Valuation Analysis Equity Valuation

Valuation Analysis
Judson W. Russell, Ph.D., CFA

University of North Carolina-Charlotte
1
Agenda
 Equity Valuation Fundamentals: Intrinsic Value
 Enterprise Valuation Fundamentals: Free Cash Flow
 Equity Valuation Fundamentals: Relative Value
2
Introduction
 Valuation is both art and science

• Art through reasonable, defensible:
• Assumptions
• Judgment and interpretation of data
• Science through application of analytical formulae
 Valuation is based on future performance
3
Introduction
 Two main valuation questions:
1)What is a company worth by valuation metrics?
2) What can or will a potential buyer pay?
4
Introduction
 Three main valuation methodologies

• Intrinsic Value Approach: A stock’s price equals the net
present value of its dividends.
• Relative Value Approach: A stock’s value is determined
by comparing similar stock values.
• Acquisition Value Approach: Calculate a company’s stock
price by determining its worth to a third party acquirer.
 Golden Rule: Footnote your assumptions
5
Introduction
 EQUITY VALUE:
• Value of shareholders’ interest
• After interest expense, preferred dividends and
minority interest expense
• Multiples of net income, book value, EPS
• Other common terms:
• Market Value, Market Capitalization,
Offer Value (in an acquisition context)
6
Introduction
 ENTERPRISE VALUE:
• Includes all forms of capital
• Market value of equity, debt, preferred stock,
minority interest
• Before interest expense, preferred dividends and
minority interest expense
• Multiples of sales, EBITDA, EBIT or any other
applicable metric (per subscriber, per bed, etc.)
• Other common terms:
• Aggregate Value, Firm Value, Total Capitalization,
Adjusted Market Value, Transaction Value
7
Introduction
Equity Market Cap.
Enterprise Value = Equity Market Cap.

Net Debt
Preferred Stock
Minority Interest
8
Introduction
 COMPARABLE (or “similar”) in terms of:
Operations Financial Aspects

Industry Size
Products Leverage
Markets Margins & Profitability
Distribution channels Growth prospects
Customers Shareholder base
Seasonality Market conditions (acquisitions)
Cyclicality Consideration paid (acquisitions)
Circumstances surrounding the
transaction
9
Equity Valuation Process
 The Graham and Dodd Approach to Security Selection
1. Study the available facts

2. Prepare an organized report
3. Project earnings and related data
4. Draw valuation conclusions based on established principles
and sound logic
5. Make a decision
10
Valuation Process
 The top-down approach starts with Analysis of Alternative

Economies and Security
an analysis of alternative economies Markets
and security markets.
 The initial objective is to decide how
to allocate investment funds among Analysis of Alternative
countries and within countries to Industries
bonds, stocks, and cash.
 The second phase is the analysis of
alternative industries. The objective Analysis of
at this stage is to determine which Individual
Companies
industries will prosper based on your and Stocks
analysis of the economy.
 The final, third, phase focuses on
security selection. The objective is
to determine which companies within
the selected industries will prosper
and which stocks are undervalued.
11
Valuation Process Example
 The top-down analysis for a U.S. homebuilder:

 Economy GDP will increase 3%
 Capital Markets Interest rates will remain
low
 Industry Housing starts to stay
strong
 Homebuilding Company Homebuilder to gain
market share.
 Sales will increase by 15% versus the industry average of

10%. Steady profit margins signify a 15% earnings increase.
12
Economic Cycles
R E C E S S IO N : R E C O V E R Y : E a r ly s ta g e E X P A N S I O N : L a te S ta g e
C o n s u m e r s ta p le s (fo o d , C o n s u m e r C y c lic a ls (a u to s , B a s ic M a te r ia ls (c h e m ic a ls ,
d ru g s , c o s m e tic s , to b a c c o ), a p p a r e l, m e d ia , re ta ile r s ), p la s tic s , p a p e r, w o o d ,
u tilitie s , s o ftw a re , a n d C o n s u m e r C re d it (s a v in g s a n d m e ta ls ), C a p ita l G o o d s
b io te c h n o lo g y f ir m s lo a n s ), a n d T r a n s p o r ta tio n (e q u ip m e n t a n d m a c h in e ry
(a irlin e s , tr u c k in g , r a ilro a d s ) m a n u fa c tu re rs )
13
Industry Analysis
 Forecast Sales
• An insightful analysis when predicting industry sales is to view the
industry over time and divide its development into stages.
• Pioneering development - A
• Rapid accelerating growth - B
• Mature growth - C
• Stabilization and market maturity - D
• Deceleration of growth and decline - E
Rate of
Sales D
Growth C
E
Time
14
Porter’s Five Forces
POTENTIAL
ENTRANTS
INDUSTRY
SUPPLIERS COMPETITORS BUYERS
SUBSTITUTES
15
Valuation Approach – Intrinsic Value
Valuation Approaches – Intrinsic Value
 The value of an asset is the present value of its expected returns.
 The process of valuation requires estimates of (1) the stream of

expected returns and (2) the required rate of return on the
investment.
 The value of a preferred stock (perpetuity) is simply the stated

annual dividend divided by the required rate of return on preferred
stock (kp).
 A preferred stock with an $8 per year dividend and required return of

