Valuation and Evaluation

1. Valuation and Evaluation

2. Basic Valuation • Assets have value by virtue of being expected to produce cash flows • Cash flows to equity holders are “dividends” • including repurchases (even buyouts) • net of stock issuance (“negative dividends”) • typically assumed to be zero • The value of the firm’s equity can be expressed as the present value of expected future dividends

3. Dividend Discount Model • Like any other asset, stock value is the present value of future cash flows Vt = E(Dt+1)/(1+r) + E(Dt+2)/(1+r)2 + … where: Vt≡ equity value at time t Dt ≡ div. (including repurchases) E ≡ expected value operator r ≡ discount rate

4. Discount rate is equity “cost of capital” • amount the firm “promises” to attract capital • amount investors could earn in alternative investments of similar risk • assumes you can borrow and lend at same rate • Dividend discount model underpins all other valuation approaches

5. Vcoke= $3,980/(1+7%)+$4,261/(1+7%)2+… where: dividends are 45% of forecast NI ($4,353 in ’03) repurchases are the use of excess cash ’03: Div. = 45% x $4,353 = $1,959 Repurch. = $2,021; $2,021+$1,959=$3,980 ’04: $4,261 discount rate is based on CAPM

6. Problems with Dividend Discount • Dividends reflect distribution of value not creation • Dividend pay-outs are arbitrary and hard to predict • Earnings are often retained in the firm and allowed to accumulate • Much of value comes far in the future • Therefore, often focus on ability to pay dividends rather than dividends themselves

7. Savings Account Example • Assume: • Invest $100 in a savings account with expected return of 10% • Cost of capital is 10% • Expect to withdraw $110 in one year • Then, Vt = $110/1.1 = $100 It is worth what you put into it

8. Now assume 12% expected return • e.g., mutual fund has locked in 12% one year bonds before rates fell Vt = $112/1.1 = $102 • Now assume 8% expected return • e.g., mutual fund has locked in 8% one year bonds before rates rose Vt = $108/1.1 = $98

9. Other Valuation Approaches • The firm’s ability to pay dividends is based on its cash inflows • Therefore, other valuation approaches focus on likely cash inflows into the firm

10. Free Cash Flows • Under reasonable assumptions value can be expressed in terms of expected free cash flows to the firm • Free Cash Flows = Cash from Operations + Cash from Investing • Free cash flows capture amount left over after covering investing

11. Practical Consideration • Ultimately care about value of equity • One way to get at that is to directly estimate cash flows available to equity; after interest • In practice, often easier to: • estimate PV of cash flows to assets • subtract off value of debt • implies value for equity since A = L + OE

12. Implementation • Assets: • Asset value is PV of free cash flows, before interest • Use free cash flows (operating minus investing) • Add back after tax interest (like ROA) • Asset values setting aside financing choices • Discount rate is technically weighted average cost of capital—more on that in finance

13. Liabilities: • PV of cash flows to existing debt = book value • PV of cash flows on future debt = 0 •  forecast cash flows to assets • subtract BV of existing interest-bearing debt

14. Vt = E(AFCFt+1)/(1+r)+E(AFCFt+2)/(1+r)2+… - Existing Debt where: AFCF is FCF adjusted for after-tax interest on existing debt existing interest-paying debt is subtracted • In the preceding example expected dividends = expected cash flows Vt = $110/1.1 = $100

15. E.g., you invest $100 in a mutual fund which invests for 2 years at 10% • At the end of year 1, the fund borrows $110 and pays you a dividend of $110 • dividends = $110 • free cash flows = $0

16. At the end of year 2, the investment pays off $121 and the fund repays the debt • dividends = $0 • free cash flows = $121 • Dividend approach Vt = $110/1.1 + $0/1.21 = $100 • Free cash flow approach Vt = $0/1.1 + $121/1.21 = $100

17. Vcoke= $4,232/(1+7%)+$4,507/(1+7%)2+… - $5,356 where expected free cash flows are from pro forma and existing debt from balance sheet NI 4,353 4,556 + Depr. 760 880 • DWorking Cap. (CA-CL) -210 -100 • Cap. Exp. -950 -1,100 + Change in Other Liab. +113 +107 + Change in Def. Taxes + 20 + 19 + Adj. Int. (.77 x 199) +145+ 145 4,232 4,507

18. Problems with Free Cash Flows • Free cash flow forecasts are generally not available • Generally must compute statement of cash flows from: • earnings forecasts • balance sheet assumptions • Much of value comes far in the future

19. Balance Sheet Valuation • If estimated values of assets (& liab.) are available, they equal PV of expected cash flow • Then, can use asset and liability values to value of the firm Vt = Asset Value - Liability Value

20. E.g., invest in a mutual fund holding an asset returning 10% and no liabilities • Market value of the asset being held is $100 if it is expected to pay out $110 in one year • Therefore, you can rely on the market value of the asset held to value the firm

21. Approach • Start with existing balance sheet • Revalue assets that are likely misvalued • E.g., Coke’s investment in bottling companies • Add assets that have been excluded • E.g., Coke’s brand • Do the same with liabilities • Typically less of an issue • Back into the equity value

22. Vcoke= (Asset book values + investment security additional values + brand values) - Liability book values Vcoke = ($24.5B + $3.5B + $70.5B) - $12.7B = $85.8B

23. Problems with Balance Sheet Method • Many assets don’t have ascertainable values • PP&E, Intangibles, etc. • Many assets have higher values to that firm than to other firms • Customized PP&E, Inventory, etc. • Doesn’t work well for Coke • Too many hard-to-value assets