First Edition rege Corporate Valuation Theory, Evidence & Practice ROBERT W. HOLTHAUSEN The Wharton School, University of Pennsylvania MARK E. ZMIJEWSKI The University of Chicago Booth School of Business 0 Cambridge BUSINESS PUBLISHERS| Brief Contents - ee Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter 10 " 12 13 14 15 16 7 Introduction To Valuation. Financial Statement Analysis Measuring Free Cash Flows Creating a Financial Mode! ‘The Adjusted Present Value and Weighted Average Cost of Capital Discounted Cash Flow Valuation Methods : “Measuring Continuing Value Using the Constant-Growth Perpetuity Model ‘The Excess Earnings Valuation Method .. Estimating the Equity Cost of Capital Measuring the Cost of Capita fr Debt and Preferred Securities ‘The Effects of Financial Leverage on the Cost of Capital Measuring the Weighted Average Cost of Capital and Exploring Other Capital Structure Issues Option Pricing Model Applications to Valuation issues Introduction to Market Multiple Valuation Methods Market Multiple Measurement and implementation Leveraged Buyout Transactions Mergers and Acquisitions Valuing Businesses Across Borders 30 80 . 126 164 210 250 284 382 - 420 . 472 - 808 544 600 668 72Contents ‘About The Authors. fi Preface lv Bret Contents xv INTRODUCTION 4 Resources 6 ‘The Economic Balance Sheet Doss Ne 1.9 Valuation Principles 9 Valuation Using Apple Inc. 11 44 Measuring The Value Of The Firm 4 Different Forms ofthe Discounted Cas (OCF Valuation Models 13, Market Mutiple Valuation Models 14 Leveraged Suyout Valuation Models 1.8 Real Options n Valuation 17 1.7 How Managers And investors Use Vs Control Transactions 18 ‘Asset and Financial Restructuring Acti ising Capital 23, Investors and Employees 24 ‘Summary and Key Concepts 22, Additional Reading and References 27 Exercises and Problems 27 Solutions for Review Exercises 28 Example Economic Balance Shoet 6 ft Equal the Accounting Balance Sheet 6 Introduction to Measuring Free Cash Flows. The Discounted Cash Fiow Valuation Model 10 lWustraton ofthe Discounted Cash Flow 3 h Flow “The Discounted Excess Flow Valuation Models 14 16 \ 1.5 Measuring The Valuo Of The Firm's Equity 16 luation Modole ites 20 Strategic Analysis and Value-Based Management 24 Contracts Betwoen a Company and ts Regulatory and Legal Uses of Valuation 25 entiying Over- and Undervalued Secures. 25 1.8 An Overview Of The Valuation Process 26 si Introduction to Valuation 2 1.4 What Do We Mean By “The Value Of A Company"? 4 412 The Economic Balance Sheet: Resources Equal Ciaims On ® ; Financial Statement Lien Analysis 30 INTRODUCTION. 2 2.4 Sources OF Information 93 Information About Company 93 Information About an Industry 94 Privately Held (Owned) Companies 95 2.2 How We Use Financial Ratios In Valuation 95 Competitive Analysis 25, Measuring the Debt and Profered Stock Costs of Capital 95 Preparing (Orving) and Assessing the Reasonablenoss of Financial Forecasts 96 ‘Assessing the Degree of Comparabilty in Market Multiple Valuation 36 Constraints and Benchmarks in Contacts. 96 2. Identitying A Company’ Industry And its Comparable Companies. 87 2.4 °The Gap, Ine.—An Iilustration Of The Cel ‘Analysis Of Financial Ratios 38 2.5 Measuring A Company's Performance Using Accounting Rates'OF Return 40 a Retumon Assets 40 Return on Investment 41 Return on (Common) Equity 42 ‘Adjusting Financial Ratios for Excess Assets 42 ‘Alternative Ways to Measure Financial Ratio Inputs 43, Limitations of Accounting Rates of Return as Measures of Performance 43, 26 Disaggrogating The Roturn On Assets 44 Disaggregating the Ratu on Assets 44 Relation Between the Return on Asset Components 45 How Does GAP Perform Relative to Other Companies in ts Industry? 46 2.7 Measuring A Company's Cost Structure Using Expense Ratios 47, The Gap, Inc's Expense Ratios 48 2.8 Analyzing A Company's Asset Utlization Using Turnover Ratios 49 29 Summary OF Disaggrogating The Gap, In.’s Rates Of Return 50 2.10 Analyzing A Company's Working Capital Management 51 lation AndContents xvil oty to Pay Curent bites $1 ‘ne Bob Adare’ Uloveed Fre Cash Flows 65 Inventories, seveunts Paco, Resour Pye, ov Adres Egy Foo Gash Pow 87 ro Te Cash Cyto Rats 22 ecceseeeaRBSeh Poweeo Crangein Cash Balance 68 £214 Analyzing A Companys Fixe Asst Sucre And Capt 3: Cash Flow Statoment Basics 69 Enpenatres Bt “re Agora Undornig tw Cath Few Statovent 69 Depa Le (e) Ung he Gash Po Sater to Measure Cepia Exper 58 Gre Gash ows ot 2:12 other Types Of Francia Statement Relations roth, ‘he Bob Ara Company Raves 91 Sende'Per Shure Per ipfoyee And Per Unt Ot Copecly 3.4 ecering Surtuoty’ Fee Cosh Row 94 And Output 55 Measuring Starbucks’ Unievered Free Cash Flow 95 Employ, Unt of Capac and Unt of Ouput Measues 5 Nequrng Status Equly Fee Cash Flow 7 Groh Rates an and Araes 55 Facoctng Sabo Eauly Mee Gash Pow Porshe Measures. 58 ‘ots Onangoin Cah Blanco. 97 2:49 anaying ACompany'Fnanll Leverage And Financlel_—_Calating Src Fee Cath Fw Using oes the Cush Pow Stated 20 Nsupent ses What sbi? $8 Using Ssh Powe Franca! Aaj andVakaton $8 Coverage Rao 89 35 Overiow Of ncome Tax Issues 100 U5. Sects and Exchange Commission 61 oranert Otfenee Dtweeh Book 2.44 Dsaporogatng The Return On (Common) Equity 61 nat Aecoutng ao 2:18 Assessing Competiive Advantage 62 ‘Temporary Differences Between Book ‘and Tax Accounting 101 Example ofa Detered Tax Labilty Resulting ‘rom Depreciation 102 Overview of the Modified Accelerated Cost Achieving and Sustaining Compotitve Advantage 64 pete Dareeperary Identitying the Source of Competitive Advantage 64 Oates reece ee ie ‘Assessing the Sustanablly of Competitive Advantage 65 Seer Laie Fort Howard Corporation 65, Cost Leadership 2s a Competitive Advantage 63 Differentiation as a Competitive Advantage 63 ‘Strategic Positioning 84 {3.6 Undorstanding And Analyzing Income Tax Disclosures 105, Nike, Inc, 68 ‘Analysis of Income Tax Disclosures 108, 2.16 Implementation And Measurement issues 69 ‘Measuring the Income Tax Rate Used on the Tax Forms 107 Some Basie Mensurement Files 69 Identifying the Diferences Between Book Financial Inflation Adjustments. 69 Statements and Tax Records 108 Seasonality. 70 8.7 Net Operating Loss Carrforwards 108 Net Operating Loss Caryforvards Are Common 100 Different Fiscal Yearends 70 ‘The George Conrades Company (Conrades) Example 110 Adjusting the Data for Infuetial Observations (Outlers) 70 rere er aes ae Caves Negative Danominators. 71 ‘on Inorest Tax Shiokés 111 Hie ete cl Accomert| C1 ‘Summary and Key Concepts 114 “Quality” ofthe Financial Disclosures 71 eran a ney Cone 1 ‘Additional Reading and References summary and Key Concepts 72 ne ee Exercises and Problems 114 Additional Reading and References. 72 es Exerolees and Probloms 72 ohutlons for Review Exerc Solutions for Review Exercises. 78 Quarter Data 70 Creating a Financial Measuring Free Model 124 Cash Flows 80 INTRODUCTION 125 \n Overview Of The Process OF Creating A Financial maieroaie 41 An Oven OFThe Process Of Creating AF ‘9.1 Introduction To Measuring Free Cash Flows 82 ‘Steps in the Process of Creating a Financial Model 127 Measuring (Unlevere) Free Cash Flows (FOF8) 63 Tecra naeeaaiiial Measuring Equty Free Cash Flows FCF) 63 Real or Nominal Cash Fow Forecasts 120 How Issuing and Repaying Debt Affects ‘Choice of Horizon for Explicit Yeer-by-Year Gash Flows 128 uty Fee Cash Flows 64 “Timing of Cash lowe Within a Year 128 ‘32 The Bob Adams Company Example 85 4.2 Forecasting Starbucks Corporation (Starbucks) 120__—e vi Contents 4.9 Selecting And Forecasting The Forecast Drivers For The ‘Company's Operations (Steps 2 And 3). 191 Forecast Drivers forthe Staroucks Corporation Financial Model 133 ‘44 Creating A Financlal Model For The Company's Operations (Step 4) 135 ‘Starbucks’ income Statement Forecasts-—Part 1 195, Not All items Dopend Solely on Revenvas 136 Starbucks’ Property, Plant, and Equipment Forecasts 138 ‘Starbucks! Income Statement Forecaste—Part 2. 198 Starbucks’ Balance Sheet Forecasta—Part 1 139 Don't Plug Up Your Financial Mode! 139 ‘Starbucks’ Cash Flow Statoment Forecaste—Part 1140 Starbucks’ Free Cash Fiow Forecasts 141 Completing Retained Earnings, Balance Sheet ans (Cash Flow Statement—Part 2. 143 45 Stross Testing The Model And Assessing The Reasonableness Of The Forecasts (Step 5 And 6) 143 (Checking and Stress Testing tho Modsl—Step 5 143 ‘Step Back and Ask, "Do the Forecasts Mako Senso?"—Step 6, Par 144 Comparing Historical Financial Ratios tothe Financial Fats Based on the Forecasts-Step 6, Part 2.144 ‘Agsessing the Reasonableness ofthe Forecasts for the Staroucks Corporation’ Operations 145 46 incorporating The Company's Capital Structure ‘Strategy 140 Incorporating an Atornative Capital Statogy In the Flancial Model 148 47 Sensitivity And Scenario Analyses And Simulations 148 4.8 Accumulating Excess Cash 148 ‘49 Forecasting Revenues And Capital Expenditures 160 ‘The Price and Quantity Components of the venue Growth Rate 150 ‘Adjusting Growth Rates fo inflation 151 Potentil Forecast Drivers for Revenues and Capita Expenditures. 151 Potential Forecast Drivers for Capital Exgencitures (and Property, Part, and Equipment) 152 tstration of a More Detailed Revenue Forecast. 153 stration of More Detailed Capital Expenditure ‘and Depreciation Forecasts 154 ‘Summary and Key Concepts 186 Additional Reading and References 156 Exercises and Problems 156 ‘Solutions for Review Exerciees 159 The Adjusted Present Value and Weighted Average Cost of Capital Discounted Cash Flow Valuation Methods 164 INTRODUCTION 106 SE 5.1 Creating Value From Financing 167 -~ Insghts trom Miler and Mocigan\ ang Others 167 ‘The Single investor Company 168 Countervaing Forces 171 5.2 The Adjusted Present Value And Weighted Average Cc ‘Capital Valuation Models 173, ‘Adjusted Present Value (APV) Method 173 Weighted Average Cost of Capital(WACC) Method 17% Calculating the Weightod Average Cost of Captal 174, ‘53 The Link Botwoen The Unlovered, Equity, Debt, And Preferred Stock Costs Of Capital 175 5.4 The Adjusted Present Value And Weighted Average Cos Capital Methods Are Not Substitutes 176 ‘55 The Andy Alper Company 177 Which Valuation Method Oo We Use to Value ‘Andy Alper Company? 177 ‘Adjusted Present Value Valuation 178 Capital Structure Ratios, Equity Cost of Capital, and Weigh ‘Average Cost of Capital implicit in the Adjusted Prese, Value Valuation of Andy Alper Company. 178 ‘Aterative Capital Stucture Assumption for the Andy Alper Company 180, 5.6 The Discounted Equity Free Cash Flow Valuation Method 181 Valuing Common Equty by Fist Measuring ‘the Value ofthe Fim 182 Valuing the Equity Directly Using the Equity Discountod Cash Flow Method 182 Equity Discounted Cash Flow Node forthe Andy Alper Company 183, ‘Complextes and Limitations of the Equity Discounted Cash Flow Method 163 ‘Assumption About Distributing Equity Free ‘Cash Flows to Equtyholders 184 6.7 The Discounted Dividend Valuation Model 185 6.8 Implementation Details 186 ‘The Vaiue of the Fem is Net of Its Currant Non- Interest-Bearing Operating Lebilties 105 Using Nominal or Real (hifation-Acjusted) Cash Flows and Discount Rates 187 Tne Concept of Expected Free Cash Flows 188 ‘The Risk-Adjusteg Discount Rate (Cost of Canta) 190, Certainty Equivalent Aopreach 191 Don't Use “Fudge Factors” 192 5.9 Comprehensive Example—Dennie Koller Inc. 198 ‘Dennis Kel, In.'s—20%% Debt Capital Structure Valuation Using the Weighted Average Cost of Capita Mathod | 194 $20 Mition Debt Capital Structure Valuation Using the Adjusted Prosent Value Method 104 Forecast for Keir with the $20 Millon Debt Capital Structure 195) ‘Adjusted Present Value Valuation of Koll withthe ‘$20 Millon Debt Capital Structure 198 How Can Keller Greate So Much Value by Using Dobt Financing? 197 Using the Adjusted Present Value Method as a "Consistency (Check’-~20% Debt Capital Stucture 199 Using the Weighted Average Cost of Capital “Method as a “Consistency Check™—~$20 Millon Dset Capital Sructure 199 Keller Inc.'s Valuation Using the Equity Discounted (Cash Flow Valuation Method 201 Using the Equity Discounted Cash Flow Method ‘or the 20% Debt Capital Stucture 202Equity Discounted Cash Flow Method for the $20, Millon Osbt Capital Structure 208 ‘The Equity Discounted Cash Flow Valuation Modol ‘Also Serves as a "Consistency Check” 208, ‘Summary and Key Concepts 203 ‘Adtional Reading and References 204 Exercises and Problems 204 Solutions for Review Exercises 208 cnarren Measuring Continuing Value Using the Constant-Growth Perpetuity Model 210 INTRODUCTION 212 8:1 Yahoo! Ine. 213 6.2 The Constant-Growth Perpetuty Model 215 Using the Free Cash Flow in Year Zero FOF.) 215 \Whon We Gan Apply the Cash Flow Perpetulty Mode!—A Company in Steady State. 216 ‘adional Considerations Companies In Gyelcal Inustiies 216 3 How Important ls The Continuing Value Component Of A ‘Company's Total Value? 217 Propostio of Tot! Value Resulting fom Continuing Value 217 ‘Yahoo's Continuing Value as @ Percentage ofits Total Value 218 Does an infinite Horizon Really Mean the Company Exists Forever? 218, {6.4 The Presont Value Woighted Average Growth Rate 219 ‘Yahoo's Present Value Weighted Average Growth Rate 220, Growth Rate Using Five Years of Free ‘Cash Flow Forecasts 221 Two-Stage Growth Rates. 222 {65 Measuring The Base Year Cash Flow For The Porpetulty 224 Preparing the Base Year Cash Flow forthe Assumed Constant Perpetuity Growth Rate 225 ‘Yahoo's Revenue and Free Cash Flow Growth Rates 227 6 Capital Expenditure And Depreciation Issues 227 “Lumpy” Capital Expenditures Resurt in “Lumpy” Free Gash Flows 228 Depreciable Life Difors trom the Economic Useful Lite 231 Pelationship Between Captal Expenditures ‘ang Depreciation 252 “Tho Flationship Botwoon CAPEX and Deprociation Inthe Yahoo Example 233 7 The Constant Growth Rate And Value Creation 253 [A Constant Growth Rate Equa oInftion (Wo Real Growth) 234 eal Groth from New Investment Can Decrease the Value ofthe Firm 235 How Do We Judge the Reascnableness of FOI In the Base Year Cash Flow? 237 ‘ce Yahoo's No Real Growih Forecasts Reasonable? 238 Yatoo with Naw investments as ofthe Continuing Value Date 239 Contents xe (68 Testing The Ressonableness Of The Continuing Value 240 Using Comparabie Companies to Assess tho Long- “err P&potl Growth Rate 240 UsiagégstBifiples to Adsess the Reasonablenass Ghthe Continuing Value 242 Yahoo's implied Market Mtples 249 Summary and Key Concepts. 243 ‘Additional Reading and References 244 Exercises and Problems 244 Solutions for Review Exercises 247 The Excess Earnings Valuation Method 250 INTRODUCTION. 252 7.1 The Basic Framework 252 Excess Free Cash Flow Form 259 An Exoess Returns Presentation of the ‘Excess Flow Model 254 7.2 The Excess Accounting Earnings Method 254 Exooss Earnings Model—Part 1—General Form of the Excess Free Cash Flow Model 255 Excess Earnings Model~Part 2—Excess Operating Gash Flow Model 255 Excess Earnings Model—Part 3—The Excess (oe Residual) Earnings Mode! 257 Extending the J. Stern Company Example to the Excess Earnings Veluation Method 258. Summary 259 ‘The Articulation of the Income Statement ‘and the Balance Sheet 260 7.8 The Weighted Average Cost Of Capital Form Of The Model 251 Dennis Keller, In. Revisited Weighted Average Cost of Capital Form of the Model 262 7.4 Tho Adjusted Prosont Value Form Of The Model 264 Dennis Kell, Inc. Revisited Adjusted Present Value Form of the Model 265, 7.8 The Equity Discounted Excess Earnings Model 267 Dennis Kelle, In. Revisited—Equty Discounted Excess Earnings Form of the Model 268 7.6 Possible information Advantages Of The Excess Earnings Valuation Method 270 77 Adjustments To Earnings And Book Value Made To Measure “Economic Earning” 272 Potential Adjustments for Implementing the Excess Eamings Model 273, ‘Summary and Key Concepts 274 ‘Additional Reading and References 274 Exercises and Problems 274 Solutions for Review Exercises 278Contents Estimating the Equity Cost of Capital 284 INTRODUCTION. 286 18.1 The Capital Asset Pricing Model 288 ‘The Effects of Diversification 287 Bota as a Measure of Securty Risk 288, [A Quick Look at Some Betas 290 ‘A Portoio Beta ls a Weighted Average ofthe Betas ‘ofthe Secures in the Portfolo 291 ‘82 Further Observation And Empitical Evidence 291 Evidence on the Capital Asset Pricing Model 292 8.3 An Overview On Estimating The Equity Cost Of Capital Using The Capital Asset Pricing Model 290, 8.4 Estimating Beta: Overview 204 ‘The Equity Cost of Capital Used in Valuation Is Forward ‘Looking but Estimated Using Historical Data 295 ‘The Market Model 205 Return Dichotorization inthe Market Model 296 Market Model Estimates for Four Example Companies 296 Equity Betas Cepture Systematic Financial Fisk and Business Fisk 297 ‘The Market Model Applied to Portfolios. 298 Market Model Regression fora Portfotio ‘of the Four Companies 209 {85 Bota Estimation: Assumptions And Choices 299 Choice of Proxy fr the Market Portfolio (Market Index). 299 Number of Observations, Time interval (Periodic) for Measuring Returns, and Chronological Time Period 900 Using Daly and Weekly Data to Adjust for Changes In Operations and Capital Structure 301 Mean Reversion in Estimated Betas and Adjusted Betas $02 {86 Adjusting Estimated Betas For Changes In Risk \. (Non-Statlonary Betas) 308 Direct Adjustments to Beta for Changes in Operations 904 Direct Aalustments to Unievered Betas for Excess Assets and Divestitures 305. Shiting Botas inthe Futuro 908 87 Using Comparablo Companies To Estimate Betas. 306 Use Individual Betas Not Portfolio Betas to Achieve Pracision Improvernents. 307 Determining the Compani/s Uniavered Bata from the ‘Comparable Companies’ Unievered Betas 307 8.8 Estimating The Market Risk Premium 309 ‘The 1926 to 2011 U.S. Retum Experience 310 Choice ofthe Proxy forthe Market Porto (Market Index) 312 Choice of Proxy forthe Risk- Pitt Retr Measure the Market Fisk Premium S127 ‘The Historical Approach to Estimating the Market Pick Premium 313 ‘Time Variation In Estimating the Markt Risk Promium 314 Estimates of the Market Risk Premium from (Chet Financial Offcers 315 Estimates ofthe Maret Risk Premium from. Implied Cost of Capital Estimates 916 Uncertainty in Estimates of the Market Risk Premium 315 ‘Where Doee Al ofthe Evidonce Leave Us? 316 89 Estimating The Risk-Free Rato Of Return To Uso In The CAPM 316 {8.10 Putting The Pieces Together 917 ‘Judgment and Guiding Principles (Links) 318 CAPM Example Using Our Four Companies 918 {8.11 Adjusting The Capital Asset Pricing Model For Market Capitalization 320 ‘8.12 The Build-Up Method 323 ‘Typoal Formulation ofthe Bul-Up Method 323, Don't Use Ad Hoe Models 324 {849°The Throo-Factor Model 324 The Model and its Estimation 325 £8.14 Implied Cost Of Capital Estimates 327 ‘The Constant Dividend Growth Model 328 implied Cost of Capa Estimates trom Forecasts of Excess Earnings or Cash Flows 328 ‘Summary and Key Concepts 229 ‘Additional Reading and References 329 Exercises and Problems 320 Solutions for Review Exercises $33 Measuring the Cost of Capital for Debt and Preferred Securities 336 INTRODUCTION 338 19. Types OfNon-Common-Equity Securtios 339 How Do Companies Finance Thelr Balance Sheets? 940 Balance Sheet Liabilties and Other Equities Not Included in Non-Common-Equity Financing 341 8.2 Crodit And Proferred Stock Ratings, Defauits, And Yields 342 CCecit Rating Agencies 342 Ratings and Recovery and Default Rates 948 93 The Debt Cost OF Capita Is Less Than The Promised Yield To Maturity 347 We Obsorve Promised Viel and Not the Debt Gost of Captal 350, ‘American Axe's Promised Viel to Maturty and Debt Cost of Capital 351 Preferred Stock and the Adjusted Promised ‘Yield Approach 953 Empirical Evidence on the Magnitude of Expected Dotaut Losses 954 Empirical Adaptation of the Capital Asset Pricing Model 988, Using Crit Default Swaps to Measuro Default sk and Recovery Rates 358 Summary 958 9.4 An Overview Of The Process Of Measuring The Cost Of Capital Of Non-Common-Equity Securities 359Measuring the Debt and Preferred Stock Costs of Capital 360 9.5 Credit Or Debt Rating Models 262 Credit Ratings and Financial Ratios 362 ‘Tho HZ Crecit Rating Model 365 Prforred Stock Rating Models. 369 Yeid Prediction Mode's 370 ‘96 Bankruptoy Prediction And Financial Distress Modols 370 ‘The HZ Financial Ratio-Based Bankruptoy Prediction Model 370 Fanclal Distress Models Based on Option Pricing Models 373 ‘87 The Cost Of Capital For Warrants, Employee Stock Options, ‘And Other Equlty-Linked Securities 373 Measuring the Value and Cost of Capita for Employee Stock Options 374 ‘Summary and Key Concepts. 975 ‘Adéitonal Reading and References. 875 Exercices and Problems 375 cnarren 10 The Effects of Financial Leverage on the Cost of Capital 382 INTRODUCTION. 384 410.1 An Overviow Of Tho Unlovering And Levering Process 384 Selecting Comparable Companies 385 “The Stops Inthe Unlevering Process 385 ‘The Steps inthe Levering Process 386 40.2 Assessing The Risk And Value Of Interest Tax Shiolds 387 Discount Rate for interest Tax Shields Is the Cost of Debt 387 Discount Rate for Interest Tax Shields ls the Uniavered Cost of Capital 388 Discount Rate for Interest Tax Shields with ‘Annual Refinancing 309 Discount Rate for Interest Tax Shields for Existing Debt, financed Dbt, and Addtional Debt 269 103 Levering Tho Unloverod Cost Of Capital 390 The Economie Balance Shest 390 ‘The General Levering Formula 301 Levering Formula When the Discount Rate for Interest Tax ‘Shiels ls the Unievered Cost of Capital or When Interest Ie Not Tax Dasuctibe (Vig = 0)" 382 Levering Formula When the Discount Rate for Interest Tax Shiels is the Cost of Debt, ¢, 382 Levering Formula for a Zoro-Growth Company with 2 Fhred Amount of Perpetual Debt (f-s =f) 988 Levering Formula When a Company Uses Annus Refinancing to Rebalance to Is Target Capital Structure 383, The Booth Company—Levering the Unloverod Cost of Capital 304 Choosing a Levering Method 987, 104 Levering The Unlevered (Asset) Beta From The Capital ‘Asset Pricing Model 398 Contenta Using the Capital Asset Pricing Model to Measure ‘Botysiom an Observed Cost of Capital 398 Intog pital Agst Pricing Modal HARM cing Stan 00 “The Booth Compary—Lovering the Unlevered Bata 400 10.5 Uniovering Tho Equity Cost Of Capital And Equity Bota 402 Choosing an Untevering Method 406 10.6 Limitations Of The Levering And Unievering Formulas 406 Considering Financial Distress Costs When ‘Choosing Comparable Companies 407 Does the Cost of Debt Times the Valuo ofthe Debt ‘Measure Expected Interest Tax Shields? 407 10.7 Limitations Of Modigilani And Miller's Levering And Unlevering Formulas 408 10.8 Asouming Zero Debt And Preferred Stock Betas 410 Levering Formulas with Zoro Botas for Debt ‘and Prefered Securties 411 Unioverng Formulas with Zero Botas for Debt ‘and Prefered Secures 413 ‘Summary and Key Concepts 414 ‘Additional Reading and References 414 Exercises and Problems 414 ‘Solutions for Review Exercises 417 HEMEL xeeren 11 Measuring the Weighted Average Cost of Capital and Exploring Other Capital Structure Issues 420 INTRODUCTION 422 114. Measuring The Weighted Average Cost Of Capital Overview. 423 11.2 Assessing And Measuring Target Capital Structures 428 Use Target Weights and Market Values to Measure Capital Stuctue Ratios 427 Operating iailties Are Not Pat ofa Company’s Capital Stucture 427 Industry Capital Structures 428 Excess Cash and Other Excess Assets 428 Minority Interest 480 Unconsolidated Afates 431 Off Balance-Sheet Entiies 431 Target Long-Term Capital Structure and the Free Cash Flow Perpetuity Method 482 11.3 Treating Copltalizing Contractual Obligations As Operating Vorsus Financing—Does it Matter? 432 ‘The Valuation Issue with Leases 434 CCorworting from the Operating Lease Method ‘tothe Capital Lease Method 488 ‘The Lease Valuation Issue Applies to (Other Circumstances 443, 1114 Situations When The Weighted Average Cost Of Capital ‘Cannot Value The Interest Tax Shields Correctly 444 Net Operating Losses 444wall Contents Capitalized Intorest 445 Paldsin-Kind Interest 445 ‘Current Cost of Debt Is Not the Same as the Effective interest Rate 445 41.5 The Income Tax Rate 446 ‘Additional Factors that Affect the Income Tax Rates 447 Evidence on the Use ofthe Highest Federal Statutory Tax Rate ‘0 Estimate the Tax Rate for interest Tax Shields, Ty, 448 11.8 Other Factors That Affect A Company's Costs Of Capital 449 111.7 The Effect Of Personal Income Taxes 451 ‘An Analysi ofthe Effect of Persona “Taxes Based on Miler 451 ‘The Relevant Tax Rates to Use for Valuing Interest Tax Shields 453, \What We Know About Personal Income Tax Rates 454 ‘Tha Effect of Personal income Taxos on Levering ‘and Unievering Formulas 456 ‘The Bottom Line on Personal Taxes 456 11.8 The Effects OF Financial Distress Costs On Capital Structure Decisions 456, Financial Distress Costs 456 Financial Distress Costs and the Costs of Debt and Equity Capital 458 ‘Adjusting Fre Cash Flows for Financial Distros ‘Summary and Key Concepts 460 ‘Adaitional Reading and References 460 ‘Appendix: Financial Statoment and Free Cash Flow fects of Leases 460, Exercises and Problems 464 Solutions for Review Exercises. 467 459 onarren 12 Option Pricing Model Applications to Valuation Issues 472 INTRODUCTION. 474 \. 12.1 The Black-Scholes And Merton Option Pricing Model Basics 475 Koy Factors that Determine the Value of an Option 475. ‘The Black-Scholes and Merton Option Pricing Models 478 4122 The Valuation Effects Of Warrants And Other Similar Equity-Linked Securtios 478 Measuring the Price (Value) of Warrants 478 Measuring the Warrant Cost of Capital 479 Determinants (nputs) ofthe Warrant Cost of Capital 480 ‘Tho KapStone Paper and Packaging Corporation 481 ‘Adjusting the Valuation for Warrants and Other ‘Similar Equity-Linked Securities 483 ‘Tre Knuth Company 486, ae 12.8 Adjustments For The Tax And Other Employee Stock Options And Other Equity-Linked ‘Compensation 486 “Types of Equity-Based Compensation and the ‘Accounting and Tax implications | 487 “Measuring the Value and Cost of Captal for Employee Stock Options 488 ‘Adjusting for Employee Stock Options Existing a8 ofthe Valuation Date 488 ‘The Knuth Company Revisited 489 Expected Issuance of Equity-Based Compansation ‘After the Valuation Dato 480 ‘Assumptions Underpinning the Use of Grant-Date Value of the Equty-Based Compensation Contracts Expense 491 Intel Corporation's Disclosures on Equity Based Compensation 492 424 Convertible Debt 494 Convertibe Debt Contract Provisions 496 ‘Separating Convertible Debt into Its Straight Debt ‘and Convertibie Feature Components 496 ‘Alcoa nas Corverible Notes 497 125 Option-Pricing-Based Financial Distress Models 499 Which Approach Works Better (Rato-Based or Option- Pricing-Based Financial Distress Models)? 801 ‘Summary and Key Concepts 602 ‘Additional Reading and References 602 Exercises and Problems 502 Solutions for Review Exercises 505 cnarren VO Introduction to Market Multiple Valuation Methods 508 INTRODUCTION 510 418.1 Tho Markot Multiple Valuation Procoss 511 , 18.2 Commonly Used Market Muitipes 512 Fm Value Vorsus Enterprise Valuo 512 [Market Mutples Used to Valuo the Fim ‘and Common Equity 512 Time-Sevies Statistics fo Typical Market Multiples 515 18.3 Risk And Growth Value Drivers. 516 ‘The Relation Between the Discounted Cash Flow ‘Model and Free Cash Flow Mutigles 516 Why Free Cash Flow Multiples Ave Not Very Popular $17 184 Additional Market Multiple Value Drivers. 518 When Should We Consider Matching on a Value Driver? $18 Staples, nc. Simulation 519 Does Fim Size Matter? 525 ‘Assumptions Underying Non-Accounting- ‘Based Markat Multiples 526, 15 kdentitying Comparable Companies 527 Understand the Businesses in Which tho Company Operates 527 {destitying Competitors ané Companies inthe Same Industry Is Only the Stating Point 520 19.6 Transitory Shocks And Market Multiples 530 18,7 Continuing Value Multiples 532‘Summary and Key Concepts 535 ‘Additional Reading and References, 635 Exercises and Problems 685 Solutions for Review Exercises 540 5 wa INTRODUCTION. 546 1141 Fret Principles For Measuring Market Multiples 548 Consistency of Calms inthe Numerator and Denominator 647 Uso a Numerator that Represents the Value of the ‘Company's Long-Run Operating Performance S47 Use a Denominator that Is a Good "Base Year" for Future Performance 548 Timing issues 548 142 Measuring Market Multiple *Numerators” 550 ‘Value of the Firm's Operations and Enterprise Value a8 Alternative Numerators 50 Relation Between the Valuation Date and the Measurement Date for Value (Numerator) 551 Measuring the Value ofthe Common Equity Shares. 