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Weeks 1 To 4 Fundamental Analysis
Weeks 1 To 4 Fundamental Analysis
Semester 1 2018
Weeks 1-4
Fundamental Analysis
Pedro Barroso
1
Introduction to fundamental
analysis
Damodaran Ch. 2
2
Fundamental Analysis
Fundamental analysis tries to estimate the intrinsic value
of the company.
Uses discounted cash flow approach
Relies heavily on accounting information to get necessary inputs.
Also includes relative valuation (P/E, P/B) and contingent claims
analysis (real options, patents).
3
Discounted Cash Flows (DCF) Review
t n
CFt
Value
1 r
t
t 1
4
Firm Valuation (Debt + Equity)
The estimate of the value of the firm is obtained by discounting
expected cash flows to the firm:
the cash flows after meeting all operating expenses, taxes, and
investments but prior to net interest expenses
We use the weighted average cost of capital, which is the cost of the
different components of financing used by the firm, weighted by their
market value proportions (or capital structure ratios if available).
t n CFt to Firm
Value of Firm
1 WACC
t
t 1
5
Equity Valuation
The value of equity is obtained by discounting expected cash
flows to equity:
the residual cash flows after meeting all expenses, tax obligations,
interest, and principal payments
We use the cost of equity, i.e., the rate of return required by equity
investors in the firm.
t=n
CFt to Equity
Value of Equity=
t=1 (1+k e ) t
where,
CFt to Equity = Expected Cash flow to Equity in period t
ke = Cost of Equity (we will often use ‘r’ as cost of equity).
6
Concept Check: Valuing Equity and Debt
Consider a company with stable cash flows in perpetuity and constant capital
structure:
The annual cash flow to the firm is 150.
The firm has debt of 600 with an interest rate of 10%.
The marginal tax rate is 50%.
The cost of equity is 15%.
The market value of equity is 800.
7
Concept Check Solution: Equity and Firm
Valuation
8
First Principle of Valuation
Always match cash flows and discount rates.
Discounting cash flows to equity at the weighted average cost
of capital will lead to an upwardly biased estimate of the value
of equity
9
The Effects of Mismatching Cash Flows and
Discount Rates
10
Discounted Cash Flow Valuation: The Steps
Estimate the discount rate or rates to use in the valuation
Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing
the firm)
Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are
nominal or real (always match these too!)
Discount rate can vary across time.
Estimatethe current earnings and cash flows on the asset, to either equity
investors (CF to Equity) or to all claimholders (CF to Firm)
Estimatethe future earnings and cash flows on the firm being valued, by
estimating an expected growth rate in earnings.
Estimatewhen the firm will reach “stable growth” and what characteristics
(risk & cash flow) it will have when it does.
Choose the right DCF model for this asset and value it.
11
Step 1: Estimate the Discount Rate
Damadoran Ch. 7 & 8 provides detailed discussion of
estimating the discount rate.
For this class, we will focus on valuing equity, and thus are
most interested in the cost of equity (ke or r)
We will assume r can be estimated using the CAPM.
E(ri) = rf + Bi*E[rm-rf]
rf can be estimated as the return on treasury bills
rm-rf can be based on historical data (roughly 4-5%)
Bi can be estimated from a time-series regression of stock returns on market
returns.
You could also estimate cost of equity using alternative asset
pricing models (e.g. Fama and French 3 factor model).
12
Step 2: Estimating Cash Flows
Estimating cash flows usually begins with a measure of
earnings.
Earnings are available in a firm’s financial statements but there
are many nuances involved in understanding accounting
earnings.
We will discuss some nuances (ex: R&D expenses) and how
they influence cash flows
13
Overview of financial statements
Damodaran Ch. 3
14
Overview of financial Statements
There are three basic accounting statements:
1) Balance Sheet – summarizes the assets owned by a firm, the
value of the assets, and the mix of financing.
Example: http://au.finance.yahoo.com/q/bs?s=RIO.AX&annual
Assets Liabilities and Owners
Equity
Fixed Assets Liabilities
Current Assets Current Liabilities
Financial Investments Debt
Intangible Assets Other Liabilities
Owners Equity
Equity
Total Assets Total Liabilities + Equity
15
Measuring Assets
Fixed Assets – priced at historical cost adjusted for depreciation
Examples: Plant, Equipment, Land, & Buildings
16
Measuring the Financing Mix
Current Liabilities – obligations that the firm has coming due in the next year
Examples: Accounts Payable, Short-term borrowing, short-term portion of long-term
borrowing
Owner’s Equity –
Example: common equity, preferred stock, retained earnings
Both equity and liabilities are typically valued using historical measures (i.e.
