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Lecture 2 (Chapter 10) Jared Staneld February 29, 2012

Chapter
Outline

10.1
The
Discounted
Free
Cash
Flow
Model
10.2
ValuaLon
Based
on
Comparable
Firms
10.3
InformaLon,
CompeLLon,
and
Stock
Prices
10.4
Individual
Biases
and
Trading

Learning
ObjecLves

Value
a
stock
as
the
present
value
of
the
companys
free
cash
ows
Value
a
stock
by
applying
common
mulLples
based
on
the
values
of
comparable
rms
Understand
how
informaLon
is
incorporated
into
stock
prices
through
compeLLon
in
ecient
markets
Describe
some
of
the
behavioral
biases
that
inuence
the
way
individual
investors
trade

The Discounted Free Cash Flow Model focuses on the cash ows to all of the rms investors, both debt and equity holders.

(Eq. 10.1) Why might valuing the enterprise of the rm be benecial?

Valuing the Enterprise

To esLmate a rms enterprise value, we compute the present value of the rms free cash ow available to pay all investors.

FreeCash Flow = EBIT (1 Tax Rate) + Depreciation Capital Expenditures Increasesin Net Working Capital

(Eq 10.2)

Discounted Free Cash Flow Model

V0=PV(Future Free Cash Flow of Firm) (Eq. 10.4) Given the enterprise value, use Eq. 10.1 to solve for the value of equity and divide by the total number of shares outstanding.

(Eq. 10.4)

ImplemenLng the Model

Since we are discounLng the cash ows to all investors, we use the weighted average cost of capital (WACC), denoted by rwacc Forecast free cash ow up to some horizon, together with a terminal value of the enterprise:

FCF1 FCF2 FCFN VN V0 = + + ... + + 2 N 1 + rwacc (1 + rwacc ) (1 + rwacc ) (1 + rwacc ) N

(Eq. 10.5)

EsLmate the terminal value by assuming a constant long-run growth rate gFCF for free cash ows beyond year N.

! 1 + g FCF FCFN+1 VN = =$ rwacc g FCF ' rwacc g FCF " % FCFN (

(Eq. 10.6)

The long-run growth rate gFCF is typically based on expected long-run growth rate of revenues

Youre a big fan of Mesut zil, the Turkish-born playmaker that plies his trade for Real Madrid. You just found out that he signed with Nike and want to support the company by purchasing some of their stock. Since you had a chance to take FINS3625, you gure it might be fun to do a DCF calculaLon to gure out how much you would be willing to buy a share of Nike stock for.

Problem:

Nike had sales of $19.2 billion in 2009 and you expect its sales to grow at a rate of 8% in 2010, but then slow by 1% per year to the long-run growth rate that is characterisLc of the apparel industry5%by 2013. Based on Nikes past protability an investment needs, you expect EBIT to be 9% of sales, increases in net working capital requirements to be 10% of any increase in sales, and capital expenditures to equal depreciaLon expenses. If Nike has $2.3 billion in cash, $32 million in debt, 486 million shares outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%, what is your esLmate of the value of Nikes stock in early 2010?

Solu,on: Plan:

We can esLmate Nikes future free cash ow by construcLng a pro forma statement as we did last Lme, we just need to calculate a terminal (or conLnuaLon) value for Nike at the end of our explicit projecLons.

Plan (contd):

Because we expect Nikes free cash ow to grow at a constant rate aker 2013, we can use Eq. 10.6 to compute a terminal enterprise value. The present value of the free cash ows during the years 20102013 and the terminal value will be the total enterprise value for Nike. Using that value, we can subtract the debt, add the cash, and divide by the number of shares outstanding to compute the price per share (Eq. 10.4).

Execute:

Year

FCF Forecast ($ million) Sales Growth versus prior year EBIT (9% of sales) Less: Income Tax (24%) Plus: DepreciaLon Less: Capital Expenditures Less: Increase in NWC (10% of sales) Free Cash Flow 19,200.0 20,736.0 22,187.5 23,518.8 24,694.7 8.0% 7.0% 6.0% 5.0% 1,866.2 1,996.9 2,116.7 2,222.5 447.9 479.3 508.0 533.4 - - - - - - - - 153.6 145.2 133.1 117.6 1,264.7 1,372.5 1,475.6 1,571.5

The
spreadsheet
below
presents
a
simplied
pro
forma
for
Nike
based
on
the
informaLon
we
have:

2009
2010
2011
2012
2013

Execute (contd):

Because capital expenditures are expected to equal depreciaLon, these lines in the spreadsheet cancel out. We can set them both to zero rather than explicitly forecast them. Given our assumpLon of constant 5% growth in free cash ows aker 2013 and a weighted average cost of capital of 10%, we can use Eq. 10.6 to compute a terminal enterprise value:

