Firm valuation (2) Class 7 Financial Management, 15.414MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Today Firm valuation x Free cashflows x Profitability, financial ratios, and terminal value Reading x Brealey and Myers, Chapter 12.4 – 12.6 x Wilson Lumber Co.MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Firm valuation Two approaches Focus on cashflows to equityholders Equity = PV of dividends Useful with moderate growth, constant payout ratio Focus on cashflows generated by assets Assets = PV of free cashflows More general, because cashflows may not be paid out Equity = assets – debt 3MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Balance sheet Assets Liabilities and EquityCurrent Assets Fixed Assets assets 2. Intangible 1. Tangible fixed fixed assets Current Liabilities Long-Term Debt Shareholders’ Equity Value = PV(FCFs) Value = Debt + PV(divs) 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 FCF approach Asset value PV of assets = FCF1 1 r  FCF2 r)(1 2  ...  FCFH r)(1 H  value Term. r)(1 H Free cashflow Cash generated by the assets after all reinvestment FCF = EBIT (1 – W) + depreciation – 'NWC – CAPX FCF = EBIT (1 – W) – 'Net assets FCF = Operating cashflow (before interest) – CAPX 5MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Working capital Assets Liabs. and equity Current assets cash accounts receivable inventory Long-term assets equipment buildings land intangibles Current liabilities accounts payable bank loans bonds Equity common stock retained earnings Net assets = Total assets – current liabilities (excl. s-t debt) Long-term debt 6MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Sustainable growth Growth 16% 12% 8% 4% 0% 1.0% 5.0% 9.0% 13.0% 17.0% 21.0% 25.0% Cash deficits g > g* Plowback 30% Plowback 70% Cash surpluses g < g* Return on equity 14MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Sustainable growth Forecasting Long-run growth = sustainable growth Faster in the short run, but not forever Forecast must be internally consistent Growth forecasts should be consistent with payout policy and profitability CitiBank financial goals, 1988 Growth: 15% ROE: 18% Payout: 30% Leverage ratio (debt / assets): 95% Are these goals feasible? 15MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Time Warner, 1989 Warner Communications ($ million) Cashflow projections 1989 1990 1991 1992 1993 1994 Oper. income $770 893 1,145 1,320 1,482 1,655 Taxes -193 -246 -458 -528 -593 -662 After-tax income 577 647 687 792 889 993 Depreciation 228 245 270 271 271 273 Deferred taxes -7 0 172 198 222 248 CAPX -336 -225 -180 -177 -183 -188 ' in NWC 5 -80 -80 -80 -80 -80 Miscellaneous -416 -15 -5 -3 -3 -3 Free cashflow $52 572 863 1,001 1,117 1,243 Source: Lazard Freres (advisor to Warner) 16MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Time Warner Firm valuation Discount rate = 11.5% FCF1 FCF2 FCF3 FCFH value Term. Firm value =    ...   1 r (1 r)2 (1 r)3 (1 r)H (1 r)H 52 572 863 1,243 T.V. =    ...   1.115 1.1152 1.1153 1.1156 1.1156 Equity value = Firm value – Debt ($970 million) Terminal value three ways Constant growth Multiples (financial ratios of comparable firms) NPVGO 17MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Terminal value 1 Constant growth Forecasted growth after 1994 = 5% 243,1 u 05 . 1 Terminal value = FCF1995 = $20,079 million r  g 115. 0  05 . 0 Is the forecast internally consistent? Projected earnings = $993; projected book equity = $5,055 Reinvestment = CAPX – Depr. + 'NWC = 188 – 273 + 80 = –$5 million g* = ROE u plowback = (993 / 5,055) u (-5 / 993) = 0% 18MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Time Warner, 1989 Warner Communications ($ million) Cashflow projections 1989 1990 1991 1992 1993 1994 Oper. income $770 893 1,145 1,320 1,482 1,655 Taxes -193 -246 -458 -528 -593 -662 After-tax income 577 647 687 792 889 993 Depreciation 228 245 270 271 271 273 Deferred taxes -7 0 172 198 222 248 CAPX -336 -225 -180 -177 -183 -188 ' in NWC 5 -80 -80 -80 -80 -80 Miscellaneous -416 -15 -5 -3 -3 -3 Free cashflow $52 572 863 1,001 1,117 1,243 Source: Lazard Freres (advisor to Warner) 19MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Terminal value 2 Financial ratios Multiples of comparable firms P/E ratio Price-to-cashflow Price-to-sales Market-to-book equity Determinants of P/E and M/B 1 ª price º P/E u «r ¬price  NPVGO¼» Higher if NPVGO is large payoutM/B = (r / ROE)  plowback 20MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 P/E ratios, Dec. 1998 350 300 250 200 150 100 50 0 0 4 9 13 18 22 27 31 36 40 45 49 All U.S. stocks Histogram P/E ratio 21MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 B/M ratios, Dec. 1998 800 700 600 500 400 300 200 100 0 -0.5 -0.1 0.3 0.7 1.1 1.5 1.9 2.3 2.7 3.1 Histogram All U.S. stocks B/M ratio 22MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Terminal value 2 Financial ratios P/E ratio Comparables P/E = 18 Earnings1994 = 993  Terminal value = 18 u 993 = $17,874 M/B ratio BVComparables M/B = 2.79 1994 = 5,055  Terminal value = 2.79 u 5,055 = $14,103 23MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Terminal value 3 Zero NPVGO How much will Warner be worth if its competitive advantage is eliminated by 1994? (Sustainability question in strategy) NPVGO = 0  Value = EPS / r Earnings1994 = 993 Terminal value = 993 / 0.115 = $8,635 24MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Time Warner Debt = $970 million 52 572 863 1,243 T.V. Firm value =    ...   1.115 1.1152 1.1153 1.1156 1.1156 Terminal Firm Equity Per Approach Value Value Value Share Constant growth $20,079 P/E 17,874 M/B 14,103 Zero NPVGO 8,635 $13,522 $12,552 $65.89 12,374 11,404 59.86 10,412 9,442 49.56 7,566 6,596 34.62 Actual offer = $70 / share 25MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 7 Time Inc. stock price, 1989 $190 180 170 160 150 140 130 120 110 100 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec