An Exercise in Valuing Cross Holdings - NYUadamodar/podcasts/valUGspr17/session12.pdf · An...
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221 An Exercise in Valuing Cross Holdings ¨ Assume that you have valued Company A using consolidated financials for $ 1 billion (using FCFF and cost of capital) and that the firm has $ 200 million in debt. How much is the equity in Company A worth? ¨ Now assume that you are told that Company A owns 10% of Company B and that the holdings are accounted for as passive holdings. If the market cap of company B is $ 500 million, how much is the equity in Company A worth? ¨ Now add on the assumption that Company A owns 60% of Company C and that the holdings are fully consolidated. The minority interest in company C is recorded at $ 40 million in Company A’s balance sheet. How much is the equity in Company A worth? Aswath Damodaran 221
Transcript of An Exercise in Valuing Cross Holdings - NYUadamodar/podcasts/valUGspr17/session12.pdf · An...
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AnExerciseinValuingCrossHoldings
¨ AssumethatyouhavevaluedCompanyAusingconsolidatedfinancialsfor$1billion(usingFCFFandcostofcapital)andthatthefirmhas$200millionindebt.HowmuchistheequityinCompanyAworth?
¨ NowassumethatyouaretoldthatCompanyAowns10%ofCompanyBandthattheholdingsareaccountedforaspassiveholdings.IfthemarketcapofcompanyBis$500million,howmuchistheequityinCompanyAworth?
¨ NowaddontheassumptionthatCompanyAowns60%ofCompanyCandthattheholdingsarefullyconsolidated.TheminorityinterestincompanyCisrecordedat$40millioninCompanyA’sbalancesheet.HowmuchistheequityinCompanyAworth?
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MoreonCrossHoldingValuation
¨ Buildingonthepreviousexample,assumethat¤ YouhavevaluedequityincompanyBat$250million(whichishalfthemarket’sestimateofvaluecurrently)
¤ CompanyAisasteelcompanyandthatcompanyCisachemicalcompany.Furthermore,assumethatyouhavevaluedtheequityincompanyCat$250million.
¤ EstimatethevalueofequityincompanyA.
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Ifyoureallywanttovaluecrossholdingsright….
¨ Step1:Valuetheparentcompanywithoutanycrossholdings.Thiswillrequireusingunconsolidatedfinancialstatementsratherthanconsolidatedones.
¨ Step2:Valueeachofthecrossholdingsindividually.(Ifyouusethemarketvaluesofthecrossholdings,youwillbuildinerrorsthemarketmakesinvaluingthemintoyourvaluation.
¨ Step3:ThefinalvalueoftheequityintheparentcompanywithNcrossholdingswillbe:¤ Valueofun-consolidatedparentcompany¤ – Debtofun-consolidatedparentcompany¤ +
€
% owned of Company j * (Value of Company jj=1
j=N
∑ - Debt of Company j)
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ValuingYahooasthesumofitsintrinsicpieces
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Ifyouhavetosettleforanapproximation,trythis…
¨ Formajorityholdings,withfullconsolidation,converttheminorityinterestfrombookvaluetomarketvaluebyapplyingapricetobookratio(baseduponthesectoraverageforthesubsidiary)totheminorityinterest.¤ Estimatedmarketvalueofminorityinterest=Minorityintereston
balancesheet*PricetoBookratioforsector(ofsubsidiary)¤ Subtractthisfromtheestimatedvalueoftheconsolidatedfirmtoget
tovalueoftheequityintheparentcompany.¨ Forminorityholdingsinothercompanies,convertthebook
valueoftheseholdings(whicharereportedonthebalancesheet)intomarketvaluebymultiplyingbythepricetobookratioofthesector(s).Addthisvalueontothevalueoftheoperatingassetstoarriveattotalfirmvalue.
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Yahoo:Apricinggame?
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3.OtherAssetsthathavenotbeencountedyet..
¨ Assetsthatyoushouldnotbecounting(oraddingontoDCFvalues)¤ Ifanassetiscontributingtoyourcashflows,youcannotcountthemarketvalueof
theassetinyourvalue.Thus,youshouldnotbecountingtherealestateonwhichyourofficesstand,thePP&Erepresentingyourfactoriesandotherproductiveassets,anyvaluesattachedtobrandnamesorcustomerlistsanddefinitelynonon-assets(suchasgoodwill).
