140221 eisti financial analysis [mode de compatibilitu00e9]

Valuation: From Theory…Valuation: From Theory…

… to Practice … to Practice EISTIEISTI

1

Philippe Foulquier, PhD, EFFAS

Professor of Finance and Accounting

Director of EDHEC Financial Analysis

and Accounting Research Centre

Philippe Foulquier – Valuation: from Theory to Practice

PlanPlan

I. Food for thoughtI. Food for thought

II. Difference between the value and the price of a companyII. Difference between the value and the price of a company

III. Financial flows and risk price of the main protagonistsIII. Financial flows and risk price of the main protagonists

Chapter I. Financial Flows and Risk Price of the ma in protagonists

Chapter II. Choice of discount rate

Philippe Foulquier – Valuation: from Theory to Practice2

I. Economic TheoryI. Economic Theory

II. Choice of the time period tII. Choice of the time period t

III. Choice of the discount rateIII. Choice of the discount rate

IV. Models measuring market riskIV. Models measuring market risk

V. How do we choose riskV. How do we choose risk--free rate, risk premiums and betas?free rate, risk premiums and betas?

VI. Choice of discount rateVI. Choice of discount rate

VII. ReferencesVII. References

PlanPlan

I. Economic theory

II. Dividend Discount Models

III. Free Cash Flow to Equity Discount Models

IV. Free Cash Flow to the Firm Discount Models

V. Value creation (EVA and MVA) – Dashboard and company management

Chapter III. Choice of cash flows


I. Comparison based on transactions: the issues

II. Price earnings ratio

III. Price earnings growth ratio (PEG)

IV. Relative P/E ratio

V. Net Asset Value or Book Value Multiple (NAV or BV)

VI. Operating multiple (sales, EBITDA, EBIT, etc.)

Chapter IV. Peer comparison

I. Privatization of ASF

II. ASF: Summary financial statement

III. ASF: FCFF forecasts

IV. ASF: WACC

V. Equity value per share

Chapter V. Case Study – Privatisation of ASF

PlanPlan


I. Asset valuation (B/S)

II. Asset valuation (B/S) / Cash flow (P&L): mix valuation

III. Case Study: AGF (Allianz Group)

Chapter VI. Case Study – AGF (Allianz Group) Valuati on

Bibliography

IntroductionIntroduction

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Pillar I Pillar II Pillar III

Financial Analysis


Str

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Chapter I. Financial Flows & Risk Price of the main protagonists

Food for thought

« An inexperienced appraiser too often clings

to the formula as if it were a lifeline and lets

himself drift on the currents without the rudder

of a critical mind to guide him »

H. Mauguière, 1961


H. Mauguière, 1961

« There are no absolute values, because things do

not impose values on us; it is man himself

who sets them »

Viel, Bredt and Renard, 1971


DifferenceDifference

betweenbetween PRICEPRICE

and and VALUEVALUE of a of a

companycompany

EXERCISEEXERCISE



• Difference between the value and the price of a company

• In its general theory, Keynes mentioned that the company’s fundamental

value corresponds to the present value of the flows of revenues du to the

ownership of the capital.

• Although the price is based on the value of the Company, it depends on


• Although the price is based on the value of the Company, it depends on

subjective elements which are not always quantifiable, e.g.:

– relationship between the buyers and the sellers

– their determination or obligation to succeed

– their respective negotiation skills

– the buyer’s interest in the company

– etc...


• Misjudging the goals of the companies can lead to inconsistent valuations

and halt negotiations.

– Industrial logic

– Financial logic


– Politico-financial logic

– “Raider” logic

– Creditor logic


Income statementOperating revenues

Parties Sales Change in inv. of finished goodsOperating charges

BALANCE SHEET Purchases of raw materialsAssets Liabilities R&D

Fixed assets Shareholders Equity Marketing

Founder / CEOBanks

Shareholders


Fixed assets Shareholders Equity Marketing Personnel costs Other operating charges

Inventories Financial debt EBITDAReceivables Depreciation and amortization

EBITCash and bank Suppliers FINANCIAL PROFIT

Corporate income taxNET INCOME

ShareholdersClients

EmployeesState


Year 1 2 3

Income statement Parties

EBIT 20 30 5 Employees & suppliers

Financial charges -5 -5 -5 Bank


Income bf. Taxes 15 25 0

Corporate income tax -5 -8 0 State

Net Income 10 17 0 Shareholders

Shareholders are paid after that all other commitments of the

company are satisfied (employees, suppliers, bank, State)

=> Shareholders’ equity = shock absorber for other contracting parties


Consumption Revenue Savings interest Risk Price

Consup. time

time Cost of

Deposit risk Own

additional eventually of which default funds

risk real insterest cost


It is important for operational choices to know the “ risk ”

relation with each party (client, bank, shareholder)!

Interest rate

Investment inflation

Cost

Invest. time Nominal risk of debt

free rate


•• CapitalisationCapitalisation

Exercise:

– Investment in year n: EUR100,000

– Sale 10y after: EUR200,000

– Assumptions: in the meantime, no


– Assumptions: in the meantime, no

income from his investment and no

invested additional funds

Question:

Return of this investment?



Capitalising income means foregoing receipt of it. It then become capital and begins itself to produce interest during the following periods

Capital at the beginning Income Capital at the endYear of the period (EUR) (EUR) of the period (EUR)

N 100000.00 5000.00 105000.00N+1 105000.00 5250.00 110250.00N+2 110250.00 5512.50 115762.50N+3 115762.50 5788.13 121550.63


V(t+1) = V(t) + 5% V(t) = V(t) (1+5%)

Compound interest : V(t+1) = V(t) * (1+i)

V(T) = V(0) * (1+i)T

N+3 115762.50 5788.13 121550.63N+4 121550.63 6077.53 127628.16N+5 127628.16 6381.41 134009.56N+6 134009.56 6700.48 140710.04N+7 140710.04 7035.50 147745.54N+8 147745.54 7387.28 155132.82N+9 155132.82 7756.64 162889.46



♦ Exercise:

Compare the three following investment rate of return:


- Tripling one’s capital in 16 years

- Doubling one’s capital in 10 years

- Asking for a 7,177% annual return

Conclusion regarding the previous exercise


•• DiscountingDiscounting

♦ To discount means to calculate the present value of a future cash flow

Discounting converts a future values into a present value while capitalisation converts values into future ones.


Having discounted the future value to a present value, we can then compare it with other values.

Discounting is based on the time value of money (time is money!)

V(0) = V(T) * [1/(1+i)T] where 1/(1+i)T discounting factor

V(T) = V(0) * (1+i)T where (1+i)T capitalisation factor


•• Present Value (PV) and Net Present Value (NPV)Present Value (PV) and Net Present Value (NPV)

PV = PV = ΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)tt NNPV = PV = ΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)t t –– VV00

where

FFtt cash flows generated by the security or project,

i i applied discounting rate

n n number of years for which the security or project is discounted


n n number of years for which the security or project is discounted

VV00 invested capital (project) or market value (security)

The NPV decision rule says to invest in projects when NPV > 0

ExerciseExercise

Comment: “in efficient fairly valued market, NPV are zero”


•• IRR IRR –– Internal Rate of Return (or yield to maturity)Internal Rate of Return (or yield to maturity)

The discounting rate that makes NPV equal to zero is called the IRR or yield to

maturity.

If an investment’s IRR is higher than the investor-required

return, you will make the investment or buy the security.


return, you will make the investment or buy the security.

Yield to maturity => financial security

Internal Rate of Return => other capital expenditure

An investment is worth making when its internal rate of return is equal to or

greater than the investor’s required return.



ExerciseExercise

Take the following example of an asset (e.g. a financial security or a capital

investment) whose market value is

Year 1 2 3 4 5


1. Based on a 10% discount rate, determinate the discounting factors and

the present value

2. Based on a market value of 4, calculate the NPV

3. Based on different discount rates, calculate the NPV

4. Investment decision

Year 1 2 3 4 5Cash flow 1 1,1 1,2 1,3 1,4



Solution: IRR=14.3%Solution: IRR=14.3%

Year 1 2 3 4 5Cash flow 1 1,1 1,2 1,3 1,4

A 10% discount rate produce the following discounting factors 10%

Year 1 2 3 4 5Discount factor 0,909 0,826 0,751 0,683 0,621


Discount factor 0,909 0,826 0,751 0,683 0,621Present value 0,909 0,909 0,902 0,888 0,869Sum PV 4,477

As a result, the present value of this investment is about 4,5. As its market value is 4, its net present value is approximately 0,5

If discount rate changes, the following values are obtained

Discounted rate 0% 5% 10% 15%PV of the investment 6,000 5,153 4,477 3,930Market Value 4 4 4 4NPV 2,000 1,153 0,477 -0,070


•• The Limits of the IRR The Limits of the IRR

Exercise: Reinvestment rateExercise: Reinvestment rate

Consider two investments A and B with the following cash flows.

Investment’s market value is 10 and 15 respectively for A and B.

Year 1 2 3 4 5 6 7Investment A 12 1


Based on a 5% discount rate:

1. Calculate discount factors, present value and net present value for each

two investments

2. Determinate the IRR of each two investments

3. Conclusion

Investment A 12 1Investment B 4 6 0 0 4 0 10


•• Exercise: Reinvestment rate Exercise: Reinvestment rate -- SolutionsSolutions

Discount rate 5%Year 1 2 3 4 5 6 7Discount factor 0,952 0,907 0,864 0,823 0,784 0,746 0,711PV(A) 11,429 0,907PV(B) 3,810 5,442 0,000 0,000 3,134 0,000 7,107Total PV(A) 12,336Total PV(B) 19,493NPV(A) 2,336NPV(B) 4,493 Synthesis NPV at 5% IRR (%)

investment A 2.336 27.8


investment A 2.336 27.8Discount rate 27,8% investment B 4.493 12.7Year 1 2 contradictory conclusionsDiscount factor 0,782 0,612PV(A) 9,390 0,612Total PV(A) 10,002NPV(A) 0,002

Discount rate 12,3%Year 1 2 3 4 5 6 7Discount factor 0,890 0,793 0,706 0,629 0,560 0,499 0,444PV(B) 3,562 4,758 0,000 0,000 2,240 0,000 4,440Total PV(B) 14,999NPV(B) -0,001


•• Exercise: Multiple IRR or no IRRExercise: Multiple IRR or no IRR

Consider the following investment and calculate IRR. What is your

conclusion?

Year 0 1 2Cash flow -2 14,4 -14,4


Consider the following investment and calculate IRR. What is your

conclusion?

Year 0 1 2Cash flow 6,4 -14,2 8

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III.1. What does it mean to discount a sum?

III.2. Diversifiable and non diversifiable risk?