652 Measuring the Value of Debt and Prefered Stock 552 Meaouring the Value of Stock Options and ‘Other Equty-Based Securities $52 Measuring the Value of Othor Secures and Off Balance-Sheet Financing 553 ‘Adjustments tothe Numerator as a Resut of ‘Adjustments to the Denominator 653 4143 The Universal Corporation—Part ‘Measuring Enterprise And Equity Value 554 “otal Cash and Cash Equivalonts) 955 Value of Universe Soourtios 555 ‘444 Measuring Markt Multiple “Denominators” 551 Measuring the Denominators—Basic Calculations S61 Adjuting Market Mutipl Inputs fr Excess Assets S62 ‘Adjusting Market Mutple inputs foe Non-Recurring tems S64 445 Tho Universal Corporation—Part 2—The Denominators 565 Universal Corporation's Restructuring and Impalement Costs 585, Roquired Cash, Excess Cash, and Total Gash (and Cash Equvalents) 586 14.6 Additional Adjustments To The Numerator And Denominator 567 Discontinued Operations 567 Miner Interests Noncontoling Interest) 568 Unconsoldated Afiates, 569 Mergers and Acquistions 570 Ohesttures. 572 1147 The Universal Corporation—Part 9-Other Adjustments $72 LUniersal Corporation's Discontinued ‘Operations (Excess Assel) 572 cnseren 14 Market Multiple Measurement and Implementation 544 Universal Corporation's Unconsolidated ‘Affilates (Excess Asset) 574 Universal Corporation's Minority Interest Universal's Market Mutples 574 Enterprise Vélup-Based Market Multiples 574 Conant oan08 Markt Miles. 75 14.8 Selecting Among Alternative Market Multiples And Establishing A Range 576 Moving Up the Lines in the Income Statement Inoraages the Need for Comparability 576 ‘Negative Denominators Can Eliminate & ‘Muitine from Consideration 576 Free Cash Flow Multiples 577 Revenve Muttiples Can Be Appropriate When We ‘Believe the Cost Structure Wil Change 577 Using Multiple Comparable Companies ‘to Offset Diflerences 577 Does the Variation in Multiples Across Companies Line Up According to Expectations? 578 Establishing @ Reasonable Range of Values anc Measuring Central Tendency 578 Selecting the Range of Values (or Value to (Use in Our Valuation 578 149 Valuing W. K. Cheng Company Using Universa's Market ‘Multiples (Betore Additional Adjustments) 579 14.10 Additional Toples—Net Operating Loss Carryforwards And ‘Accounting Differences 582 Net Operating Los’ Carryforwards as an Excess ‘Asset to increase Comparability 582 Defered Tax Valuation Alowance Relatod to Net ‘Operating Loss Caryforwards. 583 Capital Versus Operating Leases and O- Balance-Sheet Financing 583 (Changes in Accounting, Correction of Eos, and Restated Financial Statements 587 ‘Summary and Key Concepts 587 Additional Reading and References 588 Exercises and Problems 588 ‘Solutions for Review Exercises 503, S74 INTRODUCTION 602 416.1 Leveraged Buyout Activity 603 Time-Srles of Leveraged Buyout Transactions €03 Cross-Border Leveraged Buyout Transactions 604 Private Versus Public Targets and Acquirers 806 Premiums Paid and Transaction Market Mutples 606 16.2 Characteristics Of Tho Typical Leveraged Buyout Deel And Company 608 Leveraged Buyout Deal Characteristics 608, (eal Characteristics: Leveraged Buyouts Versus Leveraged Recapitaizations 610wiv Contents Characteristics of Potential Leveraged Buyout Candidates 610 16.3 Potential Motivations And Economic Forces 612 Potential Tax Benefits from Increased Interest Tax Shields 612 Potential Agency Cost Reductions from Increased Debt 612 Potential Agency Cast Reductions from Management Ownerehip 613 More Effective Monitoring by the Board of Dectors. 613. Information Asymmetry Advantage of Insiders 614 Wealth Transfer from Employees and Pre- Buyout Bondholders 614 154 The Effects On Oparating Performance And Firm Value 15 ‘The Effect of LBOs on Operating Performance ‘The Early Years (1970s-mid-1960s) 615 ‘The Effect of LBOs on Operating Performance— More Recent Transactions. 616 185 Financial Sponsors—Who They Are And What They Do 617 Private Equity Fims and Private Equity Funds. 617 What Do Private Equity ims Do Besides Raise Funds and Buy/Sell Companies? 618 How Do Private Equity Funds Perform? 619 166 Stops in Assessing The Investment Value OF Leveraged Buyout Transactions 620 ‘Stops in Assessing the Investment Value 620 18,7 An Iustrative Leveraged Buyout Transaction—John Edwardson & Company 622 Inal Price and Capital Stucture (Steps 1-2) 622 Financial Model, Caoital Stucture, and Debt Rating Stops 3-5) 625, Investor internal Rate of Return (Stepe 7-8) 632 Using the Weighted Average Cost of Capital Valuation ‘Method to Measure Exi Values and Reevaluate IRRs—Step 0 (Another View of Steps 7-8) 654 ‘Adjustod Present Value Mathad Valuation, Net Present Value ofthe Investment, Implied Equity Costa of Capital, anc Equity Betas (Stop 10) 638, ‘Summary and Key Concepts 647 ‘Additional Reading and References 648 Exerciees and Problems 648 Solutions for Reviow Exercises 655 cnarren 16 Mergers and Acquisitions 666 INTRODUCTION. 688 16:1 What Do We Know About Merger And Acquistion Transactions? 868, Time-Setes of Merger and Agguston 7 Cross-Border Merger and AtaUisition Private Versus Publ Targets ans AcqurersB72 Merger Premiums and Market Maples 672 660 16.2 What Motivates Mergers And Acquisitions, and Do They Greate Value? 675 What Motivates Merger and Acquistion Transactions? 675, Do Merger and Acquisition Transactions Create Value, and If They Do, for Whom? 87, 16.3 Why Do Mergers Sometimes Fail To Create Value For Acquirers? 678 Strategic Falires 678 Due Diigence Failures 679 Integration Planning and Execution Falures 679 Pootly Run Acquistion Process. 680 Cross-Border Acquisttons 680 Migating Fsks 680 Smergles 681 Cost ficiency Synergies. 681 Revenue Synergies 682 Financial Synergies 682 ‘Synergy Uncertainty 682 16.8 Deal Structure, Income Taxes, And Other Contract Provisions 684 “ypos of Transactions 684 Other Common Contract Provisions 686 416.6 Overview Of How To Value Merger And Acquisition Transactions 628 The Acquires Perspoctive on Valuation 688 ‘The Target's Perspective on Valuation 689 16.7 Control Promiums (Minorily Discounts) And Liquilty Premiums (Iiquicty Discounts) 689 Control Premiums (Minerty Discounts) 690 Liguiety Premiums (liquldty Discount) 681 16.8 Is The Merger And Acquistion Transaction Accretive Or Diutive? 602 Acorative and Dilute Effects of Merger and ‘Acauision Transactions on Earnings per Share and Other Performance Measures 693, Accrative and Diutve Effects of Merger anc Acquistion “Transactions on Market Multiples (and Value) 695 16,9 Negotiation Ranges And Exchange Ratios. 696 Cash Deal 696 [Negotiating @ Price within the Nagotiation Range 698 Exchange Ratios 698 Minimum and Maximum Exchange Ratios for the Negotiation Range 699 “The Exchange Ratio Based on a Proportional ‘Allocation ofthe Post-Merger Value 702 ‘Allocating Synergies Based on the Proportion of Pre-Merger Standalone Values 703 ‘Alocation of Merger Gains and Losses in @ Stock-or-Stock Merger 703, 16.10 The Xerox Corporation And Affiliated Computer Services, Inc. Merger 705 ‘The Deal 705 ost-Mexger Value of Xerox Corporation 706 ‘Allocation of the Gain to ACS and Xerox Shareholder 711 ‘Summary and Key Concepts 712 ‘Additional Reading and References 712 Exercises and Problems 712 Solutions for Review Exercises 715cnsrren V7 Valuing Businesses Across Borders 722 INTRODUCTION 724 {17.4 How Cross-Border Valuations Are Different 725 Potential Adjustments to Free Cash Flow Forecasts. 725 Potential Adjustments to the Fisk-Adjusted Discount Rate 725 Investor Currency (Centralized) and Foreign Currency (Decentralized) Discounted Cash Flow Valuation Approaches 728 Example lustrting the Equalty ofthe Two Approaches. 727 Other Potential Economie Forces Affecting ‘Cross-Border Valuations 729 17.2 Exchange Rate Basics 720 Spot and Forward Exchange Rates 790 Currency Appreciation and Depreciation, Premiums and Discount, and Real Exchange Rates 732 173 Exchange Rate Theories And Forecasting Methods 752 Purchasing Power Party (PPP) and Relative Purchasing Power Party (RPP) 735 ‘Covered and Uncovered Interest Rate Paty (and ‘the Intemational Fisher Effect) 733, ‘Are Forward Rates Unbiased and Efficient Forecast of Future ‘Spot Rates? (The Forward Premium Puzzle) 785 Understanding the Discount Rates Used inthe Example iustrating the Equality of the Two OCF Approaches. 736 Practical Applications of Exchange Rate Theories and Other Potential Methods of Forecasting Exchange Rates 737 174 Overview Of Potential Income Tax And Other Tax lesuos In A Grose-Border Setting 740 Foreign Tax Credits and Deferal of Foreign income for Worldwide Resident) Tax Regimes. 741 Worldwide (Resident) and Terttoral Source) Tex Regime Exarple—The Holdem Company (with Two Foregn Subsidiaries, Lo-Tx ine, and HiT Company) 742 A Top-Level Discussion of Strategies to Minimize “ax Labilties and Manage Cash 746 Contents Interest Tax Shields in Cross-Border Transactions ‘and Mutational Companies | 748 What Is the Bottom Line on Taxes in a Gross BordepNaluation? 746 175 Menage Cxe 1 Copal 747 Intograted Capital Markets. 747 Segmented Markets 748 Implications for Domestic Investments 749 Wat it Markets Are Naither Fully Integrated ‘or Completely Segmented? 750 Lack of a Pubscly Traded Comparable Company Inthe Relevant Market 750 176 Cross-Border Valuation In Less Developed Or Troubled Economies Or Emerging Markets 751 ‘Adjusting Expected Froo Cash Flows for Country-Specific Risks 751 Flske’s Valuation 753 Using inaurance and Insurance Premiums as an ‘Aternative to Adjusting for Poltical Risks 757 Estimating the Equity Cost of Captain Emarging Markets 758 177 Challenges Using Markot And Transactions Multiples ‘Across Borders 759 (Cross-Border Market Multiples 760 Using Within-Courtry Market Muttpes in a ‘Gross-Border Valuation 761 Using Transaction Multiples in a Cross-Border Valuation 761 17.8 Exchange Rate Exposure And Hedging Basics 761 Operating Exchange Rate Exposure 762 Transaction and Financial Exchange Rate Exposure 785 ‘Translation Exposure 765 Should Managers Hedge? 765 ‘What Methods Can a Company Use to Hedge Is Exchange Rate Exposure? 766 ‘Summary and Key Concepts 767 ‘Additional Reading and References 767 Exercises and Problems 767 Solutions for Rviow Exercises 770 Index 774Introduction to Valuation On February 1, 2012, Facebook Ine. led a registration statement with the U.S. Secures and Exchange Commission to issue publely traded stock forthe fist time, called an inal publ offering. At what value wil Facebook ade inthe market? In other words, what isthe value of Facebook? As we show inthe table below, Facebook increased ts revenues rom $163 millon n 2007 to $3.7 bilion in 2011, and it increased its net income from a lose of $198 mi- hd fle al ed jion in 2007 to a profit of $1.0 billion in 2011. Its free cash flow increased from a negative cash fow of $55 milion in 2007 to a postive $470 milion in 2011. As ofthe end of 2011, Facebook held $2.9 billon of cash (or cash-tko secures)" eee ee Revenue $272 $777 (Operating income, $55 $262 Net income. ae S58 $220 Free cash fow $83 $66 Cash After mastering the concepts and tools in this book, you will be able to value a company like Facebook. The chapters in this book lead you through a detailed, step-by-step approach to valuing companies. This book provides the necessary knowledge to adjust and implement the valuation methods to whatever valuation context you are f * See Facebook's S-1 Registration Statement fled with the Securities and Exchange Commission (SE) on February 1, 2012, avall- able on February 4, 2012, at hito//wiw. see. gov/Archives/edgaridata/126801/0001 1991251209451 7/4287954ds1.him,NOILVZINVDHO * YaLdVHO = Economic 1 Valuing Apple es 1 The dsoounted average cost trananctons such | |” compsitor: cash fow of capital and 18 mergers and ‘nates histories valuation model adjusted present | | acqusttons perormance vale valuations Asset and Forecast future balance shoot comune Market mutiple financial performance valuations restructuring a Loveraged Strategic analysis cea buyout anatysis Fundamental valuation Measuring the analy for ‘methods to value of equity Ponto selection ‘measure valve LO1 Blain the diferent concepts of vale INTRODUCTION ‘Managers and investors place very big bets and take large risks based on the valuation models discussed in this book. They are willing to make those investments and take those risks because they expect to eam sufi- cient cash in the future from these investments to create value for their companies or superior returns for theit investment portfolios. Managers and investors decide whether or not to make an investment by comparing their assessment ofthe value—~or valuation—of the future cash flows they expect to eam from an investment to the amount they must invest. They will choose investments for which their valuation of the future cash flows is sufficiently greater than the amount they must invest. The valuation models discussed in this book serve as the framework to use to assess whether investments create value. Since some type of valuation analysis serves as the basis of many decisions managers and inves- tors make every day, all managers and investors benefit from understanding valuation theory and how valuation models work. In this book, we present well-accepted methods or valuation models that man- agers and inyestors commonly use to measure value. While managers and investors use these valuation ‘models fo measure the value of many different types of investments and as the basis of many different decisions, our focus is on measuring the value of a firm and its common equity. We also discuss ways to value certain securities a firm may issue to raise financial capital. Finally, while we do not discuss project valuation directly, many of the methods presented in this book can be used to assess the value of @ company’s specific investment projects. In this chapter, you will gain a general understanding of the primary valuation models used today. Further, you will gain an understanding of the general components of value for a firm, In addition, you will see the various ways that managers and investors use valuation models. For example, the managers of Daimler and Chrysler agreed to merge the two auto manufacturers based in parton the advice of their financial advisors who relied on the models discussed in this book (see Valuation in Practice 1.1). Finally, you will gain an appreciation of the overall valuation process. 1.1 WHAT DO WE MEAN BY “THE VALUE OF A COMPANY”? ‘We have many terms that are used to describe the value of a company, for example, fair market value, market value, fair value, intrinsic value, and fundamental value just to name a few. A widely used description of fair market value isthe cash equivalent value t which a willing and unrelated buyer would agree to buy and a willing and unrelated seller would agre to sell the company, when neither party is compelled tvact, andaeiBAAF panies have reasonable knowledge of the relevant availabe informationChapter 1 | Introduction to Valuatlon AEE oR ease k od kt mee ‘The Dalmler-Benz—Chrysler Merger In November 1998, Daimler-Benz, AG Daimler), which operat- ‘dn automotive (passenger cars and commercial vehicles), aerospace, and other industry segments, ‘merged with Chrysler Corporation (Chrysler), which operated in the automtive and financial services industry segments. The merger of Daimler and Chrysler resulted in the formation of a new German, company, DaimlerChrysler, AG (DaimlerChryste) ‘The process started in mid-January 1988, when Mr. Jurgen E. Schrempp, Chairman of Daimler, and Mr Robert J. Eaton, Chairman and Chief Executive Officer of Chrysler, met and began discussions, about a possible merger between the two companies. By late April of that year, they agreed to merge ina stock-for-stock transaction. Daimler agreed to an exchange ratio that resulted in a 2895, or more. ‘han $7 bilion, premium to the Chrysler shareholders, On the day before they announced the merger, Daimler’s market capitalization (or market cap) was cover $52.5 billion and Chrysier’s market cap was over $28.5 billion, with @ combined market cap of over 79 ilion. The inital market reaction to the merger announcement was positive. Chrysler's market cap increased by more than $7.5 billion and Daimiler’s market cap increased by more than $4.5 billion, for ‘combined increase of more than $12 billion (or 1536) ‘Mr. Sehrempp and Mr. Eaton and their respective boards decided to place their bets, in part, based ‘onthe advice oftheir inancial advisors. Credit Suisse First Boston was Chrysler's financial advisor in con- rection with this merger and the financial advisor for Daimler-Benz was Goldman Sachs. Both financial advisors provided a faicness opinion to their respective clients indicating that the price pad in the merger H] 2s fair, and both used the valuation models we discuss inthis book as a basis for their conclusions. Of course, we now know that this merger did not work as well as Implied by the market's inital reaction to the announcement, as Daimler sold Chrysler in 2007. Seucs: Sea Annet Cand Arex the OsiesCheylar AG SEC Far Ft egsrton Statement, DaimlerCheyster's pstmagefrancal performance hasnt yet met mega expectations ‘This definition suggests some important characteristics about the valuation context—“arm’s length,” ie-frame constraints, information set, and specific use. For example, a willing and unrelated buyer and seller suggests that the transaction is “arm’s length”; that is, it does not include “side payments” or other remuneration beyond the transaction price between the buyer and seller. Neither party being compelled o ct suggests a time-frame context—that is, the time frame for the parties to identify and negotiate with ach ater is such that, whatever it happens tobe, it does not affect the price at which a transaction would luke place. In addition, this suggests this is not a forced transaction such as might be compelled by a out of a government agency. The definition also indicate the importance of the availability of informa- F tion—that is, the value is based on an information set that is assumed to contain all relevant and available formation, Lastly, part ofthe relevant information is the specific use of the assets being purchased, Inmost valuations, the company is valued as an ongoing business (ongoing value or going-concern value) There are, however, valuations that presume that the company will not be operated any longer, guidation value (forced and orderly), or that the company will be broken up into pieces and the pieces will be operated as separate entities, breakup value. Liquidation value is used when the com- uay’s assets, cither collectively or individually, are going to be sold off or liquidated. Forced liquidation fuggests a valuation context in which the time frame to sell the company is sufficiently short such that the company will be sold for less than it would have been sold for given more time. Orderly liquidation suggests thatthe time frame to sell the company does not affect the price at which the company is sol, Breakup value is the value of selling off the different parts of a company—for example, a conglomerate selling off all or some of the individual companies it owns. Of course, there is not just one universal opinion on the value of a company. Different individuals or ups may have differences of opinion regarding the best way to use the company's assets, or they may have. diferent expectations regarding the company's future prospects even if they do agree on the best use ofthe ascets, Naturally, buyers and sellers need not be in exact agreement over the value of a company when they ‘ransuc, The buyer often believes the value is higher than the price paid for it and the seller often believes the valu is lower than the price at which i i sold. In fact, transactions are more likely to occur when the buyer believes a company is worth more than the seller believes itis. Nevertheless, valuation models should approximate the observed market value of the company so Jong asthe inputs used reflect both a specific valu- ‘tion context and the information and expectations of the buyers and sellers engaged in market transactions.‘Chapter + Introduction te Valuation 1.2 THE ECONOMIC BALANCE SHEET: RESOURCES EQUAL CLAIMS ON RESOURCES ‘The value of the firm and the value of the securities it issues are related in a very fundamental way. A ‘company is a legal entity, that is, nothing but a collection of contracts.* One of those contracts must be with the owners of the company (shareholders), because a company cannot own itself. For example, stock certificates and corporate bylaws are the contracts a corporation has with its equity owners. In almost all ‘cases, the equity owners of a company have a residual interest in the company’s assets; that is, the equity ‘owners get the value that remains afterall other contracts are settied. As a result, the value of a company’s resources must be equal to the value of the contractual claims on its resources. ‘Value of Resources = Value of Claims on Resources Value of the Firm = Value of Non-Equity Claims + Value of Equity (Residual Interest) From this relation, it follows that a change in the value created by a company must be equal to the change in the value of the company’s securities (we use the Greek letter delta, A, to signify the change in value). Said another way, the dollar return on a company’s resources must be equal tothe dollar return fn the claims on its resources. A Value Firm = A Vatue Non-Equity Claims + A Value Equity $ Return Firm = $ Return Non-Equity Claims + $ Return Equity ‘We use several forms of these relations to develop various aspects of the valuation models presented throughout this book. Itis sometimes useful to depict this relation in more detail using an economic bal- ance sheet. Example Economic Balance Sheet Exhibit 1.1 js an example af. an economic balance sheet for a hypothetical company. The first thing to note about this exhibit is that the value of the company’s resources (or the value of the firm) is equal to the value of the claims on its resources (or the value of its securities). This is @ useful relation because information available about the securities that a company issues can be used to assess the company’s value and cost of capita, Economic Balance Sheet for a Hypothetical Company Vat fe nvr (a euiy-teanced buss operations wit cen eset Valuo of the excess ascate wernt Value of the unlovered fem Value created from financing Value of the em Value of debt Value of preteriad stock J vave of equity 1 Value of secuttes issued, Resources (Assets). ‘The value of a company's resources has two basic components—the value of ‘the unlevered firm and the value created from financing. The value of the levered firm is what the 3 sea one (193 fF Aor clacsson bout why fms exist Catse, R, “The Nae ofthe Firm." Economica & (1937, pp. 386-405,= Chapter 4 | Introduction to Valuation company would be worth if it was entirely financed with commdd 90704 had made all ofthe same investment decisions. The value created from financing arises in some tax jurisdictions because of the potential tax advantage of debt relative to other forms of financing, such as equity. In many tax jurisdic- tions, payments to debtholders in the form of interest are tax deductible at the comporate level whereas payments or flows to equltyholders are not tax deductible. ‘Te economic balance sheet doesnot show the value ofall the individual components that make up the value ofthe unlevered firm, but we are able to break it into two components: the value ofthe com- pany’s business operations on an unlevered basis andthe value of its excess assets. rhe Vale oF a Company's Business OPENS s the value ofthe company’s ongoing businesses, excli- sive of any value created from Financing and any value in asses that ae not needed for he business, such as exces eas. The value of the company’s business operations is not the sum of the individual values of the assets that the company ids to operate is businesses when consid&éed seitely. Rather, iis the value of those assets wien valued together as an ongoing business These assets include monetary assets (suchas cash and roceivales required forthe business), phySial assets (such as inventory and propery, pant and equipment, intangible asets (such as intellectual property ora superior R&D capability), and the value af growth opportunities also called the present value of growth opportunities), Thus, the value ofthe business operation includes any expected future value creation resulting from anticipated investments. The lamer re not asses aleady-inplace, but they are part ofthe value of a company. The value of the gompany’s excess assets includes all resources that are not needed to operate the specific business being valued. Excess assets include assets such as excess cash and marketable securities Gometimes referred to as cash and cash equivalents), land, buildings, equipment, patents, et pension —> = > assets, and any other asset that isnot needed to operate the business, Generally, we value excess asses Ypartely and isolate them from our valuation snalysis. Of couse, not all cash, and, buildings, equip- iment, and patents represent excess asses, Claims on Resources. In the bottom section of Exhibit 1.1, Claims on Resources, we show that the value of the firm is equal to the sum ofthe value of a company’s securities. We use a simple capital structure inthis exhibit: deb, preferred stock, and common equity. The claims on the company’s resoure- es consist of all of the securities issued by the company to raise capital. Keep in mind-that companies can issue different kinds of debt, preferred and common equity {All companies have at least one type of claim, called common equity (or equity). (We use the term. «equity interchangeably with the term common equity throughout this book.) The investors who own these securities have a residual interest in the company's resources and almost always control the company. ‘They generally elect the board of directors, which hires and compensetes management. Companies can have more than one type of common equity that has different rights, such as different voting right. ‘Another claim on te resources of the company is any debt that is outstanding. Companies can have dif ferent types of debt with varying seniority and differing terms. Debt has seniority over the other claims shown inthe ecoriomic balance sheet, Many, but not all forms of debt instruments represent a fixed claim on the company’s resources. a Companies can also issue another form of security, called preferred stock, that typically (but not always) also has a fixed claim on the company’s resources. Preferred stock is junior to the company’s debt instruments, but it is senior to the common equity. A company can also issue various classes of preferred stock. In most tax jurisdictions, the dividends paid on preferred stock are not generally tax deductible to the corporation; hence, issuing preferred stock is not generally considered to create value from financ- ing. In addition, companies can issue debt and preferred stock that are convertible into common equity at the option of the holder. Companies can also have other types of securities, such as contingent claims like employee stock options and stock warrants, or other debt-like claims, such as pension liabilities. ‘You might be wondering why the value of the company’s non- interest-bearing operating liabilities (euch as accounts payable or taxes payable) does not show up in the Claims on Resources section of the economic balance sheet. Operating liabilities result when a company does not have to pay cash for its operating expenses in the same period in which it receives the good or service provided to it. These liabilities are generally classified by accountants as currept liabilities (such as accounts payable and other payables). On occasion there are liabilities tha the accountant classifies as non-current that also fall under non-iterest-bearing operating liabilities, The reason these do not appear in the economic balance sheet iSthat inthe normal process of performing a valuation on a going-concem basis the nonsinterest-bearing operating liabilities of the company are implicitly netted against the value of the company's assets in (1.1) aC basic calculation of free cash flows. Naturally, as a company’s assets, capital structure, economic transactions, and income tax situations become more complex, the calculation of free cash flows becomes more complex as wel. : 1621 biny3¥) +500 - O- 17 pore —! REVIEW EXERCISE, 1.2 Assam The Market Value Company. Uilevered Free Cash Flow Use the infomation in Review Eerste 1.1 to measure the unlevered fic cash flow for The Marker Value Company for Year 0. The company as $500 in depreciation expense embedded within its cost of goods sat “This is he only dereciagion the company records. The company hai no excess cash so he eharg in eat ie required cash “Solution on page 29. The Discounted Cash Flow Valuation Model ‘The DCF model adjusts expected free cashflows by using time value of money principles to discount each expected free cash flow to the date ofthe valuation, using a risk-adjusted discount rate that reflects the rise of the asst. The DCF model provides useful framework to convert the sometimes abstract and qualité strtogic conceps (strategic fit, competitive advantage, market power into quantitative measures that affect value. This framework involves answering three overarching questions: How does the strategic action affect, the