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Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 6 INTRINSIC VALUE VALUATION AXA Given the nature of the company (Mature, stable growth), the value estimates are particularly sensitive to the ROE and the dividend per share assumptions. I assumed an ROE equivalent to the average sector of 11.9 % and a dividend per share equal to 0.57 which I think is appropriate for a stable mature company. Based on this analysis, the price of the AXA stock should be 8.86 Euro or $11.77, which is below the actual price range of $ 23.7 that AXA is trading at currently. Cost of Equity: 10.61 % The bottom up beta based on the company’s businesses. ……………..Assuming stable growth rate of 2.87% Dividend Payout Ratio: 67.26% DPS: 0.57 Expected Growth Retention Ratio: 32.74 % ROE: 12 % Expected Growth rate: 3.9 % Value per share: 8.86 Euros Beta: 0.94. The bottom up beta based on the company’s businesses. Risk Free Rate : 4.35 % Long term bond rate in Euros Risk Premium: 6.71% Average risk premium of Europe, Asia and the US weighted by the percentage of revenues. Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 7 XM SATELLITE RADIO HOLDINGS To evaluate XMSR’s intrinsic value, I used the high-growth discounted cash flow model. Given the nature of the company (early-stage high-growth), the value estimates are particularly sensitive to the growth and stable-growth ROC assumptions employed, which are the key assumptions. The main driver of XMSR’s going concern in the future will be the growth (35.5% annual compounded) in subscriptions, which has been rather remarkable since the company went live with its service. Based on my DCF analysis the price of the XMSR stock should be circa $31, which is below the actual price range of $38-40 that XMSR is trading at currently. Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 8 VSEA To value VSEA, we used the 3-stage FCFF model since the company is currently in a high-growth phase and has very little debt. The firm is likely to change its financing mix in the coming years. High growth is expected to last for five years, followed by a five year transition period. The key drivers of the model are the company’s 5-year growth rate and its beta. The expected growth rate, based on fundamentals is 6.97%. However, the average analyst forecast for 5-year growth is 18%. Based on this discrepancy, we used a composite 12.5% growth rate to value VSEA. We also used a bottom-up beta calculated by using the average betas of other semiconductor equipment firms. VSEA’s levered beta is 2.22. Based on our DCF valuation, VSEA should be worth $29.40, which is less than the current price of $37.09. Current Cashflow to firm Analyst Estimate (g): 18% EBIT(1-t): 47,948 Reinvestment Rate: 77.2% * ROC: 9.03% = 6.97% - Net Capex 16,855 Expected growth in EBIT(1-t) = .5*(.0697) + .5*(.18) = 12.5% - Chng WC 20,163 = FCFF 8,109 Stable Growth: Firm Value $779,473 g= 5% + Cash $398,216 Beta= 1.20 - Debt $10,716 (D/D+E)= 10% =Equity $1,166,973 Capex/Depreciation= 104.00% -Options $97,071 Value/Share 29.40$ Terminal Value10= 59512/(.0837-.05) = 1,763,949 EBIT (1-t) 45,127$ 50,691$ 56,941$ 63,961$ 71,846$ 80,703$ 83,608$ 85,012$ 84,750$ 82,737$ -Reinvestment 37,018$ 34,662$ 38,995$ 43,869$ 49,353$ 55,522$ 48,680$ 41,561$ 34,520$ 27,956$ FCFF 8,109$ 16,029$ 17,946$ 20,092$ 22,493$ 25,181$ 34,928$ 43,450$ 50,230$ 54,781$ Discount at Cost of Capital (WACC) = 12.49%(.9926) + 5.89%(0.0074) = 12.44% Cost of Equity Cost of Debt Weights 12.49% 5.89% E= 0.9926 D= 0.0074 Riskfree Rate Beta Implied Risk Premium 4.15% 2.225 3.75% Unlevered Beta Firm's D/E Ratio 2.213 0.81% VARIAN SEMICONDUCTOR (VSEA) DCF VALUATION Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 9 OPEN WAVE SYSTEMS The DCF valuation chose the 3-stage model due to the nature of the company. The high growth period