intro to valuation the role of relative valuation stuart linde head of u.s. equity research lehman...

Intro to ValuationThe Role of Relative

Valuation

Stuart LindeHead of U.S. Equity Research

Lehman Brothers

smartwomansecurities

© 2006 Smart Woman Securities. All materials are for SWS

members’ use only

November 1, 2006

Topics

• The Broad Fundamental Analysis View

• Financial Statement Overview• Relative Equity Valuations• Case Study: CBS

Information is Dangerous….

Knowing How to Apply is Deadly!

The Broad Fundamental Analysis

View

Common Analyses Elements

• Revenues– Drivers Of Business Model / Stress Test Against Industry

Model– Expectation Often Predicated On Recent History Rather Than

Realism– Industry Growth, Management Strategies And Comparisons

Are Key• Profitability

– Where Rubber Hits The Road….Is Revenue Growth Creating At Least Incremental Profitability

– Easiest To Play With – “One Time” Vs. Recurring– Q To Q Volatility

• Cash Flow– Measure Of Earnings Quality– Measure Of Growth Capabilities– Risk Of Over-Investment

The Broad View

Common Analyses Elements (cont’d)

• Valuation– P/E Most Commonly Used To Benchmark Against

Market, Other Industries And Peers– Cash Flow (EV: EBITDA); – Enterprise Value (Debt, Book And Equity Measures)– Dividend Yield– Sales– The List Goes On!

• Expectations– Greatest Opportunity To Enhance Risk Taking Broadly

Is To Anticipate Expectation Embedded In Stock.

The Broad View

Uncommon Analyses Elements: How Do They Affect the Model Levers?

Key Questions to Set Stage for Valuation:– What are the Key Drivers of Growth?

– What is the Category Growth ?

– What Macro Variables Affect the Sector?

– Are There Sector and Company Specific Risks?

– What is the Geographic Scope?

– Does Scale Come into Play?

The Narrow View

Financial Statement Overview

Income Statement Analysis

• Revenues – Examine Growth Driverso Different for Every Industryo Recurring vs Non Recurring o Macro Drivers o Example Cable Networks: Subscribers, Subscriber Fees and

Advertisingo Example Hotels: Occupancy Rate, Price, RevPAR

• Gross Margin = Revenues – COGSo Impacted by Material & Labor Costs

• Operating Margin/EBIT = GM – SG&A – D&Ao Impacted by All Operating Expenses/Run the Business

• EBITDA = EBIT + D&A

Financial Statement Overview

Income Statement Analysis (cont’d)

• Below Line Itemso Interest Expense/Incomeo Minority Interestso Non Consolidated Investmentso One Time, Non Recurring Itemso Taxes

• EPSo Basico Fully Diluted – Options Includedo Operating EPS

Financial Statement Overview

Watch for Earnings Inflation

• Quality of Operating Earnings is Critical!– Analyze Earnings Release Carefully– Remove Cheerleader Behavior

• Watch for:– Depreciation and Amortization– Corporate Expense– Interest Expense– Minority Interests– Lower Share Count– Unexpected Tax Rates Changes

Financial Statement Overview

Financial Statement Overview

Balance Sheet – Understand Leverage Drivers

Liquidity = Current Assets – Current Liabilitieso Inventories, Receivables, Payables, ST Debto Burn Rates

• LT Debt Analysis – Be Cognizant of Maturity Scheduleso Credit Crunch Could Impact Bank Rateso Floating vs Fixedo Cost of Debt Could Be Impacted By Ratios, Operations and Mkt

Conditionso Interest Rates Affect EPS

Key Leverage CalculationsNet Debt/EBITDAInterest Coverage = EBITDA/Interest Expense

Financial Statement Overview

Cash Flow Statement – Direct Impact on Balance Sheet

FCF = Net Income + Depreciation/Amortization -Changes in Working Capital and Capital

Expenditures

• Capital Expenditures = Maintenance or New Investmento Recurring vs Non Recurringo Depreciation vs Capex

• The Cash Dilemma: What to Do?o Management Needs a Well Thought Out Process for Assessing

ROICo Stock Buyback is Easy Answer but is it Best? o Buyback Often Signifies Slower Growtho High Correlation Between Incremental ROIC and Multipleso Common Stock or One-Time Special Dividend

Relative Equity Valuations

Relative Equity Valuations• P/E Ratios

• EV/EBITDA

• FCF

• Sum of the Parts

• CBS: A Case Study

Equity Valuations

Growth

ROIC

Diversification

Leverage

Fundamentals

Complexity

Valuation

Equity ValuationsThings to Think About:

• Think Before You Input; Watch for Straight Line Approach

• Fundamental Analysis Key …But Do Not Forget Technicals

• Keep Emotions Out of Equation; Let Data Speak

• Fighting Tides is Often a Lost Cause; Watch Valuation Trap Find a Catalyst or Unlock the Value

• Keep it Simple; Do Not Over Analyze

Equity Valuations

Relative Valuation

• Define Companies in Universe

• Understand Drivers of Business Model

• Analyze Prospects for Growth

• Financial Strength/Flexibility

• Other Industry/Company Specific Dynamics Economic/Macro Product Risks Sales Concentration Risk Political Risk Management Return on Invested Capital