! 1 + g FCF " ! 1.05 " V2013 = $ FCF2013 = $ % 1,571.5 = $33,002 million % ' 0.10 0.05 ( ' rwacc g FCF (

Execute (contd):

From Eq. 10.5, Nikes current enterprise value is the present value of its free cash ows plus the rms terminal value:

V0 =

1, 264.7 1,372.5 1, 475.6 1,571.5 33,002.0 + + + + = $27,006.8million 2 3 4 4 1.10 1.10 1.10 1.10 1.10

We
can
now
esLmate
the
value
of
a
share
of
Nikes
stock
using
Eq.
10.4:

P0 = 27,006.8 + 2,300 32 = $60.24 486

Evaluate:

The total value of all of the claims, both debt and equity, on the rm must equal the total present value of all cash ows generated by the rm, in addiLon to any cash it currently has. The total present value of all cash ows to be generated by Nike is 27,006.8 million and it has 2,300 million in cash. SubtracLng o the value of the debt claims (32 million), leaves us with the total value of the equity claims and dividing by the number of shares produces the value per share.

ConnecLon to Capital BudgeLng

Free cash ow is the sum of the free cash ows from the rms current and future investments, so enterprise value is the sum of the present value of exisLng projects and the NPV of future new ones.

NPV of any investment represents its contribuLon to the rms enterprise value. To maximize share price, we should accept projects that have a posiLve NPV.

We must forecast all the inputs to free cash ow. This process gives us exibility to incorporate many details However, some uncertainty surrounds each assumpLon Given this fact, sensiLvity analysis is important

Translates the uncertainty into a range of values for the stock.

Problem:

Nikes EBIT was assumed to be 9% of sales. If Nike management believes there is a chance that operaLng expenses will increase because in the excitement of signing Ozil, everyone forgets to do actual work, which would cause EBIT to be 8% of sales. How would the esLmate of the stocks value change?

Solu,on: Plan:

In this scenario, EBIT will decrease by 1% of sales compared to the previous example. From there, we can use the tax rate (24%) to compute the eect on the free cash ow for each year. Once we have the new free cash ows, we repeat the approach in the previous example to arrive at a new stock price.

Execute:

In year 1, EBIT will be 1% X $20,736.0 million = $207.4 million lower. Aker taxes, this decline will decrease the rms free cash ow in year 1 by (1-0.24) X $207.4 million = $157.6 million, to $1,107.1 million. Doing the same calculaLon for each year, we get the following revised FCF esLmates:

Year FCF

2010

2011

2012

2013

Execute:

We can now reesLmate the stock price as in the previous example. The terminal value is V2013=[1.05/(0.10-0.05) X 1,383.8=$29,060.7 million, so

V0 = 1,107.1 1, 203.8 1, 296.8 1,383.8 29,060.7 + + + + = $23,769.8million 1.10 1.102 1.103 1.104 1.104

The new esLmate for the value of the stock is P0=(23,769.8+2,300-32)/486=$53.58 per share, a dierence of about -11% compared to the result found in the previous example

Evaluate:

Nikes stock price is fairly sensiLve to changes in the assumpLons about its protability. A 1% permanent change in its margins aects the rms stock price by 11%.

Another applicaLon of the valuaLon principle is the method of comparables.

EsLmate the value of the rm based on the value of other, comparable rms or investments that we expect will generate very similar cash ows in the future.

Consider the case of a new rm that is idenLcal to an exisLng publicly traded rm.

The ValuaLon Principle implies that two securiLes with idenLcal cash ows must have the same price. If these rms will generate idenLcal cash ows, we can use the market value of the exisLng company to determine the value of the new rm. We can adjust for scale dierences using valuaLon mulLples.

ValuaLon MulLples

A raLo of a rms value to some measure of the rms scale or cash ow.

Price-Earnings raLo Enterprise Value MulLples Other mulLples

MulLples of sales Price-to-book value of equity Industry- specic raLos

Price-Earnings RaLo

Most common valuaLon mulLple

Usually included in basic staLsLcs computed for a stock (see Figure 10.2)

Problem:

Suppose IBM has earnings of , has earnings per share of $13.17. If the average P/E of comparable computer hardware stocks is 23.2, esLmate a value for IBMs stock using the P/E as a valuaLon mulLple. What are the assumpLons underlying this esLmate?

Solu,on: Plan:

We esLmate a share price for IBM by mulLplying its EPS by the P/E of comparable rms:

EPS P / E = Earnings per Share? (Price per Share Earnings per Share) =Price per share

Execute:

P0=$13.17 23.2 = $305.54. This esLmate assumes that IBM will have similar future risk, payout rates, and growth rates to comparable rms in the industry.

Evaluate:

Although valuaLon mulLples are simple to use, they rely on some very strong assumpLons about the similarity of the comparable rms to the rm you are valuing. It is important to consider whether these assumpLons are likely to be reasonableand thus to holdin each case.

