Download Calculating the Valuation Inputs for Firms With Financial Data

Complex Valuation - Amazon
1.
Most of the spreadsheet involves calculating the value
of the equity (the stockholders value) using the
Discounted Free Cashflow Method (DFCF).
a. He finds the total value of the firm (Amazon).
b. Then he subtracts the pieces of value that get paid
to others, such as bondholders and managers (through
their options).
2.
Part of the spreadsheet involves calculating the value
of the equity using the relative valuation method of
Price-to-Sales.
3.
Basic Steps for DFCF – Firm Value
a. Estimate the discount rate or rates.
b. Estimate the firm’s free cashflows from operating
assets during a period of years of unusual
circumstances including high unstable growth.
c. Estimate the year when cash flows will have stable
growth forever afterward – for Amazon – year 10.
d. Apply the appropriate discount rates to the
appropriate free cash flows. For Amazon, the first 9
years have high and sometimes changing discount
rates that decline and then remain fixed.
The fixed rate and constant growth cashflows after year
10 allow a “residual value” of cashflows to be valued
using the constant growth model P = D/(K – g).
This “residual value” is then discounted back over the
10 years using the cumulative discount rate.
4. Main Results
a. The large negative cash flows in the early years
don’t impact the value that much because they last
for a limited number of years.
But, much effort goes into calculating them.
b. Much of the value comes from the stable growth
after year 10.
The inputs to this part rely partly on the first 10
years.
Slight changes to the inputs, particularly growth,
make for large changes in value.
This illustrates why the market valuation of companies like
Amazon can be way off and why the stock price can be
volatile if peoples perceptions of these input changes
frequently.
Since many companies themselves have no idea what inputs
such as growth will be even a year or two in the future, it is
not surprising that stock investors make mistakes.
c. Growth rate depends upon
- firm size relative to market size
- barriers to entry – sustainable advantage - margin
- current growth
Topic: How to value young, high-growth firms when they have
no earnings, no financial history or comparable firms.
Basic Solution: Value the firm 10 years in the future assuming
some rough convergence to comparable industry free cash
flow to the firm (FCFF) using FCFF/(k-g).
Calculating the Valuation Inputs for Firms With Financial
Data
1. FCFF - is the cash available to the firm after taxes and
reinvestment needs required to sustain growth.
FCFF = EBIT(1-T) - (CE - D) - (NCWC)
Where EBIT = earnings before interest and taxes - also
called operating income.
T = marginal tax rate
CE = Capital Expenditure
D = depreciation
 NCWC = Change in non-cash working capital
NOTE: EBIT(1-T) is used instead of EBT(1-T) because the
cost of capital (debt) used to discount FCFF is after-tax.
2. g = RR * ROC
Where
g = Expected Growth in EBIT
RR = Reinvestment Rate = (CE - D + NCWC)
ROC = Return on Capital = EBIT(1-T)/capital invested
3. Cost of capital = k = ke[E/(D+E)] + kd[D/(D+E)]
Where
ke = cost of equity
kd = after-tax cost of debt
E = market value of equity
D = market value of debt
4. Terminal Valuen = FCFFn+1 / (kn - gn)
This value is discounted back n years at the appropriate k that
covers the first n years, usually 10 years.
Although first ten years FCFF is estimated and discounted,
value comes largely from value after 10 years for the young
firms of interest here. All inputs should be sustainable rates.
5. For the total firm value add the value of cash (C),
marketable securities (MS) and other assets whose income is
not consolidated in operating income (NOA).
6. Firm Value = C + MS + NOA +
FCFF