Equity Valuations

Understand Industry Drivers• Earnings Drivers Vary By Industry

Retail – Comp Sales, Square Footage Growth

Media – Advertising Banks – Asset Quality Energy – Commodity Prices Industrial – GDP Technology – Supply/Demand Cycle Healthcare – Regulatory

Equity ValuationsExcess Leverage Could Impact Valuation

• Bankruptcy Risk Chapter 11 and Chapter 7

• Decreases Financial Flexibility Shareholder Value M&A

• Higher Borrowing Costs Equates to Lower Net Margins

• Limits Reinvestment; Creates Asset Drain

Key RatiosNet Debt/EBITDAInterest Coverage = EBITDA/Interest ExpenseDependent on Industry Dynamics – Cyclical vs. Stable

Equity ValuationsPrice/Earnings• Absolute• Relative• PEG• TTM Versus Forward -- Must Normalize for One Time Items• Normalized Earnings• Fully Diluted

Variables• Growth – Projected and Historical• Industry/Sector• Trading Liquidity• Management• Debt• Complexity: Structure, Financing, Accting, Businesses, Control,

10k Thickness

Equity ValuationsEV/EBITDA

EV = MV of EQ + Debt – Cash – Non Consolidated Assets (Hidden Assets)

EBITDA = Earnings Before Int., Taxes and Depreciation

Variables• Debt Levels/Balance Sheet• Growth – Projected and Historical• Industry/Sector/Risks• Capital Intensity of Sector/Amount of Reinvestment• FCF• Complexity

Equity ValuationsFree Cash Flow

FCF = Net Income +Depreciation/Amortization -Changes in Working Capital and Capital

Expenditures

• FCF Used to Determine Cash on Cash Returnso Cleaner than EPS/Measures Cash Creation

Uses• Reinvestment/Acquisitions• Debt Reduction/Stock Repurchase• Dividends – One Time or Annual

Key CalculationsFCF Yield = FCFPS / Stock PriceFCF Conversion = FCF / EBITDA

Equity Valuations

Sum of the Parts

• Break Up Value of the Company

• Used in Complex Multi-Industry Situations

• Accounts for Non Consolidated Assets

• Assists in Measuring Franchise and Brand Value

Example: AOL Time Warner(US$ millions) Ownership

Interest 2002A 2003E Multiple 2003EConsolidated Operations:Cable 2,745 3,047 EBITDA 11.0x 33,516Filmed Entertainment 1,232 1,387 EBITDA 12.0x 16,648Networks 2,032 2,265 EBITDA 15.0x 33,982Music 474 465 EBITDA 8.0x 3,717Publishing 1,155 1,172 EBITDA 9.0x 10,552Corporate (332) (363) EBITDA 11.7x (4,257)Intersegment Eliminations (47) (103) EBITDA 11.7x (1,213)Total $7,260 $7,871 11.7x $92,944

Unconsolidated Operations:Time Warner Telecom 44.0% 114 114 MM shs $6.80 per share 341Court TV 50.0% 75.0 80.0 MM subs $20 per sub 800Braves, Hawks, Thrashers 100.0% $725 $783 MM value 783Viva Media 30.6% $330 $363 MM value 111Cable joint ventures (a) 50.0% 1.5 1.5 MM subs $3,200 per sub 1,634Value of NOLs 2,784 2,575 2,575Total $6,244

Total Asset Value of AOL Time Warner $99,188

Less:Net debt $23,348Comcast's Minority Interest in TWC 5,337

Value to Common Shareholders $70,503

Total shares outstanding 4,555Value per AOL/ TWX share $15.48

Equity Valuations

Case Study: CBS

Back Drop:oSpin Off From ViacomoMature AssetsoHigh Free Cash FlowoStrong Balance SheetoComplex Asset

• How to Value?

Equity Valuations

Where do we start?

• Determine Universe

• Examine Business Composition

• Analyze Growth Prospects

• Are there Company Specific Risks? Industry?

• What is the View of Management?

• Should Brand Value be Taken into Consideration?

• How Does the Economic Outlook Impact Fundamentals?

• Is there a Dividend or Other Means to Enhance Shareholder Value?

• How Does Leverage/FCF Compare to Peers?

• Complexity/Accounting Concerns

Concluding Comments

• Valuation Screens Often Precede Fundamental Analysiso More Than One Methodology Usually Required

• Relative Valuation Methods Vary by Sector

• Stocks are Sometimes Cheap for a Reasono Sector Driveno Management Track Recordo Product Pipeline

• Combining Fundamentals with Valuation Helps Minimize Risk

o Good Companies Make Great Investmentso Bad Companies Make Poor Stocks

Markets are Inefficient….

Valuation is a Key Investment Tool!

Follow-Up Reading/Courses

1. Graham & Dodd Security Analysis

– The Bible!

2. You Can Be A Stock Market Genius, Joel Greenblatt

3. Stocks for the Long Run, Jeremy Siegel

4. Investment Valuation: Tools and Techniques,

Professor Aswath Damordaran

5. Think About Taking CFA

Q&A