2. Prof. Ian Giddy New York University Valuation IBM

3. Copyright ©2000 Ian H. Giddy Valuation 3 What’s a Company Worth? l Required returns l Types of Models  Balance sheet models  Dividend discount models  Corporate cash flow models  Price/Earnings ratios l Estimating Growth Rates l Application IBM

4. Copyright ©2000 Ian H. Giddy Valuation 4 Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity

5. Copyright ©2000 Ian H. Giddy Valuation 5 Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity Book Value Liquidation Value Replacement Value Tobin’s Q: Market/Replacement tends to 1?

6. Copyright ©2000 Ian H. Giddy Valuation 6 Estimating Future Cash Flows n Dividends? n Free cash flows to equity? n Free cash flows to firm?

7. Copyright ©2000 Ian H. Giddy Valuation 7 Cash Flow to Firm ClaimholderCash flows to claimholder Equity InvestorsFree Cash flow to Equity Debt HoldersInterest Expenses (1 - tax rate) + Principal Repayments - New Debt Issues Preferred StockholdersPreferred Dividends Firm =Free Cash flow to Firm = Equity InvestorsFree Cash flow to Equity + Debt Holders+ Interest Expenses (1- tax rate) + Preferred Stockholders+ Principal Repayments - New Debt Issues + Preferred Dividends

8. Copyright ©2000 Ian H. Giddy Valuation 8 Relative Valuation l Do valuation ratios make sense? Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) Price/Book (P/BV) ratios q and variants (Tobin's Q) Price/Sales ratios l It depends on how they are used -- and what’s behind them!

9. Copyright ©2000 Ian H. Giddy Valuation 9 Disney: Relative Valuation CompanyPEExpected GrowthPEG King World Productions10.47.00%1.49 Aztar11.912.00%0.99 Viacom12.118.00%0.67 All American Communications15.820.00%0.79 GC Companies20.215.00%1.35 Circus Circus Enterprises20.817.00%1.22 Polygram NV ADR22.613.00%1.74 Regal Cinemas25.823.00%1.12 Walt Disney27.918.00%1.55 AMC Entertainment29.520.00%1.48 Premier Parks32.928.00%1.18 Family Golf Centers33.136.00%0.92 CINAR Films48.425.00%1.94 Average27.4418.56%1.20 PE ratio divided by the growth rate

10. Copyright ©2000 Ian H. Giddy Valuation 10 Discounted Cashflow Valuation: Basis for Approach  where  n = Life of the asset  CF t = Cashflow in period t  r = Discount rate reflecting the riskiness of the estimated cashflows

11. Copyright ©2000 Ian H. Giddy Valuation 11 Start with the Weighted Average Cost of Capital ChoiceCost 1. EquityCost of equity - Retained earnings- depends upon riskiness of the stock - New stock issues- will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. DebtCost of debt - Bank borrowing- depends upon default risk of the firm - Bond issues- will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capitalcost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)]

12. Copyright ©2000 Ian H. Giddy Valuation 12 Valuation: The Key Inputs l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. l Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

13. Copyright ©2000 Ian H. Giddy Valuation 13 Dividend Discount Models: General Model l V 0 = Value of Stock l D t = Dividend l k = required return

14. Copyright ©2000 Ian H. Giddy Valuation 14 Specified Holding Period Model l P N = the expected sales price for the stock at time N l N = the specified number of years the stock is expected to be held

15. Copyright ©2000 Ian H. Giddy Valuation 15 No Growth Model l Stocks that have earnings and dividends that are expected to remain constant l Preferred Stock

16. Copyright ©2000 Ian H. Giddy Valuation 16 No Growth Model: Example E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 n Burlington Power & Light has earnings of $5 per share and pays out 100% dividend n The required return that shareholders expect is 15% n The earnings are not expected to grow but remain steady indefinitely n What’s a BPL share worth? n Burlington Power & Light has earnings of $5 per share and pays out 100% dividend n The required return that shareholders expect is 15% n The earnings are not expected to grow but remain steady indefinitely n What’s a BPL share worth?

17. Copyright ©2000 Ian H. Giddy Valuation 17 Constant Growth Model l g = constant perpetual growth rate

18. Copyright ©2000 Ian H. Giddy Valuation 18 Constant Growth Model: Example E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 -.08) = $42.86 n Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend n The required return that shareholders expect is 15% n The earnings are expected to grow at 8% per annum n What’s an M6 share worth? n Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend n The required return that shareholders expect is 15% n The earnings are expected to grow at 8% per annum n What’s an M6 share worth? Plowback rate

19. Copyright ©2000 Ian H. Giddy Valuation 19 Estimating Dividend Growth Rates l g = growth rate in dividends l ROE = Return on Equity for the firm l b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)

20. Copyright ©2000 Ian H. Giddy Valuation 20 Or Use Analysts’ Expectations?

21. Copyright ©2000 Ian H. Giddy Valuation 21 Shifting Growth Rate Model l g 1 = first growth rate l g 2 = second growth rate l T = number of periods of growth at g 1

22. Copyright ©2000 Ian H. Giddy Valuation 22 n Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% n The dividends are expected to grow at 20% for 3 years and 5% thereafter n What’s a Mindspring share worth? n Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% n The dividends are expected to grow at 20% for 3 years and 5% thereafter n What’s a Mindspring share worth? Shifting Growth Rate Model: Example D 0 = $2.00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2.40 D 2 = 2.88 D 3 = 3.46 D 4 = 3.63 V 0 = D 1 /(1.15) + D 2 /(1.15) 2 + D 3 /(1.15) 3 + D 4 / (.15 -.05) ( (1.15) 3 V 0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

23. Copyright ©2000 Ian H. Giddy Valuation 23 Stable Growth and Terminal Value l When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate l This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. l While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. l When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.

24. Copyright ©2000 Ian H. Giddy Valuation 24 Choosing a Growth Pattern: Examples CompanyValuation in Growth PeriodStable Growth Disney Nominal U.S. $10 years5%(long term Firm(3-stage)nominal growth rate in the U.S. economy Aracruz Real BR5 years5%: based upon Equity: FCFE(2-stage)expected long term real growth rate for Brazilian economy Deutsche BankNominal DM0 years5%: set equal to Equity: Dividendsnominal growth rate in the world economy

25. Copyright ©2000 Ian H. Giddy Valuation 25 The Building Blocks of Valuation

26. Copyright ©2000 Ian H. Giddy Valuation 26 The Building Blocks of Valuation Spreadsheet example

27. Equity Valuation: Two Applications Prof. Ian Giddy New York University

28. Copyright ©2000 Ian H. Giddy Valuation 28 Equity Valuation in Practice l Estimating discount rate l Estimating cash flows l Estimating growth l Application with constant growth: Optika l Application with shifting growth: Fong

29. Copyright ©2000 Ian H. Giddy Valuation 29 Optika CAPM: 7%+1(5.50%) Debt cost (7%+1.5%)(1-.35) WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) Equity Value: Firm Value - Debt Value = 2278-250 = 2028

30. Copyright ©2000 Ian H. Giddy Valuation 30 Valuing a Firm with DCF: An Illustration Historical financial results Adjust for nonrecurring aspects Gauge future growth Adjust for noncash items Projected sales and operating profits Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF Stable growth model or P/E comparable Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity … Discount to present using weighted average cost of capital (WACC)

31. Copyright ©2000 Ian H. Giddy Valuation 31 Valuation Example

32. Copyright ©2000 Ian H. Giddy Valuation 32 Valuation Example

33. Equity Valuation: Alternatives Prof. Ian Giddy New York University IBM

34. Copyright ©2000 Ian H. Giddy Valuation 34 What’s a Company Worth? Alternative Models l The options approach  Option to expand  Option to abandon l Creation of key resources that another company would pay for  Patents or trademarks  Teams of employees  Customers l Examples? Lycos Messageclick.co m

35. Copyright ©2000 Ian H. Giddy Valuation 35 What’s a Company Worth? The Options Approach Present Value of Expected Cash Flows if Option Excercised Value of the Firm or project

36. Copyright ©2000 Ian H. Giddy Valuation 36 The Value of a Corporate Option l Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. l The value of these rights increases with the volatility of the underlying business. l The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits.