9% is valued as:
V = $8 / 0.09 = $88.89
17
 The valuation of common stock is more difficult than

bonds or preferred stock because an investor is
uncertain about the size of the returns, the time pattern
of returns, and the required rate of return (ke).
 However, the value of common stock is still the present

value of its future cash flows. The only cash flows an
equity investor ever gets are dividends (cash or
liquidating).
 A model to value common stock is the dividend

discount model (DDM).
18
 The DDM assumes that the value of a share of

common stock is the present value of all future
dividends as;
V = [D1/(1+ke)1 + D2/(1+ke)2 + … + D/(1+ke)]
 Since estimating D is impossible, other methods have

evolved based upon a terminal stock value, or a
constant rate of growth.
19
 Assume an investor wants to buy a stock, hold it for one year, and then sell
it. We must evaluate the dividend cash flows as well as the terminal value
in one year. These cash flows are then discounted at the investor’s
required rate of return.
 A company earned $2.50 a share last year and paid a $1 dividend (40%
dividend payout). The firm has a consistent record regarding payout and
we expect it to earn $2.75 per share during the coming year. We expect
the stock to trade at $22 at the end of the coming year. Further, the risk-
free rate is 5%, the market return is 10%, and the stock’s beta is 1.2.
 ke = rf + b(E(rm) – rf ) = 5 + 1.2 (10-5) = 11%,

 D1 = E1(dividend payout) = $2.75(.4) = $1.10
V = [D1/(1+ke)1 + Stock Value1/(1+ke)1]

V = [$1.10/(1+.11)1 + $22/(1+.11)1]
V = 0.99 + 19.82 = $20.81
20
 When valuing a firm with an infinite holding period we assume that

dividends, at some point, exhibit a constant rate of growth.
 Assume that a firm is in a state of constant growth, we can value
the infinite stream of cash flows using the following abbreviated
formula:
V = D1/(ke - g)
 For instance, in our previous example let’s assume that the holding
period is infinite and the firm’s dividends are growing at 6% per
year perpetually. The dividend in one year was $1.10 and the
required rate of return was 11%.
V = $1.10/(.11- .06) = $22.00
21
 We can employ the same technique for firm’s that have varying
rates of growth by assuming that the growth rate becomes
constant, at some point.
 For instance, suppose we have a firm experiencing rapid growth
due to its position in the product cycle. At some point the growth
rate has to slow or the firm will become the market!
 We can accommodate this scenario with a multistage model by
discounting the rapid growth phase dividends individually and then
determining the terminal value using the constant growth
methodology.
V = [D1/(1+ke)1 + D2/(1+ke)2 + … + (Dn+1/(ke-g)) /(1+ke)n]
22
 Suppose that ABC Company has a current dividend of $1.00 per

share with growth expectations of 20% for each of the next two
years. After that point, the firm expects dividends to grow at 4%
each year indefinitely. Given a cost of equity of 11%, calculate the
value of the firm’s shares.
V = [D1/(1+ke)1 + D2/(1+ke)2 + V2/(1+ke)2]

where V2= D3/(ke –g)
V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2]
V = $1.08 + $1.17 + $17.39 = $19.64
23
Valuation Approach – Intrinsic Value
 DISCOUNTED CASH FLOW ANALYSIS

• Intrinsic value of the company
• Unlevered free cash flows
• Independent of capital structure
• Free cash flows generated by the assets that are available to all
capital holders
• Present value of:
(1) free cash flows and
(2) projected terminal value
• Terminal value is used to estimate value beyond the forecast period
• Exit Multiple Method (assumes the sale of the business)
• Perpetuity Growth Rate Method
(3) Discount rate = Weighted average cost of capital (WACC)
WACC = ka = wdkd(1-t) + weke
24
Discounted Cash Flow Analysis
Using the DCF technique, BAC constructed a valuation for the Company by adding the present
value of the Company's projected after-tax cash flows to the present value of the Company's
terminal value.
DCF analysis Dollars in Millions

implies the Projected FYE 12/31
Company's 2006 2007 2008 2009 2010
Enterprise Sales 500.0 469.8 499.6 531.1 565.3
Value is: -Cash COGS and SG&A 400.0 375.8 399.7 424.9 452.2
$ 589,680,386 EBITDA 100.0 94.0 99.9 106.2 113.1
-Tax Basis Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9
Operating Income 85.9 77.8 82.1 86.6 91.2
1 -Taxes 34.4 31.1 32.8 34.6 36.5 40.00%

Net Operating Profit After Taxes 51.5 46.7 49.3 52.0 54.7
+Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9

-Capex for P,P&E 17.2 17.3 17.3 17.3 17.3
-Working Capital Changes 2.2 2.1 3.5 3.4 3.8
Operating Cash Flow 46.2 43.5 46.3 50.9 55.5
Cost of Capital 12.0% 12.0% 12.0% 12.0% 12.0%