magnitude ofthe fee cash flows? How does the strategic action affect the timing ofthe fee cash lows? How 002 Tie strategic ation affect the undealving sik af tbe cash flows? Since a company does not have a contractually finite life but can exist forever, the DCF model nor- mally discounts a company’s free cash flows to infinity. The DCF mode! to measure the value of the firm, Veo, simplified for an allequity financed company with a constant (risk-adjusted) cost of capil, tux: which is termed the unlevered cost of capital, is: FCF, FCF, FCF. o Th + tua)” —_ ‘The value of the firm is measured at a particular date, which is as of the end of Period 0 in th8 above formula, Unless we believe ihe Conipaiy’ Wil Irguitate or omerwise-go"out of Business, the assumption that a company has ag infinite life complicates our DCF caleulations, for it isnot possible to forecast and then discatnt an a of cash flows unless we make a simplifying assumption about the time[Chapter 1 | Intoduetion to Valuation S sre of the expected cashflows. The way we typically solve this problemyisgorge¥@bp detailed forecasts fora company’s expected cash flows for some finite period of time, say 10 years. Then, we measure the value ofthe firm atthe end of that finite period, We call the value atthe end of the finite period of time the company's continuing value (CV); other terms used for this concept are terminal value, residual value, and horizon value, The way we typically implement the infinite forecast horizow Ts ¥0 construct detailed forecasts for the company for C years and measure the continuing value of the firm, CVrcx 88 ofthe end of Year C. a - _ S The continuing value represents the value of the company as of the end of Year C, Using a continuing \alue in our DCF model as ofthe end of Year C, our DCF model becomes _we _FCR, CVn ALE tual!” + tual One way we can measure a company’s continuing value isto assume the company’s free cash flows ow at constant rate, g, after the continuing value date. We call this assumption « constant growth perpetuity SSSUITpIOT As long asthe prowrth rate is constant and less than the constant discount rate, , the infinite series present value calculation summarizes to the constant growth perpetuity Formula. Vero (1.2) CVp0 = FCFe+1 3) Ga 8) Substituting the above continuing value into the DCF model we get our widely acepted DCF model witha constant growth perpetuity sondnalg value?” =~ FCFo+ io _ Fekeot 14 ) < OF raal > Ilustration of the Discounted Cash Flow Valuation Using Apple Inc. In this section, we illustrate how to apply the DCF valuation model tusing Apple Inc. (Apple) while !aking some simpitying assumptions (ox example we ignore guarding options, complated tx isques, ec.). One characteristic of Apple that makes it easier 10 rales that it has ar-simple, essentially all-common equity, capital structure. Apple had a market capitalization (measure of firm value) of about 3605 billion around the end of its 2011 fiscal year (September 2011), To value Apple using # DCF val ation model, we use free cash flow forecasts for 11 years 2012 through 2022), a constant growth rate of 215% for ee cash flows generated in perpetuity after 2022, anda risk-adjusted discount rate of 12.5%. ‘We construct forecasts that yield Apple's exact market value of $360.5 billion. Wy n> ovat Given this information and the simplifying assumptions we made in ths ilustration, implement- ing the DCF model is purely « calculation exercise. We discuss the complexities and subtleties of the DCF model, how to develop such forecasts, continuing value growth rates, and risk-adjusted discount rates inthe remainder of the book. In Exhibit 1.2, we present two years of summary historical financial statements and free cash flows (2010 and 2011) and sélected years of the 11 years of forecasts (2012 through 2022) for Apple. We use the free cash flow forecast for 2022 and constant perpetual growth rate of 2.5% to measure the continuing value ofthe firm as ofthe end of 2021 [Apple has excess assets it does not need for its operations totaling $70.7 billion. These excess assets ‘elude excess cash ($15.1 billion) and long-term securities ($55.6 billion). We value Apole using the DDCF model, excluding the value ofits excess assets, and then add the value ofits excess assets to the -DCF valuation of its operations to measure its total value. "We use Equation 1.4 to measure the value of Apple's operations (excluding the value of Apple's exces ase), 77, $26,129 , $28,548 | $30,579 , $32,361 , $33,925 wea Tyas jase 12s 1.125 1125" 1.1258 4 $35.05, , $36.68 , $37 $39,787 1 * * TT 550 = ),716 million Tags * ais * Laas? * Laas * Gias ~ 005) * 7.1258” $28°-7#6 milion ope des, manufactur gmake pstonalcompuers an relied software, services, peripherals and networking sais Wed el poral gil mu layers and related accesories and serves, includ line sae of Shatpary soo and video products Se Apple's 2011 10K report avalabe fom ils website on December 20, 201, aApple Inc. Historical and Selected Financial Statement and Free Cash Flow Forecasts ‘APPLE ING. Income Statement Forecgsts q (tor the years ended September 30) {Sin ritions) Agni Aaoit_—Fa0tg—Fao1s——F2018 Fao —_—=Fa022 Rovenue 7 $65,205 $108,249 $121,200 6149.76 $165,408 178,169 s162,61 Gost of goods sold. .12 02 799541 64431 -72.890 99382 ~107,023 109690 Grose margin Se5604 Sase18 $48,409 S 06087 S7ita8 S$ 72914 Research and dovelopment....c..ssc. =1782 2429 8.016 e118 -4as3 ages Seling, general and administrative. 5517-7509 -9.389 12804-13788 14.133 Operating income. $ 33790 § 36,008 $40137 $5295 8 S4,z08 ‘Other income and expense ‘415 0 ° ° 0 Income before taxes. coe 334205 3 96,000 a1 $957 SeROIs S Baz8 Income tax expense 76283-9002 ‘ 13229 -13'559 Net income, coe S292 § 27.007 ‘APPLE INC. Bolance Sheet Forecasts (for the years ended September 20) (Sin mitions) Azo10 A201 F202 FOI. F202 ‘Cash and marketable socuries. $25600 § 25952 $ 12924 8 A960 Stez6t ‘Accounts receivable, : 10569828042 r 12.242 Inventory... uo 764408 1,738 2.118 (Other current assets 12,601 191825 24,168 Total curent assets 2... 544.968 Property lant and equipment. ‘Accumulated deprecation Property, plant and equlpment net. Long-term marketable securias Intangible ascets Other assets. Total assets. 575,183 $116.87 ‘Accounts payable $1205 § 14632 Accrued expenses and other : _aror 13,338 “otal curent Habits 20,722 S 27970 Non-curent abies 6670 Total labios Sa7392 Common stock (and other... ..esseee++ $10,622 Fetalnod earnings 37.169 Total sharahotders equity 347791 “Tota abities and equities. + 575409 Sitgs7i 3 57,718 "APPLE INC. Free Cash Flow Forecasts {for the years ended September 20) {Sin mittons) Ao ADOT 2012 Eamings betore interest and taxes (EBM $18,540 § 94,205 S917 Income taxes ald on EIT 4527-8283 Eamings before intorest and attertwes .. $14,013 § 25.922 + Depreciation expence. sor tat4 4/-Wlorking capital and other changes 9,703 “Change In required cash 4/302 Unlovered cash tow from operations. 8 332207 = Capita expenditures (et) =7,955 Unlovered tree cash flow S 25272 ‘SBE may contain ena rounding eros‘We constructed the forecasts such that the present value of Apple's discounted free cash flows plus the value ofits excess assets is equal to its current market value of $360.5 billign; thus, Apple's current market value is composed of the value of its discounted free cash flows froyaitg.pperations of $289.7 billion and.$70.7 billion in excess assets (cash and long-term securities) eRe the DCF calculation is the value of Apple’s continuing value, which we measure using Equation 1.3. Apple's continuing value 88 of the end of 2021 is equal to $397.9 billion Fonz x ee = peg - 100 x $39,767 = $397,870 mion Vewanaes = To a) Tor1a5 — 0005) However, this is the continuing value as f 2021 and no 2011. Once we dscount Apple's 2021 continuing ‘value to 201, the 2011 present value of the continuing value is equal to $122.5 billion | ($397.9 x 1/1.125"), ‘While or valuation of Appl is only an lustration ofthe DCF mde, tis cat tardoveleging soy 8 valuation fra company provides a wel way for a manager ofa public company toy vo sede ed what expectations the market has fr the company’s fiture performance to seep i cunent set value. To the extent the manager has different expectations fr the eompany, the mses con meee whether the company is overvalued or undervalued In addition, the manager wil have sose ides of how te company has to evolve in ode o meet market expectations, While we do not shows the dead aszumptionsthatae sed consruct this model, itisinteresting to note that ule Appe'c eves acer 66 between 2010 and 2011 we used much more modest row mes, 1256 tapering down e238, replica its market valuation using ur DCF model = : REVIEW EXERCISE 1.3 Valuation of Unlevered Free Cash Flows ‘Accompany has expected free cash flows of $100.2 million, $114.0 million, and $120.8 milion inthe next three Years. Afterward the fee cash flows will grow in perpetuity by 2% annually, Measure the value of this company as of today using a 12% discount rate. aes Solution on page 29. eee Swe2 we, 1.4 MEASURING THE VALUE OF THE FIRM Gs! 7 ‘Now that you have a good sense of general valuation principles and how they relate to the discounted cash flow model, we-will discuss two alternative DCF models and other valuation models commonly used now the eiferent ‘0 value companies. All ofthe valuation models discussed in this chapter and the book have applicabil- Yauston models ity ina variety of different contexts. When valuing companies, we are most often interested in the value 25 vabe of the common equity and the value of the firm. The models we discuss in this section are commonly used valuation models for valuing the firm. A subsequent section discusses how we value the common equity. The value ofthe firm is equal to the combined value of the company’s assets, which is equal to the combined value of all ofthe securities and claims that a company issues. So, if a company issues debt (pethaps of various kinds), preferred stock, and common equity, the value of the firm is the combined value of all these claims, Different Forms of the Discounted Cash Flow (DCF) Valuation Models ‘The discounted cashflow (DCF) valuation model is one of the most commonly used valuation methods 1a 1998 survey of large corporations and financial advisors, Bruner etal. (1998) report that 96% of corporations use the DCF valuation method to evaluate investment opportunities and 100% of financial advisors do 0.‘As discussed inthe prior section, the value ofan investment according tothe DCF model isthe discounted (or preset) value ofthe expected cash flows ofthe investment, where the discount rate isthe risk-adjusted rate of return, and where the time value of money framework is used to adjust for he ‘See Brune, R., K. Eades, R. Haris, and R. Higgins, “Best Practices in Estimating the Cos of Capital: Survey and Symes," Financial Practice and Education (Spring/Summer 1998). pp 13-28.‘Chapter 1 | Inteduction to Valuation” passage of time. The inputs for the DCF model are the magnitude and the timing of the expected cash flows and the risk-adjusted discount rte ‘There are two DCF methods used to measure the value of the firm: the adjusted present value ‘method (APY) and the weighted average cost of capital method (WACC). The latter is sometimes referred to as the adjusted cost of capital method. Ignoring excess assets, a company derives its value from two broad sources: the value of the company’s operations and the value-that results from the way the company chooses to finance itself. Both the APV and WACC methods value the company based on Athe combined value of the company’s operations and the value created from financing. While the two methods take somewhat different paths to measure value, both methods yield the same value if properly implemented. The difference between the two methods is how the methods incorporate the value cre- ated from financing. The APV method incorporates the benefit directly, via forecasts of cash flows shat ate attributable to finanéing choices. The WAGE method incorporates the benefit indirectly, through an aujustment to the discount rae: "You are probably wondering why there are two DCF methods if dey yield the same answer. Good question, As it tums out, the APV and WACC methods are not substitutes. Givea the information avail- able and the yaluation assumpsions made, only one ofthe two methods is appropriate as the starting point for a particular vi mn analysis. We will come back to this issue when we discuss the DCF methods ‘more detail I the book. The cash flows used to value the firm (the combined value of the debt, preferred equity, and common equity) We Me Tee Cagh flows of the unlevered Finn (Hee cash Hows} irre- spective of heli the APV or WACO tod the APV of WA PICU. The risk-adjusted discount rate wed to discount free cash flows Teflects The oVErall riskifiess Of the company’s Operations and, in the case of the WACC method, aso incorporates the potential benef of a company’s capital structure. Instead of performing a going-concem valuation, which is most common, we could assume that a company may liquidate as soon as it is practical to do 30 or after it operates for some period of time. In a liquidation, one assumes that the assets of the company are sold off in the most advantageous manner in order to pay off all of is liabilities (including any preferred stock), its ther contractual obligations, and any costs associated with closing the business (eg, employes severance packages, costs of plant closings, etc.) To the extent that any cash remains aftr all ofthat, the cash is distributed tothe equityholders. An onde iguidation tht ries to maximize vale sill tkes sometime a achive, and the resulting cash flow fom the quai an be incorporated its a DCE mode _ Fay = The Discounted Excess Flow Valuation Models ‘The discounted excess flow valuation mode! has various forms. The most basic form is the excess cash flow method. In this method, we discount free cash flows in excess ofthe required free cash flows that are based on the required rate of return and amount of capital invested. The intuition for this model is, 4uite simple. Suppose s company begins by investing $100,000 in land and the required rate of return for the risk of the land is 10% and that is the only investment. the company. makes. In this case, the required cash flow that woukd make this a zero net present value investment is $10,000 ($10,000 = {$100,000 x 10%) per year in perpetuity. If the company earns $10,000 per year and distributes that entirely to its élaimhoiders, it has created no value and is simply worth the $100,000 investment. If, however, the company earns more than $10,000 a year, which it distributes entirely to its claimhold- crs, the value created is the discounted value of the distribution above $10,000 per year. The value of the company in this case is simply the $100,000 invested plus the discounted value of the distribution above $10,000 per year ‘Another form of this model, called the excess earnings r residual income valuation model, uses. financial accounting information to discount excess accounting earnings. Other forms of the model adist ‘a company’s financial statements in an attempt to refine excess earnings to approximate excess economic earnings instead of excess accounting earhings. The exceseflow models are algebraically equivalent 10 the DCF médel,and therefore the valuation principles we discussed previously are preserved inthe excess flow valuation models. Market Multiple Valuation Models Market myliple valugypreenascs.aré used extensively by investment bankersandother valuation experts Bruner etal, (1998) 7605. that 100% of financial advisors use market multiple methods based on publicly traded comparable companies as well as comparable transactions in their valuation work. A market multiple — —Chapter 1 | Intodustion to Valuation 18 represents thie value of a fim or its equity scled by some relevant firm characteristic. The list of market pes used by manganese Tog Some of emo conan 1 mart multiples for valuing he firm to earnings before interest and taxegdBBEPthe marketvalue of the frm to earning before interest, faves, depreciation, ai amorzation (EBITDA); the market value of the fur gat and the market Value Of ths Firm To Total assets or invested capital. Analysts and invest ‘ment bankers OTE refer to the market value of the frm as “enterprise value” Thus, its not uncommon to hear investment bankers refer to multiples such as enterprise VafUE 10 EBITDA. ‘To use the market multiple valuation method (also called price multiple, comparable company, or twin company valuation method), we first identify a characteristic of the company that we believe should be a primary determinant or driver of the company’s value. Then, we identify a set of companies that are comparable to the company we are valuing for which we can observe the same characteristic as wel as their values. For each comparable company?-we calculate its market multiple by dividing its value by its characteristic (for example, divide the market value of the firm by-eamings before interest and taxes, called an EBIT multiple). From the multiples ofthe comparable companies, we choose the appro- priate multiple for the company we are valving. Then, we multiply that multiple by the characteristic of \ the company we are valuing to obtain its value. The market value estimates in these multiples are typically obtained from prices of publicly traded companies of from prices paid in contol transactions (ransactions where ther is «change i oat, sich as a merger or tonderoffe) or possibly from prices of initial public offerings (IPOs). For example, in considering the value of a company being acquired, a valuation specialist will often base the market mul- tiple on transaction prices of comparable companies that have recently been acquired. Or when valuing a ‘company for an initil public offering, the valuation specialist will ften use prices of comparable companies that have recently gone public. Market multiple valuation based on control transactions or IPO transactions is typically referred to a8 a comparable transactions analysis or-rcomparable deals analysis, respective of the source ofthe values of ie comparable companies, valua visti ‘by multiples relies on the assumption that the poy ned in eqs ts guile aap inatots ofvale forty undeingcompanis REE rot oeuning market multe valuation models the tation oT he ‘That ito aests ae identical in terms ofthe maghinae, timing, and riskiness of thelr cash, they shoul el forthe same rice. On tho otber hand, two assets re identical in ems ofthe tnd sisknes of theireash lowe, but the ash flows of oneaset are exalytvo times as large asthe ash flows ofthe ether ase in every period then that aset shoud el fr twice as much, “ ‘oss the EBIT mulpe, We assme that he value ofa company is drclyproporionl to curent F &T, amings before dedsting interest or taxes (EBIT). Ifthe value of one firm is $1000 and its EBTT is $1,000, then the market multiple approach assumes that another firm that is identical in all other relevant respects, except its EBIT is $200), wll have a value of $20,000, While market multiple valuation i Simple to understand itis quite tfc oiplement, The Key issue in implementations captured in ga the lied ise ave, ie in all ter eleva espe” Bens tha he vas tht are ued ceuling the oils ae based onthe vauaon’t- my DE ciples cussed previously and do not mistepesent market valves, afk nultple valuation Hetod i ives those valuation prisipes, OF cour, fe values used to calculate the mutples are basen C0EI39 refute bubbles Tor Sample, the principles ae nt likely tobe preserve, a ep shot Were osaede Leveraged Buyout Valuation Models Another typical technique used by investment bankers when measuring the value ofa company that is put up for sale is to consider whether that company is a candidate for a leveraged buyout (LBO) or private 25 dour quity transaction, “Ar LBO 1s. form of transaction in which a group of private investors. acquires the “Company using extensive debt financing. The ability of a company to support an LBO transaction depends on such characteristics as the maguitudof the expected cash flows, the stability of those cash flows, the extent to which the company already has debt outsanding, andthe curent conGIvOT OF We ered markets Atypical LBO analysis make Sstinfons about cashflows a company can generate, the likely capital sigur, andthe required rates of return for varius capital providers (bank deb, enor subordinated dB, “Jinfor Subordinated deb, prefered stockholders, and common stockholders). The analysis then measures the maximum price ofthe buyout that provides those rates of return tothe vsfT0U§ capital providers. The riaximuni-priee the-LBO:analyeis Benerates cation of value, in this case, conditional on a particular transaction, Conditional on this particular form of transaction, the analysis preserves the valuation pies aiscussed previously regarding the magaitudersimingsand riskiness ofthe cash flows.Chapter 1 | itrodvetion to Valuation Valuation Key 1.4 ‘The most common methods used to value the firm (the combined value of the debt, preferred equity, commorrequlty, and other potential claims) are the DCF method, the discounted excess flow method (algebraleally equivalent to the DOF method), the market multiple valuation ‘method, and LB0 analysis. 1.5 MEASURING THE VALUE OF THE FIRM’S EQUITY “The most common way to measure the value of the common equity isto first value she firm using any of ot asreniog peony ‘discussed and then to subtract an appropriate value for alLof the non-common ‘claims, such as debt and preferred stock, warranis and employee stock options, etc. As we dis- anstd pou, Opetating working capital iablitis such a accounts payable are not include as part of debt because the cost of these liabilities is implicitly neted out in valuing the company's operations. ‘The value of interest-bearing debt, as well as any pension liabilities, envizonmental liabilities, and poten- til settlements from lawsuits, must all be subtracted from the value of the firm if they are ignored in the cash flow forecasts. However, items such as accounts payable and taxes payable are not subtracted off since they are generally already factored into the through the cash flaw forecasts. The only we ally appraise the individital ass@ts.and perhaps s0i sold, We then sbbtract the-working capital Tabliiesaah boepous! Oa other debt snd preferred stock unless a-working capital linbility, debt, or preferred stock Se Fansferr6 to the buyer of any bilsnesses or asets sold. iny CASES, Whe Value of the non-equity claims—subtracted from the value of the firm to measure the value of the common equity—is an estimate of the market value of those securities. For example, if a firm has publicly traded debt, we would subtract the market value of the debt froin the value of the firm. In some situations, however, we.do not use estimates of market values. Consider a control transaction where a company (the acquirer) is acquiring a firm (Whe Targey ahd is considering how much to bid for the common equity of the target. Further, assume the debt of the target has provision that prohibits con- trol transactions if any of.the debts still outstanding. In that situation, the acquirer would have to retire the debt of the target in ordef to Complete the acquisition. Ifthe debt also required that it could only’be retired ata premium to its face value priar to its maturity-orsome other speeific-dateirthe-futare ( call premium), then die vue that would be subtracted from the value of the firm would not be the market, value ofthe debt, but rather would be the amount that would have tobe peid to call the debt and retire it “Another technique for valuing the common equity is to use aiscounted cashflow method that values the common equity directly, This method discounts the free cashflow ofthe equity by the equity cost of gg Tie Fs ck of e equity are equal to the free cash flows of the unlevered firm adjusted for all cash flaws to Ot from non-equity claims, such as payments OF FEIpHY from debt and preferred ‘Stock investors, There is an analogous discounted eXcess flow model Wat Values the equity directly’ as Br, Using iter a diconted eth oo discounted excess flow model that values the equity diel difficult to implement. Hence this technique is often reserved for special situations such af valuing ancialTisittions, I is seldom used to value manufacturing and service organizations “There are also market multiple methods that value the common equity directly. So instead of valuing the firm of enterprise value using a market multiple method and then subtracting the value ofthe non- common equity claims, we value the equity directly using an appropriate equity multiple P/E multiple or price-to-earnings ratio, defined a5 price per com “able To orion equityholders per share, is one such MVaTGple that values THE cotton he-market-to-book ratio sich is calculated ast value-of the equity, > Valuation Key 1.5 The vale ofa firs equity can be measured in vious ways, but the most common method ito Val the tr wing an appro ecigge and thor te sutact Ie aopoptats vals fF te non- Com equipChapter 1 Iniod 1.6 REAL OPTIONS.INVALUATION ose ‘The option pricing framework is another potentially useful valuation method in certain situations. Option pricing recognizes thatthe holder of an aset is not always compelled to act, bu instead acts only if tis the holder's best interest to do so. For example, the holder of a call option has tbe right to buy a specific asset at a specified price, called the exereise price, fora certain time period. Thus, ifthe value ofthe asset is above the exercise price at the time the call option is about to expire, then the holder of the call will be better off exercising the call and buying the asset atthe exerise price. Of cours, ifthe valuc of the asset is below the exercise price of the call, and ifthe holder ofthe call wants to purchase the asset, then the holder will buy the asset inthe open market and will not exercise the call Since itis cheaper to buy the asset inthe open market than by exercising the call option, the call will not be exercised. Early work on the potential applications of option pricing methods recognized that the common equity ofa levered firm is similar to a call option on the firm, where the exercise price is equal to the amount owed to the debtholders In other words, the equtyholders have the right to buy back the firm \ from the debtholders by paying off the debtholders, if they choose to do so. If the equityholders do not ‘want the fitm back, they simply do not pay off the debtholders. Obviously, ifthe assets of the company are orth moré than the amount owed the debtholders, the equtyholders are made better off by paying off the debtholders the amount owed. “More recently, managers and investors have begun to recognize the potential importance and valu- ation implications of s0 called real options. These are options that are embedded in some investment ‘opportunites that a firm takes on or that arise because of contractual arrangements with other parties. ‘They include options such as the option to delay investing, the option to expand, the option to abandon, the option to inves, and the option to purchase, among others. For example, when a manager invests in & project to build a now product, she might not have to build all ofthe anticipated capacity requirements at the beginning of the project ifthe capacity can be builtin stages. Itis possible that it will be advantageous to delay meeting some of the capacity requirements af the outst if there is a chance thatthe demand may not be as high as expected. The option to expand capacity allows the manager to analyze the situation and expand later if subsequently needed, It is common that the cost of adding capacity in siages is more expensive than the cost of building all the capaéity at once. However, that added cost must be weighed against the cost of having idle capacity if demand for the new product is not as high as expected and some of the capacity is not needed. In some investments, consideration of these options can make the difference between accepting and rejecting an investment. For some companies, especially startups, the ‘options available to them significantly affect their value Options can be valued in a variety of ways. The specific method that is most appropriate in a given situation is related to the type and quality of information tha is available. Financial options, where there is typically a wealth of relevant data, are often valued using models such as the Black-Scholes Option Pricing Model and the Binomial Option Pricing Model. These models ae also used to measure the vale of real options inthe content of operating decisions. However, in some cases the required data for jontoValustion 47 those models is not readily available and the effect of real options on value is approximated through DCF model that explicitly