death and taxes









YOURNUMBERS/FINDINGS

“Thetruthshallsetyoufree”.

17

TheModelsYouUsedinDCFValuation

DividendDiscount5% FCFE

5%

FCFF

90%

Modelused

18

TheMostValuedCompany(Companies)..

FacebookPrice DCFvalue Pricing Recommendation

Facebook $121.38 $111.18 $159.53 SellFacebook $120.31 $75.74 $59.60 SellFacebook $117.77 $155.43 $158.89 BuyFacebook 120.31 87.42 95.43 SellFacebook $120.31 $162.58 $142.36 BuyFacebook 119.68 177.05 190.11 Buy

UnderArmour,Inc.UnderArmour $32.26 26.83 23.53 SellUnderArmour $27.61 $34.15 $15.13 BuyUnderArmour $32.36 $26.00 $16.00 SELLUnderArmour $32.26 $36.43 $27.41 BUYUnderArmour $32.20 $18.28 $19.77 SellUnderArmour $30.94 $26.71 $28.48 Buy

TeslaTeslaMotors $198.15 $147.64 $100.70 SellTeslaMotors $198.00 $116.00 $87.00 SellTeslaMotors $192.43 $208.94 $50.92 BuyTeslaMotors $192.18 $345.73 $207.71 BuyTeslaMotors $184.52 $137.84 $139.61 HoldTeslaMotors $198.88 $150.81 $147.18 Sell

19

Whatyoufound…

0.

10.

20.

30.

40.

50.

60.

70.

80.

Undervaluedmorethan50%

Undervalued33-50%

Undervalued10-33%

Undervalued0-10%

Overvalued0-10%

Overvalued10-50%

Overvalued50-100%

Overvaluedmorethan100%

AxisTitle

AxisTitle

DCFValuevsMarketPrice

20

Themostundervaluedstocks…

CompanyName Price DCFValue RelativeValue Recommendation%Underor

over

KajimaCorporation $818.00 $1,656.00 $1,004.00 Buy -50.60% YGEntertainment KRW28,900.00 KRW56,799.00 KRW30,206.00 Buy -49.12% QOL ¥1,454.00 ¥2,710.67 ¥4,658.73 Buy -46.36% TeslaMotors 192.18 345.73 207.71 Buy -44.41% JD.com 181.4 315.80 974.2 Buy -42.56% EdreamsOdigeo(EUR) 2.92 5.08 8.47 Buy -42.52% Li&Fung $0.46 $0.77 $0.60 Buy -40.26% PlanetFitness $20.70 $33.96 $32.82 Buy -39.05% Square,Inc. $13.85 $21.96 $15.20 Buy -36.93% Chipotle $377.50 $582.93 $485.88 Buy -35.24% LIGNex1 $69.84 $104.87 $114.06 Buy -33.40% Facebook 119.68 177.05 190.11 BUY -32.40% HCAHoldings,Inc. $73.25 $108.21 $180.11 Buy -32.31% ZTECorporation 15.56 22.89 3.82 Buy -32.02%

21

TheMostOvervaluedstocksare...

CompanyName Price DCFValue RelativeValue OptionValue Recommendation%Underor

over

TowerInsurance $2.50 $0.15 $6.42 Buy 1566.67% AquaVenture Holdings $23.91 2.95 $18.29 Sell 710.51% ColumbiaPipelineGroup $25.50 3.79 $11.85 Sell 572.82% Groupon $3.74 $0.78 $3.43 0.31 Sell 379.49%

MGMResorts $29.19 $6.69 $25.29 $12.85 Sell 336.32% RegalEntertainmentGroup 21.57 6.05 15.21 Sell 256.53% Kronos $11.95 $3.64 $12.77 $1.19 Buy 228.30% Twitter $19.37 $6.10 $15.41 Hold 217.54%MakeMyTrip $24.25 $7.81 24.6 Sell 210.50% WholeFoodsMarket $31.04 $10.04 $25.62 Sell 209.16%

Zillow $33.87 $11.58 $7.38 Sell 192.49% JCPenney 10.51 3.71 5.19 17.60 Buy 183.29% Intrexon $28.79 $10.30 $19.38 Sell 179.51% Salesforce 71.17 29.98 65.3 Sell 137.39% TripAdvisor $48.71 $20.69 $55.47 Sell 135.43%

22

Theultimatetest…Didundervaluedstocksmakemoney?

!5.00%&

0.00%&

5.00%&

10.00%&

15.00%&

20.00%&

Spring&1995& Spring&1997& Spring&1999& Spring&2001& Spring&2003& Spring&2005&

Performance*of**Recommenda-ons*

Buy&&

S&P&500&

Sell&

23

Moreonthewinners...

