1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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?

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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