III.3. Market risk premium



IV.1. CAPM IV.2. APT IV.3. Regression or proxy models


V.1. Risk-free rate choice

V.2. Risk premium choice

V.3. Beta choice: 2 approaches


VI.1. Cost of equity VI.2. Cost of capital

Chapter 2: Choice of discount rateChapter 2: Choice of discount rate

I. Economic theoryI. Economic theory

The value of a financial asset is equal to the present value of future flows

generated by the asset

VV = = ΣΣ FF / (/ (11+i)+i)tt


VV00 = = ΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)tt

where

Ft are the flows generated by the asset,

i is the applied discounting rate

t is the number of years for which the asset is discounted

Chapter Chapter 22: Choice of discount rate: Choice of discount rate




ΣΣ??



where




??

??

??

Chapter 2: Choice of discount rate

II.II. Choice of a time period tChoice of a time period t

a) n : life of the asset

b) In accordance with the kind of investment (financial or industrial), the nature of the company…


c) Vc) V00 = [= [ΣΣΣΣΣΣΣΣt=t=11,m ,m FFt t / (/ (11+i)+i)t t ] + [V] + [Vmm / / ((11+i)+i)m m ]]

i) Liquidation value

ii) Multiple approach

iii) Stable growth model

Chapter Chapter 22: Choice of discount rate: Choice of discount rate




ΣΣ



where




??


III. 1. What does it mean to discount a sum?

• Two components in the discount rate:

–– TimeTime

–– RiskRisk


–– RiskRisk

• The distribution of returns on an investment

–– Variance or standard deviationVariance or standard deviation

–– SkewnessSkewness

–– KurtosisKurtosis


III. 2. Diversifiable and Nondiversifiable Risk

• Components of risk: firm-specific and market

• Diversification reduces or eliminates firm-specific

– An intuitive explanation: 2 reasons


– An intuitive explanation: 2 reasons

– A statistical analysis:

σ2P =αA σ

2A+(1-αA)2 σ2

B +2 αA(1-α A)ρAB σA σB

• Limits: assets can be traded easily

and at low cost


III. 3. Market risk premium

• The discount rate is a function of:

– interest rate


– interest rate

– Inflation rate

– Market risk premium (RM -Ro)




• The required rate of return of an asset “i” is a linear function of the risk,

measured by the beta of the asset

– E(ri) = rF + βi (E(rM) – rF)

– E(rM) – rF is the premium required by investor for investing in the market

portfolio instead of investing in a risk-free asset



CostCost of of equityequity = = riskrisk free rate + [ free rate + [ ββ * (* (marketmarket riskrisk premium) ]premium) ]

MARKET RISK PREMIUM IN EUROPE

13%

14%


5%

6%

7%

8%

9%

10%

11%

12%

07/200

8

10/200

8

01/200

9

05/200

9

08/200

9

11/200

9

03/201

0

06/201

0

09/201

0

12/201

0

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IV.1. CAPM IV.2. APT IV.3. Regression or proxy models


V.1. Risk-free rate choice

V.2. Risk premium choice

V.3. Beta choice: 2 approaches


VI.1. Cost of equity VI.2. Cost of capital



IV.1. Capital Asset Pricing Model

• Assumptions

– No transaction costs, assets infinitely divisible (diversification)


– No transaction costs, assets infinitely divisible (diversification)

– Efficient portfolios (higher return for a given level of risk)

– Homogeneous expectations among investors (all relevant information)

=> market portfolio

– Introduction of the risk-free asset (risk preference)

•• CAPM: E(rCAPM: E(rii) = r) = rF F + + ββββββββi i ((E(rE(rMM) ) –– rrFF))


IV.2. Arbitrage Pricing Theory (APT)

• Firm-specific and market risk components (like the CAPM)

Diversification eliminates firm-specific risk

• Market risk measured to unspecified macroeconomic variables


– APT: E(ri) = rF + βi1 (E(r1) – rF) +…+ βiK (E(rK) – rF)

Where βik beta on factor k (called factor beta )

E(rK) – rF risk premium for each of the factors in the model

called factor risk premium

– CAPM: E(ri) = rF + βi (E(rM) – rF) special case of APT


IV.3. Regression or Proxy models

•• Fama and French modelFama and French model (1992) increasingly used

E(ri) = rF + βi1 (E(rM) – rF) + βi2 (E(rsmall) –E(rbig) + βi3 (E(rhigh) – E(rlow)

3 factors: market return (CAPM)

size (gap between small and large caps: liquidity)

book value/market capitalization


book value/market capitalization

Over 1963-1990, high-return investments tended to be investments in

companies with low market cap and high book-to-price ratio

•• Other factors:Other factors: P/E, market capitalization, liquidity (through size, free float,

transaction volume, bid-ask spread), etc.



Economic theoryEconomic theory



VV00 = = ΣΣΣΣΣΣΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)tt


VV00 = = ΣΣΣΣΣΣΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)

where Ft are the flows generated by the asset,


i is the discount rate, the required rate of return of an asset “j”, a linear

function of the risk, measured by the beta of the asset:

E(rE(r jj ) = r) = rFF + + ββββββββj j ((E(rE(rMM ) ) –– rrFF))

??

?? ?? ??



V.V.11. Risk. Risk--free rate choice free rate choice

• Expected return known with certainty

• There can be no default risk (at least on local borrowing).


• There can be no default risk (at least on local borrowing).

(adjustment when default-free entity exists)

• There can be no reinvestment risk

=> different risk-free rates for each period? Zero coupon rate?

• Horizon


V.V.22. Risk premium choice. Risk premium choice

• Historical premium earned by stocks over default-free securities over long

time periods

• Three reasons for the divergence in historical risk premium


i) Time period used (risk aversion issue)

ii) Choice of risk-free securities

iii) Choice of market index

• Alternative approach: the implied equity premium


V.3. Beta choice: 2 approachesV.3. Beta choice: 2 approaches

•• V.3.1. Historical market betasV.3.1. Historical market betas

Rj = a + b RM where a: intercept from the regression

b: slope of the regression = cov(Rj, RM)/σM2


CAPM: Rj = RF + β (RM – RF) = RF (1- β) + β RM

a - RF (1- β) is called Jensen’s alphaJensen’s alpha and provides a measure of performance

of the investment during the period of the regression


EXERCICEEXERCICE : COCA: COCA--COLA COLA

State your view of the situation (β, annualised excess return, R2, Sdt Error…)

LinearLinear Relationship : ERelationship : E(ri) = rF + ββββi (E(rM) – rF) Y = Coca Cola return

X = S&P return

Points = 520

(10Y weekly)


(10Y weekly)

Y = 0,528 X + 0,042

R2 = 0,257

Std Error of beta = 0,112


V.V.33..1 1 Historical market betasHistorical market betas

In practise: using a service beta (Bloomberg, Datastream, Value Line,

Brokers…) but beta estimates are very different between the providers and

they do not reveal their estimation procedures (except Bloomberg)

Four reasons for the divergence in historical beta


i) Time period used (risk characteristic change)

ii) Choice of return interval

iii) Choice of market index

iv) Estimation procedure (e.g. adjusted beta for Bloomberg)


V.V.33..22. Fundamental betas: the bottom. Fundamental betas: the bottom--up betas processup betas process

- Less reliant on historical betas and more cognizant of the fundamental

determinants:


ii) Type of businesses (sensitivity to market conditions)) Type of businesses (sensitivity to market conditions)

ii) Operating leverage (costs)ii) Operating leverage (costs)

iii) Financial leverageiii) Financial leverage


V.3.2. Fundamental betas: the bottomV.3.2. Fundamental betas: the bottom--up betas processup betas process

- Less reliant on historical betas and more cognizant of the fundamental

determinants:


i) Type of businesses (sensitivity to market conditions)i) Type of businesses (sensitivity to market conditions)

ii) Operating leverage (costs)ii) Operating leverage (costs)

iii) Financial leverageiii) Financial leverage



iii) Financial leverage (Proposition I of Modigliani Miller)iii) Financial leverage (Proposition I of Modigliani Miller)

Scenario Scenariowithout debt with debt

EBIT 1000 1000

Net Financial expenses (rDD) -300

Profit before tax (EBIT - rDD) 1000 700


Total cash flow for shareholders and lenders = (EBIT – rD D) (1 - TC ) + rD D

= EBIT (1 - TC ) + rD D TC

VL = [EBIT (1 - TC ) / rU] + [rD D TC / rD]

= VU + TC VD (Proposition I of Modigliani Miller)(Proposition I of Modigliani Miller)

Profit before tax (EBIT - rDD) 1000 700

Tax (TC=35%) -350 -245

Profit after tax 650 455Total cash flows for shareholders and lenders 650 755



iii) Financial leverage (Hamada iii) Financial leverage (Hamada 19721972))

EV = VU + TC VD = VE + VD (1)

βEV = βUVU/(VU+TCVD)]+[βDTCVD/(VU+TCVD)]

= [βEVE/(VE+VD)]+[βDVD/(VE+VD)] (2)


E E E D D D E D

⇒ ββββE = ββββU + [(1 – TC) (ββββU - ββββD) (VD/VE) where:

βE = Levered beta in the company, determined both by the riskiness of the

business and financial leverage

βU = Unlevered beta of the company (without any debt)

TC = Corporate tax rate

VD/VE = Debt-to-equity ratio (market value)

When βD -> 0 and ββββββββE E = = ββββββββU U [[1 1 + (+ (1 1 –– TTCC) (V) (VDD/V/VEE)] )]


V.V.33..22. Fundamental betas: the bottom. Fundamental betas: the bottom--up betas process (in up betas process (in 5 5 steps)steps)

i) Identify the business(es) (sector)

ii) Determinate the β for the sector (average β for comparable companies)

iii) Calculate the average debt to equity ratio of the sector and estimate the

average unlevered β for the sector:

Unlevered Unlevered ββββββββsectorsector = = ββββββββsectorsector / [/ [1 1 + (+ (1 1 –– TTCC) (V) (VDD/V/VEE))sectorsector] ]


Unlevered Unlevered ββββββββsectorsector = = ββββββββsectorsector / [/ [1 1 + (+ (1 1 –– TTCC) (V) (VDD/V/VEE))sectorsector] ]

iv) Estimate the unlevered β for the company, thanks to a weighted average of

the unlevered β for the businesses it operates in:

Unlevered Unlevered ββββββββcompanycompany = ∑= ∑j=j=11,K ,K UnleveredUnlevered ββββββββjj x Value weightx Value weightjj

where the company is assumed to be operating in K different businesses

v) Estimate the current market values of debt and equity at the company and use

this debt to equity ratio to estimate a levered β.

