Company Valuation Presentation to Hskli slands Haraldur Yngvi

Company Valuation Presentation to Háskóli Íslands Haraldur Yngvi Pétursson, Equity Research – IFS Research 9 March 2008 -1 -

1 2 3 4 Introduction Multiples / Comparables Discounted Cash Flow (FCFF) Bank valuation -2 -

Introduction -3 -

Haraldur's Personal Introduction u Academic: — University of Iceland – Cand. Oecon u Professional — Deloitte – Accounting – 3 years – Preparations of financial accounts – Auditing of financial accounts — Kaupthing Bank – Equity Research – 4 years – Focus on the Icelandic market – Part of Kaupthing Scandinavian equity research from 2006 — IFS Research – Equity Research – Since November 2008 – Focus on Icelandic equities – Selected Scandinavian companies – S&P 500 selected sectors -4 -

Goal of Presentation u Discuss company valuation generally and main obstacles u Review in some detail the main currently employed valuation methods u Don't worry if you don't fully understand everything said — To most ordinary humans this is entirely foreign material — Valuation and Equity Research is very much "on site training" u Hopefully you'll enjoy picking up some of the terminology and the next valuation presentation you sit through should be slightly more bearable -5 -

Reasons for Valuing Companies u Key to successful trading in (and managing) corporations — Ability to estimate their value — Understanding the sources of their value u Investors do not buy corporations for aesthetic or emotional reasons – but for their expected future cashflows — Inherent value of a company based on forward-looking estimates and judgements u Valuation is fundamental for any decision & negotiations relating to e. g. — Company investments — Mergers — IPO / rights issues — Management project evaluation — Portfolio valuation -6 -

Valuation – Basics u Valuation a science or an art? A bit of both Science: Certain methods are based on solid mathematical pillars. Has (and is) being researched by entire university departments, thousand's of professors/Ph. D's/market practitioners Foundation of the world's financial system Art: Modelling and forecasting of the future (? !? ) – management/key employees, tastes/fashion/sentiment, disruptive technologies… Material role of fickle (and difficult to model) behavioural issues and biases – overconfidence, overreaction, loss aversion, herding, regret, misestimating of probabilities. . Fact remains – companies need to be valued and the following methods are the best tools currently available -7 -

Valuation - Reservations u Assumptions and inputs into the models are of paramount importance — Garbage in -> Garbage out u Several "difficult-to-model" factors hugely important — Is it for sale? Is there a buyer? Sale under distressed circumstances? is funding available? — Output from valuation models ≠ current price u Additionally some types of companies are tremendously difficult to value analytically — Start-ups — Biotech/pharmaceutical research — Highly cyclical companies — Companies with large "real options" – Rights to unexplored oil-fields / mining – Online companies (social networking, search engine. . ) -8 -

Valuation Methodologies u Discounted Cash-flow (DCF) — Free Cash Flow to Firm (FCFF), FCF to Equity, Adjusted Present Value (APV) u Multiples / Comparables — P/E, EV/EBITDA, EV/Sales etc. u Other methods — Invested capital, VC Capital Method, Option Pricing, Last round of financing, Break-up value and Dividend Models u. . and then the more "sketchy" methods — e. g. Technical Analysis u Balance between model relevance, complexity and number of assumptions u Usually at least two methods used in any valuation exercise -9 -

Valuation Method: Multiples / Comparables - 10 -

Multiples / Comparables (comps) - Introduction u The idea is to approximate a company's value by comparing it to companies with known value u Source of figures — Comparable public company multiples — Recent private company transactions u Important to only compare relative value of similar companies (apples with apples) — Similar Industry Scope — Similar Growth — Similar Risk — Similar Results (ROE) - 11 -

Multiples / Comparables (comps) - Introduction u Many benchmarks can be used (usually industry specific) — Enterprise Value / EBITDA — Enterprise Value / Sales — Price / Earnings (I: V/H) — Price / Book (I: Q-hlutfall) — Price / Net Asset Value (NAV) — Monthly Rent Multiple — Funds under management — # subscribers, # patents, # employees, #website hits / Enterprise Value — etc. - 12 -

Multiples / Comparables (comps) – Introduction cont. u Positives — Quicker and easier than analytical methods (DCF) — Reflects current market conditions (investor sentiment, bargaining power. . ) — Helpful in "reality-checking" DCF valuations u Disadvantages — Are the comparable companies similar enough? – E. g. public vs. private, future prospects, sector, management quality, market position, capital structure, tax-scheme… — Doesn't capture value of different scenarios/"what-ifs" – E. g. post acquisition cost-cutting is successful, synergies are achieved, pending lawsuit goes one way or the other. . — Disconnect between a multiple and inherent firm value. Hence does not capture systemic under- /overvaluation of companies by the market - 13 -

