Firm Valuation 2
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Firm valuation (2)
Class 7 Financial Management, 15.414
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Today Firm valuation x
Free cashflows
x
Profitability, financial ratios, and terminal value
Reading
x
Brealey and Myers, Chapter 12.4 – 12.6
x
Wilson Lumber Co.
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Firm valuation
Two approaches Focus on cashflows to equityholders Equity = PV of dividends Useful with moderate growth, constant payout ratio Focus on cashflows generated by assets
Assets = PV of free cashflows More general, because cashflows may not be paid out Equity = assets – debt
3
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Balance sheet Assets
Liabilities and Equity
Current Liabilities Current Assets
Long-Term Debt Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets
Shareholders’ Equity
Value = PV(FCFs)
Value = Debt + PV(divs)
4
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
FCF approach
Asset value PV of assets =
FCF1 FCF2 FCFH Term. value ... 2 H 1r (1 r) (1 r) (1 r)H
Free cashflow Cash generated by the assets after all reinvestment
FCF = EBIT (1 – W) + depreciation – 'NWC – CAPX
FCF = EBIT (1 – W) – 'Net assets FCF = Operating cashflow (before interest) – CAPX
5
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Working capital Assets
Liabs. and equity
Current assets cash accounts receivable inventory
Current liabilities accounts payable Long-term debt bank loans bonds
Long-term assets equipment buildings land intangibles
Equity common stock retained earnings
Net assets = Total assets – current liabilities (excl. s-t debt)
6
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Sustainable growth
16%
Cash deficits g > g*
Plowback 70%
Growth
12%
8%
Plowback 30%
4%
Cash surpluses g < g* 0% 1.0%
5.0%
9.0% 13.0% 17.0% Return on equity
14
21.0%
25.0%
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Sustainable growth
Forecasting Long-run growth = sustainable growth Faster in the short run, but not forever Forecast must be internally consistent Growth forecasts should be consistent with payout policy and profitability CitiBank financial goals, 1988
Growth: 15%
ROE: 18%
Payout: 30%
Leverage ratio (debt / assets): 95%
Are these goals feasible? 15
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner, 1989 Warner Communications ($ million) Cashflow projections
Oper. income Taxes After-tax income Depreciation Deferred taxes CAPX ' in NWC Miscellaneous Free cashflow
1989 $770 -193 577 228 -7 -336 5 -416 $52
1990 893 -246 647 245 0 -225 -80 -15 572
1991 1,145 -458 687 270 172 -180 -80 -5 863
Source: Lazard Freres (advisor to Warner)
16
1992 1,320 -528 792 271 198 -177 -80 -3 1,001
1993 1,482 -593 889 271 222 -183 -80 -3 1,117
1994 1,655 -662 993 273 248 -188 -80 -3 1,243
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner Firm valuation Discount rate = 11.5% Firm value =
=
FCF1 FCF2 FCF3 FCFH Term. value ... 2 3 H 1r (1 r) (1r) (1 r) (1r)H 52 572 863 1,243 T.V. ... 1.115 1.115 2 1.115 3 1.115 6 1.115 6
Equity value = Firm value – Debt ($970 million)
Terminal value three ways
Constant growth
Multiples (financial ratios of comparable firms)
NPVGO
17
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 1 Constant growth Forecasted growth after 1994 = 5%
Terminal value =
FCF1995 1,243 u 1. 05 = $20,079 million r g 0.115 0. 05
Is the forecast internally consistent? Projected earnings = $993; projected book equity = $5,055
Reinvestment = CAPX – Depr. + 'NWC = 188 – 273 + 80 =
–$5 million
g* = ROE u plowback = (993 / 5,055) u (-5 / 993) = 0%
18
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner, 1989 Warner Communications ($ million) Cashflow projections
Oper. income Taxes After-tax income Depreciation Deferred taxes CAPX ' in NWC Miscellaneous Free cashflow
1989 $770 -193 577 228 -7 -336 5 -416 $52
1990 893 -246 647 245 0 -225 -80 -15 572
1991 1,145 -458 687 270 172 -180 -80 -5 863
Source: Lazard Freres (advisor to Warner)
19
1992 1,320 -528 792 271 198 -177 -80 -3 1,001
1993 1,482 -593 889 271 222 -183 -80 -3 1,117
1994 1,655 -662 993 273 248 -188 -80 -3 1,243
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 2
Financial ratios Multiples of comparable firms P/E ratio
Price-to-cashflow
Price-to-sales
Market-to-book equity
Determinants of P/E and M/B
1 ª price º P/E u« r ¬price NPVGO »¼ Higher if NPVGO is large M/B =
payout (r / ROE) plowback
20
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
P/E ratios, Dec. 1998
350
300
Histogram All U.S. stocks
250
200
150
100
50
0
0
4
9
13
18
22
27
P/E ratio
21
31
36
40
45
49
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
B/M ratios, Dec. 1998
800 700
Histogram All U.S. stocks
600 500 400 300 200 100 0 -0.5
-0.1
0.3
0.7
1.1
1.5
B/M ratio
22
1.9
2.3
2.7
3.1
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 2
Financial ratios P/E ratio Comparables P/E = 18 Earnings1994 = 993 Terminal value = 18 u 993 = $17,874 M/B ratio
Comparables M/B = 2.79 BV1994 = 5,055 Terminal value = 2.79 u 5,055 = $14,103
23
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 3 Zero NPVGO How much will Warner be worth if its competitive advantage is eliminated by 1994? (Sustainability question in strategy)
NPVGO = 0 Value = EPS / r Earnings1994 = 993
Terminal value = 993 / 0.115 = $8,635
24
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner
Debt = $970 million Firm value =
52 572 863 1,243 T.V. ... 1.115 6 1.115 6 1.115 1.115 2 1.115 3
Approach
Terminal Value
Firm Value
Equity Value
Per Share
Constant growth P/E M/B Zero NPVGO
$20,079 17,874 14,103 8,635
$13,522 12,374 10,412 7,566
$12,552 11,404 9,442 6,596
$65.89 59.86 49.56 34.62
Actual offer = $70 / share
25
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Inc. stock price, 1989
$ 190 180 170 160 150 140 130 120 110 100 Jan
Feb Mar
Apr May
Jun
Jul
26
Aug Sep
Oct
Nov Dec
Class 7 Financial Management, 15.414
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Today Firm valuation x
Free cashflows
x
Profitability, financial ratios, and terminal value
Reading
x
Brealey and Myers, Chapter 12.4 – 12.6
x
Wilson Lumber Co.
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Firm valuation
Two approaches Focus on cashflows to equityholders Equity = PV of dividends Useful with moderate growth, constant payout ratio Focus on cashflows generated by assets
Assets = PV of free cashflows More general, because cashflows may not be paid out Equity = assets – debt
3
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Balance sheet Assets
Liabilities and Equity
Current Liabilities Current Assets
Long-Term Debt Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets
Shareholders’ Equity
Value = PV(FCFs)
Value = Debt + PV(divs)
4
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
FCF approach
Asset value PV of assets =
FCF1 FCF2 FCFH Term. value ... 2 H 1r (1 r) (1 r) (1 r)H
Free cashflow Cash generated by the assets after all reinvestment
FCF = EBIT (1 – W) + depreciation – 'NWC – CAPX
FCF = EBIT (1 – W) – 'Net assets FCF = Operating cashflow (before interest) – CAPX
5
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Working capital Assets
Liabs. and equity
Current assets cash accounts receivable inventory
Current liabilities accounts payable Long-term debt bank loans bonds
Long-term assets equipment buildings land intangibles
Equity common stock retained earnings
Net assets = Total assets – current liabilities (excl. s-t debt)
6
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Sustainable growth
16%
Cash deficits g > g*
Plowback 70%
Growth
12%
8%
Plowback 30%
4%
Cash surpluses g < g* 0% 1.0%
5.0%
9.0% 13.0% 17.0% Return on equity
14
21.0%
25.0%
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Sustainable growth
Forecasting Long-run growth = sustainable growth Faster in the short run, but not forever Forecast must be internally consistent Growth forecasts should be consistent with payout policy and profitability CitiBank financial goals, 1988
Growth: 15%
ROE: 18%
Payout: 30%
Leverage ratio (debt / assets): 95%
Are these goals feasible? 15
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner, 1989 Warner Communications ($ million) Cashflow projections
Oper. income Taxes After-tax income Depreciation Deferred taxes CAPX ' in NWC Miscellaneous Free cashflow
1989 $770 -193 577 228 -7 -336 5 -416 $52
1990 893 -246 647 245 0 -225 -80 -15 572
1991 1,145 -458 687 270 172 -180 -80 -5 863
Source: Lazard Freres (advisor to Warner)
16
1992 1,320 -528 792 271 198 -177 -80 -3 1,001
1993 1,482 -593 889 271 222 -183 -80 -3 1,117
1994 1,655 -662 993 273 248 -188 -80 -3 1,243
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner Firm valuation Discount rate = 11.5% Firm value =
=
FCF1 FCF2 FCF3 FCFH Term. value ... 2 3 H 1r (1 r) (1r) (1 r) (1r)H 52 572 863 1,243 T.V. ... 1.115 1.115 2 1.115 3 1.115 6 1.115 6
Equity value = Firm value – Debt ($970 million)
Terminal value three ways
Constant growth
Multiples (financial ratios of comparable firms)
NPVGO
17
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 1 Constant growth Forecasted growth after 1994 = 5%
Terminal value =
FCF1995 1,243 u 1. 05 = $20,079 million r g 0.115 0. 05
Is the forecast internally consistent? Projected earnings = $993; projected book equity = $5,055
Reinvestment = CAPX – Depr. + 'NWC = 188 – 273 + 80 =
–$5 million
g* = ROE u plowback = (993 / 5,055) u (-5 / 993) = 0%
18
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner, 1989 Warner Communications ($ million) Cashflow projections
Oper. income Taxes After-tax income Depreciation Deferred taxes CAPX ' in NWC Miscellaneous Free cashflow
1989 $770 -193 577 228 -7 -336 5 -416 $52
1990 893 -246 647 245 0 -225 -80 -15 572
1991 1,145 -458 687 270 172 -180 -80 -5 863
Source: Lazard Freres (advisor to Warner)
19
1992 1,320 -528 792 271 198 -177 -80 -3 1,001
1993 1,482 -593 889 271 222 -183 -80 -3 1,117
1994 1,655 -662 993 273 248 -188 -80 -3 1,243
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 2
Financial ratios Multiples of comparable firms P/E ratio
Price-to-cashflow
Price-to-sales
Market-to-book equity
Determinants of P/E and M/B
1 ª price º P/E u« r ¬price NPVGO »¼ Higher if NPVGO is large M/B =
payout (r / ROE) plowback
20
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
P/E ratios, Dec. 1998
350
300
Histogram All U.S. stocks
250
200
150
100
50
0
0
4
9
13
18
22
27
P/E ratio
21
31
36
40
45
49
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
B/M ratios, Dec. 1998
800 700
Histogram All U.S. stocks
600 500 400 300 200 100 0 -0.5
-0.1
0.3
0.7
1.1
1.5
B/M ratio
22
1.9
2.3
2.7
3.1
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 2
Financial ratios P/E ratio Comparables P/E = 18 Earnings1994 = 993 Terminal value = 18 u 993 = $17,874 M/B ratio
Comparables M/B = 2.79 BV1994 = 5,055 Terminal value = 2.79 u 5,055 = $14,103
23
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Terminal value 3 Zero NPVGO How much will Warner be worth if its competitive advantage is eliminated by 1994? (Sustainability question in strategy)
NPVGO = 0 Value = EPS / r Earnings1994 = 993
Terminal value = 993 / 0.115 = $8,635
24
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Warner
Debt = $970 million Firm value =
52 572 863 1,243 T.V. ... 1.115 6 1.115 6 1.115 1.115 2 1.115 3
Approach
Terminal Value
Firm Value
Equity Value
Per Share
Constant growth P/E M/B Zero NPVGO
$20,079 17,874 14,103 8,635
$13,522 12,374 10,412 7,566
$12,552 11,404 9,442 6,596
$65.89 59.86 49.56 34.62
Actual offer = $70 / share
25
MIT SLOAN SCHOOL OF MANAGEMENT 15.414
Class 7
Time Inc. stock price, 1989
$ 190 180 170 160 150 140 130 120 110 100 Jan
Feb Mar
Apr May
Jun
Jul
26
Aug Sep
Oct
Nov Dec
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