Present Value of Cash Flows 41.3 34.6 32.9 32.3 31.5
$ 1.0 $ 2.0 $ 3.0 $ 4.0 $ 5.0
Exit Multiple
Exit Multiple Valuation Method 589.7 5.5x 6.5x 7.5x
Cumulative Present Value of Cash Flows 172.7 11.0% 546.2 613.3 680.4
Present Value of Exit Price 417.0 WACC 12.0% 525.5 589.7 653.8
Enterprise Value 589.7 13.0% 505.8 567.2 628.6
Exit Multiple: 6.5x Exit Var. 1.0x

WACC: 12.0% WACC Var. 1.0%
Notes:
(1) A 40% tax rate was assumed Large Cap Co.? Y
505847.76 680423.4
25
Free Cash Flow Analysis
… ∞
FCF1 FCF2 FCF3 FCF4 FCF5 FCFn
How do we account for
the remaining cash flows
of the firm?
Terminal Value Approach

Constant Growth Method
26
Terminal Value Calculation
A. The Exit Multiple Method
27
The Present Value of the Terminal Value
1 2010 EBITDA (Terminal Value) $113.10
2 x Exit multiple 6.5x

= Pretax Sales Proceeds (future
3 value) $735.15
/ discount factor (back 5 years at
4 12%) 0.5674
5 Present value of terminal value $417.14
28
Terminal Value as % of Enterprise Value
 Provides a reality check of the DCF value
• Higher the %, more of the Enterprise Value is being

realized with the assumed sale of the business at the
end of the forecast period
• Confidence level in the 70-85% range, depending on

the company and situation
29
 How much of the Enterprise Value for the Company is

being generated by the Terminal Value?
• What is your comfort level with this percentage?
Present Value of Exit Multiple = $417

Enterprise Value = $589.7

Percentage = $417/$589.7 = 70.7%
30
Terminal Value Calculation
B. The Perpetuity Growth Method
31
 Now we’ll look at the perpetuity growth technique to

capture the terminal value of Company.
 The terminal value captures all future cash flows of the firm
assuming a constant growth factor.
 The operating cash flow of the firm in 2010 is $55.5.
Assuming a growth rate of 4% the operating cash flow in
2011 would be $57.72.
 We have a discount factor of 12% and a growth factor of
4% with a cash flow of $57.72.
32
Perpetuity Growth Formula
Terminal Value = FCFN+1

(ka - g)
where:
FCFN+1 = steady-state free cash flow in period N+1
g = nominal perpetual growth rate
ka = discount rate
Terminal Value = $55.5(1.04) =$57.72= $721.5

.12-.04 0.08
Present Value of Perpetuity Growth Terminal Value =

$721.5/(1.12^5) = $409.40
33
Relative Value Analysis
34
How do we use relative value?
 The hardest part of relative value is finding comparable

firms.
 Once you have a decent list of comparables you need to
determine which scaling variable to?
 Next, you want to compare your target firm’s multiple to the
average of the comparable set.
 Finally, make sure that you account for differences, e.g.
leverage, market position, patents, etc.
35
Comparing PE Ratios across a Sector
36
Comparing PE Ratios across a Sector
37
Relative Value
 Investors prefer to estimate the value of common stock using an

earnings multiplier model.
P0 = D1/(ke - g)
 Divide both sides by next year’s projected earnings:
P0/E1 = (D1/E1)(1/(ke - g))
 The P/E ratio (forward) is determined by:

• The expected dividend payout ratio (D1/E1)
• The required rate of return on the stock (ke)
• The expected growth rate of dividends (g)
38
Relative Value
 Assume that a firm has an expected dividend payout of 40%, a

required rate of return of 11%, and a growth rate of dividends
of 6%. Next year’s earnings (E1) are expected to be $2.75.
P0/E1 = (.40)(1/(.11-.06)) = 8.0x
 The value of the stock today is based on the P/E1 and estimate
of E1.
 P0 = P0/E1 x E1 = 8.0 x $2.75 = $22.00
39
Relative Value
 The best known measure of relative value for common stock is the
P/E ratio or the earnings multiplier.
 Analysts have also turned their attention to other measures of
relative value:
• Price/book value (P/BV) : market value of the company divided
by its book value. This metric is used a great deal with financial
stocks since many of their assets are carried at values very
close to market value. This metric can be used for firms with
negative earnings or cash flows. Several studies have
indicated that P/BV is a good indicator of future performance.
• Price/cash flow (P/CF) : market value of the company divided
by its cash flow.
• Price/sales (P/S) : market value of the company divided by its
sales.
40
Expected Growth Rate
 When a firm retains earnings and acquires assets, if it earns some positive
rate of return on these additional assets, the total earnings of the firm will
increase.
 The rate of earnings growth depends on the proportion of earnings retained
and the rate of return it earns on the new assets acquired.
 Specifically, the growth rate (g) of equity earnings without external financing
is equal to the percentage of net earnings retained (retention rate, b) times
the rate of return on equity capital (ROE).
g = (retention rate)(return on equity)

g = (b)(ROE)
 This growth rate is called the internal or sustainable growth rate.

