Prof. Ian Giddy New York University Valuation IBM.
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Transcript of Prof. Ian Giddy New York University Valuation IBM.
Prof. Ian GiddyNew York University
Valuation
IBM
Copyright ©2000 Ian H. Giddy Valuation 3
What’s a Company Worth?
Required returns Types of Models
Balance sheet modelsDividend discount modelsCorporate cash flow modelsPrice/Earnings ratios
Estimating Growth Rates Application
IBMIBM
Copyright ©2000 Ian H. Giddy Valuation 4
Equity Valuation: From the Balance Sheet
Value of Assets Book Liquidation Replacement
Value of Liabilities
Book Market
Value of Equity
Copyright ©2000 Ian H. Giddy Valuation 5
Equity Valuation: From the Balance Sheet
Value of Assets Book Liquidation Replacement
Value of Liabilities
Book Market
Value of Equity
Book ValueLiquidation
ValueReplacement
ValueTobin’s Q:
Market/Replacement tends to 1?
Copyright ©2000 Ian H. Giddy Valuation 6
Estimating Future Cash Flows
Dividends? Free cash
flows to equity?
Free cash flows to firm?
Copyright ©2000 Ian H. Giddy Valuation 7
Cash Flow to Firm
Claimholder Cash flows to claimholder
Equity Investors Free Cash flow to Equity
Debt Holders Interest Expenses (1 - tax rate)
+ Principal Repayments
- New Debt Issues
Preferred Stockholders Preferred Dividends
Firm = Free Cash flow to Firm =
Equity Investors Free Cash flow to Equity
+ Debt Holders + Interest Expenses (1- tax rate)
+ Preferred Stockholders + Principal Repayments
- New Debt Issues
+ Preferred Dividends
Copyright ©2000 Ian H. Giddy Valuation 8
Relative Valuation
Do valuation ratios make sense?• Price/Earnings (P/E) ratios
and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios and variants (Tobin's Q)
• Price/Sales ratios
It depends on how they are used -- and what’s behind them!
Copyright ©2000 Ian H. Giddy Valuation 9
Disney: Relative Valuation
Company PE Expected Growth PEGKing World Productions 10.4 7.00% 1.49Aztar 11.9 12.00% 0.99Viacom 12.1 18.00% 0.67All American Communications 15.8 20.00% 0.79GC Companies 20.2 15.00% 1.35Circus Circus Enterprises 20.8 17.00% 1.22Polygram NV ADR 22.6 13.00% 1.74Regal Cinemas 25.8 23.00% 1.12Walt Disney 27.9 18.00% 1.55AMC Entertainment 29.5 20.00% 1.48Premier Parks 32.9 28.00% 1.18Family Golf Centers 33.1 36.00% 0.92CINAR Films 48.4 25.00% 1.94Average 27.44 18.56% 1.20
PE ratio divided
by the growth rate
Copyright ©2000 Ian H. Giddy Valuation 10
Discounted Cashflow Valuation: Basis for Approach
where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the
riskiness of the estimated cashflows
Value = CFt
(1+ r)tt =1
t = n
Copyright ©2000 Ian H. Giddy Valuation 11
Start with theWeighted Average Cost of Capital
Choice Cost1. Equity Cost 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. Debt Cost 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
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©2000 Ian H. Giddy Valuation 12
Valuation: The Key Inputs
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.
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:
Value = CF
t
(1+ r)tt = 1
t =
Value = CFt
(1 + r)t
Terminal Value
(1 + r)N
t = 1
t = N
Copyright ©2000 Ian H. Giddy Valuation 13
Dividend Discount Models:General Model
VD
ko
t
tt
( )11
VD
ko
t
tt
( )11
V0 = Value of Stock Dt = Dividend k = required return
Copyright ©2000 Ian H. Giddy Valuation 14
Specified Holding Period Model
01
12
2
1 1 1V D
kD
kD P
kN N
N
( ) ( ) ( )...