considers the options that are embedded in an investment, Discounted cash flow techniques and market multiple methods can undervalue a firm relative to its true value if we ignore important options that a firm may possess. A valuation specialist must be aware of the existence of important options in considering the value of a firm or a project and incorporate that option value. Valuation Key 1.6 ‘ee Real options can have Important valuation implications in certain situations. Managers and valuation © s professionals should be aware of the extent to which important options are present in an investment and consider how to best value the consequences of those options in their valuations. ‘ora discussion of how options are valued and why’ equity in. fsm with debris lke a call option, see Black and Scholes (0973, Black, F, and M, Scholes, “The Pricing of Options and Corporate Libiies." Journal of Political Economy 91 (May-Tune 1973), pp- 637-654Chapter 1 | introduction to Valuation LO4 Describe how managers and investors use valuation mode's 1.7 HOW MANAGERS AND INVESTORS USE VALUATION MODELS ‘A valuation analysis is an important input into the decisions managers and investors make about transae- tions that involve the sale, purchase, investment, or disinvestment of an entire business or a portion of a bbusiness. In addition, these same models are used for non-transactional analyses such as making smaller investment decisions or helping set the strategic direction of a company. Managers of large multinational ‘companies, mid-sized companies, and private corporations rely on these models. Even governments rely ‘on valuation models to make decisions. In this section, we discuss the various ways managers, investors, and others rely on valuation analyses to miake important decisions, both in transaction analysis and in everyday decision making. Control Transactions Control transaction is a term used to describe any transaction that results in a change of control of an ‘entity A control. transaction does not have to involve the sale of the entire company. It could involve the sale of an equity interest so the buyer has sufficient control to make the company’s business decisions, or it could involve the sale of only a portion of a company’s business. Valuation models are used in these transactions to measure the value of the acquired entity, based on the strategy in place before the transac- tion as well asthe value based on the intended strategy afer the transaction. That information is then used to help negotiate a price between the various parties to the transaction. Mergers and acquisitions (M&As) is a term that defines transactions in which, one company acquires or merges with another company. If company can use another company’s assets more effec~ tively, the company may decide to acquire some or all of the assets of that other company (via an asset purchase, acquisition, or merger). Acquisitions can result in the purchase of a subset of a company’s assets, ofall of the company’s assets, or of all a company's common stock. After the transaction, the ‘two companies can remain separate legal entities or they can merge into one legal entity. The valuation conducted in an M&A transaction includes the expected standalone cash flows of the target, plus any expected cost or revenue synergies resulting from the transaction. Thus, the relevant cash flow forecasts used in a DCF model would include additional revenues expected to be generated (revenue synergies) and any anticipated reductions in costs (cost synergies) associated with the transaction. The cash flow fore- casts may also embed changes in the strategic direction of the enterprise that @ new owner might make. Certain activist investors, such as Carl Teahn, look for companies that are performing poorly rela- tive to their potential and then take a significant stake in the company. In many cases, that stake is not a controlling interest. Following that, they often attempt to secure one or more seats on the board of direc~ tors in order to try to force management to change the company’s operations. Since there are inherent uncertainties in being able to get managers to change the operations of the company, investors do not take activist positions like this unless they believe the value-creation opportunities are substantial. These vvalue-creation opportunities are evaluated using the valuation methods we discuss inthis book. Highly leveraged transactions include leveraged buyouts (LBOs) and, management buyouts (M1B0s), both of which are change-of-control transactions, in which contyol of the entity shifts. LBOs ate transactions in which a group of private investors uses extensive debt financing to purchase an entire company or a part of it, such as a division. The company becomes privately held, because its com- mon stock is no longer publicly traded. MBOs are transactions in which the managers of the company ‘comprise part of the group of private investors, which is not uncommon.” Valuation models in support ‘of LBOs and MBOs usually embed the benefits of being private, and the cost savings, tax savings, and working capital reductions associated with running the organization more efficiently. The benefits may also include changes in the strategy of the company. * See the discussion of the issues and an overview ofthe early rescarch in this area by Jensen and Ruback (1983); Jensen, nd R. S, Ruback, “The Market for Corporate Control: The Scientific Evidence," Journal of Financial Economics 11.0983), pp. 5-50, 1S Ago pad Hale (98), Jen, M,C. “Agen Cat of Pre Cth Plow, Cros Fane, and “Takedvers” At ni Review 2 (1986), pp. 323-329: Kspln, 5. N, “The Etfects.of Management Buyouts on Operating Performancorand Value,” Journal of Financial Economics 24 (1985. pp. 217-256.Chapter | introduction to Valuation When companies are bought and sol, itis common for some type oP fia visor, such as an investment bank tai inthe press. Not ony do financial avisrs lp perform valuations they play 4 variety of oer oe, such as runing an auction press fora company being sl advising on poten tcqures helping obtain and evaluate oes, atanging financing. aiding with-negoatin tacie, and (ne ofthe paramount concems for aboard of directors in any changeof-ontro ransstion, pa cll inthe United Sates, isthe potential legal ability asociatod with not sing reasonable business jngent and not basing the decision on relevant available information The business judgment rule itis generally applied in cous, protects the board of ciectors from legal ibility (but not om semeone fling a tawsu) if the directors make a decision with adequate information, onan informed basis, and unmotivated by personal incentives that confit withthe incentives of ther sharcholders. When making busines decisions that involve the eae of en entire business, the ol of valation models iso ati the boar in deciding whether 1o accept a bid and to protec the board from legal lability by providing the board wih adequate information and demonstrating ta is exercising reasonable business judgment in almost all change-of-contol transactions. a consul. typically an invesmen bank or ater valuation specials, stes an opinion (llrnessoptnion) tha indicates whether te price offered in the tansacton i fac While not formally required by US. law since the groundbreaking Van Gorkom eu ing, dtd in Valuation in Practice 12, almost all changeofcontel wansoctons involving the sale of «publ traded company wl have afimess opinion, The bass ofthe valuation exper’ julgment on the fumes ofthe price is based on many ofthe valuation lecniques discussed provialy inthis chepte, NUE Sse Ma Mae k od kk Le The Van Gorkom Case A faimess opinion is essentially a letter from an independent valuation spe- cialst that tells the board of directors that the price of a proposed transaction is far. The use of “fait- ress opinions” has its origins in a Delaware Supreme Court ruling in Smith v. Van Gorkom in 1985. ‘Smith was a shareholder of Trans Union, and Van Gorkom was the company's chiaf executive officer ‘The lawsuit involved the sale of a company, Trans Union, to a private buyer in 1980. Trans Union's stock was trading below $38 during the year before the sale. Mr, Van Gorkom negotiated a price of $55 with a private buyer, and the buyer gave the company's board of directors three days to accept or decine the offer. Mr. Van Gorkom did not consult the board during the short negotiations process, Mr. Van Gorkom called for a special board meeting, and after a few hours, the board of directors approved the sale of the company and recommended that shareholders accept the offer, The court ruled that the board of directors of Trans Union did not make Its decision to sell the company with suf- ficient information and that the board of directors was not sufficently informed about the value of the ‘company. In its ruling, the court also noted the lack of a report by an expert consultant, and the board was held lable for not exercising reasonable business judgment in considering this transaction. Since this ruling, the board of directors in vitually any sale of a public company obtains a fairness opinion, In rendering a faimess opinion, itis common to perform a discounted cash flow valuation, a market, multiple valuation based on comparable companies, a market multiple valuation based on comparable transactions, and an analysis of the value that would result from an LBO transaction. An investment banker may also base a fairness opinion, in part, on the process that was used to sell a company and whether there were other bids. In addition, if the company being bought and sold is a public company, itis common to examine the historical trading range of the company's stock price over some recent historical period and to examine the target prices for the company’s stock as reported in various analyst reports, The valuation expert generally makes a presentation to the board of directors concerning the valuation, so the board can come to a conclusion as to whether to proceed with the transaction, Between 1994 and 2003, 95% of the deals whose value was at least $10 million had at least one faimess opinion on the target side, and 70% of the same deals had one or more opinions on the acquirer side.® See, Kisgen, DJ. Qian, and W. Song, “Are Paimess Opinions Fsir) The Case of Mergers and Acquisitions;” working ape, Boston College, November 2005.Chapter + | Introduction to Valuation Asset and Financial Restructuring Activities Companies undertake a variety of asset and financial restructuring activities to increase the value of the firm and maximize shareholder value, Asset restructuring activities involve the sale of assets, businesses, or the stock of subsidiaries. Financial restructuring activites involve large changes in a company's capital structure, Management sometimes undertakes these activities proactively and sometimes reactively, such as in response to the threat of a takeover. In a proactive restructuring activity designed to maximize shareholder value, management uses valuation models fo better understand the economic consequences of a restructuring decision. In reactive restructuring, a response to a corporate raider ora threat of a hostile bid, management uses valuation models to analyze the economic consequences of the offer as well as the economic consequences of alternative defenses and strategies. In these cases, management will try to dem- onstrate that its actions will inrease the per-share value ofthe company above the amount of the hostile bid, Asset Restructuring Activities. A company can create value if another company can better use some of its assets, if it can use another company’s assets better, or if combining the assets of two com- panies creates value (synergies). If another company can use a company’s assets better (best and highest ‘value use), the company should divest (selloff) some of those assets (asset sale or divestiture) Asset restructuring activites can be of various types. One type of restructuring activity is corporate downsiz- ing. The goal of corporate downsizing is to reduce the size of, or eliminate, certain businesses or business ‘activities that are not profitable or less profitable than they may potentially be. One way to downsize is ‘by means of asset sales, in which a company simply sells some of its assets. For example, a company may sell a manufacturing plant or a patent that it believes a buyer can use more profitably. Another way to downsize is to sell an entire business in a transaction called a divestiture. In these transactions, the seller must evaluate the value to potential buyers and attempt to capture as much of the value added by the buyer as possible. The seller must also value the entity being sold as it currently operates it so that it may know whether the bids received will in fact create value for the shareholders relative to continuing {o operate the asset or business. In other words, is there a bid for the assets being sold that exceeds the value of those assets if the seller were to continue to operate them? The more potential buyers with whom the seller can negotiate, the more of these benefits the seller can generally capture, Mek eee Gillette's Asset Restructuring Activities The Gillette Company (Gillette) operated in five industry segments—blades and razors, Duracell, oral care, Braun, and personal care. In September 1998, Gillette embarked on an asset restructuring program, which ended up taking Gillette more than two years to complete. The expected restructuring charges reduced pretax profits by more than $440 rrllon in 1998, In 2000, Gillette announced still more restructuring and recognized pre-tax charges of $572 million due to the restructuring and the Impairment of assets. As a result of these restructuring activities, Gillette closed more than 20 factories, reduced its labor force by more than 15%, and sold its stationery products and other businesses. Between September 1998 and January 2000, Gillette's stock price decreased from $41 pet share ‘0 less than $82 per share. Adjusting for dividends, Gillette's stock return was ~20% during this period. While -20% does not look very good, it looks even worse when compared to the 4296 return on the ‘SAP 500 during that same period. However, the restructuring positioned Gillette for future growth ‘and profitablity,Gilete's net income grew substantially in both 2001 and 2002. While Its stock price decreased slightly during this period (-0.496), this was good relative to the performance of the stock ‘market, as the S&P 500 declined 35.69% during the same period. Although the restructuring process was painful it allowed Gillette to become a more efficient, competitive, and proftable company. In 2005, the Gillette Company was purchased by Procter & Gamble. Source: Tho souve fora nancial sateen ination s Gilets 2002 annul epertto sharehldes aval et ; th source oa stock maka informations CRSP. Seo Jars {2000 fra review f thee events Jas, "Around he-Giob. Gilet Retuctures” Forbes.com, ecomber 18,2000, 18 MET, itn cony2000/2/1218st il, Soo Gilete's Frm Bled wit the U.S. Secures and Exchange ‘Commission (SEC) on Ferry 18,199, end Octabo 1, 200, for these announces. > Scholarly research-atiows that, on average, the stock market perceives divestitures as value increasing: see, for example, Klein L, “The Timing and Substance of Divestiture Announcements: Individual, Simultaneous and Cumulative Effects, Journal of Finance Gly 1986), pp. 685-656.Chapter 1 | Introduction to Valuation 24 Ligudaon san exweme for of et esevcasig in whch company ssl cite singe bases ort ea company by ling ofl of ans and ying of ny agian any oto Tuto I te ene compan sige, any emaning cath cise bOR Ce coer The ‘Sto olga based ota ha be company is wh mre lds han opera Ti sees A aes ls is ee a mea SG anc iguana fe company. The sck ae ery as prety fnew of ct sales, divestitures, and liquidations. The reason for this is that the assets being sold or divested are gener- ally more valuable to a buyer than to the selling company: and in turn, the selling company captures some Oren ain, companies ta st inte enealy qe vere ed aro arbour of necng be lgldion oes than having he nary comin opr snp, Sith dpa any Eoeiy noe hho trent cies ave a company ang sek nth ble mses fr ene oft subse In paola ompay dsc hres of eeiiay(e parte gl ea) txsing shales ona pola bans The stir then becomes ane sandone conan at publ ead and opertesndpendely of he pt copay Ala tesracring ney is equity carve-out. Equity carve-ouls involve the initial public offering (IPO) of the stock ofa subsidiary. ‘he pct company kes a utd publi andes some of he ovnechip, bt unlike paca arequly cau lon he pent company wean contol ovr uly The avg ores that um toe pre company when aanonces tours fi se Seely pone" tany css, he dae of he ui tad nt toc pany traded, tein a eve mart forte drs of esd, which vies ie potent or wing equity and opson gras iret feceaployers It anopvies ame foal Heil oe campy Many spats su sen te Subadary’s usen nt part of he paras cre bess Valuation in Practice 1.4 inc. Spins Off Kraft Foods Alia Group, Inc. (Atria), the parent company of Philip Morris, USA, the largest cigarette maker in the United States, also owned 88.9% of the common stock of Kraft Foods, nc. (Kraft), itself a public company. On March 30, 2007, after legal wrangling that took several years, Atria successfully spun of its shares of Kraft to its (Altria's) shareholders on a pro-rata basis in a tax-free transaction. When Altria announced the spin-off, it stated the following in its press release: “The separation of Alia and Kraft wil benefit both parties and achieve the folowing benefits: + Enhance Kratt'sabilty to make acquisitions, including by using Kraft stock as acquisition courency, to compate more effectively n the food industry * Allow management of Aria and Kraft to focus more effectively on thelr respective business | ‘and improve Kraf's ability to recruit and retain management and independent directors. + Provide greater aggregate debt capacity to both Altria and Kraft; and + Permit Aria and Kraft to target their respective shareholder bases more effectively and improve capital allocation within the company.” Source: Se Avia Group, In. pres lease deted March 0, 2007, Ata, Group ete Spinoff Kraft Food, ne," bi ina convient GO NowsDetl aes TraaileDS6908- "The valu of the commen stock of selling companies announcing asst sales or divestitures increases approximately 2%, and there is even greater positive reaction for companies announcing theit liquidation. The later ae a peculiar group of companies. For research in tis area, ee Hite, Overs, and Rogers (1987) and Kose and Ofek (1995): Hite, G.L, J E.Owers, and R. C. Rogers, “The Market of Interfrm Assets Sales: Paral Sell.Offs and Total Liquiations" Journal of Financial Economies 18 (i987), pp. 229-252; Kose J, and B. Ofek, “Asset Sales and Increase in Focus," Journal of Financial Economics 37 (1995), pp. 105-126, "For spins, see the early esearch by Schipper and Smith, (1983); Schipper, K., and A. Smith, "Effets of Recontractng on Sharcholder Wealth: The Case of Voluntary Spin-offs” Journal of Financial Economics 12 (1983) pp. 437-461. For research that examines why spin-offs appear to create value forthe parent company, see Daley, Metrots, and Sivakumar (1997); Daley, VV. Mehrots, and R, Sivakumar, “Corporate Focus and Valuo Creation: Evidence frm Spinofl, Journal 4 Financial Economics 45 (1997) pp. 257-281. For equity cave-ous, see the early research by Schipper and Smith (2986); Schipper, and A. Smith, "Equity Carve-Outs and Seasoned Equity Offerings,” Journal of Financial Economics 15 (986), pp. 153-186. For research that investigates the information effects of equity carve-outs, se Slovin, Sus, and Ferraro (1995); Slovin, M. M. Sushka, and S. Feraro,"A Comparison of the Information Conveyed by Equity Carveouts Spots, and Asset Sell-Off," Jownal of Financial Economics 37 (1985), pp. 89-108(Chapter 11 Introduction to Valuation Financial Restructuring Activities. Financial restructuring activities (sometimes referred 10 a6 financial engineering) include such actions as issuing debt and repurchasing the company's shares, both of Which can increase the company’s financial leverage. Financial restructuring can also entail the repayment of debt or an exchange offer where equity is issued for deb, reducing the company’s financial leverage. Financial restructuring might lead to the issuance of certain securities that have tax advantages; it might be used asa defensive tactic to thwart a hostile takeover, or it might change who has control of a company. ‘We often observe a company undertaking financial restructuring activites at the same time it is undergoing asset restructuring activities; the situation that resulted in the need to restructure the compa ny’s assets might also result in a need forthe company to adjust its capital structure. An asset restructuring can also create an opportunity for a company to change its capital structure. The roe of valuation models n financial restructuring is to measure the effects of the restructuring on the value of the firm and to provide a long-term plan for the company’s financial architecture. Once these valuations ae performed, ‘management is ina much better postion to make the appropriate value-creation decision. One type of financial restructuring is a debt recapitalization, The goal of a debt recapitalization (ebt recap) isto increase the value ofthe firm by geting better financial terms, such as lower interest rates; more potential tax benefits associated with a more highly leveraged position; and potential benefits from better management incentives associated with higher debt levels. Why might a large amount of debt Improve th efficiency of a company’s operations? For some firms, a large debt overhang can bean incen- tive for managers to operate the frm efficiently because it forces them to generate the cash lows necessary to pay off the debt. A debt recap can also be very effective in creating value in situations where investors believe managers have been using the company’s cash flows to invest in negative net present value proj- cts." In this ease, the company issues a large amount of debt and pays the proceeds out to shareholders i the form ofa special dividend or share repurchase atthe time the deb is issued, This forces management 10 stop investing in negative net present value projects, for it paid out the present value ofthe expected cash flows to shareholders upfront and is now forced to use the cash flows generated by the business to service the deb, Debt recaps can serve as an effective commitment device to stop wasting resources. NEUE TMM edo tt Mod FMC's Debt Recapitalization FMC Corporation (FMC) isa civersfied global chemical company oper- ating n three business segments—agricultural products, specialty chemicals, and industrial chemicals. FMC was one of the first companies to undergo a debt recapitalization. In February 1986, FMC's board of directors approved a financial restructuring of the company. The plan did not treat all sharehold- er in the same way. Management wanted a larger percentage of the company's stock after the debt recapitalization for both itself and its employee benefit plans. Public shareholders were to receive $70 per share and one new share for each old share. FMC planned on Issuing $1.7 billion in debt to finance the debt recapitalization. The company actually ssued more debt and paid more to the shareholders to get them to approve the pian, and it reduced $187 milion of excess funding in its pension plans as part of the financing. The cash distri6u- tion paid by FMC to its shareholders resulted in FMC having a negative net worth (shareholders’ equity) Cf more than $507 milion by the end of 1986. FMC provides us with an example of @ successful debt recapitalization. By the end of 1990, FMC hhad reduced its debt level substantially and had a positive net worth (book value). FMC outperformed the S&P 500 for almost 10 years following ts debt recapitalization, Source: “AMC Cerporaton Board Approves Resaptazaton Pen, Wal Set Joumsl bran 24, 186 otha companys lrmouncemart of his event nc the formation we cuss ths pergraph see Pus (1987; ul, “Pesion Sus Uptans FHC Debt Loe" Crain's Ocago Business (Octobe 26 867, p98 Fora acueson of FMC poset rersalain pafonancs, 260 "FMC Cot Lars That There Can Be Life Ata Leverage" Baron's vk 7, 2,18 (897130, 190), pp 1-42 Another type of financial restructuring is a stock repurchase, Stock repurchases are a form of dividend because cash is distributed to the sharcholders if they sell their stock back to the company. The stock repurchase does not harm shareholders who do not sell their stack as long as the company does not overpay for the stock Jerepurchases I the company has more cash and cashflows than profitable " See Jensen (1986); Jensen, M. C., “Agency Costs of Free Cash Flow, Corporate Finance, nd Takeovers,” America Economie Review 2 (1986), pp. 323-329.Chapter 11 introcuction to Valuation 23 investment opportunities, that cash may be worth more o the shareholders ifthe managers distribute it buck to shareholders rather than retaining it in the company. An announced stockFepurchase plan that tuys back te corporation's shares sjtemalcally ver time can create valuedaesgfoners if re likey altemative is one in which. management wil reinvest operating cash flows in negative net present value (NPV) projects. OF course, ifthe managers have great investment opportunites (positive NPV projects), stockholders would rather have managementreinvest the cash instead of paying it out. Managers typically valve their companies when contemplating a stock repurchase to see how their valuation compares to the company’s market valuation. They are more likely to engage in share repurchases when they believe their shares are undervalued. Orv average, companies that announce leverage-increasing restructuring activi- les experience postive excess stock retums. Companies that announce leverage-decreasing restructuring activities, on average, experience negative excess stock rtums.* Raising Capital ‘The ability to raise capital isa characteristic of any captalism-based economy." A company has a variety \ of different sources it can access to rise capital, Capital can come from both private and public sources, and capital can come in the form of debt, equity, or a security that is a hybrid of the two. For example, a company can raise debt eapital from private sources (such as a loan from a bank or consortium of banks), «it ean raise private equity capital (such as preferred or common stock from different types of private equity investors). Private equity providers include venture capitalist, angel investors, LBO sponsors, and mezzanine financing funds, Of course, companies can also issue debt, preferred stock, o equity in the public markets. The role of valuation models is important when a company raises long-term capital, particularly with equity instruments or instruments that are part debt and part equity. Similar to their role in financial restructuring activities, valuation models measure the effects of raising capital on the value of the firm and, more importantly, serve as a basis for determining the price of the new capital. Valuations help ensure that a firm does not issue new securities below their fair value, which would harm the company's existing chaimholders, Venture capital funds are a source of private equity (both common and preferred) and sometimes ‘debt. The security issued in about 80% of venture capital investments is convertible preferred stock, Companies typically goto venture capital funds for capital when the company is young, For even younger companies, angel investors are more likely to be the very initial sources of funding. Both angel inves- tors and venture capitalists demand very high expected rates of return, so they are an expensive source of capital. However, since angel investors and venture capitalists generally invest in very risky ventures, its not surprising that these investors demand high expected rates of retum, Venture capital funds are typically short lived, so the venture capitalist who raises the fund usually wants to exit investments the fund makes within five years. Two ways forthe venture capital fund to exit an investment aze to sell the company to another investor orto have the company issue stock in public markets, called going pul [LBO funds are another for of private equity. Many LBO transactions involve public companies or subsidiaries of public companies that ae taken private, However, LBO transactions can also involve com panies that are already private. As discussed previously, LBO transactions are financed with extensive amounts of debt, The ammount of deb ina particular transaction will bea function of the credit markets atthe time ofthe transaction, the magnitude and stability of the company's cash flows, and the quality ofthe company’s assets ‘An initial public offering (IPO) occurs when a company issues stock in publily traded markets for the fist time, I'the company is issuing new shares of stock, the offering is called a primary offering, and the company receives the proceeds of the transaction. Ifthe company’s initia investors are selling "Fr research on these topics, ee Dan and Mikkelson (1984) and Maslis (1980, 1981); Dan, L,Y. and W. H. Mikkel “Converible Dob Isuance, Capital Structure Change and Financing-Relaed Information: Some New Evidence," Journal of Financial Economics val. 13, no. 2 (1984), pp, 157-186; Masulis, R. W, “The Effects of Capital Structure Change on Security Prices: A Study of Exchange Offers," Journal of Financial Ezonomics vol. 8, no. 2 (1980), pp. 139-177, Masuli, RW, “The Impact of Capital Stucture Change on Fina Value: Some Estates," Journal of Finance vol, 38, 10. 