 The firm can increase its rate of growth by 1) retaining a larger portion of its
earnings for reinvestment in the firm or 2) increasing its ROE (recall, ROE
= profit margin x total asset turnover x financial leverage).
41
Pulling it all together
 Firm XYZ is trading at $18 currently. Last year’s earnings were $2.00 per
share. The firm’s ROE is 10% and you expect it to stay that way for the
foreseeable future. The firm has a stable dividend payout policy of 40%.
The current nominal risk-free rate is 7%, the expected market return is
12% and XYZ’s beta is 1.2. Value XYZ and indicate what you should do
based on your estimate.
1. Determine required rate of return: ke = 7% + 1.2(12%-7%) = 13%

2. Determine growth rate: g = (.60)(10%) = 6%
3. Determine last year’s dividend: $2.00(.40) = $0.80.
4. Determine next year’s dividend: D1 = D0(1+g) = $0.80(1.06) = $0.85
5. Calculate the value projection: V = D1/(ke - g) = $0.85/(.13-.06) = $12.14
6. Compare the stock value to its current market price: $12.14 vs. $18.00
7. Sell recommendation.
42
Valuation Analysis
2. Overview of
Conrail Inc.
Conrail Inc.
Company Description
• Conrail, through its wholly-owned subsidiary Consolidated Rail Corporation,

provides freight transportation services within the northeast and midwest
United States. Conrail interchanges freight with other United States and
Canadian railroads for transport to destinations within and outside Conrail's
service region. Conrail operates no significant line of business other than the
freight railroad business and does not provide common carrier passenger or
commuter train service.
• Consolidated Rail Corporation is a Pennsylvania corporation incorporated on

February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization
Act of 1973, the rail properties of many of the railroads in the northeast and
midwest region of the United States which had gone bankrupt during the early
1970's, the largest of which was the Penn Central Transportation Company
("Penn Central"). The US government sold its 85% stake to the public in 1987.
44
CSX and Norfolk Southern
Analysis of Potential Acquirers
 Conrail is the ideal extension for both

into the Northeast
 “Northeast corridor” is a must for a
transcontinental railroad
 Strategic positioning with 2 major
Western rails
45
Financial Overview of Conrail
The Conrail Case Study
 Date: October 14, 1996 (pre-CSX merger announcement)

CRR Financial Information Multiple based on
as of 6/30/96 10/14/96 price of
Dollar amounts and shares in millions $71.00
LTM Revenues $3,712 2.19x
LTM EBITDA $993 8.2x
LTM EBIT $705 11.5x
Diluted Shares Outstanding (a) (b) 81.718
Market Capitalization of Equity $5,802
ESOP Preferred Stock $281
Total Debt (at book values) $2,078
Cash and equivalents $28
Enterprise Value $8,133
(a) 81.067 million common shares outstanding and 1.556 million options with an average strike of $41.28.
Option proceeds assumed to repurchase shares at current share price under the treasury stock method.
(b) Excludes ESOP junior preferred stock convertible into 9.75 million common shares.
46
3. Comparable Public
Company Analysis
“Analysis of Selected Publicly Traded Companies”
“Public Comparables”
“Trading Comparables”
“Comp Co’s”
“Common Stock Comparisons”
Comparable Public Company Analysis
Determining the Appropriate Universe
 Previous analyses of other bankers

• Industry specialists
• M&A
 Proxy Statement - “Peer group index”
 10-K / IPO Prospectus - “Competition section”
 Research (respect the Chinese Wall)
 S&P Tearsheets, Value Line, Bloomberg
 SIC code screen from FactSet
 Company’s views
48
Comparable Public Company Analysis
Public Information Checklist
1) Most recent 10-K and/or annual report

2) 10-Q from latest quarter
3) News announcements (before required
filing)
4) Research reports and EPS estimates
 Use SEC-filed documents whenever

possible
49
Valuation Analysis
What comparables
should be used to
value Conrail?
Summary of the Railroad Industry
1995 Financial Information

Name (ticker) Total Rev Rail Rev - $ Rail Rev - % Non-Rail (%-Rev) Comments
Burlington Northern $8,170 $8,170 100% BNI operates in 35 states, mostly in the
Santa Fe (BNI) western US. In September, 1995 BNI took
control of Santa Fe Pacific, making it the
second largest railroad in the US.
Canadian National C$4,100 C$4,100 100% Canadian National was owned by the
(CNI) government until late 1995 when it was
privatized. As a result of this transaction,
as well as previous governmental
ownership, its financial statements are
rather messy—eg., there are significant
NOLS, and the capital structure is strange.
Although no longer owned by the Canadian
government, CNI, as all Canadian
railroads, operates under government
regulation. CNI has some lines that
overlap with Conrail in the northeastern
US.
Canadian Pacific (CP) C$7,946 C$3,757 47% CP Ships (12%) Obviously another Canadian railroad. Note
Energy (34%) the rail and non-rail revenue percentages
Real estate (12%) exclude inter-company eliminations.
Conrail (CRR) $3,686 $3,686 100% Do you include the company you are trying
to value in the list of comparable
companies?
51