We can compute a rms P/E raLo using:

Trailing earnings Forward earnings

Trailing P/E Forward P/E

For valuaLon purposes, the forward P/E is generally preferred, as we are most concerned about future earnings.

P/E raLos are related to other valuaLon techniques.

In the case of constant dividend growth (Eq. 7.6), Div1 we had P0 = rE - g Dividing through by EPS1:

Forward P / E = P0 Div1 / EPS1 Dividend Payout Rate = = EPS1 rE - g rE - g

Problem:

Apple and Microsok are both sokware (and hardware) compeLtors. As of 5 March 2012, Apple has a price of $545.18 and forward earnings per share of $35.11. Microsok had a price of $32.08 and forward earnings of $2.76 per share. Calculate their forward P/E raLos and explain the dierence.

Solu,on: Plan:

We can calculate their P/E raLos by dividing each companys price per share by its forward earnings per share. The dierence we nd is most likely due to dierent growth expectaLons.

Execute:

Forward P/E for Apple = $545.18/$35.11 = 15.53 Forward P/E for Microsoks = $32.08/$2.76 = 11.62 Apples P/E raLo is higher because investors expect its earnings to grow more than Microsoks.

Evaluate:

Although both companies are retailers, they have very dierent growth prospects, as reected in their P/E raLos. Investors in Apple are willing to pay 15 Lmes this years expected earnings because they are also buying the present value of high future earnings created by expected growth.

Enterprise Value MulLples

P/E raLo relates exclusively to equity, ignoring the eect of debt.

What does this mean you are eecLvely assuming?

Enterprise
value
mulLples
use
a
measure
of
earnings
before
interest
payments
are
made

EBIT
EBITDA
Free
cash
ow

Because
capital
expenditures
can
vary
between
years,
most
common
is
to
use
enterprise
value
to
EBITDA
mulLples

When expected free cash ow growth is constant, we can write EV to EBITDA as:

FCF1 V0 r g FCF FCF1 / EBITDA1 = wacc = EBITDA1 EBITDA1 rwacc g FCF

(Eq. 10.8)

Problem:

CF Industries is a manufacturer and distributer of nitrogen and phosphate ferLlizer products. It has an EBITDA of $2,895 million, cash of $1,207 million, debt of $1,617 million, and 65 million shares outstanding. The ferLlizer industry as a whole has an average EV/EBITDA raLo of 4.8. What is one esLmate of Fairviews enterprise value? What is a corresponding esLmate of its stock price?

Solu,on: Plan:

We use the EV/EBITDA equaLon to solve for EV and share value

Execute:

Evaluate:

Other mulLples

MulLples of sales can be useful if it is reasonable to assume margins are similar in the future. Price-to-book value of equity can be used for rms with substanLal tangible assets. Some mulLples are specic to an industry

e.g. Cable TV Enterprise value per subscriber

LimitaLons of MulLples

Firms are not idenLcal

Usefulness of a valuaLon mulLple will depend on the nature of the dierences and the sensiLvity of the mulLples to the dierences. Dierences in mulLples can be related to dierences in

Expected future growth rate Risk (cost of capital) Dierences in accounLng convenLons between countries

LimitaLons of MulLples

Comparables provide only informaLon regarding the value of the rm relaLve to other rms in the comparison set

Cannot help determine whether an enLre industry is overvalued.

Internet boom example

Table 10.1 Stock Prices and MulLples for the Footwear Industry (excluding Nike), May 2010

Comparison with Discounted Cash Flow Methods

ValuaLon mulLple does not take into account material dierences between rms.

Talented managers More ecient manufacturing processes Patents on new technology

Comparison with Discounted Cash Flow Methods

Discounted cash ow methods allow us to incorporate specic informaLon about cost of capital or future growth

PotenLal to be more accurate

Stock ValuaLon Techniques: The Final Word

No single technique provides a nal answer regarding a stocks true value PracLLoners use a combinaLon of these approaches Condence comes from consistent results from a variety of these methods

Figure 10.4 Range of ValuaLons for Nike Stock Using Various ValuaLon Methods

InformaLon in Stock Prices

For a publicly traded rm, market price should already provide very accurate informaLon regarding the true value of its shares. A valuaLon model is best applied to tell us something about future cash ows or cost of capital, based on current stock price.

Only in the relaLvely rare case in which we have some superior informaLon that other investors lack would it make sense to second-guess the stock price.

Problem:

Suppose SWGSB Industries will pay a dividend this year of $6.50 per share. Its equity cost of capital is 11.5%, and you expect its dividends to grow at a rate of about 5% per year, though you are somewhat unsure of the precise growth rate. If SWGSBs stock is currently trading for $63.32 per share, how would you update your beliefs about its dividend growth rate?

