CORPORATE FINANCE – II

Sessions 2 and 3
Equity Valuation
N I T IN KU M A R
I N DI A N S CHOOL OF BU S I N ESS
T E R M- 4

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Equity Valuation

Question: Why value a company?

2
 Why value a company? – Investors in starts ups
New companies, start ups as
they are raising money, the
investors and the founders
have to know what is the
value of the company. So
that appropriate fraction of
equity of the company can
be allocated to different
investors.

Start ups raising money

https://inc42.com/buzz/softbank-logistics-rivigo-unicorn/#.WZgo4FUjGL0

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Why value a company? – Pricing IPOs

http://www.moneycontrol.com/news/business/economy/sbi-to-float-ipos-of-two- How to price an equity issue?

regional-rural-banks-in-one-year-2363529.html

4
 Why value a company?- Valuating Targets and M&As

For mergers
and
acquisitions

https://www.wsj.com/articles/amazon-to-buy-whole-foods-for-13-7-billion-1497618446

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Why value a company? – Analysts Recommendations
August 18, 2017

Market price: 739

Compare
market price
to own
valuation

http://economictimes.indiatimes.com/markets/stocks/recos/sell-sun-tv-network-target-
rs-710-0-shrikant-chouhan/articleshow/60116213.cms

6
Why value a company? – Activist Hedge Funds

Activist hedge funds – conduct their own

valuation of a company, if undervalued buy
large stakes in it. Change the management
team or work with the management team to
make changes to the business so that it
realizes its potential.

https://www.economist.com/news/business/21727086-third-point-corvex-and-elliott-
are-just-beginning-investor-activism-surging

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Why value a company? – Activist Hedge Funds
(Example)
July 27, 2017

https://www.bloomberg.com/news/articles/2017-07-27/bill-ackman-is-said-to-build-stake-in-
automatic-data-processing

8
Why value a company? – Activist Hedge Funds
August 24, 2017

https://www.cnbc.com/2017/08/24/ackman-media-coverage-adp-proxy-battle.html

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Why value a company? - Recap
• Stock valuation is used by:
• Retail investors and investment managers to make investment
decisions
• Investment banks to price the shares in an IPO
• Firms and their advisors to value target firms in mergers and
acquisitions
• Stock analysts to make recommendations to their clients
• Investors/owners of start up firms

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Who should know how to value a company?
• Those majoring in finance
• Ops? Marketing? Other guys?
•Yes

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Equity Valuation: Agenda
• Different Methods for Valuation
1. Discounted Free Cash Flow
2. Valuation Multiples

12
Equity Valuation: Agenda

• Market efficiency: How information

gets incorporated into stock prices?

13
Today’s Agenda
• Different Methods for Valuation
1. Discounted Free Cash Flow ✓
2. Valuation Multiples

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 Model 1
Discounted Free Cash Flow

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Firm Valuation Using Discounted Free Cash Flows
1. Big picture
2. Enterprise Value
a. Free Cash Flows
b. Terminal Value
c. Discount Rate
3. Enterprise value to equity value
4. Formula
5. Example
6. FCF Summary
7. FCF Valuation: connection to capital budgeting
8. FCF Valuation: things to remember

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1. Big picture - “Big” big picture
Net Non-Operating Assets D = Debt
(e.g., excess cash)
E = Equity
Enterprise value

• Enterprise Value = cost of taking over the business

• Example:
• Equity = 100 million, Debt = 50 million, Cash = 20 million
• EV = buy all equity (cost = 100 million), pay all debt (cost = 50 million), use cash (cost = -20
million)
• EV = total cost of taking over the business = 100 + 50 – 20 = 130 million
• Equity Value = Enterprise Value - Debt + Non-Operating Assets

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1. Big picture - “Detailed big picture”
Net Non-Operating Assets
(e.g., excess cash) D = Debt

Enterprise value E = Equity

= PV (Free Cash Flows)
+
PV (Terminal Value)

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1. Big picture - “Detailed big picture”
Net Non-Operating Assets
(e.g., excess cash) D = Debt