CSX (CSX) $10,504 $4,819 46% Shipping (38%) Although only 46% of CSX’s revenues are
Intermodal (9%) from rail operations, the shipping,
Barge (5%) intermodal, and barge lines are all
Real estate (2%) transportation businesses. Notwithstanding
the fact that rail is only 46% of CSX’s
revenues, rail contributes 77% of operating
income.
Florida East Coast $201 $149 74% Real estate (14%) FLA’s rail operations run the length of
(FLA) Mtr carrier (12%) Florida, along the Atlantic coast. FLA has
a unique ownership structure. It is owned
54% by St. Joe Paper Company, which is
in turn 69% owned by the DuPont family.
The DuPonts’ chief interest in FLA is its
extensive land holdings.
Illinois Central (IC) $644 $644 100% IC is a “single track” line that runs up and
down the Mississippi River. Unlike the
other large US railways, IC principally
hauls agriculture commodities, rather than
freight.
Kansas City Southern $775 $502 65% Asset mgt (31%) The rail operations run through MO, AR,
(KSU) Other (4%) TX, LA, MS, AL. The Asset Management
segment is comprised of two prominent
investment operations: the Janus and
Berger funds.
52

Norfolk Southern $4,668 $4,012 86% NAVL (14%) Its rail operations are principally in the SE
(NSC) and MW. North American Van Lines
(NAVL) is its other major segment. Rail
accounts for 94% of consolidated operating
income.
Union Pacific (UNP) $11,100 $9,874 90% Trucking (9%) The country’s largest railroad operating
Logistics (1%) throughout the western US. Recently
acquired Southern Pacific.
Wisconsin Central $263 $263 100% An extremely profitable railroad operating

(WCLX) in the upper Midwest. Also has equity,
investments in rail operations in New
Zealand and the UK.
53
Valuation Analysis
Required Analytical
Adjustments
One-Time Non-Recurring Items
Subjectivity of the Analysis
 “Normalizing” the income statement for one-time

items
• Adjust for non-recurring items (gains and losses)
 What was Conrail’s normalized 1995 income
statement?
• What adjustment needs to be made to operating income?
• What adjustment needs to be made to net income?
• What adjustment needs to be made to taxes?
55
Conrail’s 1995 Income Statement
CONRAIL INC.
CONSOLIDATED STATEMENTS OF INCOME
[CAPTION]
Years ended December 31,
----------------------------
($ In Millions Except Per Share Data) 1995 1994 1993
------ ------ ------
[S] [C] [C] [C]
Revenues $3,686 $3,733 $3,453
------ ------ ------
Operating expenses
Way and structures 485 499 492
Equipment 766 815 703
Transportation 1,324 1,379 1,283
General and administrative 370 350 384
Asset disposition charge (Note 2) 285
Early retirement program (Note 9) 84
------ ------ ------
Total operating expenses 3,230 3,127 2,862
------ ------ ------
Income from operations 456 606 591
Interest expense (194) (192) (185)
Loss on disposition of subsidiary
(Note 10) (80)
Other income, net (Note 11) 130 118 114
------ ------ ------
Income before income taxes
and the cumulative effect of
changes in accounting principles 392 532 440
Income taxes (Note 6) 128 208 206
------ ------ ------
Income before the cumulative
effect of changes in accounting
principles 264 324 234
Cumulative effect of changes in
accounting principles (Notes 1, 6 and 7) (74)
------ ------ ------
Net income $ 264 $ 324 $ 160
====== ====== ======
56
Note 2: Asset Disposition Charge
2. Asset Disposition Charge

------------------------
Included in 1995 operating expenses is an asset disposition
charge of $285 million, which reduced net income by $176 million.
The asset disposition charge resulted from a review of the Company's
route system and other operating assets to determine those that no
longer effectively and economically support current and expected
operations. The Company identified and has committed to sell 1,800
miles of rail lines that are expected to provide proceeds
substantially less than net book value. In addition, other assets,
principally yards and side tracks, identified for disposition have
been written down to estimated net realizable value.
Normalizing Conrail’s Income Statement for 1995
Reported Adjustment Normalized
Operating Income – Pretax Adjustment $456 000000000 000000000
Taxes – Incremental Tax Adjustment 128 000000000 000000000
Net Income – After-tax Adjustment 264 000000000 000000000
57
4. Comparable
Acquisition Analysis
“Analysis of Selected Acquisitions”
“Acquisition Comparables”
“Acq Comps”
“Deal Comps”
Comparable Acquisition Analysis
Determining the Appropriate Universe
 Previous analyses of other bankers