Book value)
17
Overview of Financial Statements
2) Statement of Cash Flows – specifies the sources and uses of
cash to the firm from operating, investing, and financing
activities during a year.
Example: http://au.finance.yahoo.com/q/cf?s=RIO.AX&annual
Cash flow from Operating Activities
Cash Receipt from Customers 9,500
Cash Paid to Suppliers (2000)
Cash from Operations 7500
Interest & Taxes Paid (5000)
Net Cash from Operations 2500
Cash Flows from Investing
Proceeds from Sale of Equipment 7500
Net Cash flow from Investing 7500
Cash flow from Financing
Dividends Paid (2500)
Net Cash flow from Financing (2500)
Net Increase in Cash & Cash Equivalents
18 7500
Overview of Financial Statements
3) Income Statement - information on the revenue and
expenses of a firm and the resulting income made by a firm
in a period.
Example: http://au.finance.yahoo.com/q/is?s=RIO.AX&annual
Revenue 3000
Operating Expenses (1000)
Operating Income (or EBIT) 2000
Financing Expenses (Interest) 500
Taxes (33.33%) 500
Net Income 1000
19
Accounting Measures of Profitability
t = tax rate, BV = Book Value, i = interest rate, D= debt, and E = equity. Then:
21
Measuring Earnings
Damodaran Ch. 9
22
Estimate the current earnings of the firm
23
Types of Expenditures
To capitalize R&D,
Specify an amortizable life for R&D (2 - 10 years)
For how many periods does the research generate ‘considerable’ income.
Collect past R&D expenses going back at least as long as the
amortizable life
Sum up the unamortized R&D over the period.
26
Capitalizing R&D Expenses: Cisco in 1999
Example: assume a 5-year life for R & D.
Year R&D Expense Unamortized portion Amortization this year
1999 (current) 1594.00 1.00 1594.00
1998 1026.00 0.80 820.80 $205.20
1997 698.00 0.60 418.80 $139.60
1996 399.00 0.40 159.60 $79.80
1995 211.00 0.20 42.20 $42.20
1994 89.00 0.00 0.00 $17.80
Total $ 3,035.40 $ 484.60
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1999 = $ 484.6 million
Adjustment to Operating Income = $ 1,594 million - 484.6 million = 1,109.4 million
(same adjustment for net income and capital expenditures)
27
The Effect of Capitalizing R&D
Conventional Accounting R&D treated as capital expenditure
Income Statement Income Statement
EBIT& R&D = 5,049 EBIT& R&D = 5,049
- R&D = 1,594 - Amort: R&D = 485
EBIT = 3,455 EBIT = 4,564 (Increase of 1,109)
EBIT (1-t) = 2,246 (t=35%) EBIT (1-t) = 2,967
Ignored tax benefit = (1594-485)(.35) = 388
Adjusted EBIT (1-t) = 2967 + 388 = 3354
(Increase of $1,109 million)
Net Income will also increase by $1,109 million
Balance Sheet Balance Sheet
Off balance sheet asset. Book value of equity at Asset Liability
$11,722 million is understated because biggest R&D Asset 3035 Book Equity +3035
asset is off the books. Total Book Equity = 11722+3035 = 14757
Capital Expenditures Capital Expenditures
Conventional net cap ex of $98 million Net Cap ex = 98 + 1594 – 485 = 1206
Cash Flows Cash Flows
EBIT (1-t) = 2246 Adjusted EBIT (1-t) = 3354
- Net Cap Ex = 98 - Net Cap Ex = 1206
FCFF = 2148 FCFF = 2148
Return on capital = 2246/11722 (no debt) Return on capital = 3354/14757
= 19.16% = 22.78%
28
The Effects of Capitalizing R&D
Capitalizing R&D has no effect on FCFF
Operating Income is increased by the same amount that capital
expenditures are increased.
So FCFF is the same.
29
Concept Check: Capitalizing R&D
Amgen Inc is currently spending $845 on R&D.
Amgen amortizes R&D over a 3-year life span, using a
straight-line method.
