IBM Valuation Prof Ian Giddy New York University

IBM Valuation Prof. Ian Giddy New York University

What’s a Company Worth? Required returns l Types of Models l IBM u. Balance sheet models u. Dividend discount models u. Corporate cash flow models u. Price/Earnings ratios Estimating Growth Rates l Application l Copyright © 2000 Ian H. Giddy Valuation 3

Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity Book Value Liquidation Value Replacement Value Copyright © 2000 Ian H. Giddy Tobin’s Q: Market/Replacement tends to 1? Valuation 5

Estimating Future Cash Flows n n n Copyright © 2000 Ian H. Giddy Dividends?

Cash Flow to Firm Claimholder Cash flows to claimholder Equity Investors Free Cash flow to Equity Debt Holders Interest Expenses (1 - tax rate) + Principal Repayments - New Debt Issues Preferred Stockholders Preferred Dividends Firm = Free Cash flow to Firm = Equity Investors Free Cash flow to Equity + Debt Holders + Interest Expenses (1 - tax rate) + Preferred Stockholders + Principal Repayments - New Debt Issues + Preferred Dividends Copyright © 2000 Ian H. Giddy Valuation 7

Relative Valuation l Do valuation ratios make sense? • Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios q and variants (Tobin's Q) • Price/Sales ratios l It depends on how they are used -- and what’s behind them! Copyright © 2000 Ian H. Giddy Valuation 8

Disney: Relative Valuation Company PE Expected Growth King World Productions 10. 4 7. 00% Aztar 11. 9 12. 00% 0. 99 Viacom 12. 1 18. 00% 0. 67 All American Communications 15. 8 GC Companies 20. 2 15. 00% 1. 35 Circus Enterprises 20. 8 17. 00% Polygram NV ADR 22. 6 13. 00% Regal Cinemas 25. 8 23. 00% 1. 12 Walt Disney 27. 9 18. 00% 1. 55 AMC Entertainment 29. 5 20. 00% Premier Parks 32. 9 28. 00% 1. 18 Family Golf Centers 33. 1 36. 00% CINAR Films 48. 4 25. 00% 1. 94 Average 27. 44 18. 56% 1. 20 Copyright © 2000 Ian H. Giddy PE ratio divided by the growth rate PEG 1. 49 20. 00% 0. 79 1. 22 1. 74 1. 48 0. 92 Valuation 9

Discounted Cashflow Valuation: Basis for Approach uwhere n = Life of the asset u CFt = Cashflow in period t u r = Discount rate reflecting the riskiness of the estimated cashflows u Copyright © 2000 Ian H. Giddy Valuation 10

Start with the Weighted Average Cost of Capital Choice Cost 1. Equity - Retained earnings - New stock issues - Warrants Cost of equity - depends upon riskiness of the stock - will be affected by level of interest rates Cost of equity = riskless rate + beta * risk premium 2. Debt - Bank borrowing - Bond issues Cost of debt - depends upon default risk of the firm - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Capital Cost of capital = Weighted average of cost of equity and cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)] Copyright © 2000 Ian H. Giddy Valuation 11

Valuation: The Key Inputs l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. l Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period: Copyright © 2000 Ian H. Giddy Valuation 12

Dividend Discount Models: General Model l V 0 = Value of Stock l Dt

Specified Holding Period Model l l PN = the expected sales price for the

No Growth Model l l Stocks that have earnings and dividends that are expected

No Growth Model: Example n n Burlington Power & Light has earnings of $5 per share and pays out 100% dividend The required return that shareholders expect is 15% The earnings are not expected to grow but remain steady indefinitely What’s a BPL share worth? E 1 = D 1 = $5. 00 k =. 15 V 0 = $5. 00 /. 15 = $33. 33 Copyright © 2000 Ian H. Giddy Valuation 16

Constant Growth Model lg = constant perpetual growth rate Copyright © 2000 Ian H.

Constant Growth Model: Example n n Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend The required return that shareholders expect is 15% The earnings are expected to grow at 8% per annum What’s an M 6 share worth? E 1 = $5. 00 b = 40% k = 15% (1 -b) = 60% D 1 = $3. 00 g = 8% V 0 = 3. 00 / (. 15 -. 08) = $42. 86 Plowback rate Copyright © 2000 Ian H. Giddy Valuation 18

Estimating Dividend Growth Rates g = growth rate in dividends l ROE = Return on Equity for the firm l b = plowback or retention percentage rate i. e. (1 - dividend payout percentage rate) l Copyright © 2000 Ian H. Giddy Valuation 19

Or Use Analysts’ Expectations? Copyright © 2000 Ian H. Giddy Valuation 20

Shifting Growth Rate Model l g 1 = first growth rate l g 2

Shifting Growth Rate Model: Example n D 0 = $2. 00 g 1 = 20% g 2 = 5% k = 15% T = 3 D 1 = 2. 40 D 2 = 2. 88 D 3 = 3. 46 D 4 = 3. 63 n V 0 = D 1/(1. 15) + D 2/(1. 15)2 + D 3/(1. 15)3 n + D 4 / (. 15 -. 05) ( (1. 15)3 Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% The dividends are expected to grow at 20% for 3 years and 5% thereafter What’s a Mindspring share worth? V 0 = 2. 09 + 2. 18 + 2. 27 + 23. 86 = $30. 40 Copyright © 2000 Ian H. Giddy Valuation 22

Stable Growth and Terminal Value l l When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. While companies can maintain high growth rates for extended periods, they will approach “stable growth” at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond. Copyright © 2000 Ian H. Giddy Valuation 23