Solu,on: Plan:

If we apply the constant dividend growth model based on a 5% growth rate, we can esLmate a stock price using Eq. 7.6. If the market price is higher than our esLmate, it implies that the market expects higher growth in dividends than 5%. Conversely, if the market price is lower than our esLmate, the market expects dividend growth to be less than 5%. We can use Eq. 7.7 to solve the growth rate instead of price, allowing us to esLmate the growth rate the market expects.

Execute:

Execute (contd):

Evaluate:

CompeLLon and Ecient Markets

Ecient markets hypothesis:

Implies that securiLes will be fairly priced, based on their future cash ows, given all informaLon that is available to investors.

InformaLon available to all investors includes informaLon in news reports, nancial statements, corporate press releases, or other public data sources.

Problem:

Veridian Dynamics announces that it is pulling one of its products from the market, a weight-loss toothpaste, owing to the potenLal side eects associated with the toothpaste (Dental Hydroplosion). As a result, its future expected free cash ow will decline by $70 million per year for the next 8 years. Veridian has 30 million shares outstanding, no debt, and an equity cost of capital of 7%. If this news came as a complete surprise to investors, what should happen to Veridianss stock price upon the announcement?

Solu,on: Plan:

In this case, we can use the discounted free cash ow method. With no debt, rwacc = rE = 7%. The eect on the Veridians enterprise value will be the loss of an eight-year annuity of $70 million. We can compute the eect today as the present value of that annuity.

Execute:

Evaluate:

Lessons for Investors and Corporate Managers

Consequences for Investors

Must have some compeLLve advantage

ExperLse or access to informaLon known to only a few people Lower trading costs than others If stocks are fairly priced according to valuaLon models, then investors who buy stocks can expect fair compensaLon for the risk they take.

Lessons for Investors and Corporate Managers

ImplicaLons for Corporate Managers

Cash ows paid to investors determine value

Focus on NPV and free cash ows Avoid accounLng illusions Use nancial transacLons to support investment

The Ecient Markets Hypothesis Versus No Arbitrage

An arbitrage opportunity is a situaLon in which two securiLes (or porxolios) with idenLcal cash ows have dierent prices.

Because anyone can earn a sure prot in this situaLon by buying the low-priced security and selling the high- priced one, we expect investors to immediately exploit and eliminate these opportuniLes. Thus, in a normal market, arbitrage opportuniLes will not be found.

The Ecient Markets Hypothesis Versus No Arbitrage

The ecient markets hypothesis states that securiLes with equivalent risk should have the same expected return. The ecient markets hypothesis is, therefore, incomplete without a deniLon of equivalent risk.

The Ecient Markets Hypothesis Versus No Arbitrage

Dierent investors may perceive risks and returns dierently (based on their informaLon and preferences). There is no reason to expect the ecient markets hypothesis to hold perfectly; rather, it is best viewed as an idealized approximaLon for highly compeLLve markets.

Excessive Trading and Overcondence

Trading is expensive because of commissions and the dierence between the bid and ask Given the diculty of nding over- and under- valued stocks, you might expect individual investors to trade conservaLvely.

However, a study of the trading behavior of individual investors at a discount brokerage found individual investors trade very acLvely.

Average turnover almost 50% above overall rates during the Lme of the study.

Overcondence hypothesis

Tendency of individual investors to trade too much based on the mistaken belief that they can pick winners and losers bezer than investment professionals. ImplicaLon is that investors who trade more will not earn higher returns.

Performance will actually be worse because of trading costs.

10-74

Hanging On to Losers and the DisposiLon Eect

Investors tend to hold on to stocks that have lost value and sell stocks that have risen in value We call this tendency the disposiLon eect. Researchers Hersch Shefrin and Meir Statman suggest that this eect arises due to investors increased willingness to take on risk in the face of possible losses.

May also reect a reluctance to admit a mistake by taking the loss.

From a tax perspecLve, this behavioral tendency is costly.

Capital gains are taxed only when an asset is sold, so delaying the tax payment reduces its present value. Capital losses are tax deducLble (to a certain extent), so investors should capture tax losses early.

Keeping losers and selling winners might make sense if losing stocks would outperform the winners going forward.

This belief does not appear to be jusLed if anything losing stocks that investors conLnue to hold underperform the winners they sell. According to one study, losers underperformed winners by 3.4% over the next year.

Investor AzenLon, Mood, and Experience

Individual investors are not generally full-Lme traders

They have limited Lme and azenLon More likely to buy stocks that have been in the news, adverLsed more, had very high trading volume, or recently had extreme (high or low) returns.

Annualized market returns at the locaLon of the stock exchange is higher on sunny days than on cloudy days.

Investor AzenLon, Mood, and Experience

Investors appear to put too much weight on their own experience rather than considering historical evidence

People who grow up and live during a Lme of high stock returns are more likely to invest in stocks.

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