Enterprise value E = Equity

= PV (Free Cash Flows)
+
PV (Terminal Value)
FCF = Free Cash Flow
Salvage Value or = EBIT(1-TC)+Depreciation
Going company value – Capex - ΔWC

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1. Big picture - “Detailed big picture”
Net Non-Operating Assets
(e.g., excess cash) D = Debt

Enterprise value E = Equity

= PV (Free Cash Flows)
+
PV (Terminal Value)
FCF = Free Cash Flow
Salvage Value or = EBIT(1-TC)+Depreciation
Going company value – Capex - ΔWC

Discount rate = WACC

Enterprise Value = V0
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1. Big picture - “Detailed big picture”
Net Non-Operating Assets
(e.g., excess cash) D = Debt

Enterprise value E = Equity

= PV (Free Cash Flows)
+
PV (Terminal Value)
FCF = Free Cash Flow
Salvage Value or = EBIT(1-TC)+Depreciation
Going company value – Capex - ΔWC

Discount rate = WACC

Equity Value = V0 – D + Net
Enterprise Value = V0 Non-Op Assets
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2. Enterprise Value
a. Free cash flows
• Free cash flow
• [operating cash produced by the firm] minus [routine capital expenditure and
working capital needs]
• We usually forecast free cash flows for a few years., say T years. Usually T = 5-10 years.
• Formula for free cash flow Corporate Tax Rate

FCF = EBIT (1-T ) + Depreciation -DWCR

t t C t t
-Capital Expenditure
t
• ΔWCR = change in working capital for year t

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2. Enterprise Value
b. Terminal Value
• Terminal Value

• Equals the firm value at the end of forecasting horizon T. It is equal to one of

• The salvage value. Normally book value +/- some adjustment to reflect true
economic depreciation.

OR

• Going concern value. This is normally computed using a perpetuity model

or using multiples.

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2. Enterprise Value
c. Discount Rate
• Since we are discounting cash flows to both equity holders and debt holders, the free cash
flows should be discounted at the firm’s weighted average cost of capital, rwacc.
• If the firm is financed solely by equity then rwacc = rE.
D E
WACCL = ´ rd (1- TC ) + ´ rL
D+E after-tax cost of debt
D+E cost of levered
equity

rL = rf + b L ( E ( rm ) - rf )
é Dù
b L = beta of levered equity, usually b L = bU ê1+
ë E úû
D, E = market value of debt and equity
rL = cost of levered equity
T C = corporate tax rate

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2. Enterprise Value
d. Bottom line

• Enterprise value
• PV (Free cash flows) + PV (Terminal Value).
• This is the value generated by the firm’s operations.

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Next step? - Recall the "detailed big picture”
Net Non-Operating Assets
(e.g., excess cash) D = Debt

Enterprise value E = Equity

= PV (Free Cash Flows)
+
PV (Terminal Value)
FCF = Free Cash Flow
Salvage Value or = EBIT(1-TC)+Depreciation
Going company value – Capex - ΔWC

Discount rate = WACC

Equity Value = V0 – D + Net
Enterprise Value = V0 Non-Op Assets
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3. Enterprise to equity Value
• Enterprise value is the value of operating assets.

• To obtain equity value add any additional non-operating assets and subtract debt.

Equity Value = Enterprise Value + Non-Operating Assets

- Debt
Equity Value
Share Price =
Number of Shares

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4. Formulas - Recap
◼ Enterprise Value
PV (Free Cash flows) + PV (Terminal Value)
Free Cash flowt = FCF t
= EBITt ´ (1- t C ) + Depreciation t - Capital Expenditure t
- DWCt
Enterprise Value = PV (FCF1 ) + PV (FCF2 )+... PV (FCFT )
+ PV (Terminal Value of Assets at T )

◼ Equity value
Equity Value = Enterprise Value + Non-Operating Assets - Debt
Equity Value
Share Price =
Number of Shares

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4. Formula
• Implementing the Model
FCF1 FCF2 FCFN VN
V0 = + + + +
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) N (1 + rwacc ) N
• Often, the terminal value is estimated by assuming a constant long-run growth rate gFCF for
free cash flows beyond year N, so that:

FCFN + 1  1 + g FCF 
VN = =    FCFN
rwacc − g FCF  (rwacc − g FCF ) 

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5. Example

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5. Example

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6. FCF Valuation Overview - Unlevered Firm
Free Cash Flow To Assets Residual “Terminal” Value
[FCF1, FCF2,… FCFT] @T

Discount @ Unlevered Rate

Value of Operating Assets

“Enterprise” Value

Plus Non-Operating Assets

Value of Equity
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6. FCF Valuation Overview - Levered Firm
Free Cash Flow To Assets Residual “Terminal” Value
[FCF1, FCF2,… FCFT] @T

Discount @ WACC

Value of Operating Assets

“Enterprise” Value

Plus Non-Operating Assets

Minus Debt

Value of Equity
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6. FCF Valuation Overview - Table
Unlevered Firm Levered Firm
Cash flows Estimate FCF Estimate FCF
Discount Rate Cost of equity WACC
Add PV (Terminal Value) PV (Terminal Value)

To get Enterprise Value Enterprise Value

Other non-operating Other non-operating
Add assets assets
Subtract Debt
To Get Equity Value Equity Value

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7. FCF Valuation: Connection to Capital Budgeting

Enterprise Value = PV(Free Cash Flows) + PV(TV)

Continuing Taking on New

Existing Projects Projects

Enterprise Value = Sum of NPV of all Current and Future Projects

Implication to maximize EV? Accept all positive NPV Projects. Will maximize the enterprise value.

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7. FCF Valuation: Connection to Capital Budgeting
• The firm’s free cash flow is equal to the sum of the free cash flows from the firm’s
current and future investments
• So we can interpret the firm’s enterprise value as the total NPV that the firm will
earn from continuing its existing projects and initiating new ones
• The NPV of any individual project represents its contribution to the firm’s enterprise
value.

• Implication:
• To maximize the firm’s share price, we should accept projects that have a positive
NPV to maximize EV.

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7. FCF Valuation: Connection to Capital Budgeting
Sources of positive NPV
• First mover advantage
• Coke

• Lower cost than competition

• Indian IT companies

• Barriers to entry
• Pharma companies and patented drugs

• Innovation in distribution
• Netflix

• Tapping into untapped demand

• Patanjali

• Exploit new technology

• Google and search

• Tapping the same market more efficiently

• Uber

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7. FCF Valuation: Connection to Capital Budgeting
Positive NPV Projects

•Are not abundant.

•Are fewer in more competitive industries.
•The advantages that make them possible may not
last
•Consider these limitations as a reality check on
your cash flow projections

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8. FCF Valuation: Things to remember
Forecasting Cash Flows - Revenues
•Sales projections
•For existing products: estimated future size of
the industry, likely market share.
•For new industries: size of the target
demographic and likely penetration.
•Competition from existing players, threat of
new entrants and new products.

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8. FCF Valuation: Things to remember
Forecasting Cash Flows - Costs
•Cost projections
• Changing technology
• Cost of inputs
• Govt policy
• How NREGA impacted labor cost of firms?
• https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2880629

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8. FCF Valuation: Things to remember
Forecasting Cash Flows - NWC
•Net working capital is often a percentage of sales revenue.
•Differs from industry to industry.
• E.g. Internet subscriber-based business industry vs aerospace
industry.
• Need specialized knowledge about an industry

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8. FCF Valuation: Things to remember
Forecasting Cash Flows – Capital Exp
•Depends on expected growth
• High growth: typically capital expenditure will exceed
depreciation
• Cannot support growth without investment
•How capital intensive is the business?
• Boeing vs. Netflix

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8. FCF Valuation: Things to remember
Forecasting Cash Flows – Growth Rate
•Historical growth rate
•Analyst forecasts

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8. FCF Valuation: Things to remember
Forecasting Cash Flows – Growth Rate
•Can you take historical growth rate?
•Caution: underlying fundamentals, business
cycle may not persist
•Earnings driver likely to persist?

