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4.ADiscountforComplexity:AnExperiment
CompanyA CompanyBOperatingIncome $1billion $1billionTaxrate 40% 40%ROIC 10% 10%ExpectedGrowth 5% 5%Costofcapital 8% 8%BusinessMix Single MultipleHoldings Simple ComplexAccounting Transparent OpaqueWhichfirmwouldyouvaluemorehighly?
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MeasuringComplexity:VolumeofDatainFinancialStatements
Company Number of pages in last 10Q Number of pages in last 10KGeneral Electric 65 410Microsoft 63 218Wal-mart 38 244Exxon Mobil 86 332Pfizer 171 460Citigroup 252 1026Intel 69 215AIG 164 720Johnson & Johnson 63 218IBM 85 353
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MeasuringComplexity:AComplexityScore
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DealingwithComplexity
¨ InDiscountedCashflowValuation¤ TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirm
baseduponthefirm’sstatementsabouttheirvalue.¤ TheConservativeAnalyst:Don’tvaluewhatyoucannotsee.¤ TheCompromise:Adjustthevalueforcomplexity
n Adjustcashflowsforcomplexityn Adjustthediscountrateforcomplexityn Adjusttheexpectedgrowthrate/lengthofgrowthperiodn Valuethefirmandthendiscountvalueforcomplexity
¨ Inrelativevaluation¤ Inarelativevaluation,youmaybeabletoassessthepricethatthemarket
ischargingforcomplexity:¤ Withthehundredlargestmarketcapfirms,forinstance:PBV=0.65+15.31ROE– 0.55Beta+3.04Expectedgrowthrate– 0.003#
Pagesin10K
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5.Becircumspectaboutdefiningdebtforcostofcapitalpurposes…
¨ GeneralRule:Debtgenerallyhasthefollowingcharacteristics:¤ Commitmenttomakefixedpaymentsinthefuture¤ Thefixedpaymentsaretaxdeductible¤ Failuretomakethepaymentscanleadtoeitherdefaultorlossof
controlofthefirmtothepartytowhompaymentsaredue.¨ Definedassuch,debtshouldinclude
¤ Allinterestbearingliabilities,shorttermaswellaslongterm¤ Allleases,operatingaswellascapital
¨ Debtshouldnotinclude¤ Accountspayableorsuppliercredit
¨ Bewaryofyourconservativeimpulseswhichwilltellyoutocounteverythingasdebt.Thatwillpushupthedebtratioandleadyoutounderstateyourcostofcapital.
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BookValueorMarketValue
¨ Youarevaluingadistressedtelecomcompanyandhavearrivedatanestimateof$1billionfortheenterprisevalue(usingadiscountedcashflowvaluation).Thecompanyhas$1billioninfacevalueofdebtoutstandingbutthedebtistradingat50%offacevalue(becauseofthedistress).Whatisthevalueoftheequitytoyouasaninvestor?a. Theequityisworthnothing(EVminusFaceValueofDebt)b. Theequityisworth$500million(EVminusMarketValueofDebt)
¨ Wouldyouranswerbedifferentifyouweretoldthattheliquidationvalueoftheassetsofthefirmtodayis$1.2billionandthatyouwereplanningtoliquidatethefirmtoday?
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Butyoushouldconsiderotherpotentialliabilitieswhengettingtoequityvalue
¨ Ifyouhaveunderfundedpensionfundorhealthcareplans,youshouldconsidertheunderfundingatthisstageingettingtothevalueofequity.¤ Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitemreflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.
¤ Youshouldnotbecountingtheseitemsasdebtinyourcostofcapitalcalculations….
¨ Ifyouhavecontingentliabilities- forexample,apotentialliabilityfromalawsuitthathasnotbeendecided- youshouldconsidertheexpectedvalueofthesecontingentliabilities¤ Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expectedvalueofliability
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6.EquitytoEmployees:EffectonValue
¨ Inrecentyears,firmshaveturnedtogivingemployees(andespeciallytopmanagers)equityoptionorrestrictedstockpackagesaspartofcompensation.Iftheyareoptions,theyusuallyarelongtermandonvolatilestocks.Ifrestrictedstock,therestrictionsareusuallyontrading.
¨ Theseequitycompensationpackagesareclearlyvaluableandthequestionbecomeshowbesttodealwiththeminvaluation.
¨ Twokeyissueswithemployeeoptions:¤ Howdooptionsorrestrictedstockgrantedinthepastaffectequity
valuepersharetoday?¤ Howdoexpectedgrantsofeitherinthefutureaffectequityvalue
today?
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TheEasierProblem:RestrictedStockGrantsAswath
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¨ Whenemployeecompensationtakestheformofrestrictedstockgrants,thesolutionisrelativelysimple.
¨ Toaccountforrestrictedstockgrantsinthepast,makesurethatyoucounttherestrictedstockthathavealreadybeengrantedinsharesoutstandingtoday.Thatwillreduceyourvaluepershare.