Levered Levered ββββββββcompanycompany = Unlevered= Unlevered ββββββββcompanycompany [[1 1 + (+ (1 1 –– TTCC) (V) (VDD/V/VEE))companycompany]]



What are the advantages of the bottomWhat are the advantages of the bottom--up betas process?up betas process?

i) Adapted to reflect actual changes in a company’s business mix and

expected changes in the future


ii) Idem for the debt ratios over time

iii) Adapted to deal with private firms, division of business, and stock with

insufficient historical data.

iv) Much lower standard error


V.3.2. Fundamental betas: the bottomV.3.2. Fundamental betas: the bottom--up betas processup betas process

What are the weaknesses of the bottomWhat are the weaknesses of the bottom--up betas process?up betas process?

i) Define how narrowly we want to define a business

ii) and after comparable companies


ii) and after comparable companies

iii) Estimating betas

iv) Averaging method (market-weighted average or arithmetic average)



V.V.11. Cost of equity. Cost of equity

CAPM: Expected return = Risk-free rate + (β * expected risk premium)

Multifactor models:


Multifactor models:

Expected return = Risk-free rate + ∑j=1,K(βj * expected risk premiumj)

What are the implications for equity investors and managers?



VI.VI.22. Cost of capital. Cost of capital

Weighted average of the costs of the different components of financing,

(equity, debt, and hybrid securities)


The cost of debt measures the current cost to the company of borrowing

funds to finance projects, function of:

i) The risk-free rate

ii) The default risk (default spreads, rating, alternative if no rating available)

iii) Tax benefit associated with debt



VI.2. Cost of capitalVI.2. Cost of capital

• Debt

– Components (leases…),

– Market value

Operating lease Present Year expense Value @ 5%

1 1000 9522 800 7263 600 518

4 450 370

5 320 2516 220 164


– Market value

• Equity

– Components (management options…)

– Market value

• Cost of capital

Cost of capital rEV = rE (VE/(VD+VE)) + rD (VD/(VD+VE))

6 220 164PV of operating lease expenses 2981


VII. ReferencesVII. References

Fama, E.F. and K.R. French. 1988. Permanent and temporary components of stock prices.

Journal of Political Economy, 96, 246-273

Fama, E.F. and K.R. French. 1992. The cross-section of expected returns. Journal of

Finance, 47, 427-466

Hamada, R.S. 1972. The effect of the firm’s capital structure on the systematic risk of

common stocks. Journal of Finance, 27, 435-452


common stocks. Journal of Finance, 27, 435-452

Markowitz, H.M. 1952. Portfolio selection. Journal of Finance, 7, 77-91

Markowitz, H.M. 1991. Foundations of portfolio theory. Journal of Finance, 46, 469-478

Modigliani F. and M. Miller. 1958. The cost of capital, corporation finance and the theory

of investment. American Economic Review, 48, 261-297

Ross, S.A. 1976. The arbitrage theory of capital asset pricing. Journal of Economic Theory,

13, 341-360

Sharpe, W.F. 1964, Capital asset prices: A theory of market equilibrium under conditions of

risk. Journal of Finance, 19, 425-442

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I. I. Economic theoryEconomic theory

II. II. Dividend Discount ModelsDividend Discount Models



III. III. Free Cash Flow to Equity Discount ModelsFree Cash Flow to Equity Discount Models

IV. IV. Free Cash Flow to the Firm Discount Models Free Cash Flow to the Firm Discount Models

V. V. Value creation (EVA and MVA)Value creation (EVA and MVA)

Chapter 3: Choice of cash flowsChapter 3: Choice of cash flows




VV = = ΣΣΣΣΣΣΣΣ FF / (/ (11+i)+i)tt

??


VV00 = = ΣΣΣΣΣΣΣΣt=t=11,n ,n FFt t / (/ (11+i)+i)tt

where




??

??

??

Chapter 3: Choice of cash flows

II. Dividend Discount ModelsII. Dividend Discount Models

• V0 = Σt=1,∞ Ft / (1+i)t = Σt=1,∞ Dt / (1+rE)t

where Dt expected dividends and rE cost of equity (levered beta)

• Flexible enough to allow for time-varying discount rates

(CAPM or multifactor models)


• Several versions of DDM based on different assumptions about future growth

i) Stable growth (Gordon Shapiro)

V0 = D1 / rE- g where g perpetual growth in dividend Dt+1 = Dt (1+g)

Particular case: g=0 => V0 = D / rE (Irving Fisher)


II. Dividend Discount Models

ii) Two stage DDM

V0 = Σt=1,n Dt / (1+rE)t + Vn / (1+rE)n

where Vn is the terminal value. If we assume

a growth rate forever after year n


a growth rate forever after year n

Vn = Dn / rE- gn

iii) Modolovski: three stage DDM

- Initial period: growth period based on the fundamentals of the company

- Transitional period: linear declining growth (Fuller and Hsia 1984)

- Final period: stable growth phase

iv) Strengths and weaknesses


III. Free Cash Flow to Equity Discount ModelsIII. Free Cash Flow to Equity Discount Models

• FCFE: variants on the DDM

Cash flows to equity left over after meeting all financial obligations vs. dividends => after the impact of financing


• 2 approaches: from the bottom up or from the top down

FCFE = net profit + depreciation and provisions – capital expenditure

- change in working capital + new debt issue – debt repayment

- exceptional items + asset disposal

FCFE = EBITDA – change in WC

+ financial profit - tax – capital expenditure


III. Free Cash Flow to Equity Discount ModelsIII. Free Cash Flow to Equity Discount Models

• The company value is V0 = Σt=1,inf FCFEFCFEtt /(1 +rrEE)t

- if FCFE growth is equal to zero => then V0 = FCFE / rE

- if FCFE growth is equal to the rate g => V = FCFE / (r - g)


- if FCFE growth is equal to the rate g => V0 = FCFE1 / (rE - g)

- if FCFE growth is variable:

V0 = Σt=1,n FCFEt /(1 + rE)t + Vn /(1 + rE)n

= Σt=1,n FCFEt /(1 + rE)t + FCFEn [(1+g)/(rE - g)] /(1 + rE)n

Given the weight of the terminal value (especially as the forecast period short),

a sensitivity study with different rE and g is recommended


IV. Free Cash Flow to the Firm Discount ModelsIV. Free Cash Flow to the Firm Discount Models

• FCFF: sum of the cash flows to all claim holders in the firm

including stockholders and bondholders.

• The company is valued the same way as in the FCFE method, but before the

impact of financing, i.e. before financial profit.


impact of financing, i.e. before financial profit.

• FCFF = EBIT – (tax + (tax rate * interests)) + depreciation – capital expenditure

- change in WC

• The value of capital employed to finance production’s process is the present

value of future FCFF discounted at weighted average cost of capital

VCE = Σt=1,inf FCFFFCFFt /(1 + WACCWACC)t



The company value is V0 = Σt=1,inf FCFFt /(1 + WACC)t

- if FCFF growth is equal to zero => then V0 = FCFF / WACC

- if FCFF growth is equal to the rate g => V0 = FCFF1 / (WACC - g)


- if FCFF growth is variable:

V0 = Σt=1,n FCFFt /(1 + WACC)t + Vn /(1 + WACC)n

= Σt=1,n FCFFt /(1 + WACC)t + FCFFn [(1+g)/(WACC - g)] /(1 + WACC)n

Given the weight of the terminal value (especially as the forecast period short),

a sensitivity study with different WACC and g is recommended



Assets Sales

Fixed assets Change in inv. of finished goods ROCE

Purchases of raw materials Economic

R&D Profitability

Inventory Marketing =

Receivables Personnel costs Net EBIT

Other charges, depr. amort. Net Fix. Assets + WC

Cash and bank EBIT

OPERATIONAL

DECISIONS

VALUE

CREATION


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1) OPERATIONAL DECISIONS define financial needs

2) VALUE CREATION => ROCE > WACC

Liabilities

Shareholders

Equity WACC

Financial debt Return required

by fund

providers

Suppliers

FINANCIAL

DECISIONS

CREATION

ROCE > WACC



• From accounting to an economic approach…

ACCOUNTING BIASES…

– Provisioning and amortization policy


– Provisioning and amortization policy

– Inventory valuation policy

– Policy to manage costs over several financial years

– Classification of assets under IFRS (fair value and financial crisis)

– Tax optimisation

– Communication policy (for example: smoothing )

– Exceptional items management

– Etc.



• From accounting to an economic approach…

…. to CASH FLOWS:

- Independent from accounting choices and rules,

- Reflect the company’s financial flows (4 categories)…


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- Reflect the company’s financial flows (4 categories)…

Economic activity: Cash flow from operating activities

Cash flow from investing activities

Financing activity: Equity cash flow and debt cash flow

- … while incorporating the length of the operating cycle (which in general

does not correspond to the length of the accounting cycle)

- and the collection lapses (working capital).



• Different types of cash flows

1- CASH FLOW (CF) …. IMPROPER


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- CF is financing that is internally generated by the firm.

- CF = EBITDA – net financial expense – corporate income tax

- CF = net income + depreciation and amortization and impairment

losses - capital gains + losses of asset disposals - net exceptional and

extraordinary items




2- OPERATING CASH FLOW (OCF)

- The operating cycle is characterised by a time lag between the positive and negative cash flows deriving from the length of the


70

positive and negative cash flows deriving from the length of the production process (which varies from business to business) and the commercial policy (customer and supplier credit).

- OCF = operating revenues – operating expenses

= EBITDA – ΔWC

- Operating cash flow = net income + depreciation and amortization of fixed assets - capital gains + losses on asset disposal – change in WC

EXERCICE : comment the 2nd formula based on a operating approach




3- FREE CASH FLOW (FCF)

- From a cash flow standpoint, capital expenditures modify the operating cycle in order to generate higher operating inflows and to achieve a higher profitability. FCF are the flow generated from


71

achieve a higher profitability. FCF are the flow generated from economic assets (equity + debt)

- FCF (before tax) can be defined as operating cash flow minus capital expenditure (investment outlays).

- FCF = EBIT (1- Tax) + DA – Δ WC – CAPEX (net investments)

- Base of DCF



• NET PRESENT VALUE (NPV)

- From the cash flows of an investment it is possible to determine its

value creation


72

- NPV represent the value of cash flows linked to the investment

discounted at the rate of return required by the market. This rate of

return depends on the investment risk.

- The NPV represents the expected amount of value creation

anticipated for the investment. An investment may be undertaken if

the NPV is positive.



• NET PRESENT VALUE (NPV)


Time

WACC

Perpetual growth rate

NPV =



Turnover - operating charges - financial charges - taxes

- Change in working capital (WC)

- Change in debt linked to operating

= Cash flow from operating activities (I)

+ Acquisition of fixed assets (CAPEX)

- Fixed assets transfers

- Change in debt from fixed assets

To determine the cash flows

related to the business, it is preferable to

to establish all the flows related to

the operational activity.