¨ Onaverage,right:About60%ofallbuyrecommendationsmakemoney;about45%ofsellrecommendationsbeatthemarket.Theaveragereturnonbuyrecommendationswasabout4%higher,onanannualizedbasis,thantheaveragereturnonsellrecommendations.

¨ Moresoonsome:Theexcessreturnsonbuyrecommendationsonsmallcapandemergingmarketcompaniesishigherthantheexcessreturnsonlargemarketcapcompanies,withhighermistakesinbothdirectionsontheformer.

¨ Skewedpayoffs:Therearetwoorthreebigwinnersineachperiod,butthepayoffwasnotalwaysimmediate.BuyingApplein1999wouldhaveledtonegativereturnsforayearormore,beforetheturnaroundoccurred.

¨ Doublewhammy:StocksthatareundervaluedonbothaDCFandrelativevaluationbasisdobetterthanstocksthatareundervaluedononlyoneapproach.

24

RelativeValuation:TheFourStepstoUnderstandingMultiples

¨ AnnaKournikovaknowsPE….Ordoesshe?¤ Inuse,thesamemultiplecanbedefinedindifferentwaysbydifferent

users.Whencomparingandusingmultiples,estimatedbysomeoneelse,itiscriticalthatweunderstandhowthemultipleshavebeenestimated

¨ 8timesEBITDAisnotalwayscheap…¤ Toomanypeoplewhouseamultiplehavenoideawhatitscrosssectional

distributionis.Ifyoudonotknowwhatthecrosssectionaldistributionofamultipleis,itisdifficulttolookatanumberandpassjudgmentonwhetheritistoohighorlow.

¨ Youcannotgetawaywithoutmakingassumptions¤ Itiscriticalthatweunderstandthefundamentalsthatdriveeachmultiple,

andthenatureoftherelationshipbetweenthemultipleandeachvariable.¨ Therearenoperfectcomparables

¤ Definingthecomparableuniverseandcontrollingfordifferencesisfarmoredifficultinpracticethanitisintheory.

Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio (1+g)/(r-g)

PEG=Payout ratio (1+g)/g(r-g)

PBV=ROE (Payout ratio) (1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF 1/(WACC -g)

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

26

TheMultiplesyouusedwere...

27

DCFvsRelativeValuation

0.

10.

20.

30.

40.

50.

60.

<50% 50-67% 67-90% 90%-100% 100-110% 110%-150% 150-200% >200% DCFasfractionofRelativeValue

DCFas%ofRelativeValue

28

Mostunderpricedonarelativebasis…

CompanyName Price DCFValue RelativeValue Recommendation %UnderorOver:RelativeJD.com 181.4 315.80 974.2 Buy -81.38% QOL ¥1,454.00 ¥2,710.67 ¥4,658.73 Buy -68.79% EdreamsOdigeo(EUR) 2.92 5.08 8.47 Buy -65.53% JustoRodero&Hijos(USD) 3.95 3.95 11.34 Buy -65.17% EnphaseEnergy,Inc. $1.27 $0.96 $3.45 Sell -63.19% UniversalMedical ¥6.64 9.49 ¥17.70 Buy -62.49% JD.com $26.16 $30.01 $69.06 Buy -62.12% WholeFoods $31.04 38.72 80.48 Buy -61.43% TowerInsurance $2.50 $0.15 $6.42 Buy -61.05% PandoraMedia $13.48 11.25 $34.29 Hold -60.69% HCAHoldings,Inc. $73.25 $108.21 $180.11 Buy -59.33% Fitbit $7.98 6.54 19.17 Sell -58.37% Chegg,Inc. $7.99 $10.00 $18.70 Buy -57.27% Chegg,Inc. 7.99 10.00 18.70 Buy -57.27% BebeStores $5.74 $6.10 $13.43 Sell -57.26%

29

Mostoverpricedonarelativebasis…

CompanyName Price DCFValue RelativeValue Recommendation%UnderorOver:

Relative

Twitter $18.98 $(19.77) $2.08 Sell 812.50% iKang HealthcareGroup $16.06 8.63 $3.20 Sell 401.88% Zillow $33.87 $11.58 $7.38 Sell 358.94% Twilio 29.23 26.83 6.57 Sell 344.90% Barnes&Noble,Inc. 13.10 11.65 3.16 Sell 314.56% ZTECorporation 15.56 22.89 3.82 Buy 307.33% TeslaMotors $192.43 $208.94 $50.92 Buy 277.91% BakerHughes $66.20 $33.59 $19.27 Sell 243.54% Fibria $31.61 $27.42 $10.48 Sell 201.62%Kroger $34.19 $36.44 $13.50 Sell 153.26% Netflix $120.81 $74.53 $48.40 Sell 149.61%J.C.Penney $9.92 $8.54 $3.99 Sell 148.62% Nathan'sFamous 63.65 54.10 26.45 Hold 140.64% CWCP(privatecompany) 34.722 34.722 14.893 Buy 133.14% Priceline $1,536.71 $1,325.00 $679.00 Sell 126.32%

30

ContingentClaim(Option)Valuation

¨ Optionshaveseveralfeatures¤ Theyderivetheirvaluefromanunderlyingasset,whichhasvalue¤ Thepayoffonacall(put)optionoccursonlyifthevalueofthe

underlyingassetisgreater(lesser)thananexercisepricethatisspecifiedatthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,theoptionisworthless.