Choosing a Growth Pattern: Examples Company Valuation in Growth Period Stable Growth Disney Nominal U. S. $ 10 years 5%(long term Firm (3 stage) nominal growth rate in the U. S. economy Aracruz Real BR 5 years 5%: based upon Equity: FCFE (2 stage) expected long term real growth rate for Brazilian economy Deutsche Bank Nominal DM 0 years 5%: set equal to Equity: Dividends nominal growth rate in the world economy Copyright © 2000 Ian H. Giddy Valuation 24

The Building Blocks of Valuation Copyright © 2000 Ian H. Giddy Valuation 25

The Building Blocks of Valuation Spreadsheet example Copyright © 2000 Ian H. Giddy Valuation

Equity Valuation: Two Applications Prof. Ian Giddy New York University

Equity Valuation in Practice Estimating discount rate l Estimating cash flows l Estimating growth l Application with constant growth: Optika l Application with shifting growth: Fong l Copyright © 2000 Ian H. Giddy Valuation 28

Optika WACC: Re. E/(D+E)+Rd. D/(D+E) Value: FCFF/(WACC-growth rate) Equity Value: Firm Value - Debt Value = 2278 -250 = 2028 Copyright © 2000 Ian H. Giddy CAPM: 7%+1(5. 50%) Debt cost (7%+1. 5%)(1 -. 35) Valuation 29

Valuing a Firm with DCF: An Illustration Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Discount to present using weighted average cost of capital (WACC) Present value of free cash flows Copyright © 2000 Ian H. Giddy + cash, securities & excess assets - Market value of debt … Terminal year FCFF Stable growth model or P/E comparable Value of shareholders equity Valuation 30

Valuation Example Copyright © 2000 Ian H. Giddy Valuation 31

Valuation Example Copyright © 2000 Ian H. Giddy Valuation 32

IBM Equity Valuation: Alternatives Prof. Ian Giddy New York University

What’s a Company Worth? Alternative Models l The options approach u. Option to expand u. Option to abandon l Lycos Creation of key resources that another company would pay for u. Patents or trademarks u. Teams of employees Messageclick. co u. Customers l Examples? Copyright © 2000 Ian H. Giddy m Valuation 34

What’s a Company Worth? The Options Approach Value of the Firm or project Present

The Value of a Corporate Option Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. l The value of these rights increases with the volatility of the underlying business. l The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits. l Copyright © 2000 Ian H. Giddy Valuation 36

Application Copyright © 2000 Ian H. Giddy Valuation 37

An Example of a Corporate Option l l J&J is considering investing $110 million to purchase an internet distribution company to serve the growing on-line market. A conventional NPV financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to J&J will be only $95 million. Thus, by itself, the corporate venture has a negative NPV of $15 million. If the on-line market turns out to be more lucrative than currently anticipated, J&J could expand its reach a global on-line market with an additional investment of $125 million any time over the next 2 years. While the current expectation is that the PV of cash flows from having a worldwide on-line distribution channel is only $100 million (still negative NPV), there is considerable uncertainty about both the potential for such an channel and the shape of the market itself, leading to significant variance in this estimate. This uncertainty is what makes the corporate venture valuable! Copyright © 2000 Ian H. Giddy Valuation 38

Valuing the Corporate Venture Option l l The corporate option would cost an expected $15 million. But what is it worth to J&J? Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million Strike Price (K) = cost of expansion into global on-line selling = $125 Million We estimate the variance in the estimate of the project value by using the annualized volatility (standard deviation) in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%. u l l Variance in Underlying Asset’s Value = SD^2=. 25 Time to expiration = Period for which “venture option” applies = 2 years 2 -year interest rate: 6. 5% Copyright © 2000 Ian H. Giddy Valuation 39

Option Pricing Option Price Time value depends on n Time n Volatility n Distance from the strike price Option Price = Intrinsic value + Time value 94. 5 94. 75 Underlying Price Copyright © 2000 Ian H. Giddy Valuation 40

Value of Call Option FUTURES PRICE STRIKE INTRINSIC VALUE SHADED AREA: Probability distribution of the log of the futures price on the expiration date for values above the strike. TIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE Copyright © 2000 Ian H. Giddy Valuation 41

Black-Scholes Option Valuation Call value = So. N(d 1) - Xe-r. TN(d 2) d 1 = [ln(So/X) + (r + 2/2)T] / ( T 1/2) d 2 = d 1 - ( T 1/2) where So = Current stock price X = Strike price, T = time, r = interest rate N(d) = probability that a random draw from a normal distribution will be less than d. Copyright © 2000 Ian H. Giddy Valuation 42

Valuing the Corporate Venture Option l l l Value of the underlying asset (S) = PV of cash flows from purchase of on-line selling venture, if done now =$100 Million Strike Price (X) = cost of expansion into global on-line selling = $125 Million We estimate the variance in the estimate of the project value by using the annualized standard deviation in firm value of publicly traded on-line marketing firms in the global markets, which is approximately 50%. u l l Variance in Underlying Asset’s Value = SD^2=0. 25 Time to expiration = Period for which “venture option” applies = 2 years 2 -year interest rate: 6. 5% Call Value = 100 N(d 1) -125 (exp(-0. 065)(2)) N(d 2) = $ 24. 2 Million Copyright © 2000 Ian H. Giddy Valuation 43

Conclusion? Johnson & Johnson should go ahead and invest in the venture -- the value of the option ($24 million) exceeds the cost ($15 million) Can this approach be used to value highly speculative ventures? Copyright © 2000 Ian H. Giddy Valuation 44

Ian H. Giddy NYU Stern School of Business 44 West 4 th Street New York, NY 10012, USA Tel 212 -998 -0563; Fax 917 -463 -7629 ian. giddy@nyu. edu http: //giddy. org Copyright © 2000 Ian H. Giddy Valuation 49