Enterprise Value / EBITDA (1/5) u Currently the most common "valuation" method for several industries u Typically in the range of 5 -15 x depending on — Company type — CAPEX requirements — Prospects — Market conditions u "EBITDA" = Earnings before interest, taxes, depreciation and amortization u Proper to use Forecasted EBITDA (the future is what you're paying for) — Trailing 12 month / 4 Quarter EBITDA is commonly used — EBITDA is adjusted for one-off items (e. g. merger costs) Sales - Cost of Goods Sold - Administrative Costs + Depreciation & Amortization = EBITDA - 14 -

Enterprise Value / EBITDA (2/5) u Enterprise Value (EV) — A measure of company's entire value — Vehicle & Apartment prices are quoted as enterprise value i. e. without any reference to current debt structure (the price assumes no debt is included) — Imagine how cumbersome it would be to hunt for a flat if prices referred to the value of equity in the flat Flat's quoted price: 10 million (50 (its value) – 40 (debt included) ) u Company share price refers to equity value -> very reasonable to calculate and work with company's EV Share Price x Number of Shares EV = Equity Value + Net Debt* Borrowing – Cash * and + Minority Interest – Associates + Operating lease commitment - 15 + Unfunded pension liabilities -

Enterprise Value / EBITDA (3/5) u Multiple in some ways better indicator of value than other measures — Helpful in comparing companies with different capital structures (w/o interest on debt) — Depreciation and amortization schedules vary between companies — Easier to approximate how much debt the company can support u Has several weaknesses — Capital Expenditure (CAPEX) requirements between companies vastly different — Some companies capitalize significant amounts of cost (e. g. R&D) and thus raise their EBITDA figure — Does not include different interests expenses, tax rate and required rate of return - 16 -

Enterprise Value / EBITDA (4/5) u Example Question: (1) Value the company (EV and Equity Value) (2) Approximate its share price Figures for Caveat Emptor Ltd. EBITDA=1. 000 Net Debt = 2. 000 #Shares outstanding=300 Similar companies are trading at average EV/EBITDA multiples of 8. 0 x - 17 -

Enterprise Value / EBITDA (5/5) u Solution to Example Question EBITDA * EV/EBITDAx 1. 000 8. 0 x = Enterprise Value 8. 000 - Net Debt 2. 000 = Equity Value (Market Cap) 6. 000 / Number of Shares 300 Share Price 20 - 18 -

Price / Earnings (PER or P/E) u Price Earnings (I: V/H) ratio shows how much accounting profit its owners are entitled to u Example: Stock price = 20, EPS= 2 => PER= 20/2 = 10 u Compared to companies similar in risk and prospects PER is an indicator of whether a particular stock is under or overpriced u Several variants — Trailing PER or forward PER (using forecasted earnings) — Primary shares outstanding or diluted number of shares — Average price over period u Generally: — High PER (>16) indicates that the market believes significant growth is on horizon — Low PER (<8) indicates that the market believes current profit levels are unsustainable - 19 -

Price/Book (P/B) and Net Asset Value (NAV) u Price / Book = Value of Equity / Book Value of Equity (I: Q-hlutfall) u Purpose of ratio is to show the market premium to the accounting equity u P/B is used for valuing investments whose value is derived primarily from the underlying value of their tangible assets — Holding companies — Real estate companies — Banks — Companies up for liquidation (solvency value) u Net Asset Value (NAV) is a significantly better measure than book equity — Calculated by correcting the value of assets & liabilities in the accounts – Book value of associates – Book value of fishing quota – Goodwill justified? – Deferred tax liability going to be paid in the near future (Real Estate)? etc. - 20 -

Misc. Industry Specific Multiples u Enterprise Value is the most common numerator u Airlines & retail businesses — EV/EBITDAR often used (notice that Rent (R) is excluded) — Takes into account that some companies buy their aircraft/stores while other companies rent them u Real Estate — Rent Multiplier or Yield% is often used EV = Monthly Rent * Multiplier (e. g. 125 -250) = Monthly Rent / Yield% * 12 — Appropriate Yield% can be found in sector research and depends on factors such as country, type of building, quality of area, sub-sector vacancy and market conditions u Commodity Companies (Oil refineries, mining etc. ) EV = Number of units of the commodity in reserves (e. g. barrels of oil) * Value per commodity unit u Asset Management EV = Assets under Management * Multiple (1%. . 4%) — Multiple depends e. g. on investor type (private banking % higher than institutional %) u …and other industry specific "rules of thumbs" - 21 -