is smoothly faded into stable growth over a 10 year period with initial growth rate at 18% in the first three years, 11% in the next three years and decreasing to 5% in the last 2 years. The intrinsic value of Openwave systems is higher than assessed in its relative valuation. We believe this is a result of the global growth in the mobile data market finally picking up speed. FCFF_3 Model: Operwave System Reinvestme nt Rate -72% 186% 188 % 189 % 123 % 124% 105% 100% 92% 76% 29 % 29% Return on Capital 22% 18% 16% 14% 13% 12% 11% 11% 11% 11 % 15% Year Base 1 2 3 4 5 6 7 8 9 10 TY Revenue Growth Rate 18% 18% 18% 11% 11% 11% 5% 5% 4% 4% 4% FCFF($) K 10384 6 - 6059 3 - 7230 4 - 8587 3 - 2482 0 - 2778 3 - 3098 9 5567 0 5839 7 778 51 809 45 7652 3 Debt Ratio 55% 55% 55% 55% 55% 55% 44% 42% 37% 29% 3% 3% Beta 8.7 8.7 8.7 8.7 8.7 8.7 7.2 5.7 4.2 2.7 1.2 1.2 Cost of Capital 19% 19% 19% 19% 19% 19% 20% 17% 15% 12% 9% 9% Beta The Valuation ($ ) Terminal Firm Value Country R P Weigh t PV of FCFF High Growth = - 120,41 2 $ 601,619 US 4 0.406 3.20 PV of Terminal Value = 377,90 1 Japan 10.29 0.568 3.28 Value of Operating Assets = 257,48 8 Europe 6.89 0.432 5.86 Value of Non-operating assets= 344,13 1 Openwave Systems Beta 8.78 Value of Firm = 601,61 9 Cost of Capital - Value of Outstanding Debt = 147,39 2 Cost of Equity 54.29% Value of Equity = 454,22 7 Cost of Debt 1.91% - Value of Equity Options = 44,560 Cost of Capital 19.32% Value of Equity in Common Stock = 409,66 7 Value of Equity per share = 33 Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 10 QWEST Qwest is a financially distressed firm that generated negative earnings and free cash flows over the past years. It has negative book value of equity of ($1,016) million and extremely high debt balance, $17,413 million. The firm is leveraged beyond its optimal debt ratio and suffers high cost of equity, 16.84%. In the two-stage FCFE model, Qwest’s equity value is at ($1.02) per share. We conclude DCF is not a good valuation tool for valuing troubled firms - Qwest equity holders’ residual claim of cash flows is negative. Cost of Equity = 16.84% Net Income = ($303) Net Income without interest income from cash= ($415) Growth rate in Net Income = 4.55% Equity Reinvestment Rate for high growth phase= 27.00% The dividends for the high growth phase are shown below (upto 10 years) 1 2 3 4 5 Expected Growth Rate 4.55% 4.55% 4.55% 4.55% 4.55% Net Income ($434.35) ($454.10) ($474.75) ($496.33) ($518.90) Equity Reinvestment Rate 27.00% 27.00% 27.00% 27.00% 27.00% FCFE ($317.08) ($331.49) ($346.56) ($362.32) ($378.80) Cost of Equity 16.84% 16.84% 16.84% 16.84% 16.84% Cumulative Cost of Equity 116.84% 136.51% 159.49% 186.34% 217.71% Present Value ($271.39) ($242.84) ($217.30) ($194.44) ($173.99) Growth Rate in Stable Phase = 2.00% Equity Reinvestment rate inn st 18.69% Cost of Equity in Stable Phase = 8.80% Price at the end of growth phase = ($5,297.45) Present Value of FCFEs in high growth phase = ($1,099.96) Present Value of Terminal Equity Value = ($2,433.26) Value of equity in operating assets = ($3,533.22) Value of Cash and Marketable Securities = $1,756.00 Value of equity in firm = ($1,777.22) Value per share = ($1.02) Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 11 SONUS A three-stage FCFF model was used to value Sonus. Using this form of discounted cash flow model, the value of Sonus was calculated to be $11.31. This implies that the stock is undervalued by 94% at a current market price of $5.84 (as of Dec. 10, 2004). The key drivers to this value are: the growth rate assumed during the firm’s high growth period the duration assumed of the high growth period the debt ratio assumed during the stable growth period Of these three drivers, the debt ratio is the least important, not because it has the least impact on the valuation of the company, but because it is the