 Screen for comparable M&A transactions
• Securities Data Corp. (SDC)
• Compile “list” from SIC code screen
 Other possibilities:
• Industry newsletters, journals
• M&A journals and almanacs
• News services
• Research reports
59
Information Checklist
 Financial information
• SEC filed documents if possible
 SDC M&A summary
• Summary description of the transaction, key dates,
premiums paid
 News run
 Merger documents (if applicable)
• Form 8-K, Proxy/S-4 for pro forma financial info
 Research & EPS estimates (if applicable)
60
 Looking for comparability regarding:

• transaction size
• Nature of acquirer:
• Strategic buyer
• financial buyer
• Recent timeframe
61
Comparable Acquisition Analysis - Multiples Summary
(Dollars in Millions)
Enterprise Value as a
Effective Transaction Multiple of:
Date Target Acquiror Enterprise Value Sales EBITDA
Comparable
Industry Jun-96 CCP Holdings, Inc. Illinois Central Corp. $157 2.06x 5.3x
Transactions
Comments: CCP was a small railroad owned by three individuals.
Sep-96 Southern Pacific Union Pacific Corp. $5,500 1.74x 7.7x

Comments: This is a large, recent transaction.
May-95 Chicago & North West. Union Pacific Corp. $2,611 2.25x 8.3x
Comments: Union Pacific had owned 32% of CNW, and completed the purchase of the remaining 68%. The statistics in
the chart reflect the transaction as if the entire 100% were purchased.
Sep-95 Santa Fe Pacific Burlington Northern $5,106 1.90x 8.5x

Comments: Another large, recent transaction.
Cancelled Kansas City Southern Illinois Central Corp. $1,625 3.25x 9.0x
Comments: The transaction from mid-1994 was cancelled since the parties could not agree on how to value the asset
management businesses.
(1) Adjusted average omits the high and low values.
62
Comparable Acquisition Analysis - Multiples Summary
(Dollars in Millions)
Enterprise Value as a
Effective Transaction Multiple of:
Date Target Acquiror Enterprise Value Sales EBITDA
Comparable
Industry Sep-92 Midsouth Corp. Kansas City Southern $347 3.39x 8.8x
Transactions
Comments: The target operates rail lines in La, Miss, Ala.
Apr-90 Soo Line Corp. Canadian Pacific Ltd. $528 0.98x 7.4x
Comments: The target operates principally in the upper Midwest---Minn and Wisc.
Oct-89 CNW Corp. CNW Acquisition Corp. $1,651 1.65x 7.1x

Comments: A very successful acquisition by the Blackstone group, a major financial buyer in the US.
Jul-89 Illinois Central Rail. The Prospect Group $672 1.22x 5.8x
Comments: Another very successful LBO, this time by another prominent financial buyer, the Prospect group.
(1) Adjusted average omits the high and low values.
63
5. Discounted Cash Flow
Analysis
 In this section we will project free cash

flow for Conrail and determine the
enterprise value by discounting these
cash flows at the appropriate discount
rate.
 We will also explore the following:
• valuation using a terminal exit multiple
• valuation using a perpetuity growth formula
• valuation incorporating the effects of synergies
65
 As the title implies we will need to determine Conrail’s

cash flows.
 Typically, we will want to look at the past three years
of financials to form a basis for our projections.
 The projection period is usually five years and then
either:
• an assumed sale of the firm takes place to capture the value of all
future cash flows (exit multiple approach), or
• we value all future cash flows assuming that growth will remain
constant at a level approximately equal to the economy’s GDP
growth level (perpetuity growth approach).
66
 Since we are interested in the firm value, we will look at

unlevered after-tax cash flows to the firm.
 This allows us to view the firm value to all stakeholders, i.e.
debt, preferred, and common.
 The basic approach is to:
• project sales
• determine EBITDA
• subtract the tax deductible depreciation and amortization amounts
• subtract taxes
• adjust for non-cash expenses, capital expenditures, and working
capital needs.
67
 Let’s start with a historical look at Conrail’s cash flows:

Conrail Historical Operating Cash Flow FYE 12/31
1994 1995 1996 CAGR 1994-1996
Sales 3733.0 3686.0 3797.0 0.9%
S ales Grow th 8.1% -1.3% 3.0%
-Cash COGS an d SG&A 2766.2 2650.2 2726.2

EBITDA 966.8 1035.8 1070.8 5.2%
E B IT DA Margin 25.9% 28.1% 28.2%
-Tax Basis Depr eciat ion & Am or tization 276.2 294.9 307.6
Oper atin g In com e 690.6 740.9 763.2 5.1%
Op eratin g In come Margin 18.5% 20.1% 20.1%
-Taxes 265.9 285.2 293.8

N et Oper atin g P r ofit Aft er Taxes 424.7 455.6 469.4 5.1%
+Depr eciation & Am or t izat ion 276.2 294.9 307.6