¤ Theyhaveafixedlife

¨ Anysecuritythatsharesthesefeaturescanbevaluedasanoption.

¨ Numberoffirmsvaluedusingoptionmodels=12¨ MedianPercentincreaseinvalueoverDCFvalue=117.38%

31

ValueEnhancement…Youtoocandoit!

32

ValueEnhancementShortCuts:Theycomewithacost¨ Oldwineinanewbottle:Alldiscountedcashflowmodels(costofcapital,

APV,EVA,Excessreturnmodels)areallvariantsofthesamemodeland,doneright,shouldyieldthesamevalue.

¨ Nomagicbullets:Valueenhancementishardwork.Thereareno“shortcuts” andadoptingEVA,CFROIoranyothermeasurewillnotincreasevalue.

¨ Tyingcompensationsystemstoameasureisarecipeforgameplaying:IfyoutiemanagementcompensationtoEVA,forinstance,canleadto:¤ TheGrowthtradeoffgame:Managersmaygiveupvaluablegrowthopportunities

inthefuturetodeliverhigherEVAinthecurrentyear.¤ TheRiskgame:ManagersmaybeabletodeliverahigherdollarEVAbutinriskier

businesses.ThevalueofthebusinessisthepresentvalueofEVAovertimeandtheriskeffectmaydominatetheincreasedEVA.

¤ Thecapitalinvestedgame:ThekeytodeliveringpositiveEVAistomakeinvestmentsthatdonotshowupaspartofcapitalinvested.Thatway,youroperatingincomewillincreasewhilecapitalinvestedwilldecrease.

33

Actingonvaluation:Itisnotjustanacademicexercise

a. Iamnotsureyet:Uncertaintyisnotashieldagainstaction.Ifyouwaituntilyoufeel“certain”aboutyourvaluation,youwillneveract.

b. Allbelieversnow?Ultimately,youhavetobelieveinsomemodicumofmarketefficiency.Marketshavetocorrecttheirmistakesforyourvaluationstopayoff.

c. Thelawoflargenumbers:Assumingyourvaluationscarryheft,youarefarmorelikelytoberightacrossmanycompaniesthanonanyindividualone.

34

Yourrecommendationswereto..

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ay)

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35

Pickingyourvaluationapproach

¨ Assetcharacteristics¤ Marketability¤ Cashflowgeneratingcapacity¤ Uniqueness

¨ Yourcharacteristics¤ Timehorizon¤ Reasonsfordoingthevaluation¤ Beliefsaboutmarkets

36

Whatapproachwouldworkforyou?

¨ Asaninvestor,givenyourinvestmentphilosophy,timehorizonandbeliefsaboutmarkets(thatyouwillbeinvestingin),whichofthetheapproachestovaluationwouldyouchoose?

a. DiscountedCashFlowValuationb. RelativeValuationc. Neither.Ibelievethatmarketsareefficient.

37

StoryTellers?NumberCrunchers?

¨ Ifyouareastoryteller,Ihopethatyouhave¤ Moreconfidenceinyournumbercrunching¤ Moredisciplineinyourstories¤ Lessintimidation,whenconfrontedwithnumbercrunchers

¨ Ifyouareanumbercruncher,Ihopethatyouhave¤ Morewillingnesstoputstoriesbehindyournumbers¤ Moreimaginationinyournumbercrunching¤ Moreunderstanding,whenconfrontedwithstorytelling

38

SomeNotVeryProfoundAdvice

1. Itsallinthefundamentals.2. Focusonthebigpicture.Don’tsweatthesmall

stuffanddon’tgetdistracted.3. Anecdotesmeanlittleandexperiencedoesnot

equalknowledge.4. Keepyourperspective.Itisonlyavaluation.5. Ininvesting,luckdominatesskillandknowledge.DonotforgettodoyourCFEs.Yourabilitytocheckyourgrade

restsonit.

Documents

VALUATION: CLOSING THOUGHTSadamodar/pdfiles/eqnotes/val...¨ Relative valuation, where we pick a group of assets, attach the name “comparable”to them and tell a story. ¨ Contingent