¨ Toaccountforexpectedstockgrantsinthefuture,estimatethevalueofthesegrantsasapercentofrevenueandforecastthatasexpenseaspartofcompensationexpenses.Thatwillreducefutureincomeandcashflows.
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TheBiggerChallenge:EmployeeOptions
¨ Itistruethatoptionscanincreasethenumberofsharesoutstandingbutdilutionperseisnottheproblem.
¨ Optionsaffectequityvalueatexercisebecause¤ Sharesareissuedatbelowtheprevailingmarketprice.Optionsgetexercisedonlywhentheyareinthemoney.
¤ Alternatively,thecompanycanusecashflows thatwouldhavebeenavailabletoequityinvestorstobuybackshareswhicharethenusedtomeetoptionexercise.Thelowercashflows reduceequityvalue.
¨ Optionsaffectequityvaluebeforeexercisebecausewehavetobuildintheexpectationthatthereisaprobabilityofandacosttoexercise.
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Asimpleexample…
¨ XYZcompanyhas$100millioninfreecashflows tothefirm,growing3%ayearinperpetuityandacostofcapitalof8%.Ithas100millionsharesoutstandingand$1billionindebt.Itsvaluecanbewrittenasfollows:
Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valuepershare =1000/100=$10
¨ XYZdecidestogive10millionoptionsatthemoney(withastrikepriceof$10)toitsCEO.Whateffectwillthishaveonthevalueofequitypershare?a. None.Theoptionsarenotin-the-money.b. Decreaseby10%,sincethenumberofsharescouldincreaseby10millionc. Decreasebylessthan10%.Theoptionswillbringincashintothefirmbutthey
havetimevalue.
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I.TheDilutedShareCountApproach
¨ Thesimplestwayofdealingwithoptionsistotrytoadjustthedenominatorforsharesthatwillbecomeoutstandingiftheoptionsgetexercised.Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Valuepershare =1000/110=$9.09
¨ Thedilutedapproachfailstoconsiderthatexercisingoptionswillbringincashintothefirm.Consequently,theywilloverestimatetheimpactofoptionsandunderstatethevalueofequitypershare.
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II.TheTreasuryStockApproach
¨ Thetreasurystockapproachaddstheproceedsfromtheexerciseofoptionstothevalueoftheequitybeforedividingbythedilutednumberofsharesoutstanding.
¨ Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Proceedsfromoptionexercise =10*10=100Valuepershare =(1000+100)/110=$10
¨ Thetreasurystockapproachfailstoconsiderthetimepremiumontheoptions. Thetreasurystockapproachalsohasproblemswithout-of-the-moneyoptions.Ifconsidered,theycanincreasethevalueofequitypershare.Ifignored,theyaretreatedasnon-existent.
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III.OptionValueDrag
¨ Step1:Valuethefirm,usingdiscountedcashfloworothervaluationmodels.
¨ Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthevalueofequity.Alternatively,skipstep1andestimatetheofequitydirectly.
¨ Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)ofotherequityclaims:¤ ValueofWarrants=MarketPriceperWarrant*NumberofWarrants
:Alternativelyestimatethevalueusingoptionpricingmodel¤ ValueofConversionOption=MarketValueofConvertibleBonds- Valueof
StraightDebtPortionofConvertibleBonds¤ ValueofemployeeOptions:Valueusingtheaverageexercisepriceand
maturity.¨ Step4:Dividetheremainingvalueofequitybythenumberof
sharesoutstandingtogetvaluepershare.
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ValuingEquityOptionsissuedbyfirms…TheDilutionProblem
¨ Optionpricingmodelscanbeusedtovalueemployeeoptionswithfourcaveats–¤ Employeeoptionsarelongterm,makingtheassumptionsabout
constantvarianceandconstantdividendyieldsmuchshakier,¤ Employeeoptionsresultinstockdilution,and¤ Employeeoptionsareoftenexercisedbeforeexpiration,makingit
dangeroustouseEuropeanoptionpricingmodels.¤ Employeeoptionscannotbeexerciseduntiltheemployeeisvested.
¨ Theseproblemscanbepartiallyalleviatedbyusinganoptionpricingmodel,allowingforshiftsinvarianceandearlyexercise,andfactoringinthedilutioneffect.Theresultingvaluecanbeadjustedfortheprobabilitythattheemployeewillnotbevested.