-Capex for P ,P &E 410.6 405.5 417.7
-Wor k in g Capit al Ch an ges 15.5 42.9 26.4
Oper atin g Cash F low 274.7 302.2 332.9 10.1%
68
Discounted Cash Flow Analysis - BASE CASE
The discounted cash flow ("DCF") analysis is based on Conrail's historical performance and Wall Street research expectations.
* Sales are projected to reach $4,401 million by FY 2001 through organic growth.
Sales figures for 1997-2001 assumed 3% growth per year.
* Rail Operating Ratio falls from 79.9% in 1996E to 77.9% in 1997 and by an additional 1% per year for 1998-2001, hitting
73.9% in 2001. This operating improvement is based on Conrail's stated goal of achieving an operating ratio of 75%.
* All working capital needs are projected to support the annual growth.
* Capital expenditures are estimated to be 11.5% of revenues in 1997 and 11% for 1998-2001, in line with historical levels.
Depreciation is a reasonable estimate from the capital expenditures and existing PP&E base.
* The following table compares Conrail's historical operating results to the projections:
Historical Projected
1994 1995 1996E 1997 1998 1999 2000 2001
Revenue Growth 8.1% (1.3%) 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
Rail Operating Ratio (1) 81.5% 79.9% 79.9% 77.9% 76.9% 75.9% 74.9% 73.9%
EBITDA Margin 25.9% 28.1% 28.2% 30.2% 31.3% 32.3% 33.3% 34.3%
Operating Inc. Margin 18.5% 20.1% 20.1% 22.1% 23.1% 24.1% 25.1% 26.1%
(1) Rail Operating Ratio = Rail Operating Expenses (including depreciation) divided by Rail Revenues
69
 Additional assumptions:
• Taxes are assumed to be 38.5% of operating income.
• Working capital will be:
• -$34.0 million 1997
• -$22.1 million 1998
• -$23.1 million 1999
• -$24.3 million 2000
• -$25.6 million 2001
• Cost of capital is 11% for Conrail based on the stability of the firm’s
cash flows.
• We will use an exit multiple of 8x EBITDA in 2001 to value the sale
of Conrail. This multiple compares to an average 8.3x EV/LTM
EBITDA multiple using Comparable Acquisition Analysis.
70
71
Terminal Value
A. The Exit Multiple
Method
The Present Value of the Terminal Value
Note: Does not match the $7,177.2 on the previous page due to rounding.
74
 Provides a reality check of the DCF value

• Higher the %, more of the Enterprise Value is being realized
with the assumed sale of the business at the end of the
forecast period
• Confidence level in the 70-85% range, depending on the

company and situation
75
 How much of the Enterprise Value for the Conrail

Base Case is being generated by the Terminal Value?
• What is your comfort level with this percentage?
76
B. The Perpetuity
Growth Method
 Now we’ll look at the perpetuity growth

technique to capture the terminal value
of Conrail.
 We will combine this technique with an
analysis of the synergy benefits from a
possible Norfolk Southern or CSX
acquisition of Conrail.
78
Synergies Valuation
 Analyze for the synergy value

independently
 Determine the “DCF value with
synergies”
• Realization percentage for additional sensitivities
analysis
• What is the timing of the realization?
79
Synergies Valuation
 Terminal Value by Perpetuity Growth

Method
• Use a steady-state FCF
• Maintenance CapX (Depreciation = CapX)
• No deferred taxes
• Estimate steady-state working capital needs
80
Perpetuity Growth Formula
Terminal Value = FCFN+1

(r - g)
where:
FCFN+1 = steady-state free cash flow in period N+1
g = nominal perpetual growth rate
r = discount rate
81
Discounted Cash Flow Analysis - SYNERGIES
The Synergies valuation analysis was created to calculate the present value of the expected
net sales and operating savings benefits from a possible Norfolk Southern or CSX acquisition
of Conrail.
*Incremental revenue synergies from single line service, new coal traffic and
highway-to-railway transfers, less of losses from enhanced competition
*Operating cost savings from reduction in general and administrative, transportation, and
equipment expenses.
*Additional capital expenditures are assumed for roadway, equipment and terminals,
plus cash severance costs. Net investments avoided are assumed in years 2000 and 2001.
* Synergies are assumed to grow at 3% per year in perpetuity.
82
Discounted Cash Flow Analysis - SYNERGIES
Using the DCF technique, Bank of America constructed a valuation for the estimated syneriges of a possible Norfolk
Southern or CSX merger with Conrail.
Assumes 100% Realization

Dollars in Millions
DCF analysis Projected FYE 12/31
implies that the
1997 1998 1999 2000 2001
synergies are
Incremental Sales 227.6 544.8 881.0 907.5 934.7
worth:
-Cash Costs to Achieve Incremental Sales (186.2) (448.3) (722.4) (744.1) (766.4)
$2,794 million Net Incremental Sales 41.4 96.6 158.6 163.4 168.3
+Cost Savings 81.0 310.3 529.3 545.2 561.5

Operating Income Contribution 122.4 406.9 687.9 708.6 729.8
(1) -Taxes (47.1) (156.7) (264.9) (272.8) (281.0) 38.50%

