VALUATION: TERMINAL VALUE, Schemes and Mind Maps of Business

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VALUATION: TERMINAL VALUE

The tail that wags the valua9on dog..

The Investment Decision

Invest in assets that earn a return

greater than the minimum acceptable

hurdle rate

The Financing Decision

Find the right kind of debt for your

firm and the right mix of debt and

equity to fund your operations

The Dividend Decision

If you cannot find investments that make

your minimum acceptable rate, return the

cash to owners of your business

Hurdle Rate

4. Define & Measure Risk
5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal Financing Type
23. The Right Financing Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

Set Up and Objective

1: What is corporate finance

2: The Objective: Utopia and Let Down

3: The Objective: Reality and Reaction

36. Closing Thoughts

3

Ways of Es9ma9ng Terminal Value

Terminal Value

Liquidation

Value

Multiple Approach Stable Growth

Model

Most useful

when assets

are separable

and

marketable

Easiest approach but

makes the valuation

a relative valuation

Technically soundest,

but requires that you

make judgments about

when the firm will grow

at a stable rate which it

can sustain forever,

and the excess returns

(if any) that it will earn

during the period.

Ge?ng Terminal Value Right

1. Obey the growth cap ¨ When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be wriNen as: Value = Expected Cash Flow Next Period / (r -­‐ g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate ¨ The stable growth rate cannot exceed the growth rate of the economy but it can be set lower. ¤ If you assume that the economy is composed of high growth and stable growth firms, the growth rate of the laNer will probably be lower than the growth rate of the economy. ¤ The stable growth rate can be nega9ve. The terminal value will be lower and you are assuming that your firm will disappear over 9me. ¤ If you use nominal cashflows and discount rates, the growth rate should be nominal in the currency in which the valua9on is denominated. ¨ One simple proxy for the nominal growth rate of the economy is the riskfree rate.

And the key determinant of growth periods is the company’s compe99ve advantage… ¨ Recapping a key lesson about growth, it is not growth per se that creates value but growth with excess returns. For growth firms to con9nue to generate value crea9ng growth, they have to be able to keep the compe99on at bay. ¨ Proposi9on 1: The stronger and more sustainable the compe99ve advantages, the longer a growth company can sustain “value crea9ng” growth. ¨ Proposi9on 2: Growth companies with strong and sustainable compe99ve advantages are rare.

Choosing a Growth Period: Examples

Disney Vale Tata Motors Baidu Firm size/market size Firm is one of the largest players in the entertainment and theme park business, but the businesses are being redefined and are expanding. The company is one of the largest mining companies in the world, and the overall market is constrained by limits on resource availability. Firm has a large market share of Indian (domestic) market, but it is small by global standards. Growth is coming from Jaguar division in emerging markets. Company is in a growing sector (online search) in a growing market (China). Current excess returns Firm is earning more than its cost of capital. Returns on capital are largely a function of commodity prices. Have generally exceeded the cost of capital. Firm has a return on capital that is higher than the cost of capital. Firm earns significant excess returns. Competitive advantages Has some of the most recognized brand names in the world. Its movie business now houses Marvel superheros, Pixar animated characters & Star Wars. Cost advantages because of access to low-cost iron ore reserves in Brazil. Has wide distribution/service network in India but competitive advantages are fading there.Competitive advantages in India are fading but Landrover/Jaguar has strong brand name value, giving Tata pricing power and growth potential. Early entry into & knowledge of the Chinese market, coupled with government-imposed barriers to entry on outsiders. Length of high- growth period Ten years, entirely because of its strong competitive advantages/ None, though with normalized earnings and moderate excess returns. Five years, with much of the growth coming from outside India. Ten years, with strong excess returns.

Don’t forget that growth has to be earned..

3. Think about what your firm will earn as returns forever.. ¨ In the sec9on on expected growth, we laid out the fundamental equa9on for growth: Growth rate = Reinvestment Rate * Return on invested capital + Growth rate from improved efficiency ¨ In stable growth, you cannot count on efficiency delivering growth (why?) and you have to reinvest to deliver the growth rate that you have forecast. Consequently, your reinvestment rate in stable growth will be a func9on of your stable growth rate and what you believe the firm will earn as a return on capital in perpetuity: ¤ Reinvestment Rate = Stable growth rate/ Stable period Return on capital ¨ A key issue in valua9on is whether it okay to assume that firms can earn more than their cost of capital in perpetuity. There are some (McKinsey, for instance) who argue that the return on capital = cost of capital in stable growth…

There are some firms that earn excess returns

¨ While growth rates seem to fade quickly as firms become larger, well

managed firms seem to do much beNer at sustaining excess returns for

longer periods.

And don’t fall for sleight of hand…

¨ A typical assump9on in many DCF valua9ons, when it comes to

stable growth, is that capital expenditures offset deprecia9on and

there are no working capital needs. Stable growth firms, we are

told, just have to make maintenance cap ex (replacing exis9ng

assets ) to deliver growth. If you make this assump9on, what

expected growth rate can you use in your terminal value

computa9on?

¨ What if the stable growth rate = infla9on rate? Is it okay to make

this assump9on then?

Es9ma9ng Stable Period Inputs a]er a high

growth period: Disney

¨ Respect the cap: The growth rate forever is assumed to be 2.5. This is set lower than the riskfree rate (2.75%). ¨ Stable period excess returns: The return on capital for Disney will drop from its high growth period level of 12.61% to a stable growth return of 10%. This is s9ll higher than the cost of capital of 7.29% but the compe99ve advantages that Disney has are unlikely to dissipate completely by the end of the 10th year. ¨ Reinvest to grow: Based on the expected growth rate in perpetuity (2.5%) and expected return on capital forever a]er year 10 of 10%, we compute s a stable period reinvestment rate of 25%: ¨ Reinvestment Rate = Growth Rate / Return on Capital = 2.5% /10% = 25% ¨ Adjust risk and cost of capital: The beta for the stock will drop to one, reflec9ng Disney’s status as a mature company. ¤ Cost of Equity = Riskfree Rate + Beta * Risk Premium = 2.75% + 5.76% = 8.51% ¤ The debt ra9o for Disney will rise to 20%. Since we assume that the cost of debt remains unchanged at 3.75%, this will result in a cost of capital of 7.29% ¤ Cost of capital = 8.51% (.80) + 3.75% (1-­‐.361) (.20) = 7.29%

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