(1  k ) k
n
t
t 1
t
t
n  1
FCFF
 g  (1  k )
t  1
n
n
t
t 1
Note: We allow for different k in each of the first t years.
7. Equity Value = Firm Value - Debt Value
8. Equity Value Per Share
= [Equity Value - Options Value]/ Shares Outstanding
9. Options value comes from management options, warrants
and convertible debt or preferred.
Typical Methods to Handle Problems
1. Negative earnings - Use Normal Earnings
A. Past average over cycle - adjust for increase in scale if
growth will occur in future
B. Estimate normal operating or net profit margins
or use prior years’ average or industry average and
apply to revenue (which is never negative)
C. Estimate normal ROC or use industry average and apply to
invested capital.
D. Reduce leverage over time - if negative earnings due to
financing costs. Assume debt ratio goes to optimum (at lowest
k) or use industry average.
-assume firm reduces future investment to pay
down debt, issues equity to pay down debt or grows
to scale that can support current debt.
2. Note: In all cases if earnings are expected to normalize
after some lag, not immediately, then estimate future normal
earnings and discount back to present.
Typically, the farther away current figures are from normal
figures, the longer it is assumed to take until convergence to
normal figures. If large growth is expected, then convergence
may be quicker.
3. To handle tax effects of net operating losses (NOL), get PV
of NOL = NOL(T)/(1+r)n where n is the year into which the
losses are carried.
4. When should normal earnings be used?
- when losses are transient - or cyclical.
- use profitability and current revenues or capital to estimate
normal earnings when scale of firm is changing.
- long-term operational/structural problems - require adjusting
margins to sustainable levels - industry average of stable
firms. If problems seem insurmountable - consider bankruptcy
so no value (or perhaps option value).
Young Firms With No History or
Apparent Comparable Firms
1. Get data from firms as similar as possible even if not
directly comparable.
- Similar businesses - Amazon - retailers/booksellers.
- Richness of information - more data on retailers than
booksellers.
- Life cycle similarity - data from retailers shows us how
margins and revenue change with age. This can be used to
project similar changes for a young firm - this is unavailable if
we select an industry with only young firms.
2. Expected Revenue Growth alternatives
- use most recent 12 months growth for firm
- growth for market the firm serves
- sustainability depends on barriers to entry or competitive
advantages
3. Sustainable Operating Margin
- examine true competitors - Amazon - Specialty retailers
- adjust firms own negative margins by removing research,
development and advertising that are unusually high but must
be expensed rather than capitalized by GAAP.
4. Reinvestment Needs - steady state
- RR = g/ROC - all figures for steady state (see earlier)
- assume RR growth = revenue growth
- assume converges to RR = industry average RR
A. Then get $reinvestment = RR*current $Capital
B. Or use $reinvestment = $Revenues/ (S/C)
where S/C = Revenues/ Capital
5. Risk
- estimate beta from financial characteristics
- use industry average (internet firms) or assume convergence
to industry average (specialty retail) in future.
6. Estimate ke with CAPM and beta
7. Estimate kd with rate for bond rating - use 0 tax rate for loss
period, carry-forward period and then apply full tax rate.
8. Use convergence to industry average capital structure
D/(E+D).
9. Use compound cost of different yearly capital costs in later
years which converge to stable rate for terminal value.
Final Value
1. Firm Value = C + MS + NOA +
FCFF


(1  k ) k
n
t
t 1
t
t
n  1
FCFF
 g  (1  k )
t  1
n
n
t
t 1
2. Equity Value = Firm Value - Debt Value
3. Equity Value Per Share
= [Equity Value - Options Value]/ Shares Outstanding
4. Perhaps adjust equity value for probability of default.
Adjusted Equity Value Per Share = (Equity Value Per Share) *
(1-default probability)
5. The most important value drivers are
- sustainable margins
- revenue growth
- important but less - convergence time, reinvestment needs
Other Considerations
1. To deal with the uncertainty in pricing young firms consider investing in a portfolio of those you find undervalued
rather than the most undervalued -you could be mistaken on
the one- I.e. diversify.
2. Valuation shows what type of assumptions are required to
justify market price - assumptions may seem reasonable or
not.
3. Earnings growth obtained by cutting investment below that
required to remain competitive and sustain future earnings
may be misleading.
4. Comparables methods are popular because they are often
easier to apply but actually implicitly rely on the same
assumptions as the FCFF method. The FCFF method makes
the assumptions easier to see and judge for reasonability.
For young firms, many get comparable ratio out 5-10 years
and discount price back.
Main problem: if all firms in comparable group are under or
over-valued then results are bogus.