Over the past three years it had R&D expenses of
$822.80, $663.30, and $630.80.
Its accounting net income (i.e. Its net income treating
R&D as an operating expense) is $1500.
Its accounting book value of equity is $5,000.
What is its return on equity after capitalizing R&D?
30
Concept Check Solution: Capitalizing R&D
32
Converting Operating Expenses to
Financing Expenses
Operating Leases are treated as operating expenses but
should be treated as financing expense.
No real difference between borrowing money to purchase an
asset versus leasing the asset.
34
Operating Leases at The Gap in 2003
The Gap has a stated EBIT of 1,012 and conventional debt of about $ 1.97 billion on
its balance sheet. Its pre-tax cost of debt is 6%. Its operating lease payments in 2003
were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
Debt Value of leases = $4,396.85 (Also value of leased asset)
Debt outstanding at The Gap = $1,970 + $4,397 = $6,367
Adjusted Operating Income = $1,012 + 978 - 4397/7 (7 year life for assets) = $1,362
million
35 Shortcut Adjusted Operating Income = 1012 + 4397 * .06 = 1275.82
The Collateral Effects of Treating Operating
Leases as Debt
Suppose the following is true of GAP in 2002:
BV of Equity = 3130
Conventional Debt = 1970
Market Equity = 7350
After Tax Cost of Debt =4%
Tax rate = 35%
Cost of Equity = 8.2%
36
The Collateral Effects of Treating Operating
Leases as Debt
Conventional Accounting Operating Leases Treated as Debt
Income Statement Income Statement
EBIT = 1,012 EBIT+ Leases = 1,012+978= 1,990
Deprecn: OL = 4397/7= 628
Adj. EBIT = EBIT+ Leases- Deprecn: OL
= 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet Balance Sheet
Off balance sheet (Not shown as debt or as an Asset Liability
asset). Only the conventional debt of $1,970 OL Asset 4397 OL Debt 4397
million shows up on balance sheet. Total debt = 4397 + 1970 = $6,367 million
BV of equity = 3130.
37
Concept Check: Converting Operating
Leases to Debt
Apple leases many of its retail stores.
In the most recent year Apple had an operating lease of 2,500,
Over the next two years it has a commitment of $2000 per year.
In year 3, Apple has a lump sum commitment of $5000.
Thus the lease life is 3 years.
Apple has a pre-tax cost of debt of 7%.
Apple currently has operating income of $20,000 and uses straight line depreciation.
What is the debt-to-equity ratio for apple after converting operating leases to a
financing expense?
38
Concept Check Solution: Converting
Operating Leases to Debt
39
One-time Extraordinary Events
Firms often report one time charges (e.g. Major restructuring).
If you use earnings that incorporate one time charges, current
earnings will not be reflective of typical earnings.
Solution: simply exclude one time charge.
40
One-time Extraordinary Events
Some firms have revenues / expenses that have zero expected
value but vary a lot from year to year
Example: gains / losses due to changes in currency values. Or gains
or losses in hedging portfolios for oil producers.
In those cases it is better to assume the zero expected value for the
future.
41
Income from marketable securities
If a security is marketed (ex: share in another company) then we
already have a market value
It does not make sense to estimate (with error!) its value (estimate a g
and an adequate cost of capital)
Better to simply ignore the income from securities and add instead its
market value
Example: Say that a firm expects to produce in year t+1 after-tax cash flows
of 200 but 20% of these come from holding securities with a market value of
500. The rest comes from operating assets. Assume a g of 5% and a r of
10%. Then:
V=160/(0.1-0.05)+500=3700
42
From earnings to cash flows
Damodaran Ch. 10
43
Cash Flows
45
Net CapEx
Net CapEx = CapEx – Depreciation
Capex = any spending designed to create future revenue.
Examples include:
Buying a new plant
Upgrading a computer system
Investing in R&D
CapEx does not include COGS since these are related to current
(but not future) revenue.
46
Net Capex
Capex is easily obtained from financial statements but...
Capex is volatile
Should smooth out Capex based on long run average
If firm is growing, may make sense to estimate it as a % of revenue.