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ValuingEmployeeOptions
¨ Tovalueemployeeoptions,youneedthefollowinginputsintotheoptionvaluationmodel:¤ StockPrice=$10,Adjustedfordilution=$9.58¤ StrikePrice=$10¤ Maturity=10years(Canreducetoreflectearlyexercise)¤ Standarddeviationinstockprice=40%¤ RisklessRate=4%
¨ Usingadilution-adjustedBlackScholesmodel,wearriveatthefollowinginputs:¤ N(d1)=0.8199¤ N(d2)=0.3624¤ Valuepercall=$9.58(0.8199)- $10e-(0.04)(10)(0.3624)=$5.42
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ValueofEquitytoValueofEquitypershare
¨ Usingthevaluepercallof$5.42,wecannowestimatethevalueofequitypershareaftertheoptiongrant:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valueofoptionsgranted =$54.2=ValueofEquityinstock =$945.8/Numberofsharesoutstanding /100=Valuepershare =$9.46
¨ Notethatthisapproachyieldsahighervaluethanthedilutedsharecountapproach(whichignoresexerciseproceeds)andalowervaluethanthetreasurystockapproach(whichignoresthetimepremiumontheoptions)
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Totaxadjustornottotaxadjust…
¨ Intheexampleabove,wehaveassumedthattheoptionsdonotprovideanytaxadvantages.Totheextentthattheexerciseoftheoptionscreatestaxadvantages,theactualcostoftheoptionswillbelowerbythetaxsavings.
¨ Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1- taxrate)togetanafter-taxoptioncost.
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Optiongrantsinthefuture…
¨ Assumenowthatthisfirmintendstocontinuegrantingoptionseachyeartoitstopmanagementaspartofcompensation.Theseexpectedoptiongrantswillalsoaffectvalue.
¨ Thesimplestmechanismforbringinginfutureoptiongrantsintotheanalysisistodothefollowing:¤ Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsasapercentofrevenues.
¤ Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofutureyears,allowingforthefactthatasrevenuesgetlarger,optiongrantsasapercentofrevenueswillbecomesmaller.
¤ Considerthislineitemaspartofoperatingexpenseseachyear.Thiswillreducetheoperatingmarginandcashfloweachyear.
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Whenoptionsaffectequityvaluepersharethemost…
¨ Optiongrantsaffectvaluemore¤ Thelowerthestrikepriceissetrelativetothestockprice¤ Thelongerthetermtomaturityoftheoption¤ Themorevolatilethestockprice
¨ Theeffectonvaluewillbemagnifiedifcompaniesareallowedtorevisitoptiongrantsandresettheexercisepriceifthestockpricemovesdown.
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NARRATIVEANDNUMBERS:VALUATIONASABRIDGE
Tellmeastory..
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Valuationasabridge
The Numbers People
Favored Tools- Accounting statements
- Excel spreadsheets- Statistical Measures
- Pricing Data
Illusions/Delusions1. Precision: Data is precise
2. Objectivity: Data has no bias3. Control: Data can control reality
The Narrative People
Favored Tools- Anecdotes
- Experience (own or others)- Behavioral evidence
Illusions/Delusions1. Creativity cannot be quantified
2. If the story is good, the investment will be.
3. Experience is the best teacher
A Good Valuation
Number Crunchers Story Tellers
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Step1:Surveythelandscape
¨ Every valuation starts with a narrative, a story thatyou see unfolding for your company in the future.
¨ In developing this narrative, you will be makingassessments of¤ Your company (its products, its management and itshistory.
¤ The market or markets that you see it growing in.¤ The competition it faces and will face.¤ The macro environment in which it operates.
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Step2:Createanarrativeforthefuture
¨ Everyvaluationstartswithanarrative,astorythatyouseeunfoldingforyourcompanyinthefuture.
¨ Indevelopingthisnarrative,youwillbemakingassessmentsofyourcompany(itsproducts,itsmanagement),themarketormarketsthatyouseeitgrowingin,thecompetitionitfacesandwillfaceandthemacroenvironmentinwhichitoperates.¤ Rule1:Keepitsimple.¤ Rule2:Keepitfocused.¤ Rule3:Staygroundedinreality.
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TheUberNarrative
InJune2014,myinitialnarrativeforUber wasthatitwouldbe1. Anurbancarservicebusiness:IsawUber primarilyasa
forceinurbanareasandonlyinthecarservicebusiness.2. Whichwouldexpandthebusinessmoderately(about40%
overtenyears)bybringinginnewusers.3. Withlocalnetworkingbenefits:IfUber becomeslarge
enoughinanycity,itwillquicklybecomelarger,butthatwillbeoflittlehelpwhenitentersanewcity.
4. Maintainitsrevenuesharing(20%)systemduetostrongcompetitiveadvantages (frombeingafirstmover).
5. Anditsexistinglow-capitalbusinessmodel,withdriversascontractorsandverylittleinvestmentininfrastructure.
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Step3:Checkthenarrativeagainsthistory,economicfirstprinciples&commonsense
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TheImpossible,TheImplausibleandtheImprobable
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Uber:Possible,PlausibleandProbable
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The Story The Checks (?)
+ Money
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The Impossible: The Runaway Story
The Implausible: The Big Market Delusion
The Improbable: Willy Wonkitis