1 (1985), pp. 107-126; Vermacien, "Common Stock Repurchases and Market Signaling: An Empirical Study." Journal of Financial Economics vo. 9, no. 2 (1981), pp. 138-183. “ Rajan and Zingales (2003) discuss this issue thoroughly in Rajan, R. and L. Zingales, Saving Capitalism from the Capitalist: Unleashing the Power of Financial Markets 10 Create Wealth and Spread Opportunity, Ceown Publications (2008).(Chapter 1 | introduction to Valuation ‘some or all oftheir stock (such as a venture capital fund or management), the offering is called a second ary offering, and in this case, the proceeds of the offering go to the selling sharcholders, Regardless of ‘whether this is a primary.or secondary offering (or combination of both), shareholders want to make ‘sure that they are receiving fair value for giving up some of their proportionate ownership in the enter- prise, In addition to a source of capital, going public provides a source of liquidity for a company’s stock. Highly liquid stock can sometimes act like a form of currency for a company, which can be valuable to its investors as well as to employees who have employee stock options or hold other equity claims on the ‘company, Valuation models naturally play a role in setting prices any time a company goes public. The tunderwriters shop the issue to various investors to assess the demand for the shares at various prices. ‘The assessed supply and demand determines the final price at which the company issues its shares. His- torically, the issue price undervalues the shares by, on average, close to 19%, as measured by the price cone day after the issue. Over the longer term, however, IPO stocks do not perform as well as a control group of stocks, We observe these results for both U.S. and non-US. IPOs." Strategic Analysis and Value-Based Management Companies use a strategic process to continually evise existing strategies and to develop new strategies, strategic plans, and tactics. They execute their strategic plans and tactics to create value. Valuation mod- els use forecasts from altemative strategic plans and other information to measure the effect of diferent strategies onthe value of the fim. Companies ean use valuation models to make many decisions beyond strategic decisions, such as deciding whether to invest in certain projects. Strategic analysis atempts to identify a company's value-maximizing business strategy. The process involves evaluating the businesses that a firm does or can operate and how it can best organize itself 10 compete in those respective maskets. One element of strategic analysis is to perform a valuation analysis of the feasible altemative strategic initiatives to determine which of the alternative business strategies creates the most shareholder value. Managers then look at the valuation implications ofthe various strate~ gies as well asthe risks inherent in each in oder to determine the best path forthe company to pursue. ‘Value-based management is one of many terms that describes how a company can operate all aspects ofits business and make all management decisions based on the effect is decisions have on share- holder value. While this entails viewing M&A activity, restructurings, and strategic analysis within the framework of shareholder value creation, it also implies using valuation models fo capture how all deci sions affect value, Value-based management entails providing all levels of management with sufficient information so that they can begin to examine the valuation consequences of their actions and to provide them with incentives to choose the altematives that increase valve. In many organizations lower-level and mid-level managers are given incentives to focus solely on earnings or earings-based measures and not on measures that consider the necessary investments, the risk of those investments, and the tim- ing of cash flows associated with such decisions. Value-based management systems attempt to provide ‘managers with incentives to maximize shareholder value." The distinguishing feature of a value-based ‘management process is its more formalized and rigorous analysis ofthe valuation effects of a multitude cof decisions and its direct compensation of management based on the value created.” A requirement for 1 value-based management process is a valuation model that is based on the company’s specific inputs and outputs. This requirement provides a distinct role for valuation models. Contracts Between a Company and Its Investors and Employees Accompany begins with a contract between the company and its shareholders and perhaps just between the founders at the outset. A company has contracts with every type of investor from whom it raises capital, which could be another company, some other legal entity, or a single individual. Companies also have contracts with their employees. Many of these contracts, especially the contracts of a pri- vately held company, require a valuation of the company to be conducted from time to time. "See Ritter and Welch (2002) fora review ofthe esearch on IPOs; Riter, I. Rand I, Welch, “A Review of PO Activity, Pricing, and Allocations,” Journal of Finance vel. LVI, no. 4 (August 2002), pp. 1795-1828 ‘See Martin and Petty (2000) fora detailed discussion of vale-based management; Marin, J.D. and J. W. Bet, Value suse eer hg eons the Shoe, Hao ss Sil Pes 20, "wie we sow neh seas development asa steps inp eal mani conn valving processChapter 1 | introduction to Valuation 28, Privately held companies often have a buy/sell agreement. The buy/sell agreespent identifies the con- ditions under which the equity of the company can be bought or sold and at what.psigggaeit delineates the ‘method used to measure this price. Similarly, privately held companies CihPReatoyce stock owner ship plan (ESOP) or some type of stock option or incentive compensation plan (based on the value of the fim) must conduct a valuation of the company, usually annually, so employees leaving the company can receive the Value of their holdings in the ESOP or the value of their stock options. Even publicly traded companies sometimes provide incentives for division managers with compensation schemes based on the value ofthe separate divisions, meaning valuations of the separate divisions must be conducted from time to time. Sometimes publicly traded companies create a special purpose entity (SPE) in order to isolate certain assets for securitization or self-insurance, to manage risk, or to allocate capital. These SPES often equite a valuation of certain claims or assets of a company."* Regulatory and Legal Uses of Valuation Governments sometimes sell off government-owned businesses in the process of privatization. Gov- cemments use valuation models to assess the value of the government-owned businesses to be sold. Regulatory agencies regularly set allowed rates of return in regulated industries based on a company's cost of capital, Sometimes income tax authorities, such as the Intemal Revenue Service (IRS) in the United States, base the amount of taxes owed by a taxpayer on the value of assets. This occurs when. someone dies and an estate must pay taxes on the value of the decedent's estate at the time of death. Sometimes in an acquisition, a company will be forced to divest of certain assets in order to cure an antitrust issue with an antitrust enforcement agency. In this case, the company will use valuation mod- cls to find the cure that maximizes the value of the entity post-ransaction. Courts also rely on valuations when ruling on damages in lawsuits that involve companies. In many of these cases, damages equal the loss in firm value that results from the alleged actions of the defendant. Lawsuits in which damage assessments are likely to rely on a valuation model include those involving patent infringements, theft of trade secrets, business disparagement, breach of contract, appraisal of the value of a merger, and misrepresentation in the purchase of a business or security, among many others. Identifying Over- and Undervalued Securities Some investors use valuation models to ineasure a company’s fundamental value based on their expec tations of the business, They then compare the fundamental value to the price of the company on the stock market in order to identify whether the company is undervalued or overvalued. These investors, then take portfolio positions that they hope will yield superior retums. Whether an investor can “beat the market"—that is, eam returns on a portfolio that exceed the returns the market would expect for that portfolio given its risk—depends on how good that individual's valuations are relative to the market's valuations and whether the market subsequently leams information that is consistent with the investor's insights.!? While we do not discuss portfolio management in this book, the valuation methods we discuss can be used in investment management in order to determine what companies to buy, sell, or sell short. At present, billions of dollars are invested in U.S. investment funds alone that base their portfolio decisions fn the Valuation models we present in this book. Some funds that are relatively passive in terms of what securities they hold (such as a fund that holds, aa broad-based index, like the S&P 500) look for companies in their portfolios that they believe are run inefficiently. They then work with management ofthese companies, showing them how more value could be created relative tothe current operations of these companies. This analysis relies on the valuation mod cls we discuss at length in the book. CalPERS (California Public Employees Retirement System), among “others, manages one of the largest public pension funds and has used this technique since the 1980s. "See Culp and Niskanen (2003), especially Chapter I-, fora discussion of SPES and the use and alleged misuse of SPES by Enron Corporation; Culp, C., and W. A. Niskanen, editors, Public Pliey Implications of the Enron Failure, CATO Taste (2008), See Fama (1994, 1998) fora discussion of the efficient markets hypothesis Efficient Maskets I,” Fitieth ‘Anniversary Invited Paper, Journal of Finance, 46 (December 1991), p. 1575-1617, Fama, G, "Market Eficiency Long- ‘Term Retuns, and Behavior! Finance," Journal of Financial Economics 49 (September 1998), p. 283-306,26 Chapter 1 | intraduction to Valuation LOS outine the steps inthe vation process 1.8 AN OVERVIEW OF THE VALUATION PROCESS ‘The implementation of any valuation process involves completing a series of specific steps. Some of these steps must be completed in a certain order, while others need not be, The process varies somewhat as a function of the type of company as well as the reason for performing the valuation. Here, we describe ‘one approach to organizing the steps in a valuation, We summarize this overview of the valuation process below and in Exhibit 1.3 EZ ‘An Overview of the Steps in a Typical Company Valuation 1 Ket te conpanye dec nda ard pote compel 2 foal histran peer, ste and sures of amp aavartage 8 Cala th valu of her anc ety sng oo te fame of th eocourted cash flow valuation model or oon ow moda * Forecast financial statements and free cash flows: | + Measie te buns fk othe company ana cst of apa 4 Cala the va of ofr and common ent eng market mile vaaton methods {Using pte aed corpares ! {+ Using compari ransacton appicabl) 1 5 Coniser ater vaaton methods ech as lveraped bye aa An early step in any valuation is identifying the company's key competitors, which we designate as being the first step. This step entails identifying the firm's lines of business and then identifying both key competitors and potential competitors for each line of business, Potential competitors include firms that sell similar products in a different geographic area—but could potentially enter the company’s geographic 4area—and companies that might choose to enter a particular line of business. In addition, other firms selling products thatthe company is thinking of selling are also potential competitors. Finally, firms that sell products that are quite different but have some ofthe same functionality (e., oll and propane gas) may be key competitors as wel. In the second step, when possible, we analyze the past performance of the company and its com- Pettors using historical financials, We also identify the strategy of the company and its competitors in sn effort to establish the sources of competitive advantage for each company, and then we determine if the identified sources of competitive advantage are detectable inthe historical data. Once the sources of competitive advantage are identified, we determine the extent to which that competitive advantage is sustainable, and—if it is sustainable—for how long. In the third step, we calculate the value of the firm using one of the forms of the DCF valuation model or excess flow model. For both the DCF and excess flow methods there are alternative forms of each method, so some thought regarding whichis the best alternative is necessary. We often measure the continuing value using the cashflow perpetuity model or, in some valuation coatexts, we use a market ‘multiple valuation. Once we analyze te historical performance and sustainability of any identified com- petitive advantage, we create forecasts ofthe financial statements and free cash flows and test the reason ableness of those forecasts. These forecasts take economic and industry-specific trends into consideration ‘To the extent there are important embedded options to consider, the forecasts ust consider how to embed those option-like features or how to measure the value of these features separately. As part of this value- tion, we also measure the company’s business risk and costs of capital, Estimating the company’s cost of capital normally relies on data from the company and from relevant comparable companies. Estimating the company’s equity cost of capital normally includes implementing a model of how assets are priced, such as the Capital Asset Pricing Model (CAPM), and how the gompany’s financial structure affects its cost of capital. This step includes collecting data on the company being valued and its comparables, choosing an asset pricing model, and implementing the asset pricing mode. [Next in step four, we measure the company's value using « market multiple valuation method, This step involves choosing comparable companies appropriate for both the method and the company being valued, choosing the specific multiples o use, adjusting the financial statements ofthe companies (if the ‘multiples are based on information in the financial statements), measuring the multiples—both numerator and engin gael company chosing te vale org of ales foreach mp, and ushi the ndf@e8T6 measure the value of the company and its common equity. If there is potential Value in the options Svailable to the company, that option value has fo be added to the market multipleChapter 1 | introduction to Valuation 27 Valuation, or we have o choose comparable companies with the same optignsjgpgrdypis-embed hat value i the measured multiples. Finally, we consider whether any other valuation methods are appropriate to use. For example, we might consider the value of the frm in an LBO transaction In this analysis, we use our projections of cash flows thatthe company would generate ift did an LBO, determine the most advantageous capital structure possible given credit mazket conditions and characteristics of the company, and value the company’ as an 1LBO transaction based on the required rates of return fr its different claimholders. Alematively, we might consider breaking up oF liquidating the company, SUMMARY AND KEY CONCEPTS ‘This chapter has provided an overview of the valuation process and the basic valuation models that are commonly used init, including discounted cash flow, discounted excess flow, market multiples, LBO transaction analysis, and the option pricing framework. In addition, we have diseussed the economic balance sheet and the sources of Value for a company, including the value of its operations, excess assets, and the value from finan itis chapter we have discussed a variety of decision Contexts in which valuations are used, both in transactions analysis and with respect to internal decisions within a firm. Further, we have discussed how managers use these valua tion methods in their decisions. This book explores all of the valuation methods discussed inthis chapter in detail and gives specific guidance on how to obtain the relevant data necessry inorder to implement the models discussed. ADDITIONAL READING AND REFERENCES ‘Coase, R., “The Nature ofthe Firm," Economica 4 (1937), pp. 386-408. Jensen, M. C., “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers; (1986), pp. 323-328. American Economic Review 2 EXERCISES AND PROBLEMS. PLI_—_Review Apple Inc.'s (Apple) financial statements in Exhibit 1.2 and its excess assets and valuation in Section 1.3. Prepare an economic balance sheet for Apple similar tothe economic balance sheet in Exhibit 11. Discuss potential reasons for the differences between the values on the economic balance sheet and Apple's financial P12 Review Apple In.’s (Apple) financial statements and free cash flows in Exhibit 1.2. Explain, wih as much ‘etal as possible based on the information inthis exhibit, why the expected free cashflow for 2012 of $20.277 decreased relative to Apple's actual free cash flow of $25,272 in 2011 P13 Accompany has expected free cashflows of $1.45 million, $2.93 million, and $3.2 million in the next three years, Beginning in Year , the expected cash flows will row by 3% in perpetuity. Measure the value ofthis ‘company as of today using both a 10% and 12% discount rate. P14 Accompany bas expected free cash flows of $1.45 million, $2.93 million, and $3.2 million in the next three years. Beginning in Year 4, the expected cash flows will grow (or decrease) by ~5% in perpetuity. Measure the value ofthis company as of today using a both 10% and 12% discount rate PLS Compare and discuss the valuations in the previous two problems. PL6 —_Acompany has expected cash flows of $1.85 million, $2.25 million, and $2.92 million inthe next Uhree years. For Years 4 through 10, the fee cash Flows will grow by 6% annually. Beginning in Year 11, the expected cash flows will grow by 3% in perpetuity. Measure the value of this company as of today using both 3 10% and 12% discount rat, PLT Reviow Exhibit Pl. for ris Seegers Inc. and measure the free cashflow for Seegers for Year Oand six years of forecasts (Year +1 10 Year +6) shown. The company does not hold any excess cash so the change in the ‘ash balance is equal tothe change in required cash The change in Retained Barings ina year is equal tothe ‘company’s net income minus the dividends declared by the company in that year. Discuss the major factors that caused the free cash flows to change from year to YeatChapter 4 inroduction to Valuation PLS Value Frits Seeger Inc. as ofthe end of Year O using the information in Exhibit PI.t and a 13% risk-adjusted Aiscount rte Frits Seagers, Inc. Financial Staternent—Actual and Forecasts “Rpts SEEGERS'INC. Income Stitement ancyBalance Shaet Forscagts forthe veers ended Décember $1) Actual . se Sy” Forecast” Year-1_YostOYoary.” Year? income Statement Revere 10000 $19500 $2100 $9.0000 $9,088 Cost of goods sot “e100 0085 7,809.1 0150 Gross margin 5 3000 $ 9009 $1,283 Seling, genecal & administrative... 120.0 2712 Operating income. $ 2700 Interest expense 170 Income before taxes. § 1930 Income tax expense. 172 Net income, $1158 Balance Sheet ‘Cash balance $ 500 ‘Accounts receivable 168.7 584.1 Inventory 1186 aM 4157 ‘otal curent assets $3353 i S1A780 Lena II s500 0 z 2.8088 Total assets, 51,8853 3,979.8 Accounts payable s 508 $1783 (Other curent operating labios 35.0 1156 127 Tota curent faites Ss 88 8 2805 $3008 Debs | 1,200.0 +9000 2,100.0 Total biti. teen $1285.68 $4984 21885 $400.8 ‘Common stock Some § 2636 $5645 8 5685 Retained eamings : 2158 S157 31,0807 10185 ‘Total shareholders equity S504 § e004 6. $1,6252 $15790 “Total lables and equtes. 918855 92,1088 $3,8087 $3,978 ‘init may contan smal roondng oro SOLUTIONS FOR REVIEW EXERCISES Solution for Review Exercise 1.1: The Market Value Company Economic Balance Sheet ‘We have sufficient information to vale the claims on the company’s resources. The company’s share price fs $12.08 and ithas 1,200 shares oustanding or an equity value of $14,496, Its debt is trading ata premium indicating that its market value is equal to 102% of ts book value o¢ $5,304. The resulting value ofthe fm is $19,800, From that amount we sub- tract the value ofthe excess asst, land valued at $3,000, and the value created from debt financing, $3,800, to measure the value of the unlevered operations, $13,000. aeValue ofthe unavered business operations without excess assets '$19,000.0 Value ofthe excess assets 3,000.0 Value of tho nlevered frm. 16,000.0 Value created from fnancing - 5 3,800.0 Value ofthe fr e $19,800.0 Value of debt Value of equty Value of securtias esued Solution for Review Exercise 1.2: The Market Value Company Unlevered Free Gash Flow ‘We show te calculation ofthe unlevered free cashflow below. Notice thatthe unlevered free cashflow is negative. The negative fee cash flow occurred not because the company was unprofitable but because the company invested more cash than it generated. Note that the Capital Expenditures equal the change inthe Net Property, Plant and Equipment pus the Depreciation Expense Tortie Vea. — je = oe ‘THE MARKET VALUE COMPANY © eas Fre Gan Pw Foyecasta Earns oto rtret ane toes EBM seat Treone tates pasdon BIT sees “ete0 Earns bir ret a has . ITLL. Roose + Deprecaon 000 henge accounts aavabi Sr «_>Phhange inventory cea 16 Change in accounts payable C+ Change in curent other labios = Change in requited cash balance. LUniavered cash flow trom operations. Capital expensitures, Unieveed tre cash low Sglution for Review Exercise 1.3: Valuation of Unlevered Free Cash Flows ‘We show the calculation of the value ofthe unlevered free cash flows below. Cost of capital 12.0% Growth rate for rae cash tow for continuing vaio 20% Se ae F 7 as Lee *Yeirg * Years Years, _Year3: 1 Unteverec ao ash fow fr continuing value (OV) $1822 Dison factoe for continuing valve : 30000 Unleere ree ash fow and Ov ‘10020 $1400 s12080 $4,200.16 Discount sector ase o7s7 o7t2 ore "Present valve Soa $0088 $0598 § 877.03 Value of the firm o $114335 138% 60% 20% Fore [Exhibit may contain arallounding errs 29After mastering the material in this chapter, you will be able to: 4. Know how to access information, identify 4. competitors, and use financial statement analysis in valuation (2.1-2.3) 7 2. Measure the performance of a company using rates of return (2.5-2.7, 2.9, 2.14) 3. Examine a company's asset utilization and working capital management (2.8, 2.10) Bi fa rel ORE TOP NEWS» ASDA te Index (CCMPIND) Index Perfo Blopiber com /ans/avoercker=cCi AOTC Index ccoup:noy STOCKS FALL AMID EUROPE DEBT Analyze a company's fixed assets and financial leverage (2.11-2.13) . Assess a company’s competitive advantage (2.15) . Describe measurement and implementation techniques (2.16) Bgembers NOW soos veFinancial Statement Analysis ‘Bloomberg provides various financial ratios as part ofits database services. Below, we show a sample of the financial ratios ‘Bloomberg reports for Dell Ino. (Del) and Hewlett-Packard Company (HP) as reported on August 10, 2011. In this chapter, we ‘wil learn how to measure ratios lke these and how we use these ratios in valuation work. Although Dell and HP are direct competitors, some of their financial ratios are not similar. The financial ratios for Dell and HP highiight how a company might not be a good comparable for a par- ticular valuation analysis even though It is a direct competitor. Choosing ‘comparable companies is just one Important use of financial statement analysis in valuation work? BLOOMBERG fueron common ay ee ee er ee Fotun on capt a re a _ Reto nace ay a ventory 42 47 08 eta ws mz a9 Bap cc accu cea. es ee 42 Gh te Be 3 88 bata wenoer Ba eg en) ask te a eens 134 “Bit Faciow tndleveraie ns Tota dt tt aes a oe et reeset res eee uals re | Fes auto common en ot oto ma tke mt sa | Gis dats earn Fr i a ‘oeeauty s? $s 12 62 80 as 2388s Neca o ticles ai oor} gobs tor? 1088 ae 24S G27 Mout Ala aah ao, os 0608 0808s ws ouacate As nt te Saree. SM S38 Seta Ivory cata Pr ee Growth, . sales gow s38 om 0% ci ue sa om 108 EBT get o mt 2 me foe eae etn owt 1% te -ion, seem fm toe foes In this chapter, we explore how to analyze financial statements and how that analysis is used in valuation. "Bloomberg L. P. provides a dynamic network of devring data, news, and analytics through various access platforms see httou/ won bloarsberp.com/sompany/#menu for more information and a description of the company, its products, and its services. atNOILVZINVDYO waLdVHO Chapter 2 | Financial Statement Analyels industries Competitive analysis Driving! assessing forecasts Estimating debt and preferred ost of capital Identiying ‘comparable ‘companies ascot Return on investment Return on equity Aglusing for excess assets Disaggre- gating tho return on assets Measuring ‘equipment tumover ratios Ability to pay curent Tabiives Time to pay accounts payable Time to sal Inventory Timeto collect Remaining epreciable We Capital expenci- tures Financial leverage ratios Coverage of fixes payments Diteroat tion Strategic postioning enitying competitive advantage Sustaining competitive advantage Flows and stooks Iraion adjustments ening adjustments Infuentiat ‘observations Negative ce Financial Accounting Sundards Board, Statement of Fitancial Accounting Standards No. 131, ‘Segments ofan Enterprise and Related Information," Sune 1997 ‘Disclosures About LO1 Know how to access invorration, identity competitors, and use fnencial statement analysis in vakation \Chapter 2 | Financia! Statement Analysis, pany for which separate financial informatio is made available and evelusted by management, and that accounts for 10% or more ofthe company’s revenues. The information reported should be the same a the information used intemal for decision-making. Operating segments are typically of two types: industry segments and geographic segments, U.S. GAAP also requires companies to disclose their majo customers, generally defined as customers who purchase 10% or more of the company's good and services. Operating segment information can be useful when valuing a company. However, detailed publicly available infor- ration is usally quite Kimited, and we generally need information not available to the public in order to analyze a segment in detail Other soures of information include stock reports and financial analyst reports Stock reporis—such as the Standard & Poor's Sick Reports (ewo-page company summres)—contain financial and other summary information for publicly traded companies ina quickly accessible and usable form. Analyst reports provide ‘wealth of information onthe companies analysts follow an often include information about important com- Petitors fora given company. Companies often ist the analysts who waite eportson them on their websites, and these analysts ae also listed in certain publications (Nelson's Directory of Inesment Research). We typically classify an analyst a ether a sell-side analyst, a buy-sde analyst, or an independent research analyst, Sellside analysts work for brokerage companies and make recommendations that brokers use to advise clients on sales and purchases of securities. Buy-side analysts work for invest- tment management companies and advise portfolio managers onthe stocks they might purchase or sel Independent research analysts work for companies that sell analyst reports to investors. Of course, analysts obtain much of their information from the management and financial statements of companies, ‘though analysts are likely to be more objective than managers are, we know that analysts ae, on aver- age, optimistic ‘The financial press (newspapers, magazines, periodicals, and news websites), financial websites, stock exchanges, and certain services also provide information on companies. Articles inthe financial press sometimes serve to collect