¨ Assetsthatyoucancount(oraddontoyourDCFvaluation)¤ Overfundedpensionplans:Ifyouhaveadefinedbenefitplanandyourassets
exceedyourexpectedliabilities,youcouldconsidertheoverfundingwithtwocaveats:n Collectivebargainingagreementsmaypreventyoufromlayingclaimtothese
excessassets.n Therearetaxconsequences.Often,withdrawalsfrompensionplansgettaxedat
muchhigherrates.¤ Unutilizedassets:Ifyouhaveassetsorpropertythatarenotbeingutilizedto
generatecashflows(vacantland,forexample),youhavenotvaluedthemyet.Youcanassessamarketvaluefortheseassetsandaddthemontothevalueofthefirm.
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AnUncountedAsset?
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Price tag: $200 million
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4.ADiscountforComplexity:AnExperiment
CompanyA CompanyBOperatingIncome $1billion $1billionTaxrate 40% 40%ROIC 10% 10%ExpectedGrowth 5% 5%Costofcapital 8% 8%BusinessMix Single MultipleHoldings Simple ComplexAccounting Transparent OpaqueWhichfirmwouldyouvaluemorehighly?
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MeasuringComplexity:VolumeofDatainFinancialStatements
Company Number of pages in last 10Q Number of pages in last 10KGeneral Electric 65 410Microsoft 63 218Wal-mart 38 244Exxon Mobil 86 332Pfizer 171 460Citigroup 252 1026Intel 69 215AIG 164 720Johnson & Johnson 63 218IBM 85 353
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MeasuringComplexity:AComplexityScore
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DealingwithComplexity
¨ InDiscountedCashflowValuation¤ TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirm
baseduponthefirm’sstatementsabouttheirvalue.¤ TheConservativeAnalyst:Don’tvaluewhatyoucannotsee.¤ TheCompromise:Adjustthevalueforcomplexity
n Adjustcashflowsforcomplexityn Adjustthediscountrateforcomplexityn Adjusttheexpectedgrowthrate/lengthofgrowthperiodn Valuethefirmandthendiscountvalueforcomplexity
¨ Inrelativevaluation¤ Inarelativevaluation,youmaybeabletoassessthepricethatthemarket
ischargingforcomplexity:¤ Withthehundredlargestmarketcapfirms,forinstance:PBV=0.65+15.31ROE– 0.55Beta+3.04Expectedgrowthrate– 0.003#
Pagesin10K
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5.Becircumspectaboutdefiningdebtforcostofcapitalpurposes…
¨ GeneralRule:Debtgenerallyhasthefollowingcharacteristics:¤ Commitmenttomakefixedpaymentsinthefuture¤ Thefixedpaymentsaretaxdeductible¤ Failuretomakethepaymentscanleadtoeitherdefaultorlossof
controlofthefirmtothepartytowhompaymentsaredue.¨ Definedassuch,debtshouldinclude
¤ Allinterestbearingliabilities,shorttermaswellaslongterm¤ Allleases,operatingaswellascapital
¨ Debtshouldnotinclude¤ Accountspayableorsuppliercredit
¨ Bewaryofyourconservativeimpulseswhichwilltellyoutocounteverythingasdebt.Thatwillpushupthedebtratioandleadyoutounderstateyourcostofcapital.
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BookValueorMarketValue
¨ Youarevaluingadistressedtelecomcompanyandhavearrivedatanestimateof$1billionfortheenterprisevalue(usingadiscountedcashflowvaluation).Thecompanyhas$1billioninfacevalueofdebtoutstandingbutthedebtistradingat50%offacevalue(becauseofthedistress).Whatisthevalueoftheequitytoyouasaninvestor?a. Theequityisworthnothing(EVminusFaceValueofDebt)b. Theequityisworth$500million(EVminusMarketValueofDebt)
¨ Wouldyouranswerbedifferentifyouweretoldthattheliquidationvalueoftheassetsofthefirmtodayis$1.2billionandthatyouwereplanningtoliquidatethefirmtoday?
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Butyoushouldconsiderotherpotentialliabilitieswhengettingtoequityvalue
¨ Ifyouhaveunderfundedpensionfundorhealthcareplans,youshouldconsidertheunderfundingatthisstageingettingtothevalueofequity.¤ Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitemreflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.
