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Introduction to Equity Valuation

Chris Argyrople, CFA

Concentric LLC

Enterprise Valuation &

Cash Flow Analysis

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Today in the Financial Markets(1998)

• Hollywood Entertainment had a tender offer for $11 / share that fell through.

• Not enough investors wanted to sell at the $11 price

• What happened ???• The stock fell 20% to close at $8.8125 !!

• DOES THIS MAKE SENSE ?? ARBs Unwinding ??

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Today in the Markets, 9/15/98

• Dow rose above 8,000 again, nobody knows where it will go next.

• Port Mgr: Likes Rainforest Café (RAIN)

• Stock closed at $6 5/16

• He says $3 net cash

• 98 EPS estimate is $0.75

• Is it a screaming buy???

• Feb 1, 1999 Price $ 5 7/8

• STOCK ULTIMATELY FELL TO $1

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M&M’s Theory

• The Value of An Asset is Independent of How it is Financed

• Example: Buy a $300,000 house. At closing, the seller just wants a certified check for $300,000. He doesn’t care whether the money came out of your passbook account or whether you wrote a mortgage.

• This logic holds for all assets

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Modigliani & Miller (M&M)

• M&M Postulated that, “Capital Structure Does Not Matter”

• Do you Agree?? Why or Why not?

My View:

• At any instant, CS DOESN’T MATTER

• But, as time horizon lengthens, CS DOES Matter.

• Debate??

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P/E Ratio can be Misleading

Company A & B

are Identical

Identical:

Assets, CashFlow,

Growth Rates

P/E’s:

A = 15.0 , B =8.5

A B Income Statement

Revenue 250.5 250.5 COGS (133.7) (133.7) SG&A (26.0) (26.0) Depreciation (34.1) (34.1)

Operating Income 56.7 56.7

Interest Expense/Inc. (1.0) (45.0)

PBT 55.7 11.7 Taxes (22.3) (4.7) NI 33.4 7.0

Memo:Debt 10 450Stock Market Value 500 60

Enterprise Value 510 510

P/E Ratio 15.0 8.5

Company

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Why P/E is Misleading

• Why is P/E Misleading? Comments?

• Why doesn’t Interest Expense properly account for associated cost of the debt?– Capitalized Interest– Yield Curve: ST Debt vs. LT Debt

• This is part of it, but:

• Cost of Debt NOT = Cost of Equity– You can’t compare Apples & Oranges

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So, is B Cheaper than A?

• Which firm’s stock is cheaper, B or A?• My answer: B is cheaper (lower P/E), but A

is probably a better equity investment.• A is less risky, throws off more free cash

flow, and has less constraints (less debt)• B’s debt constrains its choices, and if

something goes wrong, B gets hammered• Debt can make managements either: Very

Aggressive OR Very Risk Averse

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Enterprise Value

• Total Enterprise Value (TEV) = Firm Value

• TEV = Debt + Equity - Cash– Use Market Values, NOT Book Values, but, it

is ok to use Book Debt as a Proxy for Market Debt (usually)

– Measures the value of the entire company, independent of capital structure.

– This is the right way to do it. Any arguments??

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Why Subtract Cash from TEV?

• Cash is not really part of the business, it is portable & fungible

• It can be used to pay down debt (same as subtracting off cash from TEV)

• It can be dividended to equityholders (same as subtracting cash from TEV)

• IMAGINE A SHELL COMPANY WITH ONLY CASH, WHAT IS THE COMPANY WORTH? This is why you subtract cash.

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More Sophisticated TEV

TEV = Debt + Equity - Working Capital

• If there is extra working capital, it may make sense to subtract off the WC

• This technique is difficult to implement because companies require a certain amount of WC to sustain operations, so it is difficult to ascertain how much to subtract. Subtracting WC is sophistic.

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TEV Trick

• Subtract Working Capital when it is Negative

• Why? Because negative Working Capital usually requires additional funding, thus diluting current stockholders (somehow)

• Subtracting a negative is equivalent to adding the Working Capital to TEV

• When WC < 0, it would be kind of erroneous to subtract cash (wrong way)

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Valuation: Operating Cash Flow

• How do we value a company using TEV?

Answer:

• Compare Enterprise Value to Operating Cash Flow

• EBITDA = Earnings Before Interest TaxesDepreciation & Amortization

• EBITDA = Operating Cash Flow

• EBITDA = Operating Income + NonCash Charges

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What is EBITDA?

• EBITDA is the Cash Flow thrown off by the underlying business

• Because it is before Financing Charges, Taxes, and Accounting Choices it is more difficult for management to “game.”

• Obviously, EBITDA is still subject to Revenue Recognition and Inventory Accounting issues

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Why EBITDA is Better

• EBITDA is not Subject to acceleration of Depreciation or Amortization

• EBITDA is not affected by Capitalized Interest

• EBITDA is not altered by Capital Structure• EBITDA is not subject to Tax tricks

• It is a cash flow measure, and businesses are propelled by cash

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Valuation: TEV & EBITDA

• Use TEV / EBITDA as one of your primary metrics.

• Low TEV / EBITDA ratios are good

• TEV / EBITDA = measures the value of entire business vs. the operating cash flow

• Better Apples to Apples Comparison than: P/E, P/Book, and Price/Revenue ratios

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Key Valuation Points

• Ratios like P/E are of little value by themselves. They must be compared to similar firms to identify “Relative Value”

• Growth Rate drives Valuations, if this is not the case, then you have a mis-pricing

• Estimating Growth Rates is very difficult, Very Difficult if not Impossible.

• So, what do you do?

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Valuation: Cash Flow Ratios

• TEV / EBITDA = Firm Value to OCF

• TEV / Revenue = Firm Value to Revenue

• EBITDA / Sales = Cash Flow Margins

• MV Equity/FCFE = “Real” P/E, Free Cash Flow (FCFE) Mult.

• EBITDA / Interest = Interest Coverage

• Debt / EBITDA = Leverage Indicator

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Asset Valuation

• Asset Value = PV(cash flows)

• Cash flows are independent of financing,

BUT• Financing can dominate the Enterprise

Value of a company

• What does this Mean???

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FREE CASH FLOW

• Above all: FREE CASH FLOW IS KING• (if you could predict growth, then growth

would be King)

• Free Cash Flow to Equity = FCFE

• FCFE = NI + Depreciation & Amort - Capex

• NI = Net Income

• Capex = Capital Expenditures

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How Free Cash Works

Balance Sheet

Year 1 Year 2

Cash 10 10

Other Assets 400 400

Total Assets 410 410

Debt 65 35 Debt

Other Liab & Eq. 345 375 O.E.

Free Cash Flow 30

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Back to Company A & BIncome Statement Year 1 Year 2 Year 3 Year 4 Year 1 Year 2 Year 3 Year 4

Revenue 250.5 250.5 250.5 250.5 250.5 250.5

COGS (133.7) (133.7) (133.7) (133.7) (133.7) (133.7)

SG&A (26.0) (26.0) (26.0) (26.0) (26.0) (26.0)

Depreciation (34.1) (34.1) (34.1) (34.1) (34.1) (34.1)

Operating Income 56.7 56.7 56.7 56.7 56.7 56.7

Interest Expense/Inc. (1.0) 0.5 1.6 (45.0) (45.6) (46.2)

PBT 55.7 57.2 58.3 11.7 11.1 10.5

Taxes (22.3) (22.9) (23.3) (4.7) (4.4) (4.2)

NI 33.4 34.3 35.0 7.0 6.7 6.3

Capital Expenditures (47.0) (47.0) (47.0) (47.0) (47.0) (47.0)

Free Cash Flow 20.5 21.4 22.1 (5.9) (6.2) (6.6)

Beginning of Year B/S:

Cash - 10.5 31.9 54.0 -

Debt 10.0 - - - 450.0 455.9 462.1 468.7

Stock Market Value 500.0 520.5 541.9 564.0 60.0 54.1 47.9 41.3

Enterprise Value 510.0 510.0 510.0 510.0 510.0 510.0 510.0 510.0

P/E Ratio 15.0 15.2 15.5 8.5 8.1 7.6

Stock % Return 4.1% 4.1% 4.1% -9.8% -11.5% -13.8%

A B

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Free Cash Improves the B/Sheet

• In the Example, Free Cash of 30 can be used to:– PAY DOWN DEBT A GOOD THING– INCREASE CASH A GOOD THING– DIVIDEND PAYMENT A GOOD THING– ACQUISITIONS A GOOD THING– SHARE BUYBACK A GOOD THING– UPGRADE PP&E A GOOD THING – NEW PROJECTS A GOOD THING

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If Free Cash was -30

• After dipping into cash of 10, THE COMPANY WOULD HAVE TO COME UP WITH THE OTHER 20 !!! HOW?– BORROW MORE A BAD THING– ISSUE EQUITY A BAD THING– GO BANKRUPT A BAD THING– SQUEEZE WORKING CAP. A BAD THING– SELL ASSETS A BAD THING– CUT DOWN CAPITAL EXP. A BAD THING

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Argyrople Intro. Rule of Thumb

Buy Stocks: Positive Free Cash Flow

Short Stocks: Negative Free Cash Flow

You wouldn’t believe how many people don’t understand this.

This is a simple rule that will keep you out of some trouble.

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Assuming No Valuation Change (TEV)

• With No Valuation Change, Free Cash Flow is what determines the change in stock price. This is a simple concept, but most students don’t understand it.

• Company A & B are Identical from the OCF line up, but due to capital structure, A’s stock rises & B’s stock falls.

• I DON’T BELIEVE M&M EXPLAINS THIS PROBLEM

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M&M was Right & Wrong

• In our No-Growth example, Capital Structure does not affect the value of the assets (partially because the positive free cash flow firm builds cash & does not add to assets)

• Enterprise Value stays constant BUT

• Stock of Positive FCF firm Rises• Stock of Negative FCF firm Falls

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Thus, Modified M&M

• At any point in time, Capital Structure does not matter -- Value of the Assets is Independent of Financing

• Over time, Capital Structure does matter for stockholders AND it is important to the total enterprise value of the firm too (because eventually the stock of firm B will be wiped out) -- Cash Flow thrown off by Assets is altered by Financing