and summarize information from a varety of sources (the company, its management, financial analysts, reports filed with the government, et.). Financial websites such as Hoover's Inc, Google Finance, and Yahoo! Finance provide information about companies and their ‘competitors in much the same way some stock reports do. Many stock exchanges provide information on the companies that have securities that trade on tht stock exchange. Some companies—for example, ‘Thomson Reuters, Bloomberg, and Momingstar—provide information on a company 3s well as conduct analyses using that information Large archival databases are another source of individual company information. For example, the Center for Research in Security Prices atthe University of Chicago has a comprehensive database of USS. stock market data, Standard & Poor's Compustat® is a standardized database containing account- ing and some market data, Datatream and other databases provide financial statement and stock price information on cmpanies allover the globe. Suc databases allow one to investigate a company and is industry in a variety of ways. Wharton's Research Data Services (WRDS) from the Wharton School at the University of Pennsylvania provides convenient access to many databases with a web-based interface Information About an Industry ‘We also have extensive information available on industries. First, companies often disclose information ‘on the industries in which they operate in their 10-K reports and in annual reports to shareholders. Many financial analysts specialize in certain industries and write industry reports as well as individual com- pany reports. Some companies also issue reports containing information on an industry—for example, Standard & Poor's Industry Surveys. Industry financial ratios are also made available in some of these publications. Most large industries have an industry or trade association. Such associations often issue industry or trade magazines that contain information on the industry, including various industry statistics. ‘The financial press and financial websites also contain information about industries. "Various research studies document the extent to which analysts are optimistic; see, for example, Lin, H, and M. McNichls, “Underriting Relationships, Analysts" Eamings Forecasts, and Investment Recommendations” Jounal of Accounting and ‘Economies 25 (1988), pp. 101-127. This article suggests thet such optimism sometimes result fom a conflict of interest of (atleast sellsde) sna sou, inthe United States, a number of investment barks setled with Federal securities ‘Paulie brs sao of intents face by ter elie) sock analysts. (Se prong aaa or 8 variety of press releases aid other documents on this topic)Chapter 2 Financial Statement Analysis rivately Held (Owned) Companies + Vhile we have extensive information available on publicly traded companiexeaeSiiayeatistintially less formation on privately held companies, unless we have the cooperation of the private company (for npl, if We ate valuing the company because it is considering an initial public offering). Companies un and Bradstreet, Inc. and Robert Morris Associates collect limited information on privately held mmpanies, There are also databases that provide some limited valuation data on private companies sold change-of-control transactions. ~:.2.2 HOW WE USE FINANCIAL RATIOS IN VALUATION Scholarly research has shown that financial ratios contain useful information,’ which provides empiri- cal justification for their widespread use in valuation and other financial analyses. Generally, when we tse financial ratios, we typically compare a company to itself over time—a time-series analysis—or to other comparable companies—a cross-sectional analysis. We often use both types of analyses at the same time—a combined time-series and gross-sectional analysis. While we often use the financial ratios of competitors as “benchmarks” for the company we are analyzing, we often do not have an absolute benchmark” for what is “good” or “bad” value. While we are getting ahead of ourselves abit, we illustrate this point using the current ratio—the ratio of « company’s current assets to its current liabilities. Most companies have more current assets than cur- reat liabilities. We typically observe an average current ratio for a broad set of companies in the range of 1.5 to 2. A higher current ratio suggests a more liquid company. But what is a "good" current ratio? Is a good current ratio below the average or above the average? The answerto that question is, “It depends.” A. low current ratio might suggest potential financial distress; but, ifthe company has processes in place that allow ito operate efficiently with a low current ratio (for example, very low inventory levels), then a low current ratio might suggest source of competitive advantage. For example, Dell had a very low current ratio, and its working capital management techniques were seen as a source of competitive advantage. We face the same benchmarking issue for other types of ratios as well. Competitive Analysis Conducting a competitive analysis of « Gompany and its industry provides a general understanding of both the company and its industry a well as an assessment ofthe company’s postion within the industry. We normally conduct a competitive analysis early in the process of valuing a company unless we are instructed to rely on forecasts provided to us by other, such as management forecasts, Such an analysis can provide insights into the key value drivers ofa company’s business and help us identify a company's sourees of competitive advantage, if any. A competitive analysis often involves analyzing a company's vision strategy, and strategic objectives. Measuring the Debt and Preferred Stock Costs of Capital ‘The debt and preferred stock costs of capital are important inputs in most valuations. We use them when. ‘we unlever a company’s equity cost of capital o lever its unlevered cost of capital, and when we measure «a company’s weighted average cost of capital. Since a company’s debt and preferred stock are often not publicly traded, we often cannot measure its debs and preferred stock costs of capital directly from mar~ ket data In such cases, we typically measure the debt and preferred stock costs of capital using market data from comparable companies, and we determine the comparability of the companies, in past, using, financial ratios. Rady that examines accounting based rates of rerun directly is Ami, E, and I, Kama, “The Market Reaction to ROCE CComponens:Implicitions for Valuation and Finacial Statement Analysis." Working Paper, Tel Aviv University, November 204 Also see the work of Ou, J, and S, Penman, "Financial Statement Analysis and the Prediction of Stock Retums,” Journal ‘af Accouning and Economics 11 (1989), pp. 295-330; Holthasea, Rand D. Larcker, “The Prediction of Stock Retims Using Financial Statoment Information,” Jounal af Accounting and Economics 15 (1992), pp. 37312; and Abarbanell, J, and B. ‘Bushee, “Abnormal Stock Returns toa Fundamental Analysis Strategy” Accounting Review 73 (1998) p. 19-4.38 Chapter2 | Financial Statement Analysis Preparing (Driving) and Assessing the Reasonableness of Financial Forecasts ‘We use financial ratios to create or “drive” our forecast, and then we use other financial ratios to assess the reasonableness of our financial forecasts. Naturally, we do not use the same financial ratios to both drive and check the reasonableness of the forecasts. As we discuss in Chapter 4, one of the first steps in creating financial forecasts is to identify factors or “forecast drivers” to generate the forecasts. A common type of forecast driver is a growth rate, which may be one of the key factors (drivers) in a financial model. We also use financial ratios, such as expense ratios, as forecast drivers. Tumover ratios (the ratfo ofan item on the income statement to a balance sheet item—for example, revenue to accounts receivable) are another common type of driver. Once we develop our forecasts, we use other financial ratios to help us assess the reasonableness of our forecasts. For example, we compare the rates of retum (retum on assets and retumon equity) in our forecasts to the historic rates of return of the company, its industry, and its close competitors. We might also use liquidity ratios, asset utilization ratios, and asset composition ratios in a similar manner. Assessing the Degree of Comparability in Market Multiple Valuation Financial ratios can be useful in a market multiple valuation when assessing the comparability of the ‘company we are Valuing to other companies. We use financial ratios to assess the comparability of profit- ability, rates of return, cost structures, capital expenditure requirements, growth rates, and business risk, Assessing the comparability of these factors is extremely important in a market multiple valuation, Constraints and Benchmarks in Contracts Investors often use financial ratios as either constraints or benchmarks in contracts. For example, debt contracts—and to some extent preferred stock contracts—often utilize financial ratios as constrains, called covenants, to protect investors’ rights. Investors might require a company to maintain @ certain amount of liquidity, limit the amount of debt, or limit dividends by using various financial ratios. I a company violates any of these accounting-based covenants, called a technical defaalt, the investors typi- cally get additional rights, such asthe right to accelerate the maturity of the debt and possibly charge a higher promised return NEI E Nik AMM Sok koe Example Debt Covenant for Dex Media, Inc. Dex Mecia, Inc. has debt agreements that require it to ‘maintain a certain amount of earnings before interest, taxes, depreciation, and amortization (EBITDA) relative to its interest payments. We call ratios ofthis type coverage ratios. It describes one such cqve- ‘ant ints registration statement fled with the SEC so that it could issue adltional securities as follows: “The loan agreement includes certain financial covenants, including an interest coverage ratio based on EBITDA to interest expense with a minimum ratio of 4.75:1 and a debt to EBITDA ratio of 1.75:1 and other covenants limiting Dex’s ablity to incur adltional debt or lens, pay dividends and make investments,” 5 . OCT ‘Seurce: So ts 6-1 fing fegstraton statement for esng ecu) flea wh the U.S. SEC on May 14, 2004, 66 p09, svalsbe ot bmn it 3 _ Investors use other contract provisions as well to prohibit the company from selling « significant ‘amount of its assets or merging with another company. Investors also use financial ratios as benchmarks (or hurdles). For example, companies might have to meet certain hurdles described in a debt agreement 19 Teer pikes, and ARG, "An Epica Eeaminion of Debt Covenant Resticions and Accounting Relstod ‘Debt Proxies,” Journal of Accounting and Economics vol. 1-3 (January 1990), pp. 45-63; and Press, E., and J. Weintrop, "Aecounting-Based Constrains in Public and Private Debt Agreements—Their Association with Leverage and impact on ‘Accounting Chive,” Journal of Accounting and Economics vl. 1-3 (January 1990), pp. 65-56Chapter 2 | Financial Statement Analysis 87 raw cash from a line-of-credit. Some loans, called performance priced debt, determine the yield spread above U.S. Treasuries or LIBOR the borrower is charged based on accounting perormagag®-measyegs. In addition, companies sometimes use accounting-based measures of performance fo compensate managers, Wetruricr ae We use financial ratios in a variety of ways: to perform a competitive analysis of an industry or of a company within an industry, to assess business risk, to measure the debt and preferred stock costs Cf capital, to drive and assess the reasonableness of financial forecasts, to assess comparability for 2 ‘market multiple valuation, and to set constraints or benchmarks in contracts. 2.3 IDENTIFYING A COMPANY’S INDUSTRY AND ITS \ COMPARABLE COMPANIES ‘To identify a company's comparable companies, we generally begin by identifying a company's existing direct (or “head-to-head”) competitors before identifying indirect and potential competitors. For example, if we were valuing Ford Motor Company (Ford), we would first identify what markets Ford serves. As it tuims out, Ford competes in the worldwide auto, truck, financing, insurance, and leasing markets. Iden- tifying Ford’s competitors in the auto and truck markets is relatively straightforward, Its competitors in the financing, leasing, and insurance business include a much broader group of companies, ranging from ‘other car manufacturers to numerous financial institutions and insurance companies. As discussed earlier, 1 good starting point for this analysis is Ford’s 10-K report. Inits 10-K, Ford provides information on its market share in the U.S. combined car and truck market 1s well as for its major competitors. For the year ended December 31, 2010, Ford reported that the top six companies in terms of market share in the combined U.S. auto and truck market were General Motors Corp. (GM), Ford, Chrysler Corporation, Toyota Motor Company (Toyota), Honda Motor Company LTD (Honda), and Hyundai-Kia. Ford provided market share data for each individual company as well as the fact that, together, these six companies had over an 85% share of the defined market. Ford also provided information on the non-US. market, information on the countries that are most important to it atthe current time, and information on emérging markets that it believes will become more important (0 it over time, Standard and Poor's Industry Survey for Autos and Auto Parts identified over 20 different ‘manufacturers of autos.” [As of January 2012, Hoovers (wwhoovers.com) listed over 25 competitors for Ford. That list of competitors included other car manufacturers and such major financial institutions as Bank of America, Citigroup, and J.P. Morgan Chase, Therefore, analyzing a company like Ford requires an analysis of the various markets the company serves and of the competitors in each of those markets. We would also identify any of Ford's indirect competitors and any potential new competitors looming on the horizon. Indirect competitors would be companies that might affect the profitability of the auto industry but that are not directly in that space. Indirect competition may or may not be important for a company. For example, motoreycle manufacturers are indirect competitors for automobile manufacturers, but they do not have a substantive impact on either the profitability of or the demand for automobiles. Reducing the price of motoreycles would probably have a very small impact on the demand for autos. Economists Would say that these two industries have a small cross-clasticity of demand, ‘While indirect competition from motorcycle manufacturers is not very important for analyzing Ford, potential competition could be very important. Potential competitors from China, India, and South Korea could have a significant effect on the worldwide automotive market over time. Great Wall Automobile Co. of China started selling sport-utility vehicles in Russia in early 2005 at prices that were approximately 35% lower than other Asian imports. Chery Automobile, another Chinese automake, is exporting to Europe and other locations. Both companies have plans to enter the U.S. market. All of these new or potential competi- tors, though small now, will ikely influence the worldwide automotive industry over time, This potential ‘competition would be important to assess in valuing Ford, as the increased competition may affect Ford's future profitability. See Standard & Poor's Industry Surveys: Autos and Auto Parts, December 29,2011, by Etaim LevyChapter 2 | Financial Statement Analysis ‘Once we have identified a company’s competitors, we will use those companies to perform a competitive analysis of the industry and determine which companies in the industry, if any, have a competitive advantage. In addition, as-we discuss throughout the book, various steps in the valuation process require the identification of comparable companies. The relevant comparable companies used for specific steps in the valuation process are générally a subset of the competitors of a company. For example, when choosing comparable companies for @ market multiple analysis, we have t6 consider ‘which companies are similar to the company we are valuing based on such attributes as risk, profit- ability, and growth prospects. 2.4 THE GAP, INC.—AN ILLUSTRATION OF THE CALCULATION AND ANALYSIS OF FINANCIAL RATIOS In this chapter, we use The Gap, Inc. (GAP) to illustrate the calculation and analysis of financial ratios. GAP is a global retailer operating retail and outlet stores that sell apparel, acessories, and personal care products for men, women, and children. We assume for illustrative purposes that GAP’s management believes thatthe market is substantially undervaluing GAP, as GAP’s management believes that it can improve GAP's performance in variety of ways. In Exhibit 2.1, we present GAP’s summary historical financial statements A2009 and A2010 (January 2010 and January 2011 fiscal yearends, respectively) and hypothetical management forecasts (F2011-F2016) of its income statements, balance sheets, and summary fre cash flow schedules. We do not show GAP's Statement of Cash Flows (though we show GAP's operating cashflow at the bottom ofthe schedule), nor do we show its footnotes and other supple- mental disclosures. Rather, we discuss relevant footnotes and other disclosures in the chapter as needed, Naturally, a complete financial analysis includes a detailed review of all of a company’s footnotes and other disclosures in its financial statements. Prior tothe end of the 2010 fiscal year (end of January 2011), GAP distributed close to one billion dollars in dividends and share repurchases. This was excess cash that GAP management felt it did not need. GAP had a market capitalization (a measure of firm value) of roughly $11 billion atthe end ofits 2010 fiscal year (after the cash distributions to shareholders had been made). The GAP forecasts assume that management can improve the company's performance. Management believes it can grow revenues above market expectations, reduce GAP's optrating expenses to improve GAP's cost stricture, man age GAP's working capital better to reduce its investment in working capital, and reduce GAP's capital expenditure requirements without affecting its planned capital maintenance and expansion forecast, Using a cost of expital of 13.5% and a perpetual growth rate of 2.5% after 2016, we can use the valua- tion framework we discussed in Chapter 1 to value GAP using management's forecasts. We show this valuation in Exhibit 2.2: If management can attain its forecasts, this illustration indicates that GAP's market value would be 5128 billion instead of $11 billion, which is a 16% increase in its value. Naturally, management and GAP's investors would all be pleased with such an improvement in GAP? performance, The isu, of course, is whether such an improvement is feasible. As'we discuss in Chapter 4, when discussing fore- casting models, we can use financial ratios resulting from the forecasts to help assess the reasonableness of the forecasts. To analyze GAP's historical performance, we use a set of comparison companies. The comparison ‘companies we use are all companies in the Family Clothing Store industry classification (SIC = 5651), ‘which is the primary industry classification for GAP-The number of companies (other than GAP) in that, industry, and for which we ean meusure the financial ratios, varies between 17 and 19 during any one year. We should note that while all of these companies have the same primary industry classification as GAP, they might not all be equally good competitors. This industry‘sode includes such companies as Ameri- ‘can Eagle Outfitters, In. and Abercrombie & Fitch, whith are direct competitors of GAP. This industry classification, however, so contains such companies as Casual Male Retail Group, In. which does not focus on the same type of shopper as GAP but rather focuses on big and tall men, and Nordstrom, In., which sells a broader set of merchandise. ‘The companies also vary in business strategy siz, and other charles. gem eare‘Chaptor2 | Financial Statomont Analysis 3 ‘The Gap, Inc—Financial Statement and Free Cash Flow History for Fiscal Years 2009 and 2010 and Hypothetical Management Forecasts 2011-2016 a ~ Ramil Steoments end Pree Ggeh owe ‘Aiood —“Aasio Foor Fama Fania Foye F015 Revenue $14,107 S14654 §15251 $1603 si6814 ‘18.096 $18,548, Cost f goods sold fore tal) “8,750 _-9,108 3888 Gross margin Dopreciaion and amortization Operating expenses. Operating income. Interest expense. Interest income, Income before taxes san Income tax expense, Netincome, Bilofice Sheet §ivmulions) > = Cash balance $47e7 ‘Accounts receivable, Inventory, a 1,664 ‘Other current asset. Tota curent assots Property, plant, and equipment $7909 Baat r $11,151 ‘Accumulated deprecation 5684 6,392 “21534 Property, plant, and equipment (nt) ther assets Total assets... 065 $6886 $ O8e1 Accounts payable $1059 $ 1.110 ‘Accrued expenses 5 x 11088 1.142 (Curent portion of long-term debt “otal curent abies, Long-term debt Non-curent labios Total abilities Common stock (and other =7.687 Fetained earings 1501 “Tota shareholders equity 5 3et4 “Tota bites and equities. [Fe teat rome Bin aliond "> amings befor interest and toxes SIT) $21 Income taxes ald on EIT 828 amings before interest and after taxes « S203 $1968 “+ Depreciation expense ...... "708 +/- Working capital and other changes = Change in required cash Unievered cash flow ftom operations. i 995 § 2,096 = Capital expenditures (net), 2-538 Unievered free cashflow 5.1558 Cash flow ftom operations ‘Exhibit may contain small rounding errs(Chapter 2 | Financial Statement Anaiysia ‘The Gap, Inc.'s Discounted Cash Flow Valuation Using Hypothetical Management Forecasts Cost of capital 13.5% Growth rate for tee cash low for continuing value 25% Uniovered tre cash fow for continuing vale (C¥) 81.5055 Discount factor for continuing value... 9.091 Unievered free cash flow and CV... sseeseee $1,5489 $1,5629 $1,5559 $1,5454 $1490.1 $19,0592 Discount factor. 0.611 _ 0.7763 06899 __0.6026 0.5309 _ 05909 Prosent value S19646 $12183 $1,081 $ 9312 Value ofthe frm ‘Exhibit may contain emall rounding errs Generally, we would conduct a more detailed analysis of these companies before using them as com- parable companies. Identifying a specific set of comparable companies for GAP is beyond what we cover in this chapter. We will discuss this issue in detail later in the book when we discuss the use of comparable ‘companies in estimating the cost of capital and conducting a price multiples valuation. 2.5 MEASURING A COMPANY’S PERFORMANCE USING ACCOUNTING RATES OF RETURN LOZ Measuw the Accounting rates of return attempt to measure the performance of a company. We can measure a Perfomance of@ company’s accounting rates of return in many ways. All of the alternatives are typically a measure company using rates of return of accounting income divided by a measure of the average level of investment used to generate that income. Some rates of return measure the amount of income generated for each dollar of investment; for example, a company with an annual income of $124 million and an investment of $1,240 million has a 10% rate of retum on its investment. The 10% rate of return indicates that the company gener- ates $1 of income each year for each $10 of investment. Conceptually, the higher the rate of return, the better the performance, ignoring the many pitfalls of using financial statement information to measure performance. We can compare a company’s current rate of return to its historic rates of return in order to assess the change in its accounting-based performance over time, or we can compare it to thé rates of return of competitor companies in order to assess its relative accounting-based performance, Naturally, it is important to ensure that you use a consistent numerator and denominator when ‘measuring a particular type of rate of return. For example, if the denominator is average assets, then the numerator should be the income generated by those assets; thus, we would measure income before deducting interest expense (on an after-tax basis). Ifthe denominator is average common equity, then the ‘numerator should be income to the common equityholders. Similarly, if we measure income by excluding certain income effects from the numerator such as the effects of discontinued operations or the effects of excess assets then we should exclude any assets related to the excluded income from the denominator. ‘We discuss three rate of return measures that attempt to quantify the rate of return related to the ‘company’s invested capital the return on assets (ROA), the return on investment (ROD, and return on (common) equity (ROE). Each of these rates of return attempts to measure the amount of income generated per dollar of invested capital given some specific definition of income and invested capital Return on Assets. The numerator in the return on assets (ROA) formula is unlevered income, and the denominator is aver- age total assets for the period over which we are measuring the rate of return, To unlever income, we add back after-tax interest and other effects related to non-equity financing such as prefered dividends: we doChapter? | Financial Statement Analysis 44. this to present what the income would have been had the company been completely Tignoed with equity. The basie formula for computing BOA is Cer Roa = Netlncome + (1 = Income Tax Rate for Interest) X Interest Expense = ‘Average Total Assets oe After reviewing GAP's footnote for income taxes (not shown in the chapter), we assume that GAP’s effective income tax rate (income tax expense divided by income before taxes) of 39.3% (0.393 = $778/$1,982) is reasonable to use as the tax rate for interest. However, it should be noted that this is not always an appropriate assumption to make for the income tax rate for interest (we discuss this issue in more detail in the next chapter). GAP has $6 of interest expense and has no preferred dividends The retum on assets for GAP calculated for 2010 is 204 + (1 ~ 0.393) x $6 (87,985 + §7,065)/2 In the above formula, we assume that there are no minority interest positions in the company’s sub- sidiarigs (as GAP did ndt report any minority interest). If there were, we would reverse any impact of ‘minority interest in the net income of subsidiaries, for the average total assets in the denominator repre- sents the total assets, including any assets atributable to the minority interests. We often measure average total assets—and other financial ratio denominators based on an average—as the beginning-of-year bal- ance plus the end-of-year balance divided by two. This calculation assumes the change in the denominator ‘occurred evenly during the year and that the beginning and ending balances represent the-average level of assets during the year. This might not be the case for companies that undertook a major acquisition or divestiture. In that case, we might compute the average from quarterly reports or perhaps from pro forma, financials (based on the assumption thatthe transaction occurred at the beginning of the yea). ROAcar, oo = = 0.160 \ Return on Investment ‘The return on investment (ROT) is similar to the return on assets. The major difference between the two formulas is how we measure the denominator. In addition, the numerator is slightly different as well, The denominator for the return on investment is equal to average invested capital instead of average assets as used in the return on assets calculation. One way we can measure invested capital is to add the book value of debt to preferred stock and common equity, or—looking at it from the asset side of the balance sheet—we can subtract operating liabilities (accounts payable, wages payable, income taxes payable, deferred income taxes, etc.) from total assets. Some analysts add non-current net deferred tax liabilities to common equity under the assumption that this is not really a liability and that stockholder’s equity was reduced when the deferred tax liability was recorded. They would make the same adjustment in calculat- ing retumn on equity, discussed next. Since the denominator for the return on investment does not include Investments by minority shareholders, we do not adjust the numerator by removing the adjustment to net income for minority interest as we did in the return on assets calculation, ‘The reason some analysts prefer return on investment to return on assets is that the implicit financ- ing costs of a company’s operating liabilities are embedded in the company's operating expenses. (Recall cur discussion of this point in Chapter 1.) As a result, it is usually quite dificult to add back the implicit financing costs of these operating liabilities; thus, (© have a consistent numerator and denominator, we 4o not include the value of the operating liabilities in the denominator. The basic formula for the return on investment is Net Income + (1 — Income Tax Rate for Interest) X Interest Expense “Average (Book Value of Debt + Preferred Stock + Common Equity) Since GAP has no debt and no preferred stock at the beginning or end of the year, the return on invest- ‘ment for GAP for 2010 is simply RO (22) a $1,204 + (1 = 0.393) x $6 “ea z010 (84,891 + $4,080)/2 Note that GAP did have a small amount of debt outstanding during the year when it drew down its revolv- ct If we knew the average debt outstanding over the year, we Would include that in the denominator. 