CASH FLOW STATEMENT


- Change in debt from fixed assets

= Cash flow from investment activities (II)

(I) - (II) = FCF after financial expenses

- Dividends paid to shareholders

+ Capital increase in cash

+ loans issued - loans reimbursed

= Cash flow from financing activities (III)

Change in cash balance (I - II + III) - Net debt reduction

the operational activity.

This allows having a better understanding

of the business model and its sensitivity.



• Measuring the impact of decisions on value creation

- Strategic, operational and financial

decisions have a strong impact on value

creation.


creation.

- The measurement of the impact has to take

into account interactions between:

* Profit and loss

* Balance sheet

* Cash flow statement



Exercise :Exercise : Case study Case study –– FCF FCF CieCie




Exercise :Exercise : Case study Case study –– FCF FCF CieCie

Congratulations, you have been designated CFO of FCF company. During yourfirst meeting, you will analyse the launch of a new business line with themarketing, operations and budget directors.

A. In order to boost FCF’s sales (growth rate has been slow for a few years), the


A. In order to boost FCF’s sales (growth rate has been slow for a few years), themarketing director suggests launching a new product to reach a marketsegment that has been inaccessible until now.

He proposes to sell this new product at a price of EUR 239 each (year N+1),which is the same price of other exiting products. The total amount of sales(existing and new products) is estimated to be 110,000 items.

The sales amount during the previous year (N) was EUR 24,600 KEUR



B. The three directors have developed a business plan to launch thenew line of business. The budget director has analysed the projectfeasibility and points out that it will be necessary to finance anincrease in WC, based on the following information:

Information on receivables and inventory of finished goods:


Information on receivables and inventory of finished goods:

- Receivables from clients in year N amounted to EUR 4,420K

- Clients/sales ratio is stable in N+1

- End inventory in year N amounted to EUR 425K

- Change in inventories in work in progress and finished goods (income

statement) in year N amounted to EUR - 425K

- Sales in year N+1 are estimated to be equal to amount produced of

110,000 units



C. The operations director and the marketing director analysed the impact oflaunching the new line of business based on:

i ) Purchase of raw materials related to the new product

Information on purchases of raw materials and suppliers

– In N: Purchases of raw materials amount to EUR 8,000K - inventory to EUR800K

Change in raw materials inventory: EUR 0K


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Payables to suppliers: EUR 1,200K

Suppliers/purchases ratio is stable in N+1

– In N+1: Purchase of 110,000 items at EUR 80 each and the total amount is consumed

D. As well as...

ii) The launch of a marketing campaign

Information on other external costs (rent, services, marketing, R&D)

– In N: EUR 2900K

– In N+1: an increase of EUR 500K linked to sales’ increase (marketing)



D. next…

iii) Hiring of 5 people

Information on employees

– In N: EUR 10,500K in N+1: Employment of 5 people with a cost of EUR 120K each (+50% of welfare costs for the company)


(+50% of welfare costs for the company)

iv) Acquisition of new machinery and modernisation of existing machinery

Information regarding fixed assets

– In N: Number of existing machines: 10 at EUR 400K each

Depreciation over 5 years. Net fixed assets: EUR 1,280K

– In N+1 January: Acquisition of 3 machines (EUR400K each). Depreciation in 5 years

Disposal: 2 machines at EUR 0 (N: last year of depreciation – waste)



E. The former CFO planned the following financial transactions to finance the new project:

Information on debt and capital increase

– In N: EUR 1,700K Cost of debt: 7.65%

– In N+1: Debt reduction of EUR 1,300K at 7.65% and debt increase of

Philippe Foulquier – Valuation: from Theory to Practice 818181

– In N+1: Debt reduction of EUR 1,300K at 7.65% and debt increase of EUR 1,200K at 7.20%. Capital increase of EUR500K

F. Other information

– Tax rate: 40% in N and N+1

– Dividend pay-out ratio: 45.2%

– In N Cash: EUR 500K; registered capital: EUR 1,600K;

reserves: EUR1,080K

– Cost of capital: 9%



Case study Case study –– FCF Cie FCF Cie -- QUESTIONSQUESTIONS

1. In order to study the impact of operational and commercial decisions on

the company’s performance and the value creation derived from the new

project, you suggest to draw up the income statement, balance sheet

(year N and N+1), and cash flow statement (N+1); calculate the


(year N and N+1), and cash flow statement (N+1); calculate the

operating cash flow, FCF for year N+1…

2. …. and determine the company’s margins and profitability (ROE, ROCE)

3. Based on a study of the sensitivity of these indicators (cash flows,

margins, profitability, value creation), what commercial, operational and

financial policies would you suggest implementing in order to improve

the company’s profitability?



Exercise 20:Exercise 20: Case study Case study –– FCF Cie FCF Cie –– ANSWERSANSWERS

1A. The marketing director suggests to boost sales by launching a new product. Heproposes to sell it at EUR 239 each (year N+1) which is the same price of existingproducts. The total amount of sales (existing and new products) is estimated tobe 110,000 units. The sales amount for year N was EUR 24,600K.


be 110,000 units. The sales amount for year N was EUR 24,600K.

Sales = quantity sold * unit price

= 110,000 * 239 = EUR 26,290 K

Forecast

Income statement year n % of sales year n+1 Change % of sales

Sales 24 600 26 290 6,9%



1B. The three directors have developed a business plan to launch the new line ofbusiness. The budget director has analysed the project feasibility and points outthat it will be necessary to finance an increase in WC, based on the followinginformation:

a) Receivables from clients in year N amounted to EUR 4,420K


⇒ Receivables from clients / sales (N) = 4,420 / 24,600 = 17.97%

⇒ 100% - 17.97% = 82.03% paid in cash

⇒ Receivables from clients N+1 = 17.97%*26,290 = EUR 4,724K (B/S N+1)

Cash flow statement N+1

⇒ Sales collected = 26,290 * 82.03% = EUR 21,566 K (+)

⇒ Receivables from clients collected (N) = EUR 4,420 K (+)




b) End inventory in year N was EUR 425K

c) Sales in year N+1 are estimated to be equal to the produced amount of 110,000 items ata cost per item of EUR 170.


a cost per item of EUR 170.

Inventory of production (unsold goods)

initial inventory + amount produced = amount sold + final inventory

Initial inventory EUR 425K

+ amount produced EUR 18,700K (110,000*170)

= amount sold EUR 18,700K (110,000*170)

+ End inventory EUR XK => X = EUR 425K (B/S inventory N+1 = EUR 425K)




d) Change in inventories in work in progress and finished goods (incomestatement) in year N amounted to EUR -425K


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Change in inventories (unsold goods) = end inventory - initial inventory

= EUR 425K – (EUR -425K) = 0 (income statement N+1)

Forecast

Income statement year n % of sales year n+1 change % of sales

Sales 24 600 26 290 6,9%

Change in inventory of finished goods -425 -1,7% 0 ns ns

Balance sheet year n year n+1 change

Receivables 4 420 4 724 7%

Inventory of finished goods 425 425 0%



1C. The operations director and the marketing director analysed the impact oflaunching the new line of business based on taking into account the purchase ofraw materials:

i) In year N: Purchase of raw materials: EUR 8,000K, inventory to EUR 800K



In N+1: Purchase of 110,000 items at EUR 80 each and total amount is consumed


8787

⇒Purchase of raw materials in N+1 : 80 * 110,000 = EUR 8,800 K (=> Income statement N+1)

⇒Raw materials = initial inventory + amount purchased = amount consumed + end inventory

800 + 8,800 = 8,800 + X => X = 800 (B/S N+1)


Receivables 4 420 4 724 7%

Inventory of raw materials 800 800 0%




1C. The operations director and the marketing director analysed the impact of launchingthe new line of business based on taking into account the purchase of raw materials:

i) In year N: Purchase of raw materials: EUR 8,000K, inventory to EUR 800K



In N+1: Purchase of 110,000 items at EUR 80 each and total amount is consumed


⇒ Change in inventory of finished goods (P&L N+1)

= End inventory – Initial Inventory = 800-800 = 0

* Suppliers N = EUR 1,200K => Suppliers / purchases = 1,200 / 8,000 =15%

⇒ Suppliers N+1 = 15% * 8,800 = EUR 1,320K (B/S N+1)

⇒ Share of purchases paid in cash = 1 - 15% = 85%

⇒ Purchases collected N+1 = (1-15%)*8,800 = EUR 7,480K (Cash flow statement N+1)

⇒ Payables to suppliers EUR 1,200K (paid out in N+1)



1C.

Cash flow statement year n+1 comments

Sales col lected 21566 collected 1- receivables from clients n+1

Receivables from clients 4 420 collection of receivables from clients n

Accounts payable suppliers -1 200 payment of suppliers year n in n+1

Purchases -7 480 payment of part of purchases in n+1 (celle non prêtée par les fournisseurs)

Forecast

Income statement year n % of sales year n+1 change % in sales


Income statement year n % of sales year n+1 change % in sales

Sales 24 600 26 290 6,9%


Purchases 8 000 32,5% 8 800 10,0% 33,5%

Change in inventory of raw materials 0 0,0% 0 ns ns


Receivables from clients 4 420 4 724 7%





1D. The operations director and the marketing director analysed the impact oflaunching the new line of business based on taking into account:

ii) The launch of a marketing campaign with a cost of EUR 500K

Information on other external costs (rent, services, marketing, R&D)

– In N: EUR 2900K In N+1: an increase of EUR 500K linked to sales’ increase

=> external costs (rent, services, marketing, R&D) = EUR +500K


=> external costs (rent, services, marketing, R&D) = EUR +500K

Other external costs N = EUR 2,900K (P&L N)

Other external costs N+1 = 2,900 + 500 = EUR 3,400K (P&L N+1 & CF statement)

iii) Hiring of 5 people In N: EUR 10,500K In N+1: employment of 5 people with a cost of EUR 120K each (+50% of welfare costs for the company)

=> Unit cost = 120 + (120*50) = EUR180K => 5 people = 5*180 = EUR 900K

Personnel (P&L N) = EUR 10,500K Personnel (P&L N+1) = EUR 11,400K (CF stat.)



