Valuation Chapter 17: 6,9,11,13,15

Myths about valuation Since valuation models are quantitative, valuation is objective A well-researched and well-done valuation is timeless A good valuation provides a precise estimate of value The more quantitative a model, the better the valuation The market is generally wrong The product of valuation (i.e. the value) is what matters; the process of valuation is not important

The science of Valuation in M&A McCaw Cellular acquires 52% of Lin Broadcasting; the contract allows them to buy the remaining 48% 5 years later. At that time, if the two sides are more than 10% apart in price, the sales documents require them to call in an independent 3 rd banker. (McCaw Cellular acquired by AT&T) March 1995: What price should AT&T pay for the balance of Lin shares?

Lin Broadcasting, March 1995 Morgan Stanley (for AT&T) $105 / share Lehman (for Lin)$155 / share –> 10% apart, so Wasserstein Perrela is hired * Market price = $140 / share

Other public debates over valuation National Gypsum –Management$182.9 million –Creditor group1,037.0 million

Valuation Example: Exide Technologies (November 2003)

Equity value vs. TEV Equity value = market price or value of equity (or per share value) TEV = market value of equity + market value of debt – cash

Valuation Methodologies Relative valuation models Comparable companies valuation (trading market valuation) Comparable transactions valuation Discounted cash flow TEV: Adjusted Present Value (APV) Equity: Flows to equity e ) Dividend discount model (DDM)

Relative Valuation Models: Trading market (Comparable companies) valuation 1.Define a set of publicly traded comparable companies 2.Observe how those companies are valued by the market 3.Apply that valuation to the firm

Exide: Comparable Co.

* Company is 66% industrial, 34% transportation

Comparable Companies Analysis Good things: –Easy to produce Bad things: –Measures relative, not intrinsic value –Different estimates of value, depending on which multiple you use –Availability of comparables? –Vulnerable to manipulation (definition of comparables)

Comparable Transactions Valuation Identify a set of “comparable”, “recent” acquisitions Observe the prices paid (total purchase price) for those companies Apply that valuation to the firm Data limitations Doesn’t imply the firm will be sold

(Exide: Comparable Transactions)

DCF valuations Discount FCF at WACC discount cash flows of the “unlevered” firm WACC uses after tax cost of debt Adjusted Present Value (APV) discount cash flows of unlevered firm plus cash flows from interest tax shield discount rate does not include interest tax shield

Reminder: Free Cash Flow (FCF) Operating cash flow (OCF) = EBIT + depreciation* - taxes = EBIT(1-T) + depreciation FCF = OCF – reinvestment = OCF - capital spending - working capital spending = OCF - capex – ΔNWC * depreciation, or more generally any non-cash charges

Discounting WACC Firm value (TEV) = PV of FCF during forecast period + PV of terminal value Terminal value = proxy for all cash flows after the forecast period.

Terminal Value Terminal value can be estimated as: Multiple (of EBITDA, or final year’s FCF) Growing perpetuity: Terminal value n = FCF n+1 /(WACC-g)

Assumptions in terminal value Long term growth rate Reinvestment versus growth Consistency between perpetuities/multiples: if WACC=12%, in an industry with a long term growth rate of 2%, what is a sensible multiple of FCF? If a firm is already in “steady state”,

Discounting Example: Hershey

Hershey (continued)

(Exide: DCF)

(Exide: DCF – discount rate)

(Exide: DCF)

Exide: Alternative valuation summary

Other issues in DCF valuation Growth vs. reinvestment rate (capex vs. depreciation) Length of projection period? (see MSDW, National Gypsum examples) Other sources of value (cash, holdings in other firms, non-operating assets)

ZDnet 1999 IPO

ZDnet Comparables

ZDnet: Relative Value vs. CNET

example: steady state firm TLC Corp. had earnings before interest and taxes of $100 million in 2003 and faced a tax rate of 40%. The firm had depreciation amounting to $50 million, capital spending of $55 million, and working capital investment of $5 million. The firm is in steady state and should grow 3% a year in the long term. The stock was trading at $10/share in December 2003, and there were 60 million shares outstanding. The beta of the stock is The debt outstanding was $250 million (market price = book value), and the firm had a BB rating (leading to an interest rate on the debt of 8%). The Treasury bond rate is 6%, and market risk premium is 5.5%. What is your valuation of the company (assume today is Dec 31, 2003)?

example: steady state firm Union Pacific Railroad reported net income of $770 million in 2003, after interest expenses of $320 million. The corporate tax rate was 36%. It reported depreciation of $960 million in that year, and capital spending was $1.2 billion. The firm also had $4 billion in debt outstanding on the books, rated AA, carrying a yield to maturity of 8%, trading at par. The beta of the stock is 1.05, and there were 200 million shares outstanding trading at $60 per share. Working capital requirements are negligible. The treasury bond rate is 7%, and the market risk premium is 5.5% a.Estimate free cash flow in b.If the expected growth in free cash flow is 6.5%, estimate the value of the firm at the end of c.Estimate the value of equity at the end of 2003.

Discounting Lockheed Corporation Lockheed Corporation (prior to its merger) reported EBITDA of $1290 million in 1993, prior to interest expenses of $215 million and depreciation charges of $400 million. Capital expenditures in 1993 amounted to $450 million, and working capital was 7% of revenues (which were $13,500). The firm had debt outstanding of $3.068 billion (book value), trading at a market value of $3.2 billion, and yielding a pre-tax interest rate of 8%. There were 62 million shares outstanding, trading at $64 per share, and the most recent beta is The tax rate for the firm is 40%; the treasury bond rate is 7% (risk premium 5.5%). The firm expects revenues, earnings, capital expenditures and depreciation to grow at 9.5% per year from 1994 to 1998, after which the growth rate is expected to drop to 4%. Capital spending will offset depreciation in the steady state period. The company also plans to lower its debt/equity ratio to 50% for the steady state (which will result in the pre-tax interest rate dropping to 7.5%).

Lockheed: Cash flow projections