0.269Chaptor2 | Financial Statement Analysis, WEI E Tae S ae te) Rates of return measured using financial statements are popular performance measures. Rates of return measure the amount of income generated per dollar of capital invested, measured in a variety Cf ways. Alternative types of rates of return measures include retutn on assets, return on investment, and return on (common) equity. Sometimes, analysts use the return on Iong-term capital (long-term debt plus preferred stock plus common equity) as arate of return measure, called the return on long-term investment. Because of the way the denominator is measured, we add back only the portion of interest attributable to long-term debt to our numerator when we measure the numerator for this rate of return, Return on (Common) Equity ‘The return on (common) equity (ROE) measures the amount of income to common equity generated per dollar of equity invested (all measured using financial statement information). The basic formula for the return on equity is Net Income ~ Preferred Stock Dividends _ Income to Common Equity ROE = — ‘Average Common Equity ‘Average Common Equity (2.3) ‘The return on equity for GAP for 2010 is $31,204 - $0 ($4,891 + $4,080)/2 oe ROE xp, 2010 = ‘Since GAP has no debt or preferred stock outstanding atthe beginning and end of the year, the ROE and ROI will be very close. The only difference between them, in this case, is caused by the minimal amount of interest expense from debt outstanding at some point during the year, for we did not know the average debt balance for the denominator in the ROI calculation. ‘The numerator for the return on (common) equity (ROE) is income available to common equityhold- crs, and the denominator is the average common equity. The denominator is the average (common) equity of the company during the period over which we measure the numerator. Again, we typically measure this average by dividing the sum of the beginning and ending balances of the company's (common) equity by ‘two, Since we do not deduct preferred stock dividends when measuring net income, we deduct it from the ‘numerator to represent the income afterall payments to non-common equity securities. Adjusting Financial Ratios for Excess Assets ‘We can use alternative definitions for the numerator in the rate of return calculations; for example, we ccan exclude certain types of income from the numerator, such as income from excess assets, income from discontinued operations, one-time expenses from reorganizations, and extraordinary items. Regardless of the definition we use, however, we must make sure that our denominator is consistent with the defini- tion of the numerator, For example, if we exclude income from excess assets in the numerator, we also ‘exclude excess assets from the denominator. Valuation Key 2.3 Eliminating excess assets from rate of return measures is often very useful in order to gain a true sense of the profitability of a company’s operations. That said, there are situations where eliminating the effect of excess assets is not preferred. For example, we would not eliminate excess assets if we ‘wanted to understand the overall profitabilily of the company from the investors’ perspective, ‘We use the definition that best fits the context of our analysis—that best fits how we plan to use the ratio. No single definition dominates the alternatives in all contexts. For example, if we want o know the overall profitability of a company, we might prefer to include a company's excess assets however, if weChapter 2 | Financial Staternent Analysis, calculated using financial statement numbers. We know that the percentage change in the value of an investment is equal to the percentage change in the nef present value of the investment, which, as we know, depends on changes in expected future cash flows and risk. Thus, accounting earings, which generally focus on a single period, cannot reliably measure changes in the value of an investment. In rddition, historical cost accounting measures of the value of an investment do not reflect market values. ‘Altemative measures that attempt to address some of these limitations involve some sort of longer-term forecast of expected performance and tisk. ‘Even with these limitations, accounting rates of return are widely used measures of performance. We ‘know that accounting earnings and accounting rates of return as measures of performance have an empiti- cally positive correlation with changes in market value as measured by stock returns? .6 DISAGGREGATING THE RETURN ON ASSETS Disaggregating the rates of retum into their various components has two important roles in valuation. First, we disaggregate historical rates of return in order to help us better understand the source and sus~ tainability of a company’s competitive advantage or, conversely, why a poorly performing firm is at 2 ‘competitive disadvantage. Second, once we create the financial forecasts, we disaggregate rates of return based on the financial forecasts in order to assess the reasonableness of those forecasts. Disaggregating the Return on Assets “The two primary components of a company’s return on assets are its unlevered profit margin and its asset utilization. A company’s unlevered profit margin is equal to unlevered income divided by revenue. A ‘company’s asset utilization (or asset turnover) is equal to the amount of revenue the company gener- ates per dollar of assets. The product of a company’s unlevered profit margin and asset utilization ratio is equal to its return on assets (ROA). The basic formulas for unlevered profit margin and asset utilization ‘as well as how to use them to disaggregate the return on assets are as follows: ROA= Unlevered Profit Margin X Asset Usiization ron = Netincome + (1 = come Tax Ras) x IntwestEspense , __Revente __ gn. Revenue se Toval Assets “The numerator ofthe unlevered profit margin formula is identical to the numerator in the retum on assets calculation. If there is income tributable to minority issues, the same adjustment must be made to the unlevered profit margin, as discussed with respect tothe rtum on asets calculation, The unlevered profit margin and asst utilization ratios for GAP are S $1,204 + (1 = 0393) x $6 314,664 ew £393) x $6 ,, 7 ee $14,664 (Bigs + $7.065)72 ROAcap.ao1o = 0.082 X 1.949 = 0.160 = 0.160 Valuation Key 2.4 ‘We can disaggregate the return on assets into meaningful components. The components of the return ‘on assets are unlevered profit margin and asset utilization. Decomposing rates of return helps us bet ter understand the source and potential sustainablity of a company’s retum. It wl aiso help us better assess the reasonableness of a set of financial forecasts. Thar ae niin BART eitionterween earings and stock prizes, se Bal, and Brown, P “An Empiia! Free tence Nanberfounal of conn ese aan 1968), pp 139-78 For sah aa neat ss becow, P,“hecouing Eamngs and Cash Fes as Meaie of Fim Pesornc: Fae n ara cai loral of Secouning and Econ 1 (1599), p. #2, which shows tha art ra a yang of company vation tha cure csh Tos, tbh xing src Tega einen valuninfraton elate'o he trChapter 2 | Financial Statomant Analysis 48 From the formu in uation 24, we observe tat even with low profit margin, a company that has ascent high asset lization can have the sme or even a higher, rum on asts asa company with 2 igh profit margin. We also observe that two companies can have he same ers eve though ahey hve very ferent profit margins. For example company wih a TOTES acs dt els from having an 86% unlevered profit margin an asst lization rai of 1.16 (01 = 0086 X 1.16) has the same rtumn on auets as another company that hat profit marin of 27.4% and an ase tization ratio of only 0.36 (0.1 274 x 0.36). Relation Between the Return on Asset Components ‘We examine a sample of companies from 2006 through 2010 for different industries. To be included in the sample, « company must have the necessary data available to measure the relevant ratio in at least one year in the Compustat®"* North American Industrial Annual files, which requires that @ com- pany have a publicly traded security on the New York Stock Exchange, American Stock Exchange, or NASDAQ Exchange. In Exhibit 2.3, we show the asst utilization and unlevered profit margin ratios for selected industries with an ROA of approximately 5%." Return.on Assets and Components for Selected Industries in the Compustat® | Francia! Pato Sample, 2000-2010 ROA-= Unloverad Profit Margin x Rovonue to Total Assats 70.0% 60.0% 50.0% 400% 20.0% 20.0% UUnievered Proft Margin 10.0% 0% Ges OO oa py lo gages 0 ae apes = pease ec verve to Taal Asses ‘The solid line in the exhibit shows the unlevered profit margin and revenue fo total assets com- binations that result in a return on assets equal to 5%. For example, a 10% unlevered profit margin and a 0.5 ratio of revenue to total assets results in a 59% return on assets, as does a 2.5% unlevered profit margin and a ratio of revenue to total assets equal to 2.0. The diamonds on the graph show the specific combinations for selected industries. If a diamond is above the solid line, it indicates that the industry's return on assets is somewhat greater than 5%; if it’s below the solid line, it indicates that the industry's return on assets is slightly less than 5%. We can quickly observe from this graph that many of the industries have a retum on assets that is close to 5 percent, even though they have different — sometimes substantially different—unlevered profit margins. The grocery store industry, for example, is high-tumover (revenue to total assets of more than 2.5) and low-margin (unlevered profit margin of 2%) business with a return on assets of close to 5%. However, the real estate investment trust business Standard & Poor's Compusta® isa standardized datsbuse delivering accounting and market data on over 54,000 secur tis to clients through a variety of databases snd anatial software products. Standard & Poors Investment Services is vision of MeGraw-Hill, ne "This type of analysis was first presented in Selling, , and C. Stickney, “The Effects of Business Eavironment and Suategy on a Firm's Rate of Return on Assos," Financia Analysts Journal Ganuary-Rebruary 1989), pp. 43-52.Chapter 2 | Financia! Statement Anaiyais is a low-volume (revenue to total assets of 0.14) and high-margin (unlevered profit margin of 36%) business that also has a retumn on assets of about 5%. How Does GAP Perform Relative to Other Companies in Its Industry? In Exhibit 2.4, we show the ratios for GAP’s return on assets, unlevered profit margin, and revenue to total assets forthe fiscal years 2006 through 2010. We also show various percentiles of the distribution of those ratios for other companies in the Family Clothing Store industry classification (SIC = 5651), ‘which is the primary industry classification for GAP. The number of companies (other than GAP) in that industry, and for which we could measure the financial ratios, varies between 17 and 20, Return on Asset and Related Ratios for The Gap, Inc. and the Distribution of, Companias in the Family Clothing Store Industry Classification (SIC = 5651) Return on Assets «The Gop, ine ; as% 199% 0% 4am team 10th pecenie 26% 18% 189% 20K 25th percentile cece . 5.0% 1.6% 5.9% 29% 54% . | sotn porcatle tex ak 7am mam | rst pecentle 148% 159K 132% 4am tR sth parcontl tso% 11% tees aKa Unlevered Prot Margin The Gap, Ine. esos sr 58% TH 78a tot percentio 10% 8% 207% = 10% 27H 25 erent Igoe ae at 2am as 0m percent 53% 9% HOBO | 75h percentile eum oak aH ram 72% | 0 percent 105% 2a thse tz aa | | Revenue to Total Assets (Utilization or Turnover) : The Gap, Ie. teeta. tats 188 | | ron percontte 17 114 109 4081204, 25th percentile 1.85, 1.60 1.48 141 138° _ Sn percents ; te ts taste | + ran percetle 237 1 ‘0th percentile In 2006, GAP’s return on assets is below the 50th percentile ofits industry group and steadily increases during this period and by 2010, itis above the 75th percentile, We can examine the two primary components of the return on assets to learn more about what caused the change in GAPYs return on assets relative to the other companies. It tums out that GAP's unlevered profit margin also steadily increased uring tis period, from the 50th percentile to above the 75th percentile, while its asst utilization ratio (revenue to total asst) stayed relatively constant, varying between 1,83 and 1.95. Thus, the increase in GAP's unlevered profit margin is the main reason why its return on assets increased relative to that of the other companies. REVIEW EXERCISE 2.1 ‘The Gap, Inc. Return on Asset Forecasts for 2011 and Beyond Use th information jp-Extybit 2.1 to calculate GAP’s return on asets and its components for one or more of the yeat inthe £ HIT through F2016). Compare GAP's retum on assets and its componeats inthe forecasts to GAP's timessries and to SIC 5651 in Exhibit 24 Solution on page 78.2.7 MEASURING A COMPANY’S COST STRUCTURE » USING EXPENSE RATIOS caer CBRE ne ‘A company’s cost structure—that is, the relation between a company's revenues and its costs—can E be one source of its competitive advantage or competitive disadvantage, Understanding a company’s cost structure allows us to more thoroughly understand its accounting-based rates of return because itallows us to understand what drives a company’s unlevered profit margin. In addition, we use an analysis of a company’s cost structure when we identify comparable companies and when we forecast © its financial statements and cash flows, ‘A.common way to analyze a company’s cost structure is to analyze the expense ratios (an expense item divided by operating revenues) of each of its relevant expenses. When comparing the company to itself and to comparable companies, expense ratios related to a company’s operations often provide useful insights into understanding its profit margin. Common operating expense ratios include the cost of goods sold ratio and the selling, general, and administrative expense ratio. Certain expense ratios are usually less informative—for example, the income tax expense ratio (income tax expense to revenues) and the expense ratios for such one-time costs as reorganization costs ‘We typically analyze those types of expenses in other ways. Since generally accepted accounting prin- ciples in the U.S. do riot generally require companies to use the same accounting principles for financial statement and income tax purposes, analyzing income tax expenses and measuring income tax rates is complex. We analyze a company’s income taxes by computing its income tax rates with both income Slatement information and its income tax footnote disclosures (which we discuss in Chapter 3). We show the formulas for the cost of goods sold expense ratio; selling, general, and administra- tive expense ratio; and depreciation and amortization expense ratio below. We can measure other expense ratios in a similar manner. Cost of Goods Sold ‘Cost of Goods Sold Expense Ratio sy (2.5) Setng. Gene nd Adin see Sen, Gene nt Admini Epes Rai = SSH Genera Adinave po gy Depteciton nd Anortaion Depreciation and Amortization Expense Ratio: proction and Amoraten (27) Revenue At frst glance, one might think that we want managers to minimize a company’s expense ratios because it appears that lower expense ratios lead to higher profit margins, higher rates of retum, and, therefore, better performance. This conclusion is not always correct for expenses that affect a company’s future performance. Generally accepted accounting principles (GAAP) in the United States and the GAAP of most other countries in the world tend to expense an expenditure for which the future benefits ‘cannot be reasonably measured, even though the expenditure likely has future benefits, Examples of such expenditures include expenditures on marketing and research and development. A company could ‘minimize its expense ratio for marketing (or research and development) to increase its current-year prof- itability. That decision, however, could have negative effects on the company’s performance in future years and ultimately destroy value. Thus, minimizing expense ratios is not necessarily consistent with ‘maximizing the value of the firm. Consistency in the numerator and denominator is important when analyzing financial ratios. For «example; we typically exclude non-operating revenues when measuring operating expense ratios. Consis- teney across companies is also important when analyzing financial ratios. Companies sometimes classify costs differently; for example, one company may include depreciation in cost of goods sold, while another company might show it as a separate line item in the income statement. Similarly, companies sometimes use different accounting principles; for example, one company might use the last-in-first-out (LIFO) inventory method, and another company might use the first-in-first-out (FIFO) inventory method. Our goal when measuring financial ratios is to adjust the financial statements for all material inconsistencies ‘overtime and across companies if the adjustment affects the qualitative results from the analysis. Chapter 2 | Financial Statement AnalysisChaptor2 | Financial Statement Analysis The Gap, Inc.’s Expense Ratios In Exhibit 2.5, we show certain expense ratios for GAP for the fiscal years 2006 through 2010. We also show various percentiles of the distribution of those ratios for other companies in the Family Clothing ‘Store industry classification (SIC = 5651), which is the primary industry classification for GAP. Expense.Ratios for The Gap, Inc. and the Distribution of Companies in the Family Giothing Store Industry Cassifeation (SIC = 5651) Cost of Goods Sold to Revenue The Gap, ne. eo7% 10th pocontle : 520% 25th percentile + 578% 50th pecontie 60.7% 7th percent... ee rire 0th percentile 82.4% Operating Expenses to Revenue The Gap, Inc. = 2% 25.2% {0th percentile... 5 » 16896 169% 25th percentile... : 2 23.8% 23.0% 50m parontio 258% 25.7% 75th paeontie 2 sho% at 313% sot percentile 2 470% 38396 Depreciation and Amortization to Revenue ‘The Gap ne. ase 40% 48% toth porcentio 19% 21% 20% 2s percentile 29% 30% 83% 0th percent... 32% 41% 38% 75th percentile 44% 50% 53% sch percentile 4% 83 82% «88% “Advertising Expense to Revenue | The Gap, ine + 86% 36% 35% 10th percentile 05% 05% SK OK (OE 25th percentile 12% 0% 08% ase 1.056 Sot percentile 18% 17% HATH 1.95 75th percentlo 35% 30% = 28% 8B Bch percentile : ee es ee Recall that GAP had an increase in its return on assets over the 2006 to 2010 period and moved from below the 50th percentile to above the 75th percentile relative to other stores in SIC 5651. This improve ‘ment was caused by a steady inerease in its unlevered profit margin, Using the expense ratios, we stiould bbe able to botter understand why this happened. Looking at Exhibit 2.5, it appears that most of this change ‘was caused by a steadily declining ratio of cost of goods sold to revenue (from 60.7% to 55.4%) as GAP ‘moved from the 50th percentile o very near the 25th percentile. GAP’s operating expense ratio is roughly around the median forall years, as is its depreciation and amortization expense ratio, and its advertising expense ratio is above the 75th percentile in all years. However, there is little systematic movement in the sum of these three expense ratios over time, as the combined ratio for operating expense, deprecia- tion and amortization, and advertising expense to revenue is 35.54 in 2006 and 34.6% in 2010. As we discussed earlier, when making such comparisons, we assume that the companies we are analyzing have consistently prepared income statements. Valuation Key 2.5 ‘A company’s cost, structure can be a source of its competitive advantage, We can use expense ratio™ neat SBRAPGEPURR0 Ino torn, auch a coat of goods sod to vevenue~to analyze a oom pany’s cost structure: We also typically use expense ratios as forecast drivers in financial models.Chapter 2 | Financial Statement Analyeis REVIEW EXERCISE 2.2 The Gap, Inc, Expense Ratio Forecasts for 2011 and Beyond aS ‘Use th information in Exhibit 2.1 to calculate GAP’s expense ratios for one or more ofthe years inthe forecasts ‘2011 through F2016). Compare GAP's expense ratios inthe forecasts to GAPYs time-series and to SIC S651 Pin Exhibit 25, Solution on page 78. 2.8 ANALYZING A COMPANY’S ASSET UTILIZATION USING TURNOVER RATIOS ‘A companys asset uiization—tht i, the revenue generated per dolar of investment in acerin type LOB Esme a of asset—is another potential source of a company’s competitive advantage. Like expense ratios, we often company’s asset use asset utilization ratios to create and assess the reasonableness of forecasts. A common way to measure _Uilzation and 4 sumpany's as ulization it analyze i set ulation or turnover rato, nessured by dividing YOO So operating revenues by an operating asset tem on its balance sheet We discussed the overall measure of asst utilization, hich is revenue divided by average total assets. This ratio measures the dallas of revenue generated per dollar of investment inal types of assets. We can disaggregate this vera mea- sure of ase lization ino various components. Turnover aio give some sense of whether company invests more or less in parila asst, relative to revenues, eter over tine or relative to competors Common ase utilization measures include measures for eas aecounts receivable inventory fer curentaisets: property, plant, and equipment, and other non-curtent assets, We typically examine a company’s curent asset tinoverrtos inthe context of how the company manages te working capita which we discuss ater inthe chpter. That analysis is somewhat fren from te reveouetumover ratios discused here. Two common asset ulation ratios unrelated 19 working capital ae revenues to average 03 and ne) proper, plant, and equipment. The formulas for thse ratios ate ax follows: Revenue 7 oss Property, Plant and Equipment Turover Ratio = ———____Revenue_ ae aed al Aates Gres aoa Pad esmeat a Revenue [Net Property, Plant, and Fquipment Tumover Ratio = ———_____Revenue_ saci nee ‘Average Net Property, Plant, and Equipment 29 The calculations for the above turnover ratios for GAP are as follows: $14,664 Sross Property, Plant, and Equipment Tumover Ratioga ano = = S664 __ eee eens (aor + S1STB)A 196 ‘Net Property, Plant, and Equipment Turnover Ratiogap, ano = Again, at first glance, we might conclude that we want managers to maximize a company's asset utilization because conceptually, higher asset utilization ratios lead to higher rates of return, and therefore beter performance. However, as with expense ratio, this conclusion is only correct if maximizing the asset utilization ratios does not affect the company’s future performance in a negative way. For example, cutting inventory levels teads to greater inventory turnover at first, but if customers begin to experience. delays in receiving their orders, sales are likely to decline, In order to calculate the overall asset tumover ratio (Sales to total assets) from individual tumover ratios, we actually calculate inverse turnover ratios for each asset in the balance sheet (for example, cashjtevenue, accounts receivable/revenue, etc.). To then determine the overall asset utilization measure (revenue to total assets), we compute the inverse of the sum of the individual inverse tumover ratios. We illustrate this with GAP in the next section of the chapter. OF the two property, plant, and equipment tun- ‘over ratios, the one that feeds nto the overall asset tumover ratio isthe net property, plant, and equipment ‘tumover ratio. Thus, we tend to focus our attention on the net turnover ratio,50 Chapter2 | Financia Statement Analysis REVIEW EXERCISE 2.3 ‘The Gap, Inc. Asset Utilization Ratios for 2011 and Beyond Use the information in Exhibit 2.1 to calculate GAPYs asst utilization ratios for one or more of the years inthe forecasts (F201 through F2016). How are GAP's asset wilizaton ratios in the forecasts changing relative t0 20107 ‘Solution on page 78. ‘We do not compare the tumover ratios to those of the companies that are in SIC 5651, for the changes in GAP's return on assets were caused primarily by changes in its unlevered profit margins and not in its asset utilization, Valuation Key 2.6 ‘Asset tlization can be a source of a company’s competitive advantage. We can use turnover ratios— the ratio of revenue to an asset line item such as accounts receivable or fixed assets—to analyze a ‘company's asset utlization. We also sometimes use these ratios, or working capital management ratios, as forecast drivers in financial models. & 2.9 SUMMARY OF DISAGGREGATING THE GAP, INC.’S RATES OF RETURN In Exhibit 2.6, we graphically present the process of disageregating a company’s rate of return and ilus~ trate this disaggregation using GAP. For now, we will concentrate on the retum on assets, for we have not yet discussed disageregating the return on equity. Inthe exhibit, you can clearly see how the return ‘on assets is disaggregated into unlevered profit margin and overall asset utilization (revenue divided by total assets), Below each of these components, we further break them down into thei respective expense ratios and turnover ratios, BRIE Disaggrecating the Return on Equity and Return on Assets for The Gap, Inc "SueaSosesctoe cane soe ifonaenosce Sroaesr 2 Tamcavseo Ws inet ee ereChopter 2 | Financial Statement Anaiysie 54 2.10 ANALYZING A COMPANY'S WORKING CAPITAL MANAGEMENT ne Working capital is equal to current assets minus curent liabilities. Most companies have more current assets than current liabilities; therefore, most companies have postive working capital. U.S. GAAP require companies to disclose curent assets and current liabilities on their balance sheets. Current assets a cash, cash-like assets, and other asses expected to be used or converted into cash within one year or within the company's normal operating eycle, whichever is longe. Examples include cash, accounts receivable, and inventory. Current liabilities ae lisblites that mature or are discharged within one year. Examples include accounts payable, wages payable, income taxes payable, short-term bank nots, and the current portion of long-term debs. We define operating working capital as operating current assets minus operating curet liabilities, excluding short-term deb, the current portion of long-term deb, and excess cash, Operating working capital isan investment made by the company so that it can operate its busi- ness All else equal, companies prefer to minimize the amount of operating working capital they carry. \ Icis dfficul, however, to minimize working capial, holding everything else constant. For example, a company could reduce its working capital by requiring all customers to pay in cash; such a policy, however, would also likely have the negative effect of decreasing revenues. A company could also reduce working capital by holding less inventory: however, such a policy would also likely lead to reductions in revenues since it would take longer to get products to customers. Last, «company could reduce its working capital by not paying its accounts payable until after the due dates, but again, this action would likely cost the company addtional financing charges, or it to purchase the necessary materials to operate the company. In this section ofthe chapter, we discuss various ways we ean analyze working capital Ability to Pay Current Liabilities We often use three ratios to examine the overall working capital management of a company. These ratios are the current ratio, the quick (or acid test) ratio, and the ratio of cash flow to current liabilities. We calculate the current ratio as the ratio of a company’s current assets to its current liabil Current Assets _ Carent Rate = Corrent Linbilities (2.10a) ‘The current ratio attempts to measure the ability of a company to pay its current liabilities with its ‘current assets. Naturally, going-concemn companies must continually replenish their current assets such as receivables and inventory, so current assets cannot be depleted. The quick or acid test ratio isthe ratio of cash, marketable securities, and accounts receivable to current liabilities. This ratio also attempts to mea sure the ability of a company to pay its current liabilities with the company’s more liquid current assets Accounts Receivable ©: uick