1D. iv) Acquisition of new machinery and modernisation of existing machinery

Information regarding fixed assets

– In N: EUR 1,280K (net) depreciation over 5 years

Number of existing machines: 10 acquired at EUR 400K each

– In N+1: Acquisition of 3 machines at EUR 400K each (depreciation over 5 years)

Disposal: 2 machines at EUR 0 (N: last year of depreciation – waste)


* N: acquisition price / unit = EUR 400K Depreciation period = 5 years

⇒ annual depreciation per unit = EUR 80K => Depreciation N = EUR 800K (P&L N)

* N+1: acquisition of 3 machines = 3*400 = EUR 1,200K and annual depreciation per unit = EUR 80K

* N+1: disposal of 2 machines – waste => disposal price = 0

=> total machines = 10 + 3 - 2 = 11

⇒ Depreciation N+1 = 80 * 11 = EUR 880K (P&L N+1)

* Net fixed assets N+1 = net fixed assets N + investment – disposals – depreciation

= 1,280 + 1,200 – 0 – 880 = EUR 1,600K (B/S N+1)

Cash flow from investment activities CAPEX = EUR -1,200K disposals = EUR 0K



1D. Cash flow statement year n+1 comments

Sales collected 21566 collected 1- receivables from clients n+1

Receivables from clients 4 420 collection of receivables from clients n

Accounts payable suppliers -1 200 payment of suppliers year n in n+1

Purchases -7 480 payment of part of purchases in n+1 (celle non prêtée par les fournisseurs)

External costs -3 400 payment of external costs

Personnel costs -11 400 payment of wages


9292

-Acquisition of fixed assets (CAPEX) -1 200

- Disposals of fixed assets 0

= Cash flow from investment activities -1 200

= Cash flow from operating activities


Net fixed assets 1 280 1 600 25%






1D.

Forecast


Sales 24 600 26 290 6,9%



Purchases 8 000 32,5% 8 800 10,0% 33,5%


External costs (rent, services, marketing, tax) 2 900 11,8% 3 400 17,2% 12,9%

Personnel 10 500 42,7% 11 400 8,6% 43,4%

Depreciation 800 3,3% 880 10,0% 3,3%

EBIT 1 975 8,0% 1 810 -8,4% 6,9%



1E. The former CFO planned the following financial transactions to finance the new project: Information on debt and capital increase

– In N: EUR 1,700K Cost of debt: 7.65%

– In N+1: Debt reduction of EUR 1,300K at 7.65% and debt increase of EUR 1,200K at 7.20%.

– Capital increase of EUR500K

* In N: LT debt = EUR 1,700K (B/S N) => fin. expenses (P&L N) = 7.65%*1,700 = EUR130K


9494

* In N: LT debt = EUR 1,700K (B/S N) => fin. expenses (P&L N) = 7.65%*1,700 = EUR130K

* In N+1: debt reduction = EUR -1,300K => deductible fin. expenses = 7.65% * 1,300 = EUR 99K

Debt increase = EUR 1,200K => additional fin. Expenses = 7.2% * 1,200 = EUR 86K

Total fin. expenses (P&L N+1) = 130 - 99 +86 = EUR 117K (cash flow statement)

LT debt = 1,700 – 1,300 + 1,200 = EUR 1,600K

* Cash flow from financing activities:

Capital increase = EUR 500K

Loans issued = EUR 1200K

Loans reimbursed = EUR 1300K



1F. Other information

- Tax rate: 40% in N and N+1 Payout ratio: 45.2%

- In N cash: EUR 500K, share capital: EUR 1,600K, reserves: EUR 1,080K

- Cost of capital: 9%

* Dividend calculation


* Dividend calculation

Income before interest for year N = EBIT – fin. expenses = 1,975-130 = EUR 1,845K

Tax rate of 40% => 1,845*(1-40%) = 1,845 – 738 = EUR 1,107K

Payout ratio = 45.2% => dividend of year N paid in year N+1 = 1,107*45.2% = EUR 500K

* In N: share capital = EUR 1,600K reserves = EUR 1,080K Net Income = EUR 1,107K

=> Shareholders’ equity in N = 1,600 + 1,080 + 1,107 = EUR 3,787K



1F. Other information

- Tax rate: 40% in N and N+1 Payout ratio: 45.2%

- In N cash: EUR 500K, share capital: EUR 1,600K, reserves: EUR 1,080K

- Cost of capital: 9%

*Shareholders’ equity calculation for year N+1:

Income before interest in N+1 = EBIT – fin. Expenses = 1,810 – 117 = EUR1,693K

Tax rate of 40% => Net income = 1,693*(1-40%) = 1,693 – 677 = EUR 1,016K


9696

Tax rate of 40% => Net income = 1,693*(1-40%) = 1,693 – 677 = EUR 1,016K

En N+1 : share capital = 1,600 + 500 (capital increase) = EUR 2,100K

Reserves N+1 = reserves N + net income (N) – dividends N

= 1,080 + 1,107 – 500 = EUR 1,687K

Net income N+1 = EUR 1,016K

⇒ Shareholders’ equity (N+1) = 2,100 +1,687 – 1,016 = EUR 4,803K

*Cash N+1 = Cash in opening B/S N (EUR 500K) + change in cash balance (EUR 351K)

Change in cash balance (EUR 351K) = cash flow from operating activities (EUR 1,1651K) + cash flow from investment activities (EUR -1200K) + cash flow from financing activities (EUR -100K)


IV. Free Cash Flow to the Firm Discount ModelsFCF company

Forecast


Sales 24 600 26 290 6,9%


Purchases 8 000 32,5% 8 800 10,0% 33,5%



9797


External costs (rent, services, marketing, tax) 2 900 11,8% 3 400 17,2% 12,9%

Personnel 10 500 42,7% 11 400 8,6% 43,4%

Depreciation 800 3,3% 880 10,0% 3,3%

EBIT 1 975 8,0% 1 810 -8,4% 6,9%

Financial expenses 130 0,5% 117 -10,0% 0,4%

Earnings before taxes 1 845 7,5% 1 693 -8,2% 6,4%

Corporate tax income 738 3,0% 677 -8,2% 2,6%

Net income 1 107 4,5% 1 016 -8,2% 3,9%




Net fixed assets 1 280 1 600 25%




Cash 500 851 70%


Cash 500 851 70%

Total assets 7 425 8 400 13%

Share capital 1 600 2 100 31%

Reserves 1 080 1 687 56%

Net income 1 107 1 016 -8%

Total shareholders equity 3 787 4 803 27%

Long-term debt 1 700 1 600 -6%

Suppliers 1 200 1 320 10%

Overdraft 0 0 ns

Taxes 738 677 -8%

Total liabilities 7 425 8 400 13%



Cash flow statement year n+1

Sales collected 21566

Receivables from clients 4 420

Accounts payable suppliers -1 200

Purchases -7 480

External costs -3 400

Personnel costs -11 400

- Dividends paid to shareholders 500

+ Capital increase in cash 500

+ Loans issued 1200

- Loans reimbursed 1 300


Personnel costs -11 400

Financial expenses -117

Corporate income tax -738

= Cash flow from operating activities 1 651

- Acquisition of fixed assets (CAPEX) -1 200

- Fixed assets transfers 0

= Cash flow from investment activities -1 200

FCF 451

- Loans reimbursed 1 300

= Cash flow from financing activities -100

Change in cash balance – net debt reduction 351

Cash at the beginning of the year 500

Cash at the end of the year 851



2. Etude de cas FCF - Answer element

Margins N N+1

EBITDA / Sales 11,3% 10,2%

EBIT / Sales 8,0% 6,9%

Net income / Sales 4,5% 3,9%


3. What commercial, operational and financial policies would you recommend to

implement to improve the profitability of the company?

Profitability N N+1

ROE 29,2% 21,2%

ROCE [EBIT-(tax+(tax rate*interest)]/[WC + fixed assets] 20,7% 17,4%

Cash Flow N+1

= Cash flow from operating activities 1 651

= FCF 451

Organization of business decisions

Today’s challenges for the top Today’s challenges for the top

management: Profitability vs. Marginmanagement: Profitability vs. Margin

Impacts of strategic decisionsImpacts of strategic decisions

(operational, commercial(operational, commercialTOP-DOWN



101

(operational, commercial(operational, commercial

and financial) onand financial) on

11. Economic approach (vs. accounting). Economic approach (vs. accounting)

22. Value creation (profitability vs. margin). Value creation (profitability vs. margin)

33. Risk measurement and reward. Risk measurement and reward

(shareholder equity and debt)(shareholder equity and debt)

BOTTOM-UP

approach

TOP-DOWN

approach

IV. DuPont Model – definition and target

� Issue: how to identify a subset of relevant ratios to perform

the analysis of a company?

� The DuPont model, carried out by executives of DuPont de Nemours company in the 60’s, promotes a systematic analysis approach based on a central ratio, broken down into:



central ratio, broken down into:

- Three ratios (first level of analysis)

- Which in turn are broken down into other ratios (second level of analysis)

� … to avoid missing critical elements and refine the analysis.

� It also highlights interdependences among ratios.


� Issue: how to identify a subset of relevant ratios to

perform the analysis of a company?

Central ratio: ROE = Net income / Shareholders’ equity (SE)



Central ratio: ROE = Net income / Shareholders’ equity (SE)

1st level of analysis

Net income = Net income * Turnover * Assets

SE Turnover Assets SE

Financial Profitability = net margin * asset turnover * financial leverage







� Net margin:Net margin: measure of a company’s sales performance

i.e. the amount of net income generated by one euro of sales

– A function of endogenous & exogenous variables that make up the net income:

- amount sold, selling price,

- purchasing or manufacturing cost of goods sold, sales and administrative expenses, - depreciation of fixed assets

- debt interest - taxes







�� Net margin:Net margin: more or less high or volatile depending on the sector considered

�� Objectives of the analysis:Objectives of the analysis:

- to analyse the level (high enough?)

- to identify key variables and their sensitivity

- to define actions that can be implemented







�� Asset turnover:Asset turnover: measure of asset management performance

i.e. the amount of sales in euros that can generate each euro of investment in the assets of the company.

� Even though the amount of assets necessary to operate depends largely on the business sector, companies aim to optimise this ratio

EXERCISE EXERCISE : WHAT IS THE RELATION BETWEEN NET MARGIN AND ASSET : WHAT IS THE RELATION BETWEEN NET MARGIN AND ASSET TURNOVER? Illustrate for different sectorsTURNOVER? Illustrate for different sectors







107

�� Exercise: SOLUTIONExercise: SOLUTION

There is an offset (not perfect)

High net margin + low asset turnover

≈

Low net margin + high asset turnover







108

�� Financial leverageFinancial leverage: : measures the part of the company’s assets (equity + debt) financed by shareholders i.e. debt level of the company

– The more important the recourse to the leverage effect is, the higher ROE…

– under the condition that the cost of debt is more than offset by the additional net margin generated by the debt… and up to an inflexion point … (linked to risk increase correlatively to the debt increase)


Synthesis of level 1 analysis of DuPont model

Sales performanceSales performance

Net margin = Net income / TurnoverNet margin = Net income / Turnover



109

Financial profitability Financial profitability

(ROE)(ROE)

Efficiency of asset managementEfficiency of asset management

Asset turnover = Turnover / AssetsAsset turnover = Turnover / Assets

Insolvency riskInsolvency risk

Financial leverage = Assets / EquityFinancial leverage = Assets / Equity


� The DuPont model extended to fund providers

� Issue: how to identify a subset of relevant ratios to perform the

analysis of a company?