44
8. FCF Valuation: Things to remember
Forecasting Cash Flows – Growth Rate
•Growth rate forecasted by analysts
• Likely to be better than historical growth rates. Why?
•Drawback
• Very specialized business
• Analysts don’t cover all companies
• Forecast accuracy quickly fades farther out the future

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8. FCF Valuation: Things to remember
Forecasting Cash Flows – Terminal Value

•How far is N?
• Be wary of overoptimism!

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What did we do? Recap
1. Big picture ✓
2. Enterprise Value ✓
a. Free Cash Flows
b. Terminal Value
c. Discount Rate
3. Enterprise value to equity value ✓
4. Formula ✓
5. Example ✓
6. FCF Summary ✓
7. FCF Valuation: connection to capital budgeting ✓
8. FCF Valuation: things to remember ✓

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Valuation Methods
Method 1. Free Cash Flow
1. Free Cash Flow
2. Terminal Value
3. Discount Rates
Method 2. Comparables ✓
1. Finding a valuation driver ✓
2. Finding a comparable firm ✓

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Today’s Agenda
1. Valuation Method: Comparables
2. How information gets incorporated into prices?
• Market efficiency

• Drivers of market efficiency

• Market reaction to public and private

information

49
Stock Valuation Using Comparables
1. General Approach

2. Valuation Driver

3. Comparable firms

4. Examples

5. Advantages and Limitations

6. Comparables Vs. FCF

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1. General Approach
• Intuition: How to value office space?
• Multiply the [size of the office space] with the [average price per
square foot] of the recently sold buildings.
• Value driver
• Size
• Multiplier
• Price/sqft of comparables

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1. General Approach
Value = Valuation Driver firm × Multipliercomparable

Valuation driver? Multiplier comes from

Experience, Economics comparable firms

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2. Valuation Driver
•A good valuation driver is the key determinant of business value.
•Examples
• Earnings, EBITDA, free cash flows
• Subscription businesses
• Sales or # subscribers
• Real estate
• Square feet or acreage
• Oil companies
• Proven and probable reserves
• IP businesses
• Patents

•There is no single rule to decide what is the best driver. Experience matters.

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2. Valuation driver
Recall - Enterprise versus Equity Value
Non-Op Assets D = Debt
(e.g., excess cash)
E = Equity
Enterprise value

Enterprise value = value of a firm’s operating assets

Equity value = value of shares

= Enterprise value + non-operating assets – debt.

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2. Valuation Driver
Enterprise versus Equity Value
• Most multiples give enterprise value.
• #customers or subscribers
• Size of oil reserves
• EBITDA

• How about the P/E multiple?

• P/E multiple leads to equity value directly.

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3. Guidelines for Picking Comparable Firms
http://finance.google.com gives reasonable comparable firms. Refine
this list based on things:

◆Pick comparables of similar size.

• Market values within 50%-150% are generally OK
• If we don’t know value, we could use sales, assets, or earnings.

◆Pick comparables in similar industry.

◆Pick comparables with similar leverage.

• P/E ratios cannot be compared across firms with different leverage.
• If firms have very different leverage, use enterprise value multiples and
compute enterprise value, then adjust to get equity value.

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4. Examples
a. P/E Ratio
▪ The current P/E ratio is based on current earnings.

▪ Suppose XYZ current earnings = $40.04 per share, price

= $447.27, so current P/E = 447.27/40.04 = 11.17

▪ The forward P/E ratio is based on next year forecast earnings.

▪ XYZ’s next year expected earnings = $39.3 per share,

price = $447.27, so forward P/E = 447.27/39.3 = 11.38

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4. Examples
a. P/E Ratio
• P/E reflects growth expectations.

• Glamor stocks: high P/E ratios, high expected growth.

• Value stocks: low P/E ratios, low expected growth

• Many studies argue that glamor stocks are overpriced.

• (Aside: How can you test it?)

• Studies show that long-term returns of glamor stocks are lower than those of value
stocks.

• The extra return earned by value stocks is called “value premium.”

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4. Examples
a. P/E Ratio
• Value Premium = difference in performance between value and growth stocks

• Why do value stocks outperform growth stocks?

• One interpretation is that high P/E ratios reflect irrational exuberance by the
market for faddish stocks.