37. Copyright ©2000 Ian H. Giddy Valuation 37 Application

38. Copyright ©2000 Ian H. Giddy Valuation 38 An Example of a Corporate Option l J&J is considering investing $110 million to purchase an internet distribution company to serve the growing on-line market. l A conventional NPV financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to J&J will be only $95 million. Thus, by itself, the corporate venture has a negative NPV of $15 million. l If the on-line market turns out to be more lucrative than currently anticipated, J&J could expand its reach a global on-line market with an additional investment of $125 million any time over the next 2 years. While the current expectation is that the PV of cash flows from having a worldwide on-line distribution channel is only $100 million (still negative NPV), there is considerable uncertainty about both the potential for such an channel and the shape of the market itself, leading to significant variance in this estimate. l This uncertainty is what makes the corporate venture valuable!

39. Copyright ©2000 Ian H. Giddy Valuation 39 Valuing the Corporate Venture Option l The corporate option would cost an expected $15 million. But what is it worth to J&J? l Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million l Strike Price (K) = cost of expansion into global on-line selling = $125 Million l We estimate the variance in the estimate of the project value by using the annualized volatility (standard deviation) in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%.  Variance in Underlying Asset’s Value = SD^2=.25 l Time to expiration = Period for which “venture option” applies = 2 years l 2-year interest rate: 6.5%

40. Copyright ©2000 Ian H. Giddy Valuation 40 Option Pricing 94.5 Option Price = Intrinsic value + Time value Option Price Underlying Price 94.75 Time value depends on n Time n Volatility n Distance from the strike price Time value depends on n Time n Volatility n Distance from the strike price

41. Copyright ©2000 Ian H. Giddy Valuation 41 Value of Call Option INTRINSIC VALUETIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE STRIKE FUTURES PRICE SHADED AREA: Probability distribution of the log of the futures price on the expiration date for values above the strike.

42. Copyright ©2000 Ian H. Giddy Valuation 42 Black-Scholes Option Valuation Call value = S o N(d 1 ) - Xe -rT N(d 2 ) d 1 = [ln(S o /X) + (r +  2 /2)T] / (  T 1/2 ) d 2 = d 1 - (  T 1/2 ) where S o = Current stock price X = Strike price, T = time, r = interest rate N(d) = probability that a random draw from a normal distribution will be less than d.

43. Copyright ©2000 Ian H. Giddy Valuation 43 Valuing the Corporate Venture Option l Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million l Strike Price (X) = cost of expansion into global on-line selling = $125 Million l We estimate the variance in the estimate of the project value by using the annualized standard deviation in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%.  Variance in Underlying Asset’s Value = SD^2=0.25 l Time to expiration = Period for which “venture option” applies = 2 years l 2-year interest rate: 6.5% Call Value = 100 N(d 1 ) -125 (exp(-0.065)(2)) N(d 2 ) = $ 24.2 Million

44. Copyright ©2000 Ian H. Giddy Valuation 44 Conclusion? Johnson & Johnson should go ahead and invest in the venture -- the value of the option ($24 million) exceeds the cost ($15 million) Can this approach be used to value highly speculative ventures?

46. n www.stern.nyu.edu

47. www.giddy.org

49. Copyright ©2000 Ian H. Giddy Valuation 49 Ian H. Giddy NYU Stern School of Business 44 West 4 th Street New York, NY 10012, USA Tel 212-998-0563; Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org