¤ Youshouldnotbecountingtheseitemsasdebtinyourcostofcapitalcalculations….
¨ Ifyouhavecontingentliabilities- forexample,apotentialliabilityfromalawsuitthathasnotbeendecided- youshouldconsidertheexpectedvalueofthesecontingentliabilities¤ Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expectedvalueofliability
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6.EquitytoEmployees:EffectonValue
¨ Inrecentyears,firmshaveturnedtogivingemployees(andespeciallytopmanagers)equityoptionorrestrictedstockpackagesaspartofcompensation.Iftheyareoptions,theyusuallyarelongtermandonvolatilestocks.Ifrestrictedstock,therestrictionsareusuallyontrading.
¨ Theseequitycompensationpackagesareclearlyvaluableandthequestionbecomeshowbesttodealwiththeminvaluation.
¨ Twokeyissueswithemployeeoptions:¤ Howdooptionsorrestrictedstockgrantedinthepastaffectequity
valuepersharetoday?¤ Howdoexpectedgrantsofeitherinthefutureaffectequityvalue
today?
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TheEasierProblem:RestrictedStockGrantsAswath
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¨ Whenemployeecompensationtakestheformofrestrictedstockgrants,thesolutionisrelativelysimple.
¨ Toaccountforrestrictedstockgrantsinthepast,makesurethatyoucounttherestrictedstockthathavealreadybeengrantedinsharesoutstandingtoday.Thatwillreduceyourvaluepershare.
¨ Toaccountforexpectedstockgrantsinthefuture,estimatethevalueofthesegrantsasapercentofrevenueandforecastthatasexpenseaspartofcompensationexpenses.Thatwillreducefutureincomeandcashflows.
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TheBiggerChallenge:EmployeeOptions
¨ Itistruethatoptionscanincreasethenumberofsharesoutstandingbutdilutionperseisnottheproblem.
¨ Optionsaffectequityvalueatexercisebecause¤ Sharesareissuedatbelowtheprevailingmarketprice.Optionsgetexercisedonlywhentheyareinthemoney.
¤ Alternatively,thecompanycanusecashflows thatwouldhavebeenavailabletoequityinvestorstobuybackshareswhicharethenusedtomeetoptionexercise.Thelowercashflows reduceequityvalue.
¨ Optionsaffectequityvaluebeforeexercisebecausewehavetobuildintheexpectationthatthereisaprobabilityofandacosttoexercise.
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Asimpleexample…
¨ XYZcompanyhas$100millioninfreecashflows tothefirm,growing3%ayearinperpetuityandacostofcapitalof8%.Ithas100millionsharesoutstandingand$1billionindebt.Itsvaluecanbewrittenasfollows:
Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valuepershare =1000/100=$10
¨ XYZdecidestogive10millionoptionsatthemoney(withastrikepriceof$10)toitsCEO.Whateffectwillthishaveonthevalueofequitypershare?a. None.Theoptionsarenotin-the-money.b. Decreaseby10%,sincethenumberofsharescouldincreaseby10millionc. Decreasebylessthan10%.Theoptionswillbringincashintothefirmbutthey
havetimevalue.
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I.TheDilutedShareCountApproach
¨ Thesimplestwayofdealingwithoptionsistotrytoadjustthedenominatorforsharesthatwillbecomeoutstandingiftheoptionsgetexercised.Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Valuepershare =1000/110=$9.09
¨ Thedilutedapproachfailstoconsiderthatexercisingoptionswillbringincashintothefirm.Consequently,theywilloverestimatetheimpactofoptionsandunderstatethevalueofequitypershare.
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II.TheTreasuryStockApproach
¨ Thetreasurystockapproachaddstheproceedsfromtheexerciseofoptionstothevalueoftheequitybeforedividingbythedilutednumberofsharesoutstanding.
¨ Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Proceedsfromoptionexercise =10*10=100Valuepershare =(1000+100)/110=$10
¨ Thetreasurystockapproachfailstoconsiderthetimepremiumontheoptions. Thetreasurystockapproachalsohasproblemswithout-of-the-moneyoptions.Ifconsidered,theycanincreasethevalueofequitypershare.Ifignored,theyaretreatedasnon-existent.