oF Acid Test Ratio = Q st Ratio ‘Curren Liabilities (2.10b) ‘The eash flow to current liabilities ratio is the ratio of a specific measure of cash flow (cash flow from operations or free cash flows) to current liabilities. This ratio is a measure of the company's ability to pay its current liabilities with its cash flow. The formula for this ratio using operating cash flow is: Operating Cash Flow rating Cash Flow to jabilites Ratio Operating Current Liabilities Ratio = Co ce (2.100) As with most financial ratios, we can define the numerator and denominator in various ways as per cur earlier discussion. Once again, the choice of numerator and denominator should depend on the con- text of the analysis, and consistency between the numerator and denominator is important. Sometimes we exclude short-term debt from current liabilities and excess assets from current assets if we want to focus cour analysis on operating assets and liabilities. The calculation of GAP's current, quick, and operating cash flow to current liabilities ratios is shown on the next page. Note, we do not provide the cash flow statement for GAP, but we can see its operating cash flow for 2010 in Exhibit .1 of $1,539.Chapter 2 | Financlal Statement Anais, 87 Current Ratiogar 2010 $2,095 $1,661 S661 on ‘$2,095 oe Quick or Acid Test Ratioggs, 10 = $1,539 $2,095 Exeess assets can sometimes have a significant effect on these financial ratios because companies often hold excess assets in short-term investments. A company’s current and quick ratios would change ignificantly if it has significant excess (current) assets and we assume that the company distributed those excess assets to its equityholders or used them to pay off its debt. To illustrate the effect of eliminating fan excess asset, we assume 50% of GAP's cash is an excess asset; GAP’s current ratio would decrease to 1.5 [1.5 = ($3,926 — 0.5 x $1,661)/S2,095] and its quick ratio would decrease to 0.4 (0.4 = 0.5 X $1,661/82,095). A way to deal with adjustments such as for excess assets isto first adjust the financial statements for the effect of the excess assets and then compute the ratios with the adjusted financials, Operating Cash Flow to Current Liabilities Ratio, 210 = 0.73 Inventories, Accounts Receivable, Accounts Payable, and Trade Cash Cycle Ratios Inventories, accounts receivable, and accounts payable all involve the production and sales cycle of a ‘company. A company must first purchase materials and services, which it will eventually sell. While a ‘company usually makes these purchases “on credit” the length of the maturity period is typically short ‘Then, it takes time for the company to produce and sell its inventory, and it takes additional time for the ‘company to collect cash on its credit sales, Thus, companies typically have a trade eash cycle or cash conversion eyele they must finance—that is, the time from when the company pays its payables until the time itis able to sell its inventory and ultimately collect its receivables. Before we analyze the trade cash cycle in more detail, let us first analyze cach component of the trade cash eycle—days of purchases outstanding, days of inventory held, and the accounts receivable collection period. These measures are variations of the turnover ratios we previously discussed. We can ‘measure these ratios using either the average balance or ending balance. Below, we show the formulas for these ratios using the average balances because they are the most common. We measure the days of accounts payable outstanding, the days sales held in inventory, and the accounts receivable collec tion period as Average Accounts Payable Days of Accounts Payable Outstanding = “SE SSNS 11) Average Inventory Days of Sales Held in Inventory = gerne 12) 15 of Sales Held in Inventory = 6.1 oF Goods Sold/365 cae ‘Average Gross Accounts Reveivable ‘Accounts Receivable Collection Period = *"="=8* Gross ACCOM 2.19) Credit Sales/365 ‘Once we know these three ratios, we can measure a company’s trade cash cyclo—that is, the time from when it must pay out cash until the time it collects cash. In other words, « company’s trade cycle ‘measures the length of time for which the company must finance its purchases. The greater this number, | the larger investment the company has to make in receivables and inventory net of payables. The formula for the trade cash cycle is: Accounts Trade Cash _ Receivable , ,DASof Days of sDIe + Inventory ~ Payables (2.14) Cycle ~ Collection * EE ontanding Period [As with al nancial ratios, the above measurement ofa company’s trade cash eyce, while com- monlyued, i or the underiying economic concept we attempt to meastre. For example, itdoes not ince ao the cash a company must pay out to operate is business before it collets cash' from receivables, and it does not adjust for the profit margin embedded in accoufs ssccivable, These limitations are in addition to the limitations of using annual averages of thgsaSeai@PValarices“for the financial ratios used in the trade cash cycle formula. That being said, we can still lean something from comparing this measure for a company over time or across companies in cross-section. In 1988, Dell’ trade cash eycle was almost 60 days, and as it began to work on improving its working capital mana sent, is trade cash cycle fel steadily. By 1995, its trade cash cycle was negative forthe first ime, and by the early 2000s, it was almost ~60 days. This occured through a combination of reducing both the days of inventory held and the accounts recsivable collection period while simultaneously leaning on suppliers to extend days payables outstanding. While its competitors instituted the same practices, Dells trade cash cycle was consistently lower. Some people compute accounts receivable tumover, inventory turnover, and accounts payable tumover ratios instead ofthe “days” calculations. These turnover ratios are closely related to the above calculations and, in fact, are just the denominator (not divided by 368) over the numerator. Hence, inven- tory tumover would simply be cost of goods sold divided by average inventory and accounts receivable tumover would simply be credit sales divided by average accounts receivable, You can also simply com- pute the relevant turmover ratio by dividing 365-by the relevant “days” calculation. These ae different fromthe asset utilization ratios discussed in Section-2.8 because, in that case, every tumovet ratio was computed relative to revenues, but here, we tr to relate the numerator and the denominator more closely (© inventory and cost of goods sold instead of inventory and revenues) “Analysts also sometimes examine the “quality” ofa company’s net account receivables by analyzing the ratio ofthe provision for bad debis to gross accounts receivable (net accounts receivable plus allow- ance for uncollectble accounts, called the provision for bad debts ratio Allowance for Uncolectble Accounts Provision for Bad Debs Ratio = AUewanee for acolesibleAccouns p45 Belo, we stow the caleuation of GAP's invanfry, accoms rcelvabe, end acouni peyble ratios, Since GAP dos not have any accounts receivable, ts asouns receivable cleo pved is 20 andthe provision fr bad debs ati ont elevant. ($1,027 + $1,049)/2 ($8,127 + $1,620 — $1,477)/365 (s1a77 + sto) 81277365 Accounts Receivable Collection Periodgsp, 3919 = 0 days (no accounts receivable) Trade Cash Cyclegar, an = 0 + 69.5 ~ 45.8 = 23.7 days Days of Accounts Payable Outstandinggar. oo = 458 Days of Sales Held in Inventorycag. ano = 9.5 Provision for Bad Debts Ratiogae, nox = Not a Meaningful Figure (no accounts receivable) Even though GAP accepts credit cards, it has no accounts receivable, According to GAP’s 10-K report, GAP recognizes revenue and assumes the cash is in transit when a customer purchases merchan- dise atthe register, even if a customer pays with a credit card, Other companies do not follow this same Policy for credit card sales. These companies record a receivable because it takes two to three days for ‘company to receive payment from third-party credit card sales, For example, Nordstrom, Ine., one of GAP's competitors, changed its accounting treatment of this issue and reclassified its two or three days of outstanding credit card balances from cash (which is how GAP treats them) to accounts receivable Nordstrom also has its own credit cards, which have a longer accounts receivable collection period. Its accounts receivable balances and allowances for uncollectible accounts for 2010 and 2009 were $2,026 and $2,035, and $85 and $76, respectively. Nordstrom's accounts receivable collection period for 2010, ‘when it had $9,310 of revenues, was 82.8 days: (82,035 + $76) + ($2,026 + $85) /2 Accounts Receivable Collection Period = lays Accounts Receivable Collection Period Ear 12.8 days Nordstrom has a 4% provision for bad debts for its accounts receivable, which we caleulate as $85 Provision for Bad Debis Ratio = $2,026 + $85 [ Chapter 2 | Financia! Statement Analysis,Los Analyze a company’s fixed assets and financial leverage ‘Chapter 2 | Financial Statement Anaiysis REVIEW EXERCISE 2.4 The Gap, Inc. Working Capital Management Ratio Forecasts for 2011 and Beyond Use the information in Exhibit 2.1 to calculate GAP's working capital management ratios for ane or more of the years in the forecasts (F2011 through F2016). How axe GAP's working capital management ratios jn the, orecasts changing relative to 20107 Solution on plage 79. 2.11 ANALYZING A COMPANY'S FIXED ASSET STRUCTURE AND CAPITAL EXPENDITURES Naturally, when valuing a company, understanding its capital expenditures (its investments in fixed assets—property, plant, and equipment) is important, We can use both a company’s property, plant, and equipment accounts and its depreciation accounts in order to assess the depreciable life of its fixed assets. We can also examine its capital expenditures relative to revenues, depreciation, and earnings. As with most of the financial ratios we have discussed, these financial ratios can be useful in identifying compa- rable companies and in preparing and assessing the reasonableness of forecasts. Depreciable Life (Age) All else equal, companies with older plant and equipment will have higher capital expenditures in the future. The specific ratios to learn about the age of the assets are: Average Gross Property, Plant, and Equipment Depreciation 2.16) Depreciable Life of Gross Plant = Average Net Property, Plant, and Equipment Depreciation a7) Depreciable Life of Net Plant = “The depreciable life of the net plant is useful because it provides a crude indication ofthe average remaining life of the net plant so long as the company uses estimated useful lives that are close to the economic lives. Consider two companies in the same industry that use the same depreciation polices. If one company has a depreciable life of net plant that is smaller than the other, then it is likely that the two companies have assets of different ages. This has implications forthe replacement of those asses. Such analysis can be useful in identifying comparable companies or in forecasting capital expenditures. Depreciation should include all depreciation—that is, depreciation expense plus additional depre- ciation taken but capitalized (for example, depreciation included in inventory). Companies sometimes disclose this information in a separate schedule; if no, the cash flow statement can provide information on depreciation in addition tothe information provided on the income statement. IF possible, we would also prefer to exclude such non-depreciable assets as and from the numerator in the above cafculations. ‘We assume that GAP has no amortization of intangible assets. A detailed reading of the footnotes indi- cates that GAP has a minimal amount of amortization, which we choose to ignore for the purposes of this ‘example. GAP does not disclose the cost of land separataly in its 10-K, so we are unable to eliminate it from the calculation as we would like to. The calculations of these ratios for GAP for 2010 are as follows (7,427 + $7,573)/2 Depreciable Life of Gross Plantog, ano or 137 (52,608 + $2,563)/2 ciable Life of Net Planteye, 2010 = ee Depreciable Life of Net Plantae seta 9 However, for GAP (and other retailers), this is just a small proportion of its assets, as many retailers have Teased signit FoF assets and do not record many leased assets on their balance sheets. We will provide more discussion about this issue when we disciés leverage in Section 2.13.Capital Expenditures S We can analyze a company’s capital expenditures relative to its revenues amtamSacaROor amis and cash flows. We can also measure a company’s capital expenditures relative to its depreciation. The goal of analyzing these ratios isto help us asses, and possibly forecast a company’s capital expenditures. ll else equal, companies have large relative capital expenditures if they are capita intensive, are in need of replcing assets, or are growing. Some example ratios include the following: Capital Expenditures Capital Expenditures to Revenue = “PT PE (2.18) Capital Expenditures apital Expenditures to EBITDA =

Sea8 = 0-5 $249 apital Expenditures ciationgye ania = ego = 0.384 Capital Expenditures to Depreciationg, g = 038 ‘Note that our calculation of EBITDA includes interest income in EBITDA; thus, we are assuming itis part of the company’s operations. GAP’ capital expenditures to revenue ratio is quite small, but remem ber that GAP leases most of its stores, so the capital expenditure number does not fully reflect its total investment in fixed assets. 2.12 OTHER TYPES OF FINANCIAL STATEMENT RELATIONS—GROWTH, TRENDS, PER SHARE, PER EMPLOYEE, AND PER UNIT OF CAPACITY AND OUTPUT Analyzing per share measures and growth rates is a standard part of most financial analyses. Historical ‘growth rates—both annual growth rates and compound annual growth rates—are widely used company characteristics utilized by analysts. Analysts often use historical growth rates as part of the basis for developing forecasts. We also analyze a company using its financial statement information in combina- tion with its non-financial information, For example, we often use a per share measure as an input into the calculation of certain market multiples (for example, the P/E ratio) and to compare a company to itself overtime. We also use ratios based on non-financial information in order to analyze a company's histori cal performance, identify comparable companies, and prepare and assess the reasonableness of forecasts, For example, in the retail industry, analysts often measure such company characteristics as revenue or camings per square foot of retail space or number of stores. Employee, Unit of Capacity, and Unit of Output Measures Itis sometimes useful to examine various financial statement items—for example, revenues, assets, cash flows—on a per employee, per unit of capacity, and per unit of output basis. All else equal, we can use such measures as operating income per employee as a proxy for productivity, Similarly, we can use mea- sures based on the unit of capacity as a proxy for capacity utilization, ‘Chaptor2 | Financial Statement Analysis56 Chapter2 | Financia! Statement Analysis For GAP, for example, we might measure capacity using the number of square feet of retail space; for paper mills and heavy manufacturing, we might measure capacity using tons of productive capac- ; for the airline industry, we might measure capacity using available seat miles. We can use measures based on output to realize the average revenue and cost per unit of output. We might measure revenue per transaction for an online retailer or revenue per check for a restaurant. Naturally, we would analyze these measures by comparing the company we are valuing to its comparable companies currently and ‘over time, just as we do for all other financial ratio. ‘Since many of the financial statement items are affected by inflation but the denominators are not (number of square feet or number of employees, etc.), we often adjust the numerators in these calculations for inflation in order to restate them in constant dollars (or any other currency) to more readily see real ‘ends, Naturally, we would want to use an inflation index that is relevant to the numerator. A common inflation index is the Consumer Price Index; another general index that could be more appropriate for ‘manufacturers is the Producer Price Index; however, these indices might not be relevant for all indus- tries. Some industries might face a different price level index than that faced by the general economy (for example, the personal computer manufacturer industry, which has faced decreasing prices at times), Growth Rates and Trend Analyses We often measure grow rats for free cash flows and for certain items onthe income statement, balance sheet, and cash flow statement. Growth rates are often used to drive revenues in forecasting models. We can- not, however, measure a growth rate ifthe base years negative. For example, a company that as earings last year of $10, and this year of $12, has a 20% growth rate (0.2 = $12/S10 ~ 1). The same calculation is ‘not meaningful if that company has camings lst year of ~$10 and this yéar of $12; ($12/—S10) ~ 1 isnot 4 meaningful calculation, We discuss this issue—negative denominators—in more detail ltr. ‘Sometimes, we also examine the index trend of a characteristic of interes, in which we divide all years by the frst year to measure the cumulative growth fate. For example, if @ company’s operating income during a five-year period is $100, $110, $125, $180, and $220, its index tend for those five years is 1.0, 11, 1.25, 18, and 2.2. Te index tend in the first year is always equal to 1.0 because we ae dvid ing « number by itself. Tis feature ofthe index trend is useful because we can easily compare different characteristics of the company to each other (for example, comparing revenue to operating income), or wwe can compare one characteristic of the company to that of comparable companies. For example, ifthe index tend of sales goes from 1 to 1.5 over a five-year period andthe index tren of operating income ‘oes from to 2 over the same period, it indicates thatthe company is likely benefiting from economies of scale as it grows. Ifthe operating income trend index moves in lockstep with sales, then the firm is not experiencing any scale economies. Growth rates for companies tend to vary somewhat every year, as in the example of operating income mediately above. In the first year the growth rate was 10% (0.1 = $110JS100 ~ 1), and inthe second year, the growth rate was 13.64% (0.1364 = $125/$110 ~ 1). Analysts often compute a compound annual growth rate, CAGR, which indicates what yearly growth rate would have resultd from the observed growth for the period analyzed. Therefore, in our example above, we would be asking: what yearly growth in operating income would have resulted from it growing from $100 to $220 in four years. ‘We calculate the compound average growth rate in X, over the period from tot + n, as ‘ = : cate f= (Sf a ee Ee CAR og =f 1 = (228) a ‘Therefore, if the company’s operating income started at $100 and grew 21.8% each year for four years, the operating income would have reached $220, Per Share Measures ‘We also measure the per share amount of free cash flows and of various items on an income statement, balance sheetaaggaanieffow statement. On the income statément, we might analyze revenues, gross mar- ain, operating'inegpne, and net income on a per share basis. On the balance sheet, we might analyze the ‘major components of assets as well as their book value on a per share basis. On the cash flow statement,Chapter 2 Financial Statement Analysis 87 we might analyze cash flow from operations and capital expenditures on a pe share bass. Last, we might analyze free cashflow and equity free cash flow on a per share basis, Naturally, rather than analyze all ofthese per share measures, we choose the pr share measures of importance basen she context ofthe analysis. Normally, these involve parts of the income statement. ES ws To measure a financial statement number on a per share basis, we divide this number by the number of shares outstanding. A company usually reports more than the shares it has outstanding In addition tothe number of shares it has outstanding, it might report the numberof shares i is authorized to issue andthe nurnber of shares it has issued. The number of shares outstanding is equal to the number of shares a company issued net of the numberof shares it has repurchased and not reissued, called treasury shares ‘When available, we typically use one of two U.S. GAAP definitions forthe numberof shares out- standing in order to measure basic earings per share and diluted earnings per share. For basi earnings per share, we divide net income to common equity by the weighted average shares outstanding. The weighted average shares outstanding is the number of shares outstanding during the year weighted by how long the shares were outstanding during the year. For diluted earnings per share, we again divide net income to common equity by the weighted average shares outstanding, but we adjust both the \ numerator and denominator forthe dilative effets of non-equity securities (such as convertible debt, convertible prefered stock, and stock options) that we assume are converted into common equity. For some companies, the difference between the two eamings per share numbers an be substantial because of thir reliance on stock options to compensate employees 2.13 ANALYZING A COMPANY’S FINANCIAL LEVERAGE AND FINANCIAL RISK We define financial leverage as the use of non-common equity financing. All else equal, the more non- common equity financing a company uses, the more financial leverage it has. We measure a company’s financial leverage and financial risk in two ways using financial statement relations. We use financial leverage ratios to measure the degree to which a company is using financial leverage. We use coverage ratios fo measure the ability of a company to service, or cover the payments on, its non-equity securities. ‘When using financial statement values to measure the degree to which a company is using financial lever- age, we often use the ratio of a specific measure of non-equity securities (for example, debt) to a specific measure of total investment (for example, total assets or total invested capital). To measure a company’s ability to service its non-equity securities, we typically use a ratio of a specific measure of income or cash. flow to a specific measure of required payments to non-equity security holders. [As we discuss in many parts of this book, we always use market values to measure a company’s financial leverage ratio in order to measure its cost of capital or evaluate its capital structure strategy. In this section, we use financial statement numbers to measure financial leverage ratios. We do not recom- ‘mend using financial leverage ratios based on financial statement numbers to measure a company's cost ‘of capital —for example, to lever and unlever the cost of capital (beta) or to measure the weighted average cost of capital. If that is the case, why are we discussing these ratios that are dependent on financial state ment figures? We discuss financial leverage ratios based on financial statement numbers because they are commonly used by analysts and managers, in debt contracts, and by debt rating agencies. Moreover, these leverage ratios are correlated with ratings, yields, and the probability of default. In doing a valuation analysis, we might need to determine ifa company is in compliance with its debt covenants, or we might need to estimate its debt rating. As such, we discuss these ratios in this section of the chapter. In Chapter 9, we show how one can use these ratios to estimate a debt rating, ‘A common way to examine the financial leverage of a company is to examine the ratio of debt and over non-equity financing to total assets (or total invested capital or common equity). For the numerator in our financial leverage ratios, we use such figures as total debt, otal debt plus preferred stock, long-term debt, and long-term debt plus preferred stock. ‘When measuring these financial leverage ratios, analysts sometimes net out cash against non-equity claims, assuming that the cash could be used to redeem the non-equity claims. We show three popular financial leverage ratios here. Por companies that have other noa-equity securities, we could also assign financial leverage ratios to those securities as well ‘otal Debt to Total Assets = Pot Deb (222) Total Assets‘Chapter 2 | Financial Statomont Analy, ‘otal Liabilities Total Liabilities sos = TE . bilities to Total Assets = TT (2.23) Total Debt To 10 Common Equity = = a . tal Debt to Common Equity = Son Eanlty (2.24) From Exhibit 2.1, as of the end of 2010, GAP has current and non-current liabilities but no debt; however, we can also see that GAP had $6 million in interest expense in 2010, which means that GAP hhad a small amount of debt at some point during the year. The debt GAP incurred was associated with drawing on its line-of-eredit, probably to fund a buildup of inventory during its busy season. For GAP, the calculations of these financial leverage ratios—measured using year-end financial statement data as ‘opposed to market data—are as follows: so ebt to Total Assetsear ano = ae = Total Debt o Total Assetsoan ano ™ Gags 0 $2,985 otal Liabilities to Total Assets. 2n0 Total Libis to Total Assesoan ano = $5 pgs ~ 0423 $0 ‘Total Debt to Common Equity, aio = 0 $4,080 ~ Measurement Issues—What Is Debt? Debt is sometimes difficult to define and measure for two reasons. First, not all liabilities on an accounting balance sheet are debt. Accountants define liabilities a"? “A liability has three essential characteristics: (a) itembodies a present duty or responsibility to one or more other entities that entails settlement by probable future transferor use of assets ata specified or determinable date, on occurrence of a specified event, or on demand, (b) the duty or responsiblity obligates a particular entity, leaving it litle or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligatng the entity has already happened.” While not all liabilities are debt, accountants do not have 2 specific definition of debt. We use the term debt to represent certain types of financing. These include notes, mortgages, bonds (debentures), and other financing instruments that typically have an explicit or implicit interest rate attached to them; thus, from a valuation perspective, we can define debt as an amount contractuelly owed to another party that has an explicit or implicit interest payment that we can measure, This definition excludes such liabilities as deferred income taxes, unearned revenue, and most other operating liabilities (fr example, accounts payable, wages payable, accruals, etc.) For other reasons, convertible debt is also not entizely debs, even though accountants classify it as debt under U.S. GAAP. The convertible feature of convert: le debt is a claim on equity, and the value of that convertible feature is not debt, Under International Financial Reporting Standards (IFRS), convertible debt is actually split into a debt and equity compo- nent on the balance sheet. “The second reason it is difficult to define and measure debt is that companies can use debt tht does rot appear on the balance sheet, called off-balance-sheet financing. An example of off-balance-sheet financing is a non-capitalized operating lease. A company typically rents or leases some of its assets. We ‘know that companies in certain industries, such asthe airline, retail, and restaurant industries, lease many of their assets. Since these companies do not own leased assets, the most straightforward way to record lease payments is to record an operating expense for the amount ofthe lease payment each year; we call such leases operating leases, and they are a form of off-balance-sheet financing, USS. GAAP, however, requires companies to capital leases with certain characteristics that essentially transfer the ownership of the asset leased; we call those leases capitalized leases or capital leases." When a company capitalizes the present value of the lease payments on a leased asset, it records an asset (leased asset) and liability (lease liability) equal to the present value of the lease payments. Each period, the company depreciate (expenses) the leased asset and recognizes interest expense on the lease lability. Over the life of the lease, the sum of the expenses of & capitalized lease (depreciation and interest) is equal tothe sum of the lease payments. Inthe early years of a lease, however, «capitalized lease has higher expenses than an operating lease (which reverses in Financial Accwuntigg Standards Boatd, Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements." December 1985, p. 3. See Statement of Financial Accounting Standards No, 13, "Accounting for Lease,” November 1976, p. 7.