In this example, we’re going to go through

six separate steps. First gather the income statement, the balance

sheet and the statement of cash flows. The original financial statements issued by

the firms are quite large and contain a lot of infomation. We’re going to simplify and reorganise the

financial statements to make them more suitable for valuation purposes. Then, we’re going to analyse the historical

performance of the companies by using key financial ratios. These ratios will tell us how profitable the

company has been and how fast the revenues have been growing. We will use this information as the basis

for forecasting future cash flows. We will use a multi-stage model, whereby we

make detailed cash flow forecasts for an interim transition period. And we also make some assumptions about the

steady state period. Discounting these cash flows will give us

the intrinsic value of the equity. As our example firm we will use Tesla Motors. This is a manufacturer of electrical cars. First, we collect the income statement for the last three years. Then, we collect the balance sheet for Tesla for the last three years. This is the asset side. And the liabilities and equity side of the balance sheet. Then we collect the cash flow statement. While we’re not going to use this statement extensively, it provides some information that was missing from the other statements. Especially, the depreciation and CAPEX. We can simplify the income statement a bit to make it more manageble. This table contains the main items we looked at in the lecture on financial statements, for valuation purposes, and for the forecasting of futures cash flows, we will be focussing on two of the items , the revenues and the earnings before interest and taxes, the EBIT. These two items represent the basis for forecasting future free cash flows for the firm. The balance sheet has also been simplified a bit. Unfortunately, as we discussed in the financial statement lecture, the standard way of presenting the balance sheet might not be appropriate for valuation. A better approach is to reorganise the balance sheet so it better reflects the operational and financial assets and liabilities Following the same approach we used in the financial statement lecture, we arrive at the following reorganised balance sheet The left hand side consists of net working capital and net fixed assets. The right hand side consists of the net interest bearing debt and the equity. A key issue is how to forecast the future cash flows. We want to use the free for the firm approach The free cash flow for the firm is calculated using this expression. But how do we estimate the future EBIT? How do we estimate the depreciation? The capital expenditures (CAPEX)? And investment in net working capital? The approach we’re going to use involves using financial ratios A driver of the growth rate in cash flows will be the growth rate in revenues We’re going to use revenues as the basis for calculating the other parts of the free cash flow equation We will estimate EBIT using the EBIT margin (the operating margin), which is the operating income divided by the revenues We will do the same for all the other ratios we will be using. Investment divided by revenues, net working capital divided by revenues, and depreciation divided by revenues The rationale for this approach is that in order to grow, the company needs to grow revenues, and in order to support, or maintain the revenue growth, the company needs to invest in both fixed assets and working capital. The amounts of profits (EBIT), we also model as a function of the revenues. There are other, more complicated, ways of forecasting the cash flows, but the revenue approach we will go through is quite intuitive and and simple to use. We start with the revenue growth. We collect the revenues for the last three years, and calculate the annual growth rate. We see that the growth in the first year was nearly 60%, which fell to 26.5% in the second year. This suggests that the growth in revenues is the declining. It therefore makes sense to forecast a falling revenue growth also going forward. We assume that the growth rate falls every year until it reaches a steady-state phase. From this year onwards, the growth rate is assumed to be 2.5%. The choice of the growth in the steady-state period must be lower or equal to the assumed growth rate of the economy. for example measured by the GDPgrowth It does not make sense to have a growth rate that is higher than that of the economy in general since that implies that in the long run the company will represent a very large part of the economy. That does not make any sense. Therefore, it is prudent to assume the same growth rate for the firm as for the general economy. We can plot our assumptions for the revenue growth as follows We will see later that this revenue growth rate will determine the cash flow growth rate in the steady-state With this revenue growth forecast, we can easily calculate the expected future revenues for the company. We just multiply the starting revenue in 2015 with the expected revenue growth rate. Next, we will forecast the EBIT (or the operating income) We do that by using the EBIT margin which is EBIT divided by revenues If we calculate the historical EBIT margins we see that Tesla has had a declining profitability Declining EBIT margins for the last three years. That is probably because this is a young company in the beginning of its life cycle. It is doing a lot of investments and growing. Which is quite costly. While the revenues are growing rapidly as we saw in the previous slide they’re still not high enough to generate positive profits However, it is likely that at some point in time in the future the profits will turn from negative to positive Let’s assume that that happens in two years from now The forecast