Net Operating Profit Contribution After Taxes 75.3 250.2 423.1 435.8 448.8
-Merger Outlays & Costs / Investments Avoided (551.7) (439.7) (262.1) 34.5 34.5
Net Operating Cash Flow (476.4) (189.4) 161.0 470.3 483.3
(2) Cost of Capital 13.0% 13.0% 13.0% 13.0% 13.0%

Present Value of Cash Flows (421.6) (148.3) 111.6 288.4 262.3
$ 1.0 $ 2.0 $ 3.0 $ 4.0 $ 5.0
$ 1.0 $ 2.0 $ 3.0 $ 4.0 $ 5.0

Perpetuity Growth Rate
Perpetuity Valuation Method 2,794.4 2.5% 3.0% 3.5%
Cumulative Present Value of Cash Flows $92.4 12.0% $3,070.4 $3,250.0 $3,450.7
Present Value of Terminal Value 2,702.0 WACC 13.0% 2,653.2 2,794.4 2,950.4
Enterprise Value $2,794.4 14.0% 2,311.8 2,425.0 2,548.8
Perpetuity Growth Rate: 3.0% Growth Rate Var. 0.5%

WACC: 13.0% WACC Var. 1.0%
Notes:
(1) A 38.5% marginal tax rate was assumed. Large Cap Co.? Y
(2) A higher WACC of 13.0% was utilized give the uncertainty of synergy realization. 2311840.68 3450738.5
83
Terminal Value of the Synergies
Note: Does not match the $2,702 on the previous page due to rounding.
84
What is the Total DCF
for Conrail?
What is the Total DCF Valuation?
Base Case DCF

Conrail’s FCFs + 50% of
Synergies
$8,880 million + $1,400 million
= $10,280 million
86

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Valuation Analysis

Judson W. Russell, Ph.D., CFA

 Equity Valuation Fundamentals: Intrinsic Value

 Enterprise Valuation Fundamentals: Free Cash Flow

 Equity Valuation Fundamentals: Relative Value

 Valuation is both art and science

 Two main valuation questions:

1)What is a company worth by valuation metrics?

2) What can or will a potential buyer pay?

 Three main valuation methodologies

 Golden Rule: Footnote your assumptions

Equity Market Cap.

Enterprise Value = Equity Market Cap.

 COMPARABLE (or “similar”) in terms of:

Operations Financial Aspects

 The Graham and Dodd Approach to Security Selection

1. Study the available facts

 The top-down approach starts with Analysis of Alternative

 The top-down analysis for a U.S. homebuilder:

 Sales will increase by 15% versus the industry average of

 The value of an asset is the present value of its expected returns.

 The process of valuation requires estimates of (1) the stream of

 The value of a preferred stock (perpetuity) is simply the stated

 A preferred stock with an $8 per year dividend and required return of

 The valuation of common stock is more difficult than

 However, the value of common stock is still the present

 A model to value common stock is the dividend

 The DDM assumes that the value of a share of

V = [D1/(1+ke)1 + D2/(1+ke)2 + … + D/(1+ke)]

 Since estimating D is impossible, other methods have

 ke = rf + b(E(rm) – rf ) = 5 + 1.2 (10-5) = 11%,

V = [D1/(1+ke)1 + Stock Value1/(1+ke)1]

 When valuing a firm with an infinite holding period we assume that

V = $1.10/(.11- .06) = $22.00

V = [D1/(1+ke)1 + D2/(1+ke)2 + … + (Dn+1/(ke-g)) /(1+ke)n]

 Suppose that ABC Company has a current dividend of $1.00 per

V = [D1/(1+ke)1 + D2/(1+ke)2 + V2/(1+ke)2]

V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2]

V = $1.08 + $1.17 + $17.39 = $19.64

 DISCOUNTED CASH FLOW ANALYSIS

DCF analysis Dollars in Millions

1 -Taxes 34.4 31.1 32.8 34.6 36.5 40.00%

+Depreciation & Amortization 14.1 16.2 17.8 19.6 21.9

Cost of Capital 12.0% 12.0% 12.0% 12.0% 12.0%

Exit Multiple: 6.5x Exit Var. 1.0x

Terminal Value Approach

A. The Exit Multiple Method

1 2010 EBITDA (Terminal Value) $113.10

2 x Exit multiple 6.5x

5 Present value of terminal value $417.14

 Provides a reality check of the DCF value

• Higher the %, more of the Enterprise Value is being

• Confidence level in the 70-85% range, depending on

 How much of the Enterprise Value for the Company is

Present Value of Exit Multiple = $417

B. The Perpetuity Growth Method

 Now we’ll look at the perpetuity growth technique to

Terminal Value = FCFN+1

Terminal Value = $55.5(1.04) =$57.72= $721.5

Present Value of Perpetuity Growth Terminal Value =

 The hardest part of relative value is finding comparable

 Investors prefer to estimate the value of common stock using an

 Divide both sides by next year’s projected earnings: