Presentation is loading. Please wait.

# AAA 2008 Annual Meeting CPE Session #44

## Presentation on theme: "AAA 2008 Annual Meeting CPE Session #44"— Presentation transcript:

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

After this session you should be able to:
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 CPE session #44 AAA Annual Meeting 2008

Estimating fair value of a share of Sprint 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 CPE session #44 AAA Annual Meeting 2008

So, why use an income approach?
Forge conceptual links for students between observable fair value and intrinsic value derived with other valuation technique Expose students to common income-approach model (one of many) Segue to next session on intangible asset impairment at Sprint Nextel Students often take for granted Level 1 inputs Need to understand where prices come from Value derives from future cash flows – this case provides a simple way to start building understanding (or reinforcing it) CPE session #44 AAA Annual Meeting 2008

Building blocks of the Sprint Nextel case
Valuation technique: Income approach (SFAS ) General class of models: Multiperiod excess earning method (SFAS ) 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 CPE session #44 AAA Annual Meeting 2008

Valuation technique: Income approach (SFAS 157.18)
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. Asset / liability may be stand-alone or a group of assets and liabilities Unit of account refers to the level of financial statement aggregation or disaggregation as specified by other accounting pronouncements IF the investment is carried as an equity method investment, the unit of account in the “bundle” of assets IF the investment is consolidated, the fair value measurement is allocated to units of account Unit of account is not necessarily the same as the unit of valuation CPE session #44 AAA Annual Meeting 2008

General class of models: Multiperiod excess earnings
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 CPE session #44 AAA Annual Meeting 2008

General class of models: Multiperiod excess earnings
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 CPE session #44 AAA Annual Meeting 2008

Specific model: Residual operating income model
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 CPE session #44 AAA Annual Meeting 2008

Defining Residual Operating Income
Residual operating income is net operating profit after-tax in excess of expected operating profit. Calculated as: “Expected” operating profit Excludes interest expense and nonoperating revenues and expenses Start-of-year Net Operating Assets CPE session #44 AAA Annual Meeting 2008

Sprint Nextel: 2006 Net Operating Profit After Tax
Operating income \$2,484 Tax at 38% \$ 944 Net Operating Profit After Tax \$1,540 NOTE: The valuation model uses projected net operating profit after tax. We calculate the amount for 2006 as an example. CPE session #44 AAA Annual Meeting 2008

Defining Residual Operating Income
Residual operating income is net operating profit after-tax in excess of expected operating profit. Calculated as: “Expected” operating profit Excludes interest expense and nonoperating revenues and expenses Start-of-year Net Operating Assets CPE session #44 AAA Annual Meeting 2008

Defining Net Operating Assets
Traditional Balance Sheet equation: A = L + E Operating v. Nonoperating Balance Sheet equation: NOA = Net Debt + E

Sprint Nextel: 2006 Net Operating Assets
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 CPE session #44 AAA Annual Meeting 2008

The Residual Operating Income Valuation Model
Book value of Net Operating Assets Present value of Year 2 ROPI Present value of Terminal period ROPI Book value of Net Debt Present value of Year 1 ROPI CPE session #44 AAA Annual Meeting 2008

Sprint Nextel: 2006 Net Nonoperating Liabilities (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 CPE session #44 AAA Annual Meeting 2008

Forecasting ROPI for Sprint Nextel: A simplified approach
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” CPE session #44 AAA Annual Meeting 2008

Forecasting Sales for Sprint Nextel
2006 2007 2008 2009 2010 Terminal period Sales \$41,028 \$49,234 Forecasted Sales = Prior-year sales × 1.2 CPE session #44 AAA Annual Meeting 2008

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 CPE session #44 AAA Annual Meeting 2008

Forecasting Net Operating Profit After Tax for Sprint Nextel
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 NOTE: This is higher than the historical profit margin and the stock value is very sensitive to this margin. CPE session #44 AAA Annual Meeting 2008

Forecasting Net Operating Profit After Tax for Sprint Nextel
2007 2008 2009 2010 Terminal period 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% CPE session #44 AAA Annual Meeting 2008

Forecasting Net Operating Assets for Sprint Nextel
Start with 2006 NOA Assume a growth rate for NOA – 5% Use this rate to forecast net operating assets each year NOTE: An alternate approach uses historical Total Asset Turnover ratio to forecast NOA. CPE session #44 AAA Annual Meeting 2008

Forecasting Net Operating Assets for Sprint Nextel
2007 2008 2009 2010 Terminal period NOA start of year \$75,270 \$79,034 \$82,985 \$87,134 \$91,491 Forecasted NOA = Prior-year NOA × 1.05 2006 NOA from balance sheet CPE session #44 AAA Annual Meeting 2008

Forecasting Expected Operating Profit for Sprint Nextel
Calculate expected net operating profit after tax with a weighted average cost of capital of 8.07% CPE session #44 AAA Annual Meeting 2008

Forecasting Expected Operating Profit for Sprint Nextel
2007 2008 2009 2010 Terminal period 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? CPE session #44 AAA Annual Meeting 2008

Forecasting Residual Operating Profit for Sprint Nextel
2007 2008 2009 2010 Terminal period 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 Classroom discussion ideas: Why are residual earnings negative for Sprint Nextel? What does that mean conceptually? CPE session #44 AAA Annual Meeting 2008

Sprint Nextel: ROPI valuation
2007 2008 2009 2010 Terminal Residual Operating Income -\$2,383 -\$1,948 -\$1,381 -\$652 -\$813 Discount Factor WACC= 8.07% 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 Classroom discussion ideas: What happens to WACC if company becomes riskier? How does the level of WACC affect expected income?

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 Classroom discussion ideas: 12/31/2006 stock price is \$18.79. WHY is our estimate different? CPE session #44 AAA Annual Meeting 2008

Sprint Nextel case: Model assumptions and inputs
Discounting expected and not contractual future amounts Assumptions are to be those that market participants would use in pricing the asset (SFAS ) Level 2 inputs required to estimate the model: WACC: market beta, risk-free rate, credit spread CPE session #44 AAA Annual Meeting 2008

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 CPE session #44 AAA Annual Meeting 2008

Sprint Nextel case: Teaching Ideas
Case assumes students understand Discounting of lump sums and perpetuities WACC: theory and calculations Basics 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 CPE session #44 AAA Annual Meeting 2008

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 CPE session #44 AAA Annual Meeting 2008

Link to other applications:
Jennings McAnally STice Unit of account Individual assets: Marketable security Loan Firm: Group of assets and liabilities Goodwill (impairment) Method Market & Income Market &Income Inputs Levels 1-3 Levels 2 and 3 Data Developed From Sprint-Nextel financials CPE session #44 AAA Annual Meeting 2008

Download ppt "AAA 2008 Annual Meeting CPE Session #44"

Similar presentations

Ads by Google