is that the EBIT breaks even in 2017 and that the company is able to increase its profit margin up to 30% in 2021. This margin is quite high, and because we assume that the company has a strong brand, but after 2021, more competitors enter the market and the profits deteriorate until reaching a steady-state EBIT margin of 20% in the long run. If we draw the EBIT margin over time it looks like this. The EBIT forecast is generated by by multiplying the revenue forecast with the EBIT margin expectations. Next, we continue with the investments in fixed assets, or the capital expenditures, or CAPEX for short. Again, we measure the historical CAPEX compared to the revenues We calculate a ratio of CAPEX to revenues We see that this ratio has increased over the recent years. This suggests the company has invested a lot recently Let’s assume that Tesla continues to make substantial investments in the near future. The company has been quite successful with its product and it makes sense that the management wants to capitalize on this success and grow rapidly in In order to grow they need to invest in the necessary machinery and equipment to make this happen. After a while, there will be less need to grow the asset base, and the investment-to-revenue ratio wil fall. We assume a steady-state CAPEX-to-revenue ratio of 10%. And this is what it looks like if we draw the graph. To calculate the future CAPEX, all we need to do is to multiply the revenue forecast with the expected investment-to-.revenue ratios. And this is what we get. Next in line is the net working capital. Again, we use the revenues as the starting point. and calculate a ratio of net working capital to revenues. We see that the net working capital is negative. This suggests the accounts payable exceeds the inventory and the accounts receivable We assume that this is not sustainable in the long run and the net working capital will turn positive. We assume that the working capital-to-revenues ratio will increase and reach a steady-state of 10% in the long run. We can calculate the net working capital by multiplying the revenues with the ratio. What we use to calculate the free cash flow is actually the change in net working capital so we need to calculate the change We need to subtract the increase in net working capital as the increase represents an investment in day-to-day operations of the firm. Then we come to depreciation. Ideally, we should model the investment into each asset or group of similar assets separately, and calculate the depreciation schedule for each of the assets. This is quite time consuming. For simplicity, we can simply forecast the depreciation using a ratio of depreciation-to-revenues. We see that this ratio is increasing This is caused by Tesla making substantial investments in recent years We assume that this continues also into future as a function of the company’s expansion and investments. The steady-state depreciation-to-revenues ratio is assumed to be 10%. This is the same level as the CAPEX-to-revenues ratio This makes sense since the CAPEX and depreciation are closely linked, in fact the sum of the investments and depreciation in the steady-state period should be approximately equal since the depreciation is just a periodization of the CAPEX We then calculate the expected depreciation using this ratio and expected revenues The last element we need is the tax rate. Let’s assume that the income tax rate is flat at 30%. We have now completed step 3 – the forecasting of cash flows using ratios. We can collect all of the forecasts into one table and calculate the free cash flow for the firm using the equation at the top (of the slide). If we also calculate the change in free cash flow we are able to identify that the growth rate of cash flows is constant at 2.5% from 2025 onwards. The reason that we have a constant growth rate of 2.5% for the free cash flow is that we assume that the revenue growth rate in the steady-state was 2.5%, combined with the fact that all the other cash flow elements are functions of the revenues through the use of ratios. This makes revenue growth the major determinant of the cash flow growth rate in the steady-state phase In order the value (of the cash flows) today, we need to use a discount rate since we’re using the free cash flow for the firm approach, the relevant discount rate is the weighted average cost of capital, or WACC for short The weighted average cost of capital is just the weighted average of the costs of debt and equity capital The weights are calculated from the market values of debt and equity Sometimes it is difficult to find the market value of debt then we use the book values instead We can calculate the cost of equity using an asset pricing model. such as the CAPM (Capital Asset Pricing Model), the single-factor model, or a multi-factor model. The cost of debt is typically calculated based on the rating of the company, for example we can use the yield spread on corporate bonds with similar rating The yield spread is the difference in the yield of a corporate bond over the risk free government bond. This table summarises the we need to do the valuation. we have transition period from 2016 to 2024. We discount the cash flows from each of those years If we assume that the discount rate is 10% Then the present value of the cash flows in the first nine years is -2.8 billion dollars. If we assume that the discount rate is 10% then the value of the cash flow is -2.8 billion dollars. The negative value in the transition period is because the company is growing and making substantial investments in this period generating a negative cash flow stream. The cash flow turns positive in 2022 but since most of the years especially the years closer in time to today have a negative cash flow, and the transition period cash flow is negative The