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III.OptionValueDrag
¨ Step1:Valuethefirm,usingdiscountedcashfloworothervaluationmodels.
¨ Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthevalueofequity.Alternatively,skipstep1andestimatetheofequitydirectly.
¨ Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)ofotherequityclaims:¤ ValueofWarrants=MarketPriceperWarrant*NumberofWarrants
:Alternativelyestimatethevalueusingoptionpricingmodel¤ ValueofConversionOption=MarketValueofConvertibleBonds- Valueof
StraightDebtPortionofConvertibleBonds¤ ValueofemployeeOptions:Valueusingtheaverageexercisepriceand
maturity.¨ Step4:Dividetheremainingvalueofequitybythenumberof
sharesoutstandingtogetvaluepershare.
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ValuingEquityOptionsissuedbyfirms…TheDilutionProblem
¨ Optionpricingmodelscanbeusedtovalueemployeeoptionswithfourcaveats–¤ Employeeoptionsarelongterm,makingtheassumptionsabout
constantvarianceandconstantdividendyieldsmuchshakier,¤ Employeeoptionsresultinstockdilution,and¤ Employeeoptionsareoftenexercisedbeforeexpiration,makingit
dangeroustouseEuropeanoptionpricingmodels.¤ Employeeoptionscannotbeexerciseduntiltheemployeeisvested.
¨ Theseproblemscanbepartiallyalleviatedbyusinganoptionpricingmodel,allowingforshiftsinvarianceandearlyexercise,andfactoringinthedilutioneffect.Theresultingvaluecanbeadjustedfortheprobabilitythattheemployeewillnotbevested.
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ValuingEmployeeOptions
¨ Tovalueemployeeoptions,youneedthefollowinginputsintotheoptionvaluationmodel:¤ StockPrice=$10,Adjustedfordilution=$9.58¤ StrikePrice=$10¤ Maturity=10years(Canreducetoreflectearlyexercise)¤ Standarddeviationinstockprice=40%¤ RisklessRate=4%
¨ Usingadilution-adjustedBlackScholesmodel,wearriveatthefollowinginputs:¤ N(d1)=0.8199¤ N(d2)=0.3624¤ Valuepercall=$9.58(0.8199)- $10e-(0.04)(10)(0.3624)=$5.42
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ValueofEquitytoValueofEquitypershare
¨ Usingthevaluepercallof$5.42,wecannowestimatethevalueofequitypershareaftertheoptiongrant:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valueofoptionsgranted =$54.2=ValueofEquityinstock =$945.8/Numberofsharesoutstanding /100=Valuepershare =$9.46
¨ Notethatthisapproachyieldsahighervaluethanthedilutedsharecountapproach(whichignoresexerciseproceeds)andalowervaluethanthetreasurystockapproach(whichignoresthetimepremiumontheoptions)
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Totaxadjustornottotaxadjust…
¨ Intheexampleabove,wehaveassumedthattheoptionsdonotprovideanytaxadvantages.Totheextentthattheexerciseoftheoptionscreatestaxadvantages,theactualcostoftheoptionswillbelowerbythetaxsavings.
¨ Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1- taxrate)togetanafter-taxoptioncost.
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Optiongrantsinthefuture…
¨ Assumenowthatthisfirmintendstocontinuegrantingoptionseachyeartoitstopmanagementaspartofcompensation.Theseexpectedoptiongrantswillalsoaffectvalue.
¨ Thesimplestmechanismforbringinginfutureoptiongrantsintotheanalysisistodothefollowing:¤ Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsasapercentofrevenues.
¤ Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofutureyears,allowingforthefactthatasrevenuesgetlarger,optiongrantsasapercentofrevenueswillbecomesmaller.
¤ Considerthislineitemaspartofoperatingexpenseseachyear.Thiswillreducetheoperatingmarginandcashfloweachyear.
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Whenoptionsaffectequityvaluepersharethemost…
¨ Optiongrantsaffectvaluemore¤ Thelowerthestrikepriceissetrelativetothestockprice¤ Thelongerthetermtomaturityoftheoption¤ Themorevolatilethestockprice
¨ Theeffectonvaluewillbemagnifiedifcompaniesareallowedtorevisitoptiongrantsandresettheexercisepriceifthestockpricemovesdown.
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