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4. Examples
a. P/E Ratio
P0 Div1 / EPS1 Dividend Payout Rate
Forward P/E = = =
EPS1 rE − g rE − g
•Firm with high P/E
• Firms with high growth rates
• Firm with low cost of equity
• Firm with high payout rate
• Firms which generate cash well in excess of their investment
needs so that they can maintain high payout rates

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4. Examples
a. P/E Ratio
• Value Microsoft’s shares using P/E ratios of comparables. Microsoft earns about
$2.59 per share, has current market value of $262 billion, and share price of
$31.50

Comparable Market Cap

Firms ($ billion) P/E
IBM 217 13.93
HP 49.6 -
Oracle 153 14.28
Apple 406 11.17
Intel 115 12.44

• Based on the above, Microsoft shares should be worth?

• $28.93 (11.17×2.59) to $36.99 (14.28×2.59).
• Which estimates are more plausible and why?

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4. Examples
b. # Subscribers
• For businesses such as cable TV or mobile phones, value drivers
are
• # customers
and valuation is expressed as value per paying customer.

• Applying a customer value multiple to # customers gives the

enterprise value of a firm, or the value of the operating assets.
• To this, subtract debt and add any non-operating assets to
get equity value.

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4. Examples
b. # Subscribers
Example
Riverview Cablevision is a cable TV firm serving households
in the NYC region. It has 500,000 subscribers. Estimate its
enterprise value given the following data for comparable
cable TV firms. Use # subscribers as valuation driver.

Comparable Firms Cablevision Comcast

# Cable Subscribers 3,100,000 24,100,000

Firm Value ($ billion) $15.1 $110

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4. Examples
b. # Subscribers
Comparable Firm Multiple: Value per subscriber
Cablevision $4,839 (15,100/3.1)
Comcast $4,564 (110,000/24.1)

Value Riverview
Enterprise Value = Valuation Driver × Multiple
= # subscribers × value per subscriber
= 500,000 × ($4,564 to $4,839)
= $2.28 to $2.42 billion

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4. Examples
b. # Subscribers
Example (continued)

If Riverview owes $500 million debt and has unrelated

investments in startups and excess cash currently valued at
$260 million, what is its equity value?

Solution
Firm value from previous slide = $2.28-$2.42 billion
Equity value = Enterprise Value + Non-operating assets – debt
= ($2.28-$2.42 billion) + $260 million - $500 million = $1.88-
$2.02 billion.

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4. Examples
b. # Subscribers
Example (continued)
Caution - What is the limitation of your valuation analysis?

Possible Limitations
• Type of TV product channel package (premium, sports etc.) may be
different between Riverview and comparables.
• Riverview may serve a different geographical segment subject to
different pricing regulations.
• Riverview may have different concentration of customers. If it serves
densely populated metro areas, its costs may be lower than those of its
comparables, so its profitability and value per customer may be higher.

66
4. Examples
c. Enterprise Value Multiple
•When do we use enterprise valuation multiples?
• When we want to compare firms with different leverage

•Because enterprise value represents the entire value of the firm before interest
payments are made to the debt holders
• We divide by earnings or cash flows before interest payments are made
• Use EBITDA

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4. Examples
c. Enterprise Value Multiple
• Enterprise Value Multiple

V0 FCF1 / EBITDA1
=
EBITDA1 rwacc − g FCF

• As with P/E ratio, this valuation multiple is higher for firms with
• high growth rates
• low capital requirements (so that free cash flow is high in proportion to EBITDA)
• low cost of capital
• firms with low risk

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5: Advantages and Limitations
•Multiples are most useful in case of
• firms have limited earnings histories or cash flows or unpredictable paths to
maturity.
• young firms funded by venture capitalists
• firms going public
•For established firms, multiples are used to do a gut check on free cash flow
methods.

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5. Advantages and Limitations
• Caution - Multiple based valuations have limitations
• Invisible differences between firms and their comparables.
• E.g., differences in accounting policies, differences in off-balance sheet
assets or liabilities.

• Misvaluation of entire sectors.