If data not available or reliable (new firm), we can use an industry average
(capex as % of revenue or depreciation)
47
Capital expenditures should include
R&D expenses .The adjusted net capex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures
+ Current year’s R&D expenses - Amortization of R&D
48
Estimating Net CapEx: Cisco 1999
CISCO had total acquisitions of $2516. Then adjusted net Capex would
be:
Cap Expenditures (from statement of CF) = $ 584 mil
- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil
51
Working Capital: General Propositions
Damadoran Ch. 11
55
Cash Flow Growth
Recall
t n
CFt
Value
1 r
t
t 1
56
Ways of Estimating Growth in Earnings
I. Look at the past
The historical growth in earnings per share is usually a good
starting point for growth estimation
58
Motorola: Arithmetic versus Geometric
Growth Rates
59
A Test
You are trying to estimate the growth rate in earnings per
share at Time Warner from 1996 to 1997. In 1996, the
earnings per share was -0.05. In 1997, the expected
earnings per share is 0.25. What is the growth rate?
-600%
+600%
+120%
Cannot be estimated
60
Dealing with Negative Earnings
When the earnings in the starting period are negative, the
growth rate cannot be estimated. (0.30/-0.05 = -600%)
There are a couple of ‘solutions’ (none of which are very
good):
Use the higher of the two numbers as the denominator (0.30/0.25
= 120%)
Use the absolute value of earnings in the starting period as the
denominator (0.30/0.05=600%)
62
Extrapolation and its Dangers
If net profit continues to grow at the same rate as it has in the past 6
years, the expected net income in 5 years will be $ 4.113 billion.
Growth rates are a function of firm size. If the firm is changing in size,
not appropriate to extrapolate far into future.
63
Example: Google
Over the past 5 years the net income of Google grew at about 23% a
year. Could this rate of growth go on indefinitely? Why not?
In the long run the output of the US economy should grow at about 2%
in real terms. Assume inflation of 2%.
64
II. Analyst Forecasts of Growth
While the job of an analyst is to find under and over valued stocks
in the sectors that they follow, a significant proportion of an
analyst’s time is spent forecasting earnings per share.
65
Quality of earnings forecasts
Analysts have more information than historical growth:
Firm-specific, industry and macroeconomic recent public
information
Private information (whispered earnings)
Reproduced from table II of La Porta, Expectations and the Cross Section of Stock returns,1996, JF
+
in Existing ROI from in New Investment on
Projects
X current to next Projects
X New Projects Change in Earnings
$1000 period: 0% $100 12% = $ 12
68
Growth Rate Derivations
In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects
100 $12
120 X 12% = $120
in the more general case where ROI can change from period to period, this can be expanded as follows:
For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:
69
Expected Long Term Growth in EPS
The inputs we need to estimate long term growth are:
Reinvestment Rate = Retained Earnings/ Current Earnings =
1 – DPS/EPS =Retention Ratio
Return on Investment = ROE = Net Income/Book Value of Equity
70
Estimating Expected Growth in EPS: ABN
Amro
Current Return on Equity = 15.79%
71
Expected ROE changes and Growth
Assume now that ABN Amro’s ROE next year is expected
to increase to 17% (for new projects only) while its
retention ratio remains at 53.88%. What is the new
expected long term growth rate in earnings per share?
Long term growth = .17 * .5388 = .0916 or 9.16%
72
Changes in ROE and Expected Growth
When the ROE is expected to change,
73
Changes in ROE: ABN Amro
Assume now that ABN’s expansion into Asia will push up the
ROE to 17% (for all existing and new projects), while the
retention ratio will remain 53.88%. The expected growth rate in
that year will be:
75
Concept Check Solution: Estimating
Growth Using Fundamentals
76
ROE and Leverage
ROE = ROC + D/E [ROC - i (1-t)]
Where:
ROC = EBITt (1 - tax rate) / Book value of Capitalt-1
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / BV of Debt
t = Tax rate on ordinary income
Note: This equality assumes no cash.
79
Alternative Measurement of Growth
80
Equity Reinvestment Rate
Equity Reinvested in Business:
Net Capital Expenditures + Change in Working Capital – Net
Debt Issued
Ex: http://www.4-traders.com/APPLE-INC-4849/
81
Young firms, abnormal ROC or negative
In some cases the recent performance of the firm can not be
seen as representative of what we could expect for the long run
(example: Linkedin or Amazon)
Damodaran Ch.12
83
Getting Closure in Valuation
A publicly traded firm potentially has an infinite life. The
value is therefore the present value of cash flows until infinity:
t = CF
Value = t
t
t = 1 (1 + r)
t = N CF
Value = t Terminal Value
(1 + r) t (1 + r) N
t =1
84
Ways of Estimating Terminal Value
Terminal Value
85
Stable Growth and Terminal Value
86
Limits on Stable Growth
The stable growth rate cannot exceed the growth rate of
the economy but it can be set lower.
If you assume that the economy is composed of high growth
and stable growth firms, the growth rate of the latter will
probably be lower than the growth rate of the economy.
The stable growth rate can be negative. The terminal value will
be lower and you are assuming that your firm will disappear
over time.
87
Growth Patterns
A key assumption in all discounted cash flow models is the
period of high growth, and the pattern of growth during that
period. In general, we can make one of three assumptions:
there is no high growth, in which case the firm is already in stable
growth
there will be high growth for a period, at the end of which the growth
rate will drop to the stable growth rate (2-stage)
there will be high growth for a period, at the end of which the growth
rate will decline gradually to a stable growth rate(3-stage)
Each year will have different margins and different growth rates (n
stage)
89
Concept Check: Terminal Value
Alloy Mills is a textile firm that is currently paying dividends of
$100 million. The firm has no debt.
DamodaranCh.13
92
Putting it all together
We now know:
How to estimate cash flows in a given period
How to estimate the growth rate of cash flows
How to estimate the terminal value of the firm
93
What cash flows to use?
95
Dividend Discount Models: The
Gordon Growth Model
Let’s start with the simpler model of valuing stocks:
present value of expected dividends.
DPS1
Valuestock
ke g
96
Limitations of the Gordon Growth Model
Very sensitive to final growth rate
97
Concept check: Using GGM to value ConEd
ConEd is in stable growth; based upon size and the area that it
serves. Its rates are also regulated; It is unlikely that the
regulators will allow profits to grow at extraordinary rates.
98
Using GGM to value ConEd
Most recent dividends: 2.60
http://finance.yahoo.com/q?s=ED&ql=0
99
Using GGM to value ConEd
Cost of Equity = 2.60% + 0.47*4% = 4.48%
Value of Equity per Share = $2.60*1.02 / (.0448 -.02) = $
106.94
100
Estimating Implied Growth Rate
One possibility is that our growth rate is too high.
101
Two Stage DDM
Allows for two stages of growth
Initial phase where the growth rate is not stable
Subsequent stable growth period
n
DPSt DPS n 1 1
Value t
t 1 (1 k e , hg ) ke , st g n (1 k e,hg )
t n
Where:
DPSt=expected dividends per share in year t
ke = cost of equity (hg: high growth, st: stable growth)
hg= extraordinary growth rate for first n years
gn = growth rate forever after year n.
102
Limitations of Two-Stage DDM
Need to define length of extraordinary growth period.
Focus on dividends will lead to biased results for firms that are
not paying out as much in dividends as they can.
104
ABN Amro: Summarizing the Inputs
Market Inputs
Long Term risk-free Rate (in Euros) = 4.35%
Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)
Current Earnings Per Share = 1.85 Eur; Current DPS = 0.90 Eur;
Note: We assume here that the new ROE applies only to the new projects.
105
ABN Amro: Valuation
Year EPS DPS PV of DPS (at 8.15%)
1 2.00 0.97 0.90
2 2.17 1.05 0.90
3 2.34 1.14 0.90
4 2.54 1.23 0.90
5 2.75 1.34 0.90
Value Per Share = 0.90 + 0.90 + 0.90 + 0.90 + 0.90 + 23.11 = 27.62 Eur
The stock was trading at 18.55 Euros on December 31, 2003
106
S & P 500 - rationale for using the two-
stage model
Markets overall do not grow faster than the economy. But in the US
earnings have outpaced nominal GNP growth over the last 5 years and it is
currently expected they will continue to do so in the next 5 years.
Though it is possible to estimate FCFE for many of the firms in the S&P
500, it is not feasible for several (financial service firms).
107
Concept Check: Valuing the S&P 500 Using
a two-step DDM
On 1/1/2001 the S&P 500 was trading at 1320.
Analysts were estimating that the earnings of the stocks in the index
would increase by 7.5% a year for the following 5 years.
The risk free rate was 5.1% and assume a market risk premium of 4%
108
Concept Check Solution: Valuing the S&P 500 Using
a Dividend Discount Model
1 2 3 4 5
Expected Dividends 35.48 38.14 41.00 44.07 47.38
Present Value 32.52 32.04 31.57 31.11 30.65
110
Concept Check: Valuing the S&P 500 in the
present using a Dividend Discount Model
On 3/3/2015 the S&P 500 was trading at 2117.
The risk free rate was 2.08% and the market risk premium was 4%
Discounted Ch.14
112
Dividends and Cash Flows to Equity
The only cash flows that an investor will receive periodically from an
equity investment in a publicly traded firm is the dividend that will be
paid on the stock.
Actual dividends, however, are set by the managers of the firm and may
be much lower than the potential dividends (that could have been paid
out)
managers are conservative and try to smooth out dividends
managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities
When actual dividends are less than potential dividends, using a model
that focuses only on dividends will understate the true value of the
equity in a firm.
113
Measuring Potential Dividends
Some analysts assume that the earnings of a firm represent its
potential dividends (see Dow 36,000). This cannot be true for
several reasons:
Earnings are not cash flows, since there are both non-cash revenues and
expenses in the earnings calculation
Even if earnings were cash flows, a firm that paid its earnings out as
dividends would not be investing in new assets and thus could not grow
Valuation models, where earnings are discounted back to the present, will
over estimate the value of the equity in the firm
The potential dividends of a firm are the cash flows left over after
the firm has made any “investments” it needs to create future
growth and net debt repayments (debt repayments - new debt
issues)
114
FCFE
Cash flows to Equity for a Levered Firm
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
115
Estimating FCFE when Leverage is Stable
FCFE = Net Income- (1- ) (Capital Expenditures -
Depreciation)- (1- ) Changes in Working Capital
Where: = Debt/Capital Ratio
116
Example Estimating FCFE: Disney in 1996
Net Income=$ 1533 Million
Capital spending = $ 1,746 Million
Depreciation = $ 1,134 Million
Increase in non-cash working capital = $ 477 Million
Debt to Capital Ratio = 23.83%
Estimating FCFE (1997):
117
FCFE Models. What are the options?
Much like the DDM, FCFE models can have multiple stages:
If firm has reached stable growth then we can use a 1-stage model:
FCFE1
Valuestock
ke g n
If firm is expected to grow faster than a stable firm for an initial period
and then reachn aFCFE
stable rate FCFE we use two stage1 model:
Value t t
n 1
t 1 (1 k e , hg ) t
k e , st g n (1 k e , hg ) n
119
Concept Check: Using FCFE to Value Nestle
The fundamentals of the firm suggest growth of about
15% and rf is 4%.
Suggests a three-stage model but we will use the two stage
growth model.
120
Concept Check: Using FCFE to Value Nestle
General Inputs:
Long Term Government Bond Rate (Sfr) = 4%
Current EPS = 108.88 Sfr; Current Revenue/share =1,820 Sfr
Capital Expenditures/Share=150 Sfr; Depreciation/Share=73.8 Sfr
121
Concept Check Solution: Using FCFE to Value
Nestle
1 2 3 4 5
Earnings $125.63 $144.95 $167.25 $192.98 $222.67
- (Net CpEX)*(1-DR) $54.86 $63.30 $73.04 $84.28 $97.24
-D NWC*(1-DR)$26.92 $31.06 $35.84 $41.35 $47.72
Free Cashflow to Equity $43.84 $50.59 $58.37 $67.35 $77.71
Present Value $40.42 $43.00 $45.74 $48.65 $51.75
Earnings per Share in year 1 = 108.88(1.1538) = 125.63
Net Cap Ex(1-DR)_1: (150-73.8) * 1.1538*(1-.376)=54.86
D NWC(1-DR)_1: (1820*.1538) * .1541* (1-.376) =26.92
Earnings per Share in year 6 = 222.67(1.04) = 231.58
Equity Reinvestment in year 6: EPS * Reinvestment Rate: 231.58 * .25= 57.89
FCFE6 = 231.58 - 57.89= 173.68 Sfr
Terminal Value per Share = 173.68/(.0847-.04) = 3885.50 Sfr
Value= $40.42 +$43 +$45.74 +$48.65 +$51.75 +3885.50/(1.0847)5=2817.17 Sf
122
Fundamental principles of relative
valuation
Damadoran Ch. 17
123
The Essence of relative valuation
In relative valuation, the value of an asset is compared to
market values for similar assets.
124
Relative valuation is pervasive…
Most valuations on Wall Street are relative valuations.
Almost 85% of equity research reports are based upon a multiple and
comparables.
More than 50% of all acquisition valuations are based upon multiples.
Rules of thumb based on multiples are not only common but are often the
basis for final valuation judgments.
125
So, you believe only in intrinsic value? Here’s why
you should still care about relative value
Even if you are a true believer in discounted cash flow
valuation, presenting your findings on a relative valuation
basis will make it more likely that your findings /
recommendations will find a receptive audience.
126
Advantages of Relative Valuation
Can be completed with far fewer explicit assumptions
than DCF analysis
127
Limitations of Relative Valuation
Very difficult to come up with true comparable firm
Many similar firms will still differ with respect to risk, growth,
or cash flows.
128
Standardized Values and Multiples
You can standardize by dividing by the:
Earnings of the asset
Price / Earnings Ratio (PE) and variants (PEG and
Relative PE), Value / EBIT, Value / EBITDA, Value /
Cash Flow
Book value of the asset
Price / Book Value (of Equity) (PBV), Value / Book Value
of Assets, Value / Replacement Cost (Tobin’s Q)
Revenues generated by the asset
Price / Sales per Share (PS), Value / Sales
Asset or Industry Specific Variable (Price / kwh, Price per
ton of steel ....)
129
The Four Steps to Understanding Multiples
Define the multiple
The same multiple can be defined in different ways by different users. When
comparing and using multiples, estimated by someone else, it is critical that we
understand how the multiples have been estimated
Describe how the multiple compares to a “normal” value
Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it is
too high or low. (Suggestion: http://people.stern.nyu.edu/adamodar/ )
Analyze the multiple
It is critical that we understand the fundamentals that drive each multiple, and
the nature of the relationship between the multiple and each variable.
Apply the multiple
Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.
130
Definitional Tests
Is the multiple consistently defined?
Proposition 1: Both the value (the numerator) and the
standardizing variable (the denominator) should be to the
same claimholders in the firm. The value of equity should be
divided by equity earnings or equity book value, and firm
value should be divided by firm earnings or firm book value.
131
Descriptive Tests
What is the average and standard deviation for this multiple, across the universe
(market)?
How large are the outliers to the distribution, and how do we deal with the outliers?
Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on
one side of the distribution (they usually are large positive numbers), this can lead to a
biased estimate.
Are there cases where the multiple cannot be estimated? Will ignoring these cases
lead to a biased estimate of the multiple?
132
Analytical Tests
What are the fundamentals that determine and drive these multiples?
Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
In fact, using a simple discounted cash flow model and basic algebra should
yield the fundamentals that drive a multiple
133
Analytical Test: Example
135
Controlling for Differences across firms
No matter how carefully you construct your list of comparable firms, your
firms will not be identical with respect to cash flows, growth, & risk.
136
Earnings multiples
Damadoran Ch. 18
137
Price Earnings Ratio: Definition
PE = Market Price per Share / Earnings per Share
Price:
is usually the current price (though some like to use average price over
last 6 months or year).
EPS:
Time variants: expected EPS in most recent financial year (current), EPS
in most recent four quarters (trailing), EPS expected in next fiscal year
or next four quarters (both called forward) or EPS in some future year
Before or after extraordinary items
138
Looking at the distribution…
PE Ratio Distribution: US firms in January 2005
700
600
500
400
Current PE
Trailing PE
300
Forward PE
200
100
0
0-4 4-8 8-12 12-16 16-20 20-24 24-28 28 - 32 32-36 36-40 40-50 50-75 75-100 >100
PE Ratio
139
PE: Deciphering the Distribution
140
PE Ratio: Understanding the
Fundamentals
To understand the fundamentals, start with a basic equity
discounted cash flow model.
With the dividend discount model,
DPS1
P0
r gn
(1 g ) n
(1 b)(1 g )[1 ]
P0 (1 rHG ) n
(1 b)(1 g ) n (1 g n )
EPS 0 rhg g (rst g n )(1 rhg ) n
143
Expanding the Model
In this model, the PE ratio for a high growth firm is a
function of growth, risk and payout, exactly the same
variables as for the stable growth firm.
144
Example: Estimating a PE Ratio from
Fundamentals
Assume that you have been asked to estimate the PE
ratio for a firm which has the following characteristics:
145
Example: Estimating a PE Ratio from
Fundamentals
Required rate of return = 6% + 1(5.5%)= 11.5%
Can split into two stages: high growth and low growth and
compute PE as follows:
(1.25)5
0.2 * (1.25) * 1 5 5
(1.115) 0.5 * (1.25) *(1.08)
PE = + 5
= 28.75
(.115 - .25) (.115-.08) (1.115)
146
PE and Growth: Firm grows at x% for 5
years, 8% thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios
180
160
140
120
100 r=4%
PE Ratio
r=6%
r=8%
80 r=10%
60
40
20
0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate
147
PE and Risk: Effects of Changing Betas on PE Ratio:
Firm with x% growth for 5 years; 8% thereafter
50
45
40
35
30
g=25%
PE Ratio
g=20%
25
g=15%
g=8%
20
15
10
0
0.75 1.00 1.25 1.50 1.75 2.00
Beta
148
V. Comparing PE ratios across firms
Company Name Trailing PE Expected Growth Standard Dev
Coca-Cola Bottling 29.18 9.50% 20.58%
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88%
Anheuser-Busch 24.31 11.00% 22.92%
Corby Distilleries Ltd. 16.24 7.50% 23.66%
Chalone Wine Group Ltd. 21.76 14.00% 24.08%
Andres Wines Ltd. 'A' 8.96 3.50% 24.70%
Todhunter Int'l 8.94 3.00% 25.74%
Brown-Forman 'B' 10.07 11.50% 29.43%
Coors (Adolph) 'B' 23.02 10.00% 29.52%
PepsiCo, Inc. 33.00 10.50% 31.35%
Coca-Cola 44.33 19.00% 35.51%
Boston Beer 'A' 10.59 17.13% 39.58%
Whitman Corp. 25.19 11.50% 44.26%
Mondavi (Robert) 'A' 16.47 14.00% 45.84%
Coca-Cola Enterprises 37.14 27.00% 51.34%
Hansen Natural Corp 9.70 17.00% 62.45%
Note: 22.65
Average It would be
12.60% better to use Beta as a measure of risk, but we will stick with the
33.30%
data given in the book.
149
A Question
You are reading an equity research report on this sector, and the
analyst claims that Andres Wine and Hansen Natural are under
valued because they have low PE ratios (8.96 and 9.70,
respectively compared to an average PE of 22.66). Would you
agree?
Do you now believe that Hansen Natural Corp is over or under valued?
151
Concept Check Solution: Are Andres Wine
and Hansen really undervalued?
Note the predicted PEs of both companies are considerably less than the average PE
of 22.66, suggesting that controlling for growth and standard deviation does
account for much of the apparent undervaluation.
152
Fundamental analysis: recent research
Bibliography:
Asness, Frazzini, and Pederson (2013), Quality Minus Junk
Elton and Gruber (2013), Mutual Funds
Frazzini, Kabiller, and Pederson (2013), Buffet’s alpha
Gibson, Safieddine, and Sonti (2004, JFE), Smart
Investment by smart money: evidence from seasoned
equity offerings
Bartram and Grinblatt (2018, JFE), Agnostic
fundamental analysis works
153
Fundamental analysis: does it work?
From a semi-strong EMH perspective, fundamental analysis of
publicly traded securities should be a waist of time
154
Mutual fund performance
Many studies on this. Elton and Gruber (2013) survey their results (table I of their paper):
So before expenses, mutual funds seem to (marginally) outperform benchmarks (but after
expenses, not really). Still an open topic though.
155
Mutual fund performance
Could some be better at stock picking than others?
Robust internationally.
Onthe other hand, this investor claims to follow a method, laid out by Graham
and Dodd (1934) – the founders of fundamental analysis.
160
Buffet’s alpha: Comparing to other stocks
be a scientific concern.
161
Buffet’s alpha with QMJ and BAB as factors
163
The primary market
For market prices, in EMH, sophisticated institutional investors
(perhaps using fundamental analysis) should not outperform.
But when firms issue new stock, prices usually are not market
prices.
164
Institutional buying and the SEO
Suggests institutional
investors are able to pick
stocks - at least in the
primary market.
165
Recent research: Summary
It is one ongoing debate whether institutional investors outperform their
benchmarks.
Could be proxy for some other, unknown, risk factor or just reflect market
inefficiencies.
166