steady-state is from 2025 onwards with a constant growth rate for cash flows of 2.5% Assuming that the cash flow in 2025 comes at the end of 2025 we can calculate the terminal value by dividing $1575.6 million with the discount rate less the growth rate This will give us the value at the beginning of 2025 To calculate the terminal value as a value at the beginning og 2016 we need to discount the terminal value at the beginning of 2025 to the beginning of 2016 That is 9 years The resulting terminal value is $8.9 billion. The total value of the firm is the sum of the transition value and the terminal value In our case, it is approx. $6.1 billion. This is the intrinsic value, which is also called the fundamental value or the “fair value”. We’re not finished yet! We wanted to calculate the intrinsic value of equity what we have here is the intrsinsic value of the total firm or the intrinsic enterprise value To calculate the intrinsic equity value we need to subtract the market value of debt For simplicity, we assume that the market value of debt is the same as the book value of debt We can therefore use the net interest bearing debt we calculated in the re-organised balance sheet as our estimate of the market value of debt The value of equity is therefore $4.6 billion. By dividing this number by the number of shares outstanding we get the intrinsic share “price”. The total number of shares outstanding is 130.95 million which gives us an intrinsic value of 35.3 $/share The next step is to compare this value to to the market price The market price per share of Tesla at 31/12/2015 was 240 $/share suggesting that the stock is overprices since the stock is selling way above its intrinsic value If we were an equity analyst following Tesla Motors we would make a “sell” recommendation for this stock An investor owning this stock would therefore be recommended to sell his or her Tesla stocks. In the lecture on the Index model we saw that the rationale for active portfolio management was that some stocks were underpriced or overpriced This deviation between the intrinsic value and the market value represents the “alpha” from the index model We can therefore calculate the alpha for the Tesla stock We found that the intrinsic value is much lower than the market value If the market also figures this out short-selling the Tesla stock should provide superior returns A short position in Tesla will generate a positive alpha What is the size of the alpha? In order to calculate the alpha as a return we need to make an assumption Often it is assumed that the price difference between the intrinsic value and the market value is realized over a (for example) five year period. In that case, the five year alpha would be 580%. That is the return we would get from selling the stock at the current market price of 240 $/share and then buying back the share when the market pushes the price down to 35.3 $/share On an annual basis, the alpha is 46.7% Another important valuation method is valuation multiples Valuation using multiples is one of the most popular valuation methods in practice The reason for that is that it is a very simple valuationm approach as we will see in the next slide a valuation multiple is calculated as the ratio of a market value divided by a value driver The market value can either be the market value of equity or the market value of all the assets what we call the enterprise value The denominator in the ratio the value driver can be items from the income statement the balance sheet or from the statement of cash flows In addition, other alternatives are metrics created from the financial statements such as EBITDA EBITDA is a proxy for cash flows that financial analysts ofte use and EBITDA is created by adding back depreciation and amortization to EBIT. sometimes, metrics that are not in the financial statements can also be used such as oil and gas reserves for valuation multiples for oil and gas companies When calculating and using these ratios it is very important that there is consistency between the numerator and the denominator in the ratio For instance, the market value of equity is a leveraged market value therefore the denominator also need to be levered Suitable denominators are net income and the book value of equity These are calculated net of interest and debt and are therefore levered EBIT, on the other hand, is not suitable in the denominator since EBIT is unlevered In that case, it is better to use the enterprise value in the numerator The resulting ratio is Enterprise value to EBIT multiple or EV/EBITDA multiple The way we use the multiples to value the equity or enterprise values of the firm is quite simple To calculate the company’s equity we multiply a valuation multiple such as the P/E ratio with the earnings of the company This is much easier than the discounted cash flow approach and much, much quicker Unfortunately, because of this simplicity it is not easy to capture the details surrounding the expectations of a company’s profitability and growth in revenues and earnings. as we could do with the discounted cash flow model The procedure for using valuation multiples is as follows First, select a group of peer companies or comparable companies These are typically that are in the same business or industry as the company you’re trying to value. Then. calculate the average multiple For example P/E for all the companies Then, use this industry average multiple to value the company’s equity like we did up here However, there could be an issue related to to the leverage on a multiple such as P/E For this reason, it could be more appropriate to use an unlevered multiple A popular unlevered multiple is the enterprise value-to-EBITDA ratio (EV/EBITDA) Let’s go through an example for how we use valuation multiples Let’s say we want to value the Helix Corporation.