PN = the expected sales price for the stock at time N
N = the specified number of years the stock is expected to be held
Copyright ©2000 Ian H. Giddy Valuation 15
No Growth Model
VD
ko
Stocks that have earnings and dividends that are expected to remain constant
Preferred Stock
Copyright ©2000 Ian H. Giddy Valuation 16
No Growth Model: Example
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
VD
ko
Burlington Power & Light has earnings of $5 per share and pays out 100% dividend
The required return that shareholders expect is 15%
The earnings are not expected to grow but remain steady indefinitely
What’s a BPL share worth?
Burlington Power & Light has earnings of $5 per share and pays out 100% dividend
The required return that shareholders expect is 15%
The earnings are not expected to grow but remain steady indefinitely
What’s a BPL share worth?
Copyright ©2000 Ian H. Giddy Valuation 17
Constant Growth Model
VoD g
k g
o
( )1Vo
D g
k g
o
( )1
g = constant perpetual growth rate
Copyright ©2000 Ian H. Giddy Valuation 18
Constant Growth Model: Example
VoD g
k g
o
( )1Vo
D g
k g
o
( )1
E1 = $5.00b = 40% k = 15%
(1-b) = 60% D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend
The required return that shareholders expect is 15%
The earnings are expected to grow at 8% per annum
What’s an M6 share worth?
Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend
The required return that shareholders expect is 15%
The earnings are expected to grow at 8% per annum
What’s an M6 share worth?
Plowback rate
Copyright ©2000 Ian H. Giddy Valuation 19
Estimating Dividend Growth Rates
g ROE b g ROE b
g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate
i.e.(1- dividend payout percentage rate)
Copyright ©2000 Ian H. Giddy Valuation 20
Or Use Analysts’ Expectations?
Copyright ©2000 Ian H. Giddy Valuation 21
Shifting Growth Rate Model
V Dg
k
D g
k g ko o
t
tt
TT
T
( )
( )
( )
( )( )
1
1
1
1
1
1
2
2V D
g
k
D g
k g ko o
t
tt
TT
T
( )
( )
( )
( )( )
1
1
1
1
1
1
2
2
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1
Copyright ©2000 Ian H. Giddy Valuation 22
Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Shifting Growth Rate Model: Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3
+ D4 / (.15 - .05) ( (1.15)3
V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
Copyright ©2000 Ian H. Giddy Valuation 23
Stable Growth and Terminal Value
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
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.
While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time.
When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.
Copyright ©2000 Ian H. Giddy Valuation 24
Choosing a Growth Pattern: Examples
Company Valuation in Growth Period Stable Growth
Disney Nominal U.S. $ 10 years 5%(long term Firm (3-stage)nominal
growth rate in the U.S. economy
Aracruz Real BR 5 years 5%: based upon Equity: FCFE (2-stage)
expected long term real growth rate for Brazilian economy
Deutsche Bank Nominal DM 0 years 5%: set equal to Equity: Dividends nominal
growth rate in the world
economy
Copyright ©2000 Ian H. Giddy Valuation 25
The Building Blocks of Valuation
Choose aCash Flow Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Net Income
- (1- ) (Capital Exp. - Deprec’n)
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE)
[ = Debt Ratio]
Cashflows to Firm
EBIT (1- tax rate)
- (Capital Exp. - Deprec’n)
- Change in Work. Capital
= Free Cash flow to Firm (FCFF)
& A Discount Rate Cost of Equity
Basis: The riskier the investment, the greater is the cost of equity.
Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
Cost of Capital
WACC = ke ( E/ (D+E))
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
& a growth pattern
t
g
Stable Growth
g
Two-Stage Growth
|High Growth Stable
g
Three-Stage Growth
|High Growth StableTransition
Copyright ©2000 Ian H. Giddy Valuation 26
The Building Blocks of Valuation
Choose aCash Flow Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Net Income
- (1- ) (Capital Exp. - Deprec’n)
- (1- ) Change in Work. Capital
= Free Cash flow to Equity (FCFE)
[ = Debt Ratio]
Cashflows to Firm
EBIT (1- tax rate)
- (Capital Exp. - Deprec’n)
- Change in Work. Capital
= Free Cash flow to Firm (FCFF)
& A Discount Rate Cost of Equity
Basis: The riskier the investment, the greater is the cost of equity.
