Copyright ©2003 Ian H. Giddy Valuation 1. Raising Equity Finance & Valuing a Business Prof. Ian...
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Copyright ©2003 Ian H. Giddy Valuation 1
Raising Equity Finance & Valuing a Business
Prof. Ian GIDDYStern School of Business
New York University
Copyright ©2003 Ian H. Giddy Valuation 3
Telkom South Africa
1. Why did South Africa follow its initial 30% privatization of Telkom with an initial public offering? What are the advantages and disadvantages of a public listing for a company?
2. What is an ADR? Why did Telkom use the ADR technique in conjunction with its Johannesburg IPO?
3. What does a company have to do to ensure a successful IPO? What makes shares attractive to investors?
4. Was the Telkom IPO priced correctly? How would you value a company in order to judge the price for an IPO?
Copyright ©2003 Ian H. Giddy Valuation 4
Valuing a Firm with DCF
Historical financial results
Adjust for nonrecurring aspects
Gauge future growth
Adjust for noncash items
Projected sales and operating profits
Projected free cash flows to the firm (FCFF)
Year 1 FCFF
Year 2 FCFF
Year 3 FCFF
Year 4 FCFF
Terminal year FCFF
Stable growth model or P/E comparable
Present value of free cash flows
+ cash, securities & excess assets
- Market value of debt
Value of shareholders equity
…
Discount to present using weighted average cost of capital (WACC)
Copyright ©2003 Ian H. Giddy Valuation 5
What’s a Company Worth?
Required returns Types of Models
Balance sheet modelsComparablesCorporate cash flow models
Estimating Growth Rates Applications Option-based models
Copyright ©2003 Ian H. Giddy Valuation 6
Copyright ©2003 Ian H. Giddy Valuation 7
IBM’s Financials
Copyright ©2003 Ian H. Giddy Valuation 8
Equity Valuation: From the Balance Sheet
Value of AssetsBookLiquidationReplacement
Value of Liabilities
BookMarket
Value of Equity
Copyright ©2003 Ian H. Giddy Valuation 9
Equity Valuation: From the Balance Sheet
Value of AssetsBookLiquidationReplacementOr what?
A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)
Copyright ©2003 Ian H. Giddy Valuation 10
Relative Valuation
In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include:
• Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples,
Cash Flow multiples)
• Price/Book (P/BV) ratios and variants (Tobin's Q)
• Price/Sales ratios
Copyright ©2003 Ian H. Giddy Valuation 11
Comparables
Value Indicator Earnings Cash Flow Revenues Book
Value Indicator Earnings Cash Flow Revenues Book
Average Comparable Industry Firms Deals
Average Comparable Industry Firms Deals
Target
Company
Numbers or
Projections
Target
Company
Numbers or
Projections
Estimated
Value of
Target
Estimated
Value of
Target
Copyright ©2003 Ian H. Giddy Valuation 12
IBM: Comparables
Copyright ©2003 Ian H. Giddy Valuation 13
Corporate Cash Flow
Copyright ©2003 Ian H. Giddy Valuation 14
Discounted Cashflow Valuation: Basis for Approach
where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the
riskiness of the estimated cashflows
Value = CFt
(1+ r)tt =1
t = n
Copyright ©2003 Ian H. Giddy Valuation 15
Start with theWeighted Average Cost of Capital
Choice Cost1. Equity Cost of equity
- Retained earnings - depends upon riskiness of the stock
- New stock issues - will be affected by level of interest rates
- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt
- Bank borrowing - depends upon default risk of the firm
- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity and
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©2003 Ian H. Giddy Valuation 16
IBM’s Cost of Capital
IBM
Cost of Capital Cost Amount Weight
Debt10-year bond yield 4.95%Tax rate 29%After-tax cost 3.5% 61.9 31%
EquityRisk-free Treasury 4.50%Beta 1.47Market Risk Premium 5.50%From CAPM 12.6% 137.4 69%
Total 9.77% 199.3
Source: IBMfinancing.xls
Copyright ©2003 Ian H. Giddy Valuation 17
Valuation: The Key Inputs
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.
Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:
Value = CF
t
(1+ r)tt = 1
t =
Value = CFt
(1 + r)t
Terminal Value
(1 + r)N
t = 1
t = N
Copyright ©2003 Ian H. Giddy Valuation 18
Dividend Discount Models:General Model
VD
ko
t
tt
( )11
VD
ko
t
tt
( )11
V0 = Value of Stock Dt = Dividend k = required return
Copyright ©2003 Ian H. Giddy Valuation 19
No Growth Model
VD
ko
Stocks that have earnings and dividends that are expected to remain constant
Preferred Stock
Copyright ©2003 Ian H. Giddy Valuation 20
No Growth Model: Example
E1 = D1 = $5.00
k = .12
V0 = $5.00/0.12 = $41.67
VD
ko
Burlington Power & Light has earnings of $5 per share and pays out 100% dividend
The required return that shareholders expect is 12%
The earnings are not expected to grow but remain steady indefinitely
What’s a BPL share worth?
Burlington Power & Light has earnings of $5 per share and pays out 100% dividend
The required return that shareholders expect is 12%
The earnings are not expected to grow but remain steady indefinitely
What’s a BPL share worth?
Copyright ©2003 Ian H. Giddy Valuation 21
Constant Growth Model
VoD g
k g
o
( )1Vo
D g
k g
o
( )1
g = constant perpetual growth rate
Copyright ©2003 Ian H. Giddy Valuation 22
Constant Growth Model: Example
VoD g
k g
o
( )1Vo
D g
k g
o
( )1
E1 = $5.00k = 12%
D1 = $3.00 g = 6%
V0 = 3.00 / (.12 - .06) = $50.00
Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend
The required return that shareholders expect is 12%
The earnings are expected to grow at 6% per annum
What’s an M6 share worth?
Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend
The required return that shareholders expect is 12%
The earnings are expected to grow at 6% per annum
What’s an M6 share worth?
Copyright ©2003 Ian H. Giddy Valuation 23
Shifting Growth Rate Model
V Dg
k
D g
k g ko o
t
tt
TT
T
( )
( )
( )
( )( )
1
1
1
1
1
1
2
2V D
g
k
D g
k g ko o
t
tt
TT
T
( )
( )
( )
( )( )
1
1
1
1
1
1
2
2
g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1
Copyright ©2003 Ian H. Giddy Valuation 24
Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Mindspring pays dividends $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Shifting Growth Rate Model: Example
D0 = $2.00 g1 = 20% g2 = 5%
k = 15% T = 3 D1 = 2.40
D2 = 2.88 D3 = 3.46 D4 = 3.63
V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3
+ D4 / (.15 - .05) ( (1.15)3
V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
Copyright ©2003 Ian H. Giddy Valuation 25
Choosing a Growth Pattern: Examples
Company Valuation in Growth Period Stable Growth
PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth
rate in the world economy
DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term
US growth rate
Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth
rate in the Europeaneconomy
Copyright ©2003 Ian H. Giddy Valuation 26
Better Than Dividends:Free Cash Flows
Revenue- Expenses- Depreciation
= EBITAdjust for tax: EBIT(1-T)
+ Depreciation- Capex- Ch working capital
= Free Cash Flows to Firm
Revenue 81.20
-Expenses (67.99)
-Depreciation (4.95)
EBIT 8.26
EBIT(1-t) 5.90
+Depreciation 4.95
-CapEx (4.31)
-Change in WC (0.90)
FCFF 5.64
Copyright ©2003 Ian H. Giddy Valuation 27
Deriving IBM’s Free Cash Flows
Data 4Q02ttmSales, ttm 81.20$ billionOperating costs 67.99$ billion 84%Depreciation 4.95$ billionEBIT 8.26$ billionTax 2.36$ billion 29%Cap Ex 4.31$ billionChange in WC 0.90$ billionInterest expense 0.15$ billion
Free Cash Flows $bRevenue 81.20
-Expenses (67.99)
-Depreciation (4.95)
EBIT 8.26
EBIT(1-t) 5.90
+Depreciation 4.95
-CapEx (4.31)
-Change in WC (0.90)
FCFF 5.64
Interest 0.15$
FCFE 5.49$ IBMvaluation.xls
Copyright ©2003 Ian H. Giddy Valuation 28
Equity Valuation in Practice
Estimating discount rate Estimating cash flows Estimating growth Application with constant growth: Optika Application with shifting growth: IBM
Copyright ©2003 Ian H. Giddy Valuation 29
Valuing a Firm with DCF: The Short Version
Historical financial results
Adjust for noncash items
Projected sales and operating profits
Free cash flows to the firm (FCFF)
Calculate weighted average cost of capital (WACC)
Estimate stable growth rate (g)
Present value of free cash flows
- Market value of debt
Value of shareholders equity
Discount to present using constant growth model
FCFF(1+g)/(WACC-g)
Copyright ©2003 Ian H. Giddy Valuation 30
Optika: Facts
The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m.
Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%.
The market value of equity is €1.3b. Is this firm fairly valued in the market? What
assumptions might be changed?
Copyright ©2003 Ian H. Giddy Valuation 31
Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%
T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%
Firm Value 2681
Equity Value 2431
Optika
optika.xls
Copyright ©2003 Ian H. Giddy Valuation 32
Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%
T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%
Firm Value 2681
Equity Value 2431
Optika
CAPM:
7%+1(5.50%)
Debt cost
(7%+1.5%)(1-.35)
WACC:
ReE/(D+E)+RdD/(D+E)
Value:
FCFF/(WACC-growth rate)
Equity Value:
Firm Value - Debt Value
= 2681-250 = 2431
optika.xls
Copyright ©2003 Ian H. Giddy Valuation 33
Valuing a Firm with DCF: The Extended Version
Historical financial results
Adjust for nonrecurring aspects
Gauge future growth
Adjust for noncash items
Projected sales and operating profits
Projected free cash flows to the firm (FCFF)
Year 1 FCFF
Year 2 FCFF
Year 3 FCFF
Year 4 FCFF
Terminal year FCFF
Stable growth model or P/E comparable
Present value of free cash flows
+ cash, securities & excess assets
- Market value of debt
Value of shareholders equity
…
Discount to present using weighted average cost of capital (WACC)
Copyright ©2003 Ian H. Giddy Valuation 34
Case Study: IBM
Copyright ©2003 Ian H. Giddy Valuation 35
Case Study: IBM
Constant growth model valuation:FCFF 5.64WACC 9.77%Growth rate 5.70%
Firm Value 146.51 billionless debt -61.86 billionEquity value 84.65 billion divided by 1.69 gives 50.09$ per share
2-stage growth model valuationStage 1 10%Stage 2 5.70%
End of year 2002 2003 2004 2005 2006 2007 2008Revenue 81.20 89.32 98.25 108.08 118.88 130.77 138.23-Expenses -67.99 -74.79 -82.27 -90.49 -99.54 -109.50 -115.74-Depreciation -4.95 -5.45 -5.99 -6.59 -7.25 -7.97 -6.94EBIT 8.26 9.09 9.99 10.99 12.09 13.30 15.55EBIT(1-t) 5.90 6.49 7.14 7.85 8.64 9.50 11.10+Depreciation 4.95 5.45 5.99 6.59 7.25 7.97 6.94-CapEx -4.31 -4.74 -5.22 -5.74 -6.31 -6.94 -6.94-Change in WC -0.90 -0.99 -1.09 -1.20 -1.32 -1.45 -1.53FCFF 5.64 6.20 6.82 7.51 8.26 9.08 9.57
235.25Total 6.20 6.82 7.51 8.26 244.34PV 5.65 5.66 5.68 5.69 153.32Total PV 176.00less debt -61.86 billionEquity value 114.13 billion divided by 1.69 gives 67.53$ per share
IBMvaluation.xls
Copyright ©2003 Ian H. Giddy Valuation 36
Mt CameroonEcotours
Copyright ©2003 Ian H. Giddy Valuation 37
Case Study: Mt Cameroon Ecotours
What alternative financing sources are available to Mount Cameroon Ecotours?
How would foreign investors assess the risks of investing in this private venture in Cameroon? What could be done to reduce the risks to foreign investors? What might be their exit plan?
What is a reasonable estimate of the company's value?
How much of the company's equity shares would have to be given up in order to raise the required EUR5 million?
Copyright ©2003 Ian H. Giddy Valuation 38
Banpu
Thursday: Structured Financing
Cap des Biches
LBO
Korea Asset
Funding
Finance Co. Bhd
Copyright ©2003 Ian H. Giddy Valuation 39