Valuation Method: Discounted Cash Flow (FCFF) - 22 -

Discounted Cash Flow Valuation u DCF is the cornerstone of valuations and is the "analytically most correct" way — In reality: several "fudge-factors" and disagreement between practitioners u Robust in valuing anything that gives cash-flow in the future given assumptions — Bonds, derivatives, companies, etc. u Valuation of future cash that the investor will get from holding the firm. At the end of the day: "Cash is King" "Cash is fact – profit is an opinion" "Earnings do not pay the bills" u Used when significant information is available on company and its prospects u Also used to select between internal projects and to price the impact of various scenarios e. g. during negotiations - 23 -

Fundamentals of any Discounted Cash Flow Valuation Expected cashflow u Expected cashflow in each period Year Discount rate u Divided by the appropriate discount factor that reflects the riskiness of the estimated cashflows u Example: How much is an infinite stream of ISK 15 million/year worth? Assuming a 10% discount rate: - 24 -

Discounted Cash Flow Valuation in 4 Steps u Step 1 Compile information — Historical accounts (last 2 -3 years). Review sales, margins, CAPEX, WC ratios, notes etc. — Research business, strategy, products, customers, markets, competition etc. — Industry and environment forecasts (official forecasts, research from experts, news etc. ) — Discuss main risk factors — Look up information on similar companies - 25 -

Discounted Cash Flow Valuation u Step 2 Estimate the appropriate discount factor weighted average cost of capital (WACC) Components of WACC are: 1) Cost of Debt (Kd) — Risk Free Rate (e. g. 10 year government bond) Nominal or real – must harmonize with forecasts — Appropriate Credit Risk Premium 2) Cost of Equity (Ke) (CAPM) — Several models used (APT, MFM, Proxy) but Capital Pricing model (CAPM) most common — Equity risk premium is an estimate of the premium investors require in excess of risk-free assets for owning equities (4 -7% most typically used) — Beta is a measurement of firm's/similar firms volatility compared to the market (if higher than 1 company/sector is riskier than market in average). When compiling and averaging betas it is necessary to take into account different company leverage - 26 -

Discounted Cash Flow Valuation u Step 2 cont. — WACC calculation example (typical Icelandic firm) u Or… . . . as is very common: Present WACC as a figure (8. . 15%) and provide a sensitivity table - 27 -

Discounted Cash Flow Valuation u Step 3 Prepare a "visible" forecast period (5 -10 years and longer for some industries) — Forecast Sales, margins, capital expenditure, working capital requirement — And derive Free Cash Flow to Firm - 28 -

Discounted Cash Flow Valuation u Step 3 cont. * Forecasts should trend downwards to achieve long run growth rates * Assumptions should be reviewed for consistency with past performance and business model * COGS & SG&A include Depreciation so it needs to be subtracted (non-cash item) * Depreciation should harmonize with CAPEX & the value of property, plant and equipment (PP&E) in the long run 29 -

Discounted Cash Flow Valuation u Step 3 cont. * Helpful to create a balance sheet and model the difference in inventories, receivables and payables between years. * Tax relief from debt is included in the discount factor * CAPEX needs to be sufficient to fund the strategy (e. g. the opening of new stores) - 30 -

Discounted Cash Flow Valuation u Step 4 Calculate Firm Value (EV) by discounting the Free Cash Flow to Firm with the WACC — Deal properly with Terminal Values u Beyond the visible cashflow period, the value of the company is captured using a terminal value calculation (using either a DCF to perpetuity or comps calculation) * Equity Value calculated from EV * 30 -70% split is a rough guide for mature companies * 0. . 5% often used for perpetual growth - 31 -

Discounted Cash Flow – Presenting the Results u The Ultimate Answer to the Great Question of Life, the Universe and Everything -Hitchhiker's guide to the Galaxy u All diligent valuations are presented as sensitivity tables — Demonstrate the link between assumptions and the final value — Allow the reader, which probably disagrees with some assumptions, to use the analysis - 32 -