Models:
CAPM: Riskfree Rate + Beta (Risk Premium)
APM: Riskfree Rate + Betaj (Risk Premiumj): n factors
Cost of Capital
WACC = ke ( E/ (D+E))
+ kd ( D/(D+E))
kd = Current Borrowing Rate (1-t)
E,D: Mkt Val of Equity and Debt
& a growth pattern
t
g
Stable Growth
g
Two-Stage Growth
|High Growth Stable
g
Three-Stage Growth
|High Growth StableTransition
Spreadsheet example
Equity Valuation:Two Applications
Prof. Ian GiddyNew York University
Copyright ©2000 Ian H. Giddy Valuation 28
Equity Valuation in Practice
Estimating discount rate Estimating cash flows Estimating growth Application with constant growth: Optika Application with shifting growth: Fong
Copyright ©2000 Ian H. Giddy Valuation 29
Optika OptikaGrowth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt spread 1.5%Market risk premium 5.50%
T+1Revenues 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187-Change in WC 16=Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%
Firm Value 2278
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
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)
Copyright ©2000 Ian H. Giddy Valuation 31
Valuation Example
Fong Industries (Pte) Ltd SingaporeProfit & Loss (S$'000)FYE 30 Jun 1994 1995 1996 1997 1998 1999
Turnover 9,651 57,888 125,010 120,323 136,003 134,813
Directors' Fees & Rem 107 249 368 820 961 964Amortisation 0 269 279 280 35 39Depreciation 639 1,041 1,277 3,812 4,673 4,494Interest Expense 227 445 615 1,002 1,078 697Bad Debts W/O 100Fixed Assets W/O 4 543 27FX loss 85 282
Profit b/f Tax 933 1,990 838 1,250 3,774 6,897
Assoc Co (74) 37 (14)
933 1,990 838 1,176 3,811 6,883
Tax 3 96 292 929 178
Profit a/f Tax 930 1,990 742 884 2,882 6,705
Effective Tax Rate 0.32% 0.00% 11.46% 24.83% 24.38% 2.59%
EOI 7,292 (768) (7) (156)
EBITDA 1,799 3,745 108.17% 3,009 -19.65% 6,270 108.37% 9,597 #### 12,113ISC 792.51% 841.57% 489.27% 625.75% 890.26% 1737.88%
Fong Industries (Pte) Ltd SingaporeProfit & Loss (S$'000)FYE 30 Jun 1994 1995 1996 1997 1998 1999
Turnover 9,651 57,888 125,010 120,323 136,003 134,813
Directors' Fees & Rem 107 249 368 820 961 964Amortisation 0 269 279 280 35 39Depreciation 639 1,041 1,277 3,812 4,673 4,494Interest Expense 227 445 615 1,002 1,078 697Bad Debts W/O 100Fixed Assets W/O 4 543 27FX loss 85 282
Profit b/f Tax 933 1,990 838 1,250 3,774 6,897
Assoc Co (74) 37 (14)
933 1,990 838 1,176 3,811 6,883
Tax 3 96 292 929 178
Profit a/f Tax 930 1,990 742 884 2,882 6,705
Effective Tax Rate 0.32% 0.00% 11.46% 24.83% 24.38% 2.59%
EOI 7,292 (768) (7) (156)
EBITDA 1,799 3,745 108.17% 3,009 -19.65% 6,270 108.37% 9,597 #### 12,113ISC 792.51% 841.57% 489.27% 625.75% 890.26% 1737.88%
Copyright ©2000 Ian H. Giddy Valuation 32
Valuation Example
Fong IndustriesGrowth1 25% for 3 yearsGrowth2 5% thereafterTax 25% effective
Revenue 134,813 (S$'000); T0
Expenses 91.01% of Revenue
EBIT 7,580 (S$'000)WC 10% of Revenue (unlevered) 1.06 (levered) 1.09
Kd 5.50%
MVe 218,993 (S$'000) PERMkt 32.66
MVd 7,379 (S$'000)
Combined 226,372 (S$'000)
Rm 12.00%
Rf 4.00%
Ke 12.69%
WACC 12.41%
Fong IndustriesGrowth1 25% for 3 yearsGrowth2 5% thereafterTax 25% effective
Revenue 134,813 (S$'000); T0
Expenses 91.01% of Revenue
EBIT 7,580 (S$'000)WC 10% of Revenue (unlevered) 1.06 (levered) 1.09
Kd 5.50%
MVe 218,993 (S$'000) PERMkt 32.66
MVd 7,379 (S$'000)
Combined 226,372 (S$'000)
Rm 12.00%
Rf 4.00%
Ke 12.69%
WACC 12.41%
T1 T2 T3 T4
Revenue 168,516 210,645 263,307 276,472-Expenses 153,375 191,719 239,648 251,631-Depreciation 4,533 4,533 4,533 4,533EBIT 10,608 14,394 19,125 20,308EBIT(1-t) 7,956 10,795 14,344 15,231+Depreciation 4,533 4,533 4,533 4,533-CapEx 4,533 4,533 4,533 4,533-Change in WC 3,370 4,213 5,266 1,317FCFF 4,586 6,582 9,078 13,915
187,6554,586 6,582 196,733
Firm Value 147,773Equity Value 140,394 $0.65
PERcomputed 20.94
T1 T2 T3 T4
Revenue 168,516 210,645 263,307 276,472-Expenses 153,375 191,719 239,648 251,631-Depreciation 4,533 4,533 4,533 4,533EBIT 10,608 14,394 19,125 20,308EBIT(1-t) 7,956 10,795 14,344 15,231+Depreciation 4,533 4,533 4,533 4,533-CapEx 4,533 4,533 4,533 4,533-Change in WC 3,370 4,213 5,266 1,317FCFF 4,586 6,582 9,078 13,915
187,6554,586 6,582 196,733
Firm Value 147,773Equity Value 140,394 $0.65
PERcomputed 20.94
Equity Valuation:Alternatives
Prof. Ian GiddyNew York University
IBM
Copyright ©2000 Ian H. Giddy Valuation 34
What’s a Company Worth?Alternative Models
The options approachOption to expandOption to abandon
Creation of key resources that another company would pay forPatents or trademarksTeams of employeesCustomers
Examples?
Lycos
Lycos
Messageclick.com
Messageclick.com
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
Copyright ©2000 Ian H. Giddy Valuation 36
The Value of a Corporate Option
Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today.
The value of these rights increases with the volatility of the underlying business.
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.
Copyright ©2000 Ian H. Giddy Valuation 37
Application
Copyright ©2000 Ian H. Giddy Valuation 38
An Example of a Corporate Option
J&J is considering investing $110 million to purchase an internet distribution company to serve the growing on-line market.
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.
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.
This uncertainty is what makes the corporate venture valuable!
Copyright ©2000 Ian H. Giddy Valuation 39
Valuing the Corporate Venture Option
The corporate option would cost an expected $15 million. But what is it worth to J&J?
Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million
Strike Price (K) = cost of expansion into global on-line selling = $125 Million
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
Time to expiration = Period for which “venture option” applies = 2 years
2-year interest rate: 6.5%
Copyright ©2000 Ian H. Giddy Valuation 40
Option Pricing
94.5
Option Price
= Intrinsic value + Time value
Option Price
Underlying
Price94.75
Time value depends on Time Volatility Distance from the strike price
Time value depends on Time Volatility Distance from the strike price
Copyright ©2000 Ian H. Giddy Valuation 41
Value of Call Option
INTRINSIC VALUE TIME 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.
Copyright ©2000 Ian H. Giddy Valuation 42
Black-Scholes Option Valuation
Call value = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 - (T1/2)
whereSo = 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.
Copyright ©2000 Ian H. Giddy Valuation 43
Valuing the Corporate Venture Option
Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million
Strike Price (X) = cost of expansion into global on-line selling = $125 Million
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
Time to expiration = Period for which “venture option” applies = 2 years
2-year interest rate: 6.5%
Call Value = 100 N(d1) -125 (exp(-0.065)(2)) N(d2) = $ 24.2 Million
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?
Copyright ©2000 Ian H. Giddy Valuation 49
Ian H. Giddy
NYU Stern School of Business
44 West 4th Street
New York, NY 10012, USA
Tel 212-998-0563; Fax 917-463-7629
http://giddy.org