Equity Valuation 101 The Question Behind the Question Vincent Catalano, CFA Managing Partner Outer Drive Associates, LLC
What’s It All About, Alfie? • Wall Street Analysts want to know • What’s Real and What’s Not • Senior Corporate Management & IRO’s want to know • The question behind the question Outer Drive Associates, LLC
Valuation Models • Methodologies • Discounted Cash Flow • Cash Flows, Growth Rates, Discount Rates • Comparables • P/E ratios Outer Drive Associates, LLC
Discounted Cash Flow Model · A Few Good Questions · · · What is Free Cash Flow? How is it Defined? How is Free Cash Flow distinct from reported earnings? What is the Sustainable Growth Rate of a Business? How are Future Cash Flows Discounted to the Present Value? · Uncertainty factor Outer Drive Associates, LLC
Discounted Cash Flow Model (Show me the real money) • Free Cash Flows • • • Net Income + Depreciation - Capex +/- changes in working capital = Free cash flows Outer Drive Associates, LLC
DCF Model Example • • NI + Depr. - Capex +/- WC changes = = • Free cash flows = Outer Drive Associates, LLC $200 m 100 m - 50 m 60 m $310 m
Discounted Cash Flow Model • Growth Rate • Return on Equity x Retention Rate • (1 - Dividend payout ratio) • Discount Rate • Capital Asset Pricing Model • risk free rate + beta (expected return on the market - risk free rate) Outer Drive Associates, LLC
Sustainable Growth Rate Example • ROE • Retention Rate = = 20% 50% • Sustainable growth rate = 10% • (1 - dividend payout ratio) Outer Drive Associates, LLC
Discount Rate Example • Risk free rate • beta • Excess return on mkt. = = = 5% 1. 2 7% = 13. 4% • (exp. ret. on mkt - risk free rate) • (12% - 5%) • Discount rate • (rfr + b(exp. ret. on mkt. - rfr) Outer Drive Associates, LLC
Basic DCF Example • FCF • g • k = = = $310 m 10% 13. 4% • $310 m (13. 4% - 10%) = $9, 119 m • (FCF div. by k - g) Outer Drive Associates, LLC
Digging a Little Deeper (Get busy living or get busy dying) • Dupont Formula • Net Profit Margin • Asset Turnover Ratio • Financial Leverage profitability efficiency leverage or risk Outer Drive Associates, LLC
Digging a Little Deeper • Dupont Formula • Net Profit Margin x Asset Turnover Ratio x Financial Leverage = Return on Equity • For Example: • • NPM AT FL ROE = = 10% 2. 5. 8 20% Outer Drive Associates, LLC
Digging a Little Deeper • Trend Analysis • • NPM AT FL ROE this year = = last year 10% 1. 5 1. 3 20% 15% 2. 0 . 67 20% Outer Drive Associates, LLC
What are the Goals? (Indiana Jones and the Last Crusade) • DCF inputs • Cash Flows – The quest for economic profit • Growth Rate – Sustainability of cash flows • Discount Rate – Uncertainty of future cash flows Outer Drive Associates, LLC
Comparables Model • The principle concept of the comparables method is to compute a ratio from a company generated metric (such as earnings) and a market generated metric (such the price of the stock) and then compare the result with other “comparable” companies or to itself. • The most popular metrics used in ratio form are • Price/Earnings Ratio · Price/EBITDA Ratio · Price/Sales Ratio Outer Drive Associates, LLC
Understanding the Buy Side and the Investment Decision-Making Process • Buy side analysts use • DCF inputs – Cash Flows • The quest for economic profit • Growth Rate – Sustainability of cash flows • Discount Rate – Uncertainty of future cash flows Outer Drive Associates, LLC
Understanding the Buy Side and the Investment Decision-Making Process • Buy side analysts may also use • Comparables method • Other valuation tools – EVA, CFROI, Enterprise Value Outer Drive Associates, LLC
Understanding the Buy Side and the Investment Decision-Making Process (I coulda been a contenda) • Portfolio Managers • Incorporate research produced by analysts • All analysts - sell side, buy side, outside • Evaluate market factors • Funds flows • Charts and other technical metrics • Competitors Outer Drive Associates, LLC
Understanding the Buy Side and the Investment Decision-Making Process • The Players • The investment decision-making process is performed by the primary managers of investment assets, the portfolio managers. • The four largest groups of portfolio managers are: • Pension Fund Managers • Private Money Managers • Mutual Fund Managers • Hedge Fund Managers Outer Drive Associates, LLC
Understanding the Buy Side and the Investment Decision-Making Process • Investment Styles • The varieties of investment styles are many. And understanding the “style” differences is key to understanding the investment decision process itself. Portfolio managers, while relying on the company specific of analysts, incorporate a different set of tools when they construct portfolios to achieve a desired goal. The most common of these styles are: • • • Growth Value GARP (Growth at a reasonable price) Quantitative Technical Outer Drive Associates, LLC
Conclusion (I want the truth. You can’t handle the truth. ) • • Investment Professionals are not a homogeneous group Variety of analytical approaches Variety of investment decision-making approaches Driven by a need to compete and perform Outer Drive Associates, LLC
Therefore. . . • Understanding your market will lead to understanding • The Question Behind the Question Outer Drive Associates, LLC
Outer Drive Associates, LLC • Helps senior corporate management and IR professionals truly understand how the equity market analyzes your company and values your stock. • Help you develop a refined understanding of the myriad shades of difference among the hundreds of investment models underpinning institutional portfolios that determine the actions of fund managers. It’s much more sophisticated than Growth, Value, Income and GARP. • Provide knowledge that gives CEOs, chairmen, presidents, CFOs, business heads and members of boards opportunities to improve their companies’ valuations by being better prepared to work with professional investors and analysts. • Outer Drive Associates, LLC has one and two day programs for senior corporate executives that focus on showing how the investment market really operates. Outer Drive Associates, LLC
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