establishing a foundation. fin 591: financial fundamentals/valuation2 course focus valuation...

Establishing a Foundation

FIN 591: Financial Fundamentals/Valuation

2

Course Focus Valuation analysis What does the term “value” mean? Value to whom?

Where should the focus be to determine if value is created?

Any conflicts exist by focusing on value?


3

Management’s Objectives What is management’s objective?

Maximize sales? Maximize profit or EPS? Maximize market share? Maximize compensation? …


4

How is Shareholder Value Created?

Maximize firm value Firm value

= Market value debt

+ market value

equity Firm’s investments

& financing affect its value.


5

Competitiveness Competition matters and strategy is

important Competition comes in two basic forms:

Perfect competition Imperfect competition

Don’t confuse strategy and planning Planning: Ideas to make a product or service

and sell it profitability Strategy: Plans that focus on the actions and

responses of competitors.


6

Strategic Thinking About creating, protecting and

exploiting competitive advantages Perfect competition

No competitive advantage focus on costs

Tactical decisions; not strategic!!

Imperfect competition Exploit competitive advantages


7

Porter’s 5 Forces


8


9

$

Qty

Fixed costs

Variable costs

Total revenue

Breakeven AnalysisWhich cost structure is better?High fixed costs or high variable costs?


10

Economies of Scale Matter


11

Economies of Scale


12

Experience Curve Theory

Deflated costs

Total Accumulated Qty

Unit $

As output doubles, (deflated) costs decline linearly.

Plotted in log-log scale

Unit cost = Beginning cost x (n / no)

= -.51 Experience curve has slope = 70%

For manufacturing & distribution operations, costs should follow 70% curve. If constant costs aren’t declining 70-80% each time industry volume doubles, buyers are probably paying a premium for services which may or may not be of value to them.

Source: Perspectives on Experience (Boston Consulting Group, 1972)

no = beginning units; n = later units


13

Competition Demystified

Markets

Have competitive advantage Don’t have competitive advantage

Operate efficiently1 dominant firm 2+ dominant firms

Game structure/simulation

Prisoner’s dilemma entry/preemption

Cooperation/bargaining

You

Others

You exit

Manage competitive advantage


14

MVA & Productivity An earlier edition of the textbook

concluded: High labor productivity create more value

than low labor productivity Companies that create more value, create

more jobs.


15

Why Use Multiples P/E & price-to-sales ratios used

frequently in valuation applications Quick and convenient Relies on a scaled average price of similar

firms to estimate value Fails to specify why prices are what they

are Agnostic about what determines price

See: Reference book by Barker

Highlights shortcomings of PE ratio Valuation textbook: Chapter 12.


16

Justification for P/E? Dividend growth model

Current price = Dividend next period / (r - g)Current price = Payout ratio * current EPS * (1 + g) / (r - g)

Divide both sides by “current EPS”P/E = Payout ratio * (1 + g) / (r - g)

P/E ratio depends on: Constant payout ratio Constant income growth Constant discount rate

Incorporates both business risk and financial risk.


17

Playing PE Games Acquirer: PE = 25; NI = $1 mill.; shares = 1 mill. Target: PE = 10; NI = $100k; shares = 100k Exchange ratio = 1 share acquirer for 2 shares

target New EPS = ($1 mill. + $100 k) / 1.050 mill. shares

= $1.05 vs. $1 before acquisition If PE of combined firm = 25; new price = $26.25 vs.

$25 Moral:

Larger firm can offer smaller firm a significant premium and still have its EPS and stock price increase

Where’s the economic value added?


18

P/S Multiplier Price / sales per share

Assumes operating characteristics have the same relation to sales for all firms

Problems: Doesn’t reflect differences in efficiencies Doesn’t reflect differences in capital

investments Doesn’t reflect differences in growth prospects

Relationship to P/E ratio Price / earnings = Price / (ROS% * sales) Price / sales = ROS% * (Price / earnings)

So what?


19

A Simplified Valuation Model

Assume a firm with no growth opportunitiesMarket value of the firm

= Corporate ROIC * book value of assets Required market rate

Example:A company earns 15% rate of return on its $50 million capital. The required market rate of return is 12%. What is the firm’s value?

Answer: .15 * $50 M / .12 = $62.5 M If ROIC = 9%, value = $37.5 M.


20

Present Value of Growth Opportunities

PVGO =Investment * Investment’s ROICRequired market

rate Example:

PVGO = $1000 * .15/.12

= $1250 If ROIC is 10%, value

= _______.


21

Growth and Value Growth is only valuable if:

Return on invested capital (ROIC) > WACC NPV > 0

If ROIC = WACC Growth neither creates nor destroys value

NPV = 0

If ROIC < WACC Growth destroys value

NPV < 0.


22

A Long-Term View True value improvement comes from

management following a long-term investment strategy

LVI = (1 - dividends for next 5 years ) * 100 Current stock price

Provides estimate of investors’ confidence in management to sustain a long-term competitive advantage in its markets

Look at Exhibit 4.9 in Valuation text Dividends have been discount, contrary to the

above formula.


23

EXHIBIT 4.9 PRESENT VALUE OF EXPECTED DIVIDENDS* FOR SELECTED S&P 500 COMPANIES

*Assuming 7% growth in dividends during next 5 years. Cost of equity based on risk free rate of 4.3%, market risk premium of 5.0% and Bloomberg beta

Source: Bloomberg; McKinsey analysis

Present value of dividends expected over the next 5 yearsDollars

Abbott LaboratoriesBoeingCampbell SoupDow ChemicalEli LillyFord Motor CoGilletteHewlett-PackardInternational Business MachinesJohnson & JohnsonKelloggLockheed MartinMcDonald'sNew York TimesOccidental PetroleumPepsiCoRohm & HaasSears RoebuckTexas InstrumentsUnited Parcel ServiceWal-Mart Stores

Dividends as percentageof stock pricePercent

4.973.383.236.666.731.903.361.523.044.805.263.071.982.925.453.204.234.610.404.731.82

Share priceDollars

43.5942.1426.8041.5770.3316.0036.7322.9792.6851.6638.0851.4024.8347.7942.2446.6242.7145.4929.3874.5553.05

11.48.0

12.116.0

9.611.9

9.26.63.39.3

13.86.08.06.1

12.96.99.9

10.11.46.33.48.7Average


24

Is the Market Price Correct?

Are financial markets efficient?

Information is reflected in prices immediately

Firms should expect to receive fair value for securities they sell

Financial managers can’t time issues of bonds and stocks

Securities markets can’t be affected by management “cooking the books”.


25

Efficient Markets and the Information Set

All informationrelevant to a stock

Information setof publiclyavailableinformation

Information set ofpast prices


26

Evidence

Academic studies generally supportive of weak form and semi-strong form EMH

Evidence to the contrary exists Fads in stock prices Seasonalities

January effect, day-of-the-month & week effects

Others P/E effect, moving averages

How can EMH explain October 1987 & 1997?


27

EXHIBIT 4.8 MARKET REACTION TO PHARMACEUTICAL PRODUCT ANNOUNCEMENTS

Source:Datastream; Factiva; McKinsey analysis

Abnormal returns percent, 1998-2003

Lilly-Zovant

AstraZeneca-Nexium

Lilly-Evista

Wyeth-Enbrel

Wyeth-Protonix

Abbott-Humira

Pfizer-Zeldox

NovoNordisk-Ragaglitazar

Schering-AngeliqNovoNordisk-LevormeloxifeneBMS-Vanlev 2

AstraZeneca-Iressa

BMS-Vanlev 1

Developmentsuccesses(e.g., approvals)

Developmentsetbacks(e.g., withdrawals)

Announcement return -1/+1 day

Announcement return -3/+3 days

(6.4)

(12.3)

(12.6)

(15.5)

(16.4)

(19.2)

(25.5)

7.9

8.6

11.1

11.8

12.0

14.8

(1.4)

(13.7)

(10.0)

(7.7)

(18.4)

(20.3)

(24.9)

5.0

4.6

2.3

10.8

8.3

14.1


28

EXHIBIT 4.10 NO CLEAR IMPACT OF U.S. GAAP RECONCILIATIONS

Source: SEC filings; Datastream; Bloomberg; McKinsey analysis

Average cumulative abnormal return (CAR) index

Positive earningsimpact (n = 16)

Negative earningsimpact (n = 34)

CARt-Stat

(0.5%)(1.54)

1.7%14.63

CARt-Stat

-1/+1

Day relative to announcement

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30

110108

106

104

102

10098

96

94

9290


29

EXHIBIT 4.11 NO CONSISTENT MARKET REACTION TO SFAS-142 GOODWILL ANNOUNCEMENT

Source: Datastream; McKinsey analysis

Abnormal return on announcement datePercent

Goodwill amortization as percent ofyear end equity market value, 2001


30

Average

Time Warner

CARt-Stat

0.1%0.3

-1/+1

Day relative to announcement

EXHIBIT 4.12 MARKET REACTION AT ANNOUNCEMENT OF GOODWILL IMPAIRMENT

Source: SEC filings; Datastream; Bloomberg; McKinsey analysis

Cumulative abnormal return (CAR) index, n = 54


31

Impact of option expense on pre-tax income(percent)

EXHIBIT 4.13 VOLUNTARY OPTION EXPENSING HAS NO IMPACT ON SHARE PRICE

*Defined as the absolute value of option expense divided by the pre-tax earnings before option expense

Source:SEC Filings; Datastream; Bloomberg; McKinsey analysis

Abnormal return on announcement date (percent)

Summary statisticsn = 120R2 = 0.4%Slope = 0.01t-Stat = 0.7P-value = 47.1%


32

EXHIBIT 4.14 EFFECT OF INVENTORY ACCOUNTING CHANGE ON SHARE VALUE

Source: S. Sunder, “Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,” Empirical Research in Accounting: Selected Studies, 1973

Cumulative abnormal return, months from date of accounting changePercent

110 firms switching to LIFO 22 firms switching from LIFO


33

0

10

20

30

40

50

60

Dec-98 Jun-99 Dec-99 Jun-2000 Dec-2000

EXHIBIT 4.15 MARKET VALUE OF 3COM COMPARED TO THE VALUE OF PALMONE OWNERSHIP BY 3COM

$ BillionFuture separation announced

5% carve-out

Full spin-off

Source: Datastream


34

EXHIBIT 4.16 SHARE PRICE DISPARITY OF DUAL-LISTED COMPANIES

Relative difference in valuationPercent

Royal Dutch Petroleum NV relative to Shell T&T PLC

Unilever NV relative to Unilever PLC

-40

-30

-20

-10

0

10

20

30

40

50

Jan-73 Jan-83 Jan-93 Jan-03Source: Datastream

-40

-30

-20

-10

0

10

20

30

40

50

Jan-73 Jan-83 Jan-93 Jan-03


35

Can Fundamental AnalystsBeat the Market?

Based on belief that stock market values reflect economic values

Fundamentalists also believe that there is publicly available info that allows them to form better estimates of value than contained in market prices

Price = Dividend1 / ( 1 + r) + Dividend2 / (1 + r )2

+ … Why isn’t the info reflected in the price?


36

The End

establishing a foundation. fin 591: financial fundamentals/valuation2 course focus valuation...

Documents

firm value firm value

foundation slide

shareholder value

term value mean

competitive advantage

high fixed costs

high variable costs

important competition