• Comparable-based valuation only indicates value relative to another firm,
not absolute value. Thus, it is possible that both the firm and its
comparable are misvalued.
• Tech firms during 1999-2001 period

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6. Comparables Vs. FCF
FCF Based Comparable
Valuation Based
Valuation
Critical Input • Cash flow forecasts • Good comparables
• Growth forecast • Clean value drivers
• Terminal Value
• Discount rate
Output • Absolute $ Value • Value Relative to
(Fundamental Value) comparables
DCF can incorporate specific information about the firm’s cost of capital or future growth,
likely to be more accurate. But depends on validity of assumptions.

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Stock Valuation Techniques:
The Final Word
• No single technique provides a final answer regarding a stock’s true
value. All approaches require assumptions and forecasts.
• Most investors use a combination of these approaches
• Perform sensitivity analysis
• You are in good shape if the results are consistent across a variety
of methods.

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Information and Stock Prices
1. Markets Aggregate Information

2. Efficient markets hypothesis

a. Public information

b. Private information

c. Market reaction to public and private information

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1. Markets Aggregate Information
•So far…
• We learned about valuation models to arrive at “fair”
prices.
• But other investors are doing the same thing.
• Prices reflect “aggregate information”. How?

74
1. Markets Aggregate Information
•What’s the basic economic motivation behind a trade?
• Any trade, such as stock buy/sell, is a result of different valuation by two
parties.
•Investors trade until they reach consensus.
•Thus, markets aggregate information across many investors.
•Information in Stock Prices
• For a publicly traded firm, its current stock price should already provide very
accurate information, aggregated from a multitude of investors, regarding
the true value of its shares.

75
2. Efficient Market Hypothesis
•Efficient Market Hypothesis
•Markets aggregate information and this is reflected in
stock prices.
•That is, stock prices fully reflects all available
information.
•Examples?

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2. Efficient Market Hypothesis
Examples
August 18, 2017

Price before the news : 1021 Price after the news: 923
2. Efficient Market Hypothesis
Examples
August 25, 2017

Price on Aug 23: 893 Price on Aug 25: 912

2. Efficient Market Hypothesis
Examples
August 28, 2017

Price before the news: 912 Price after the news: 940
2. Efficient Market Hypothesis –
Implication
•Efficient Market Hypothesis
•Stock prices fully reflects all available information.
•Current prices reflect fair value.

80
2. Efficient Market Hypothesis
Main Driving Force
Efficient Markets Hypothesis
• What is the main driving force behind EMH?
• Competition among investors. Competition should eliminate profitable
trading opportunities.
• The degree of competition will reflect any new information into prices.
• More competition => prices adjust quickly to new information
• Less competition => prices adjust relatively slowly to new information

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2. Efficient Market Hypothesis
Visualizing Competition
When there is sufficient competition, profits should be arbitraged away quickly

Mutual Fund Competition, Managerial Skill and Alpha Persistence (2018)

(Gerard Hoberg, Nitin Kumar, N. R. Prabhala)
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2422906

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2. Efficient Markets Hypothesis
Public Vs Private Information
•Public, Easily Interpretable Information
• If the information is easily available to all investors (news reports, financials statements, etc.) about the
firm’s future cash flows, then all investors can determine the effect of this information on the firm’s
value.
• In this situation, we expect the stock price to react nearly instantaneously to such news.
•Difficult-to-Interpret Information
• Some investors are skilled in analyzing certain information, which may be difficult to interpret clearly.
• In this case, the efficient markets hypothesis will not hold in the strict sense. However, as these
skilled traders begin to trade, they will tend to move prices, so over time prices will begin to reflect
their information as well. So this information gets incorporated into prices slowly.
• (Aside: Even with perfect private information, you may not benefit from it. Why?)

83
2. Efficient Markets Hypothesis
Incentives to Gather Information
•Difficult-to-Interpret Information
• If the profit opportunities from having private information are
large, others will devote the resources needed to acquire it.

84
2. Efficient Markets Hypothesis
Market Reaction to Private Information

85
2. Efficient Markets Hypothesis
Market Reaction to Private Information

86
2. Efficient Markets Hypothesis
Market Reaction to Private Information

87
Mapping to the textbook
• 9.3, 9.4, 9.5

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