least likely to change. Most companies in this sector (i.e., networking equipment) do not have high debt-to-capital ratios (it is difficult for most technology companies to issue substantial amounts of debt financing, and it is even tougher for them during the earlier stages). The growth rate during the high growth period is the most important variable because it has the greatest impact on the value of the company, and it is one that can change based on different factors (market conditions, financing availability, capital expenditures, management objectives, etc.). As can be seen below, changing the length of the high growth period does not have as much of an impact on Sonus’s valuation as changing the assumption of the growth rate during the high growth period. Changes in capital spending and the return of capital of the firm would directly affect the growth rate, and thus affect the valuation of the company. Keeping all other variables constant, changing the growth rate of the firm during the high growth period affects its valuation as follows (growth rate used in the valuation in bold): Growth Rate (High Growth Period) Value per Share 15% $6.74 20% $8.92 24.31% $11.31 30% $15.39 35% $20.04 Keeping all other variables constant, changing the length of the high growth period affects its valuation as follows (length of growth rate period used in the valuation in bold): Length of High Growth Period Value per Share 5 $9.30 7 $10.64 10 $11.31 13 $11.32 15 $11.59 Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 12 Keeping all other variables constant, changing the debt ratio during the stable growth period affects its valuation as follows (debt ratio used in the valuation in bold): Debt Ratio (Stable Growth Period) Value per Share 5% $11.31 10% $11.95 15% $12.66 20% $13.46 25% $14.37 The valuation of the company can be visually depicted as follows: Output from the program Cost of Equity = 11.71% Equity/(Debt+Equity ) = 99.15% After-tax Cost of debt = 2.93% Debt/(Debt +Equity) = 0.85% Cost of Capital = 11.63% Intermediate Output Expected Growth Rate 24.31% Working Capital as percent of revenues = -3.34% (in percent) The FCFF for the high growth phase are shown below (upto 10 years) Current 1 2 3 4 5 6 7 8 9 10 Terminal Year Expected Growth Rate 24.31% 24.31% 24.31% 24.31% 24.31% 20.05% 15.79% 11.52% 7.26% 3.00% Cumulated Growth 124.31% 154.53% 192.10% 238.80% 296.86% 356.37% 412.63% 460.18% 493.60% 508.41% Reinvestment Rate 121.75% 121.75% 121.75% 121.75% 121.75% 100.40% 79.06% 57.71% 36.37% 15.02% EBIT * (1 - tax rate) $79,732 $99,116 $123,212 $153,166 $190,401 $236,690 $284,143 $328,999 $366,914 $393,560 $405,367 $417,527.62 - (CapEx- Depreciation) $62,492 $122,066 $151,742 $188,632 $234,490 $291,496 $288,703 $263,329 $214,488 $145,050 $61,752 $64,246.43 -Chg. Working Capital $34,580 ($1,396) ($1,735) ($2,157) ($2,681) ($3,333) ($3,417) ($3,230) ($2,730) ($1,919) ($850) ($1,517.93) Free Cashflow to Firm ($17,339) ($21,555) ($26,795) ($33,309) ($41,407) ($51,473) ($1,143) $68,900 $155,157 $250,428 $344,465 $354,799.12 Cost of Capital 11.63% 11.63% 11.63% 11.63% 11.63% 10.98% 10.32% 9.67% 9.02% 8.36% Cumulated Cost of Capital 1.1163 1.2462 1.3911 1.5530 1.7336 1.9239 2.1226 2.3278 2.5378 2.7500 Present Value ($19,309) ($21,502) ($23,944) ($26,663) ($29,691) ($594) $32,461 $66,652 $98,681 $125,260 Growth Rate in Stable Phase = 3.00% Reinvestment Rate in Stable Phase = 15.02% FCFF in Stable Phase = $354,799.12 Cost of Equity in Stable Phase = 8.65% Equity/ (Equity + Debt) = 95.00% AT Cost of Debt in Stable Phase = 2.93% Debt/ (Equity + Debt) = 5.00% Cost of Capital in Stable Phase = 8.36% Value at the end of growth phase = $6,614,758.73 Present Value of FCFF in high growth phase = $201,350.57 Present Value of Terminal Value of Firm = $2,405,359.69 Value of operating assets of the firm = $2,606,710.26 Value of Cash, