Module I: Investment Banking and ValuationObjectivesLiquidation or Adjusted-AssetsComparables using Public FirmsExample of Comparables MethodValuation Matrix: P/E RatiosValuation: Price/Sales RatiosValuation: Market/Book RatiosCompare ResultsPitfalls in Comparables: IPitfalls in Comparables: IIPitfalls in Comparables: IIIAssessmentDCF ApproachesSlide 15Computing the Discount RateEquity Discount RatesDiscount RatesCAPMNext Week – September 9 and 11J. K. Dietrich - FBE 432 – Fall, 2002Module I:Investment Banking and ValuationSeptember 4, 2002J. K. Dietrich - FBE 432 – Fall, 2002ObjectivesUnderstand how investment bankers value firms–Liquidation or adjusted-asset value–Public comparables (multiples approach)–Discounted-cash-flow methods»WACC (entity) approach»Flow to equity (fundamental analysis) methods»Adjusted present value Compare and contrast these methods and understand advantages and limitations of eachJ. K. Dietrich - FBE 432 – Fall, 2002Liquidation or Adjusted-AssetsValue of equity in firm is simply:Equity = Assets – LiabilitiesA crude estimate of value is the book value of equity and is used as a reference (times book)Adjust assets for market value rather than accounting valuesAn adjusted estimate of equity value is:Equity = Adjusted Assets - LiabilitiesJ. K. Dietrich - FBE 432 – Fall, 2002Comparables using Public FirmsUsing comparables of publicly traded firms is very widely used by analysts (both buy and sell side)Often called multiples approachUses a combination of accounting and market numbers to value companies. Most common multiples are:–Price/earnings–Asset/sales–Market/bookJ. K. Dietrich - FBE 432 – Fall, 2002Example of Comparables MethodGreens Health Inc., a privately owned Supermarket chain has expected earnings of $20 million per year on sales of $205 million with total assets of $80 million.In a proposed IPO, Greens will issue 10 million shares so forecast EPS is $2 per share; the firm is all equity.Using data on suitable comparables, compute a valuation matrixJ. K. Dietrich - FBE 432 – Fall, 2002Valuation Matrix: P/E RatiosVons 18Safeway 19PE RatioComparables Implied Stock Price 3638Average18.5 37Using an average stock price of $37, firm value is estimated to be $25 10m = $370 million Source: Compustat (Wharton) Raios for 1995J. K. Dietrich - FBE 432 – Fall, 2002Valuation: Price/Sales RatiosVons .24Safeway .38P/S RatioComparables Implied Firm Value 49.2 77.9Average1.3 63.6Firm value is estimated to be $63.6 millionJ. K. Dietrich - FBE 432 – Fall, 2002Valuation: Market/Book RatiosVons 2.0Safeway 6.9M/B RatioComparables Implied Firm Value 160.0552.0Average1.3 356.0Firm value is estimated to be $356.0 millionJ. K. Dietrich - FBE 432 – Fall, 2002Compare ResultsRange of values is $63 to $360 millionWide differences in Vons and Safeways ratiosWhat are differences in firms and how do they affect comparability of valuations?–Vons has debt-to-asset ratio of .66–Safeway’s debt-to-asset ratio is .82–Both firms are highly leveragedP-E and P/B valuations are closer than P/S approachJ. K. Dietrich - FBE 432 – Fall, 2002Pitfalls in Comparables: IRemember when using P/E ratios that the estimated value is the value of equity, not firm value.Example: –Suppose Greens carried $114 million of debt. With equity of $250 million and debt of $114, firm value is now V = E + D = $364 million. –How does this affect value using P/S ratios?J. K. Dietrich - FBE 432 – Fall, 2002Pitfalls in Comparables: IIAre the comparables really comparable? Firms differ in many significant dimensions including–Growth rates–Cash flows–Risk (most obviously capital structure; note that Greens equity value was unchanged by the fact that it carried debt. Is this realistic?J. K. Dietrich - FBE 432 – Fall, 2002Pitfalls in Comparables: IIISuppose the unobserved true relation between stock price and earnings is Price = $9.00 + 12EPSFor Vons, say EPS =$1.50, so Price = $27 and P/E =18For Greens, we have value = $9.00 +12 x 2 = $33The multiples approach misprices by $4.00 or twelve percent of firm value -- other relations could be off more.J. K. Dietrich - FBE 432 – Fall, 2002AssessmentAdvantages–Quick, easy to understand, and widely usedDisadvantages–Based on accounting concepts–Ignores growth opportunities and future cash flows–Fails to account for differences in capital structureJ. K. Dietrich - FBE 432 – Fall, 2002DCF ApproachesAll DCF approaches discount cash flows by the appropriate discount ratesIngredients–Cash flow forecasts for future periods (the past is irrelevant)–An associated discount rate which measures the return on investments of comparable riskThree main approaches–WACC, APV, Flow to EquityJ. K. Dietrich - FBE 432 – Fall, 2002DCF ApproachesSimplest approach is to assume first-year cash flow and perpetual growth and discount ratesMore convincing approach is to use explicit cash flow projections over a forecast period and discount continuing value using simplest approach for cash flows after forecast periodgrFlowCashPVJ. K. Dietrich - FBE 432 – Fall, 2002Computing the Discount RateThe discount rate applied to these cash flows represents the opportunity cost of capitalIt can also be thought of as the expected or required return for an investment that is equally riskyJ. K. Dietrich - FBE 432 – Fall, 2002Equity Discount RatesUnlevered Cost of Equity (rA)–What the cost of capital would be if the firm had no leverage. –Depends on asset risk, but not not capital structure–Equals weighted-average cost of capital (WACC)Levered Cost of Equity (re)–Cost of equity capital at a given leverage. Clearly depends on asset risk and also on leverage.J. K. Dietrich - FBE 432 – Fall, 2002Discount RatesWe obtain discount rates for equity using a model of risk such as the CAPMCAPM states that the expected or required return on an asset the sum of two components–The risk free rate–A risk premium The risk premium is times the market risk premium, historically about 8%J. K. Dietrich - FBE 432 – Fall, 2002CAPMBeta measures the sensitivity of the stock’s return to the return on the market portfolio. Note that beta depends on the firm’s leverage. The Capital Asset Pricing Model states that the expected return on an asset isr r r rf m f ( )J. K. Dietrich - FBE 432 – Fall,
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