Discounted Cash Flow Valuation u Other DCF methods: u Free Cash Flow to Equity (FCFE) Same as Free Cash Flow to Firm but — Interest (and tax savings from interest) and changes in net debt (repayments) are subtracted from the FCFF. Discounted with cost of equity (not WACC) — Has many proponents arguing (a) more intuitive measure of cashflow (b) overleveraged companies in jeopardy more obvious, etc. u Adjusted Present Value (APV) – less common — Takes into account changing debt structure – helpful for leverage finance/private equity 1. Calculate value of firm assuming no debt 2. Calculate the present value of tax savings due to interest (discounted with kd) 3. Value the effect of borrowing on likelihood and cost of bankruptcy (difficult) - 33 -

Discounted Cash Flow Valuation u Key Drivers of Cashflow — Sales growth rates – Market, strategic considerations, pricing, economy, competition — EBITDA margin – Cost development, fixed vs. floating costs etc. — Capital expenditure (CAPEX) – Maintenance and investment CAPEX — Working capital requirement – Must support current operations and strategy (inventories, receivables & payables) — Cash tax rate – A specialist area (legislation, relief from previous tax loss, deferred tax) u Model also highly sensitive to — Discount factor — Terminal value growth - 34 -

Bank valuation - 35 -

Value Measures – banks equity u Book Value — Reported value of equity, based on the prevailing accounting standards u Economic Value — Difference between market value of assets and liabilities at a given time u Market Value — Current share price multiplied by the number of outstanding shares u Intrinsic Value — Discounted value of future earnings — Analyst's most used tool — DDM the most common valuation model — Analysts may argue for a discount or a premium - 36 -

Premiums and discounts u Discounts — Size (or lack thereof) — Liquidity and free float — Asset quality — Balance sheet structure — Capital raising risk — Ownership, corporate governance and transparancy — Holding company and conglomerate discount — Management quality — Demand - 37 -

Premiums and discounts u Premiums — Wheight of money – Mutual fund inflows – Asset-class allocation – Liquidity and free float — Excess capital — Index issues — Takeover or other speculation - 38 -

The dividend discount model (DDM) u Some DDM Strengths — Communicability and basis — Absolute valuations — Comparability — Simple sensitivity measures u Key assumptions — Cost of Equity — Return on Equity — Long term growth - 39 -

The dividend discount model (DDM) u DDM has various forms — Basic one stage model — Multistage models u The most basic DDM — Fair value P/B multiple = — ROE = return on equity — COE = cost of equity — g = long-run growth Þ Book value per share * P/B multiple = Fair value per share Þ Fair value per share * number of shares = Total fair value - 40 -

The dividend discount model (DDM) u Cost of Equity — Risk free rate Varies by markets – Normally 10 yr government bonds are used for base – — Market risk premium – Generally 4 -5% — The troublemaker – Beta Historic vs. future – Time period and frequency – Liquidity – Earnings volatility – — Judgement - 41 -

The dividend discount model (DDM) u Return on Equity (Net profit / average equity) — Earnings – Trading profits and loss, included? – Goodwill writedown? – Other one-offs? – Place in the economic cycle – Bad debt charges – Numerous other company specific issues – Aim to estimate the "through the cycle" ROE - 42 -

The dividend discount model (DDM) u Growth – long term — A banks earnings growth can not be higher in perpetuity than long term GDP growth – Better to err on the side of caution – Higher growth in developing than developed countries – One of the reasons for a multiple stage models - 43 -

The dividend discount model (DDM) u Example – 3 banks - 44 -

Valuation Method: Multi stage DDM - 45 -

The dividend discount model (DDM) u Underlying assumption in the one stage model — Value of equity grows at the same rate as earnings — Dividend payout ratio therefore must be — A bank can not payout more than this ratio in the long run as capital restrictions will eventually come into place — The payout ratio can be higher, but that would lead to less gearing, lower ROE and actual value of discounted dividends will be lower — Is there an excess capital? – A war chest – A fear factor - 46 -

The dividend discount model (DDM) u Two stage models are common — Give short term flexibility in e. g. — Earnings estimates — Growth u Lets look at one simple example — COE is 10% — Growth is 4% — ROE (long term) is 14, 8% — Assume dividends at 5% during forecast period — Payout ratio (POR) => - 47 -

The dividend discount model (DDM) u Our basic assumptions — Equity = last year + earnings – dividends — Equity in perpetuity = Equity last forecast * (1+g) — Earnings in perpetuity = Earnings last forecast * (1+g) — Dividend last year (and perpetuity) according to our POR - 48 -

The dividend discount model (DDM) u The valuation process is in two parts (hence two stage model) — First we calculate the present value of dividends in the forecast period — Discount rate = COE — Then we calculate the PV of perpetuity — Fair value multiple as before — Add PV of dividends over forecast - 49 -

Questions and Answers Q&A - 50 -