110

Central ratio: ROCE = net EBIT/ Assets

1st level of analysis

Net EBIT = Net EBIT * Turnover

Assets Turnover Assets

Economic profitability = net operating margin * asset turnover


Level 2 analysis of DuPont model

Financial profitability (ROE)Financial profitability (ROE)

Gross margin (COGS/Turnover)Gross margin (COGS/Turnover)

Operating expenses/ TurnoverOperating expenses/ Turnover

Operating marginOperating margin

Interest / TurnoverInterest / Turnover

Taxes / Income before taxTaxes / Income before tax

Sales performanceSales performance

Net margin = NI / turnoverNet margin = NI / turnover

Days receivables ratioDays receivables ratio

Days inventory ratioDays inventory ratio



111

111

Net margin = NI / turnoverNet margin = NI / turnover

Efficiency of asset managementEfficiency of asset management

Asset turnover = Turnover / assetsAsset turnover = Turnover / assets

Days inventory ratioDays inventory ratio

Days payable ratioDays payable ratio

Fixed assets management efficiencyFixed assets management efficiency

Debt and insolvency risk managementDebt and insolvency risk management

Financial leverage= Assets / EquityFinancial leverage= Assets / Equity

Current ratioCurrent ratio

Acid test ratioAcid test ratio

Debt ratioDebt ratio

Interest coverage ratioInterest coverage ratio

Debt coverage ratioDebt coverage ratio

Sales growthSales growthSales growthSales growth

Sales mixSales mixSales mixSales mix CUSTOMERSCUSTOMERSCUSTOMERSCUSTOMERS

PricingPricingPricingPricing

Cost of salesCost of salesCost of salesCost of sales INTERNAL PROCESSESINTERNAL PROCESSESINTERNAL PROCESSESINTERNAL PROCESSES

Selling expSelling expSelling expSelling exp INNOVATIONINNOVATIONINNOVATIONINNOVATION

R&DR&DR&DR&D INNOVATIONINNOVATIONINNOVATIONINNOVATION

Admin expenseAdmin expenseAdmin expenseAdmin expense INTERNAL PROCESSESINTERNAL PROCESSESINTERNAL PROCESSESINTERNAL PROCESSES

Net IncNet IncSalesSalesNet IncNet IncSalesSales



112112

Accts receivableAccts receivableAccts receivableAccts receivable CUSTOMER CUSTOMER CUSTOMER CUSTOMER

RELATIONSRELATIONSRELATIONSRELATIONS

Inventory turnover Inventory turnover Inventory turnover Inventory turnover SUPPLIERS & INTERNALSUPPLIERS & INTERNALSUPPLIERS & INTERNALSUPPLIERS & INTERNAL

Fixed asset turnoverFixed asset turnoverFixed asset turnoverFixed asset turnover PROCESSESPROCESSESPROCESSESPROCESSES

Debt/equityDebt/equityDebt/equityDebt/equity

Interest coverageInterest coverageInterest coverageInterest coverage FINANCIAL MANAGEMTFINANCIAL MANAGEMTFINANCIAL MANAGEMTFINANCIAL MANAGEMT

Liquidity ratiosLiquidity ratiosLiquidity ratiosLiquidity ratios

Net IncNet IncEquityEquityNet IncNet IncEquityEquity

SalesSalesAssetsAssetsSalesSalesAssetsAssets

AssetsAssetsEquityEquityAssetsAssetsEquityEquity

CustomersCustomers

FinancialFinancial

Vision &Vision &StrategyStrategyVision &Vision &StrategyStrategy

Internal BusinessInternal Business



113113

CustomersCustomers StrategyStrategyStrategyStrategy

Learning &Learning &GrowthGrowth

ProcessesProcesses

Source: “Perform”, Vol 2, Issue 2, Balanced Score Card


V. Value creation (EVA and MVA)V. Value creation (EVA and MVA)

V.1. Background

• Stern-Stewart (US) created a tool to calculate the variable part of managers’ remuneration based on performance measures.

• Criteria:

– EVA or Economic Value Added


– EVA or Economic Value Added

– MVA or Market Value Added

V.2. Value creation

• A company creates value when its operations generate profitability above its financial resources

- Capital employed (CE)

- Cost and return on capital employed


V. V. Value creation (EVA and MVA)Value creation (EVA and MVA)

V.3. Economic Value Added (EVA)

• EVA measures the internal (economic) performance of a company. It is the difference between the after-tax operating profit and the cost of CE


. EVA = EBIT (1 - TC) - (WACC * CE)

• If EVA > 0 => value is created for the shareholder

(performance higher than market expectations)

• Debate:

What impact do share buybacks followed by their cancellation have on EVA?


V. Value creation (EVA and MVA)

V.4. Market Value Added (MVA)

• MVA measures the external performance of a company.

• It is the difference between the market value of the invested capital and its


• It is the difference between the market value of the invested capital and its book value.

• Often, the market value of the debt is equal to its book value=> MVA is equal to the difference between market capitalisation (CAPI) and book value (BV).

• MVA is defined as the market estimate of the present value of EVA flows.MVA = CAPI - BV = Σt=1,n EVA t /(1 + WACC)t


V.5. Value creation Dashboard – Management of a company

NAV NAV

Shareholders' Risk Value creation equity Adjusted dash board

Capital & RAC Sum-of- the-parts

Reevaluateditems Excess


items ExcessRI (EXC)

Value creation dashboard

value creation V(RACj)BUj RACj RoRACj CoCj(bêtaj) RoRACj - CoCj % RACj xRACj

1 V(RAC1)

2 V(RAC2)……

n V(RACn)

EXC V(EXC)Total V(NAV)


V.5. Value creation Dashboard – Management of a company

An example of value creation in non-life insurance

Net premiums Activity RAC RAC Margin as V(RACj) V(RACj)

Activity j of reinsurance as % of % of RoRAC CoC RoRAC-CoC

EURm breakdown premiums breakdown premiums xRACj breakdown

1. Liablity 1456 10,4% 80% 34,3% 6,0% 7,5% 11,2% -3,7% 66,7% 14,0%

2. Industrial risks 897 6,4% 30% 7,9% 3,5% 11,5% 9,4% 2,1% 122,6% 5,9%

3. Property damage 4951 35,3% 20% 29,1% 3,5% 17,7% 8,1% 9,6% 219,5% 39,2%


4. Transport 745 5,3% 35% 7,7% 3,8% 10,7% 9,4% 1,3% 114,2% 5,4%

5. Automobile 5963 42,6% 12% 21,0% 2,5% 21,0% 7,6% 13,4% 275,8% 35,5%

Total of operational 14012 100,0% 24% 100,0% 3,4% 13,9% 8,5% 5,4% 163,3% 100,0%

activities

Surplus capital 1000 100,0%

in EURm

Total Group EURm 14012 3400 471 163,3% 5552

Group valuation 148,9% 6552

(NAV + RAC)

RAC: Risk Ajusted Capital

PlanPlan








PlanPlan

I. Comparison based on transactions: the issuesI. Comparison based on transactions: the issues

II. Price earnings ratioII. Price earnings ratio



III. Price earnings growth ratio (PEG)III. Price earnings growth ratio (PEG)

IV. Relative P/E ratioIV. Relative P/E ratio

V. Net Asset Value or Book Value Multiple (NAV or B V)V. Net Asset Value or Book Value Multiple (NAV or B V)

VI. Operating multiple (sales, EBITDA, EBIT, etc.)VI. Operating multiple (sales, EBITDA, EBIT, etc.)

Chapter 4: Peer comparison

I. Comparison based on transactions: the issuesI. Comparison based on transactions: the issues

• Well identified

• On the same type of investment

• Realised under similar conditions


=> Need to know all the transaction conditions(in particular, guarantees likely to be granted by the seller, payment details, etc).

• We will analyse1- P/E 2- PEG3- Relative P/E4- NAV or BV multiple 5- Operating multiple (sales, EBITDA, EBIT, etc.)


II. Price earnings ratioII. Price earnings ratio

• PER or P/E: stock price / (restated) net profit per share.

• It establishes the relationship between the value of an asset and the net profit it is going to generate.


• Net profit is normalised (economic approach). This means attributable net profit, excluding exceptional items.

• The number of shares must include all existing and potential shares (including convertible bonds, bonds repayable in shares ORA, warrants BSA, etc.), and net profit must be restated (financial charge savings)


III. Price earnings growth ratio (PEG)III. Price earnings growth ratio (PEG)

• Target: to partly offset the static aspect of P/E

• Growth can be included based on: P/En = P/En-1 /(1+gn)where gn indicates the growth rate of the net profit per share during year n.

• PEG = P/E / average profit growth over 3 years


IV. Relative P/EIV. Relative P/E

• Target: to take into account that relative P/E can be sensitive to macro-economic issues apart from different accounting practices in each country

• Relative P/E is determined:

- based on a financial market (relative P/E Paris / relative P/E New York)- based on a sector (average sector relative P/E / average market relative P/E - based on peers ( share relative P/E / average sector relative P/E)


V. Net Asset Value or Book Value Multiple (NAV or BV)V. Net Asset Value or Book Value Multiple (NAV or BV)

• In sectors where book value accounts for a large part of value, the net asset value or BV multiple is often used

• Including profitability widens the scope of the measure, notably by comparing NAV multiples with each company’s profitability

• The regression line is a very good valuation tool when it is statistically relevant


• The regression line is a very good valuation tool when it is statistically relevant

VI. Operating multiple (sales, EBITDA, EBIT, etc.)VI. Operating multiple (sales, EBITDA, EBIT, etc.)

• The most common criteria are market capitalisation comparisons with :

– Sales – EBITDA– EBIT– Etc.

PlanPlan








I. Privatization of ASF I. Privatization of ASF

II. ASF: Summary financial statementII. ASF: Summary financial statement

III.III. ASF: FCFF forecastsASF: FCFF forecasts

III.1. ASF revenue forecasts (2005-2032)III.2. ASF cost forecasts (2005-2032)


PlanPlan


III.2. ASF cost forecasts (2005-2032)III.3. ASF FCFF forecasts (2005-2032)

IV. ASF: WACCIV. ASF: WACC

IV.1. Current and future financial structure VD / VEIV.2. Beta of equityIV.3. Cost of equity with the current financial structure rE,CIV.4. Cost of equity without debt rUIV.5. Cost of equity with the future financial structure rE,F s and WACC

V. Equity value per shareV. Equity value per share

Chapter 5: Case Study

I. Privatization of ASF

• The largest toll motorway operator in France and the 2nd largest in Europe

• Three concessions :

– ASF: 2478km – Expiry:2032


– ASF: 2478km – Expiry:2032

– ESCOTA: 459km – Expiry:2026

– Puymorens Tunnel: 5.5km – Expiry 2037

• Toll revenues 2005E: 98%

(2% service station sub-concession and lease payments using fibre-optic)


II. ASF: Summary financial statement1999 2000 2001 2002 2003 2004 CAGR

Toll revenues 1747 1840 1883 2053 2190 2343Change 5,3% 2,3% 9,0% 6,7% 7,0% 6,0%Other revenues 35 47 47 51 49 46Change 34,3% 0,0% 8,5% -3,9% -6,1% 5,6%Total revenues 1782 1887 1930 2104 2239 2389Change 5,9% 2,3% 9,0% 6,4% 6,7% 6,0%

Purchases and external charges -231 -234 -262 -262 -262 -264Change 1,3% 12,0% 0,0% 0,0% 0,8% 2,7%


Change 1,3% 12,0% 0,0% 0,0% 0,8% 2,7%in % of revenues -13,0% -12,4% -13,6% -12,5% -11,7% -11,1%Personnel expenses -239 -250 -289 -295 -313 -331Change 4,6% 15,6% 2,1% 6,1% 5,8% 6,7%in % of revenues -13,4% -13,2% -15,0% -14,0% -14,0% -13,9%Taxes -213 -239 -254 -266 -278 -291Change 12,2% 6,3% 4,7% 4,5% 4,7% 6,4%in % of revenues -12,0% -12,7% -13,2% -12,6% -12,4% -12,2%Other operating income/expense 31 31 26 30 32 29Change 0,0% -16,1% 15,4% 6,7% -9,4% -1,3%in % of revenues 1,7% 1,6% 1,3% 1,4% 1,4% 1,2%Total Charges -652 -692 -779 -793 -821 -857Change 6,1% 12,6% 1,8% 3,5% 4,4% 5,6%in % of revenues -36,6% -36,7% -40,4% -37,7% -36,7% -35,9%


II. ASF: Summary financial statement1999 2000 2001 2002 2003 2004 CAGR

EBITDA 1130 1195 1151 1311 1418 1521Change 5,8% -3,7% 13,9% 8,2% 7,3% 6,1%in % of revenues 63,4% 63,3% 59,6% 62,3% 63,3% 63,7%Depreciation -337 -352 -397 -422 -444 -476Change 4,5% 12,8% 6,3% 5,2% 7,2% 7,2%in % of revenues -18,9% -18,7% -20,6% -20,1% -19,8% -19,9%EBIT 793 843 754 889 974 1045Change 6,3% -10,6% 17,9% 9,6% 7,3% 5,7%in % of revenues 44,5% 44,7% 39,1% 42,3% 43,5% 43,7%


in % of revenues 44,5% 44,7% 39,1% 42,3% 43,5% 43,7%

Financial expenses -438 -429 -421 -475 -470 -435Change -2,1% -1,9% 12,8% -1,1% -7,4% -0,1%Total ordinary EBT 355 414 333 414 504 610Change 16,6% -19,6% 24,3% 21,7% 21,0% 11,4%in % of revenues 19,9% 21,9% 17,3% 19,7% 22,5% 25,5%

Extraordinary items -1 -2 -21 -4 -1 -1Total EBT 356 416 354 418 505 611 11,4%Taxes -136 -151 -93 -142 -177 -210Tax rate (% EBT) -38,2% -36,3% -26,3% -34,0% -35,0% -34,4%Minority interest -2 -1 -1Net profit 218 261 219 266 325 398Change 19,7% -16,1% 21,5% 22,2% 22,5% 12,8%in % of revenues 12,2% 13,8% 11,3% 12,6% 14,5% 16,7%



2005 2006 […] 2026 2027 […] 2031 2032Total RevenuesPurchases and external chargesPersonnel expensesTaxesOther operating income/expenseTotal Charges

EBITDA


EBITDADepreciationEBITTax rateNet EBIT

+ Depreciation- Change in WC+ Capital expenditure

FCFF



III.1. ASF revenue forecasts (2005-2032)

• Volume

– Economic growth


– Economic growth

– Petroleum price

– Geographical area

– Weight light vehicle / heavy vehicles

– Breakdown work / leisure time

– Network extension forthcoming

– Etc.

Conclusion forecasts (see Excel file)



III.1. ASF revenue forecasts (2005-2032)

• Price




– Agreement with the French government

i) Inflation (0.85% or 0.7%)

ii) Capital expenditure (around EUR3.4bn in 2002-06, and in 2007-12)

• Conclusion on total revenue forecasts (see Excel file)



III.2. ASF cost forecasts (2005-2032)

• Purchase and external costs (mostly maintenance)




– Geographical area - inflation

– Traffic volume - economy of scale

• Personnel costs (automatic toll)

• Local taxes

• Conclusion on total cost forecasts (see Excel file)



III.3. ASF FCFF forecasts (2005-2032)

• EBITDA margin

• Depreciation


• Depreciation

• Tax

• Net EBIT

• Capital expenditure and change in WC

• Conclusion on FCFF forecasts (see Excel file)


IV. ASF: WACC

IV.1. Current and future financial structure VD / VE

en MEUR Date mEURDebt CNA(*) Fixed rate 2002 2003 2004 2005 392Debt CNA(*) Variable rate 7892 7408 7254 2006 497Debt from territorial administrations 746 746 746 2007 458Other 73 56 44 2008 789


Source : Annual report

Current VD / VE Future VD / VE

VD = EUR7.6bn VD = EUR3.8bn

VE = EUR11.3bn VE = EUR11.3bn

VD / VE = 67% VD / VE = 34%

Other 73 56 44 2008 789TOTAL 11 28 38 2009 469(*) Caisse Nationale des Autoroutes 8722 8238 8081 2010 821

2011 6372012 405Beyond 3575Total 8043


IV. WACC

IV.2. Beta of equity

IV.2.1. Traditional analyst approach Current leverage Future leverageBeta sector 0,60 Beta sector 0,60Tax rate 35% Tax rate 35%


Hamada (1972)Limits: sector beta ≠ unlevered beta

IV.2.2. Multifactor model rE = rF + ∑ λk βF,k

IV.2.3. Forward looking (fundamental approach)

Current leverage 67% Current leverage 34%Relevered beta 0,86 Relevered beta 0,73

Levered beta = unlevered beta [1 + (1 - Tax rate) (VD / VE)]


IV. WACC

IV.3. Cost of equity with the current financial structure rE,C

i) Risk free-rate


ii) Risk premium

iii) βE

iv) rE,C = 6.4% C: current financial structure


IV. WACC

IV.4. Cost of equity without debt rU

• Modigliani Miller: proposition II


rE = rU + (1 – TC) (rU - rD) (VD / VE)

where rE cost of capital for a company with debtrU cost of capital for a company without debtrD cost of debtTC corporate tax

=> rU = 5.7%


IV. WACC

IV.5. Cost of equity with the future financial structure rE,F s andWACC

• MM II => rE,F = rU + (1 – TC) (rU – rD,F) (VD,F / VE,F)

where rE,F cost of capital for a company with future debt structurer cost of capital for a company without debt


rU cost of capital for a company without debtrD,F cost of debtTC corporate tax

=> rE,F = 6.0%

• WACC = [rD,F (1 – TC) (VD,F / (VD,F + VE,F))] + [rE,F (VE,F / (VD,F + VE,F))]= 5,3%



• Discounted FCFF

• Present value of FCFF

• Net Debt


• Net Debt

• Equity Value

• Number of shares

• Equity Value per share



Valuation Valuation perWACC in EURbn share (in EUR)

3,75% 20007 86,64,0% 19074 82,65,0% 15737 68,1

5,25% 14992 64,95,50% 14278 61,8


Discount rate for the French State = 3.75% (bonds -30 years)

5,50% 14278 61,85,75% 13595 58,96,00% 12941 56,06,25% 12314 53,36,50% 11713 50,76,75% 11137 48,27,00% 10585 45,88,00% 8590 37,2

PlanPlan








PlanPlan

I. Asset valuation (B/S)I. Asset valuation (B/S)

II. Asset valuation (B/S) / Cash flow (P&L): mix va luationII. Asset valuation (B/S) / Cash flow (P&L): mix va luation

III. Case Study: AGF (Allianz Group)III. Case Study: AGF (Allianz Group)



Chapter 6: Cash flow-Asset Mix Valuation


• “The company is worth what is owns” (B/S) versus “the company is worth what is earns” (CF)

• Focus on the tangibles and intangibles which comprise a company’s assets and liabilities

• Net asset value - NAV


• Net asset value - NAVEach item with no economic justification must be restated, and hidden wealth must be found

i) Intangible assets

• establishment costs• client base• R&D• patents and licences• brands



• Valuing a patent

– assumptions:

• royalties = 5% of sales T= 40%


• royalties = 5% of sales TC = 40%

• sales = EUR2bn

• perpetual growth rate g = 1%

• discount rate i = 10%

– solution: VA = EUR667m

– watch out for the sensitivity of parameters i and g



• Brand valuation

– by cost

– by revenue


– by revenue

– by over-price or over-profit

– by goodwill

– by comparison



ii) Tangible assets

iii) Fixed financial assets and current assets

iv) Liabilities


iv) Liabilities

v) Off balance sheet

vi) Net Asset Value: Pros and cons


II. Asset valuation (B/S) / Cash flow (P&L): Mix Valuation

II.1. Goodwill

Used in addition to an asset valuation insofar as it is an answer to NAV’s lack ofprojection momentum.

Goodwill links a dynamic future cash flows valuation and the valuation of asset values.

II. 2. Anglo-Saxon method


II. 2. Anglo-Saxon method

Based on shareholders’ equity profitability cash flows (after financial expenses)Shareholders’ equity value: V = NAVEI + GWwhere NAVEI = NAV excluding intangibles

GW = Σt=1,n(NPt - [NAVEI t * rE ]) / (1+ rE )t = goodwillNPt = net profit for year trE = ro + ß (rM - ro) NP - [NAVEI * rE] = super profitn = number of years during which we expect the company will keep its competitive advantage (which is the basis for better profitability than expected by the market)



II.3. Goodwill based on capital employed

• Based on capital employed profitability cash flows (shareholders’ equity +debt => cash flows before financial expenses).

• Valueof thecompanyis : V = NAVEI + GW


• Valueof thecompanyis : V = NAVEI + GW

where NAVEI = NAV excluding intangiblesGW = Σt=1,n(EBITDA t*(1-TC)-(CEt*WACC))/(1+WACC)t = goodwillCE = capital employed needed for operations

= tangibles at market value + working capital requirements (WCR)EBITDA t*(1-TC)-(CEt*WACC) = super profitn = number of years during which we expect the company will keep its competitive advantage (which is the basis for better profitability than expected by the market)



II.4. Sum-of-the-parts

Previous approaches can be refined owing to:

* The economic value based on:

- Allocated capital by activity


- Allocated capital by activity- Normalised profitability according to activity- Cost of capital by activity

* The true value by reconciling the theoretical economic value and the balance sheet based on :

- The difference between allocated shareholders’ equity and true equity (shareholders’ equity in B&S)

- Revalued assets such as capital gains, over or under provisioning,goodwill booked B&S, etc.



II.4.1. NAV with no growth

V0 = NAVEI +GW = NAVEI + Σt=1,n [NAVEI (RoNAVEI - rE)]/(1+ rE)t

= NAVEI RoNAVEI / rEwhere RoNAVEI = net asset value excl. intangibles profitability


where RoNAVEI = net asset value excl. intangibles profitability

II.4.2. NAV with growth rate “g”

V0 = NAVEI0 + GW

= NAVEI0 + Σt=0,n [NAVEI t (RoNAVEI - rE)]/(1+ rE)t

= NAVEI0 (RoNAVEI - g) / (rE - g)

where : NAVEIt+1 = NAVEI t (1 + g)



II.4.3. Sum-of-the-parts, allocated capital per activity and GW

Division of NAV between assets allocated to “j” activities and unallocated capital, at growth rate “g”

V0 = NAVEI + GW = (SE - AC) + RI + AC + GW


V0 = NAVEI + GW = (SE - AC) + RI + AC + GW= (SE -Σj=1,mACj) + RI + Σj=1,mACj

+ Σj=1,m Σt=0,n [AC jt[RoACj - rEj)]]/(1+ rEj)t

= (SE -Σj=1,mACj) surplus shareholders’ equity+ RI revaluation items (including deduction of intangibles)+ Σj=1,m ACj (RoACj - gj) / (rEj - gj)



II.4.3. Sum-of-the-parts, allocated capital per activity and GW

where :

NAVEI = net asset value excluding intangibles = SE + RI

SE = shareholders’ equity


SE = shareholders’ equity

RI = revaluation items

= unrealised capital gains - intangibles+ other accounting restatements

ACj,t = shareholders’ equity allocated to activity “j” over period “t” with ACj,t+1= ACj,t (1+g)

RoACj = Return on allocated capital of the activity “j”

rEj = Cost of capital of the activity “j”


III. Case Study: AGF

III.1. How do we organise fundamental analysis?

A. Market and local constraints


i) General economic backdrop

ii) Regulatory and fiscal issues

iii) The market




A. Market and local constraints

i) General economic backdropii) Regulatory and fiscal issues


ii) Regulatory and fiscal issuesiii) The market

B. Operating data

i) Company’s market positioningii) Distribution networkiii) Products and marginsiv) Management and personnelv) Retrocession and reinsurance




C. Company’s financial data

i) Technical analysisii) Asset/liability management (ALM)


ii) Asset/liability management (ALM)iii) Evaluation of economic profit

D. Valuing the company’s prospects (simulation)Matrix 2 columns x 4 lines

C1. Market assumptionsC2. Company assumptionsL1. Change in premium assumptionsL2. Change in claims assumptionsL3. Change in expenses assumptionsL4. Change in financial income assumptions



III.2. Valuation

- Determine the number of “j” activities

- Determine allocated capital for each activity according to the required economic solvency margin (independent of regulatory standards)


- Determine the allocated capital profitability for each activity

* Normalised profitability on a P&C cycle* In force and new business in life* Risk weighted assets and tier one in banking* Assets under management multiple in asset management activity



III.2. Valuation

- Determine the cost of capital for each “j” activity

- Determine surplus capital compared with allocated capital* valuation issue (RoAC ≤ R )


* valuation issue (RoAC ≤ RE)* Target and economic interpretation

- Determine asset revaluation items* Net unrealised capital gains* Goodwill* Other accounting restatements

- Determine sensitivity of the valuation to beta and the risk premium



Total Allocated Capital

AGF - COA Capital Allocation 20072 702 Life insurance 2 87380% Shareholders'equity (SE) / Net Technical Prov 4,8%

SE / Net technical provisions - unit-linked 1,2%Technical provisions - traditional 55 434Technical provisions - unit linked 17 654

3 351 Minority interests 0,0%649 Health insurance 649

SE / Net premiums 45%Net premiums 1 442Minority interests 0%

3 080 P&C insurance 3 086SE / Net premiums 55%Net premiums 5 611


Minority interests 0%1 087 Credit Insurance (AGF share) 791

SE / Net premiums 100%

Net premiums 1 098

Minority interests 28%1 214 Assistance (AGF share) 127

(assistance + credit) SE / Net premiums 26%Net premiums 485Minority interests 50%

207 Asset Management & Bank 207SE / AuM 0,25%AuM for own account 101 233AuM For third party 18 300= Total AuM 119 533Minority interests 0%Bank 161

7 852 = Allocated Capital 7 732



Total Excess or Deficit of Capital

Available Capital 2007NAV Tangible 10 099(+) 50% In-Force Value 1 749


(+) 50% In-Force Value 1 749= Adjusted Capital 11 848(+) Subordinated debts 1 544(+) Other Financial Debts 337= Total Availble Capital 13 729Excess or Deficit / NAV 2 366Excess of Deficit / Adjusted Capital 4 116Excess or Deficit / Total Available Capital 5 997



III.1. Life insurance valuation

Embedded value 2007e

Shareholder's equity 11 643(-) Goodwill -999

(-) Value of Business Acquired (VOBA) -102


(-) Other intangibles items 0(-) Deferred Acqusition Costs -692(+) Equalization Reserves 0(+) Off-Balance Sheet unrealised capital gains 1 000(-) Off-Balance Sheet Adjustment -752= Net Asset Value (Tangible) 10 099(-) Cost of Capital (Life & Health) -800(+) In-Force Value (Life & Health) 3 499

= Embedded value 12 797



III.1. Life insurance valuation

Life profit contribution 2007 Normalised ROEVProfit Profit / ROE

Life insurance 554 586 10,5%New business Value 187 3,4%Expected return on EV 399 7,2%


Expected return on EV 399 7,2%Expected return on surplus 0,0%Expected return in force value (discount rate) 8,0%New business premium (APE) 623New business margin 30,0%

NAV In-Force value

Embed-ded value

Normalised profit

ROE/ ROEV perpetual growth

Beta Cost of capital

Multiple/ Emb. Value

Valuation

Life insurance 2 873 2 699 5 571 586 10,5% 3,0% 1,10 9,0% 1,3 7 034



III.2. Other activities valuationNormalised profit contribution 2007 Normalised ROEV

Profit Profit / ROEHealth insurance 149 93 14,3%Combined ratio 95,5% 99,5%Financial yield 4,2%Ratio of provisioning 150% 156%Financial assumptions Dividend CG yield %Equity 2,5% 6,0% 8,5% 5%Bonds and other 4,0% 0,0% 4,0% 95%


Bonds and other 4,0% 0,0% 4,0% 95%P&C insurance 912 516 17%Technical profit 360 70%Realised capital gains 120 23%Combined ratio 95,3% 99,3%Financial yield 5,0%Ratio of provisioning 180% 188%Financial assumptions Dividend CG yield %Equity 2,5% 6,0% 8,5% 22%

Bonds and other 4,0% 78%Assurance crédit 253 196 25%Combined ratio 71,0% 75%Financial yield 4,4%Ratio of provisioning 110% 116%Financial assumptions Dividend CG yield %Equity 2,5% 6,0% 8,5% 17%

Bonds and other 3,5% 83%



III.2. Other activities valuation

Normalised profit contribution 2007 Normalised ROEVProfit Profit / ROE

Assistance 24 22 17%Financial services 109 109 53%Holding -72 97


Holding -72 97Central costs 0 0Capital excess 0 174Debts 0 -77Cost of Debt 4,1%= Adjusted Profit 1 929 1 619 13%(-) GW(-) Exceptional= Net profit 1 929 1 619ROE / ROEV 17% 13%



III.3. Total Valuation

Valuation (end of 2007) NAV In-Force value

Embed-ded

value

Sustainable

earnings

ROE/ ROEV

Growth Beta Cost of Capital

Multiple/ Emb. Value

Valuation

Life & Health Insurance 3 521 2 699 6 220 679 10,9% 3,0% 1,09 8,9% 1,3 8 371 Life Insurance 2 873 2 699 5 571 586 10,5% 3,0% 1,10 9,0% 1,3 7 034


Life Insurance 2 873 2 699 5 571 586 10,5% 3,0% 1,10 9,0% 1,3 7 034 Health Insurance 649 649 93 14,3% 3,0% 1,00 8,5% 2,1 1 336Non-Life Insurance 4 004 4 004 734 18,3% 2,2% 1,15 9,2% 2,4 9 602 P&C Insurance 3 086 3 086 516 16,7% 2,0% 1,20 9,4% 2,0 6 141

Credit Insurance 791 791 196 24,8% 3,0% 1,00 8,5% 4,0 3 129

Assistance 127 127 22 17,3% 3,0% 1,00 8,5% 2,6 331Asset Management & Bank 207 207 109 52,6% 3,0% 1,00 8,5% 9,0 1 866Central Costs net 0 0 0 9,0% 0

= Operational Activities 7 732 2 699 10 431 1 522 14,6% 2 ,7% 1,1 9,0% 1,9 19 839Surplus/Deficit of capital, net 2 366 2 366 97 4,1% 1,00 8,5% 0,5 1 142= Total Group 10099 2 699 12 797 1 619 12,6% 2,7% 1,1 8,9% 1,6 20 981Valuation per Share (EUR) 55,5 70,3 115,3

Bibliography

• S.A. Ross, R.W. Westerfield, J.F. Jaffe, B.D. Jordan, Modern Financial Management, Eighth Edition, McGraw-Hill, 2008

• Richard A. Brealey, Stewart C. Myers, Franklin Allen, Principles of Corporate Finance, Eighth Edition, McGraw-Hill/Irwin, 2004


• Aswath Damodaran, Investment Valuation, Second Edition, Wiley, 2002

140221 eisti financial analysis [mode de compatibilitu00e9]

Documents

financial flows risk

choice of discount ratevii

risk premiums

general theory

equity value

asset valuation bsii

price earnings ratioiii

discount rateiii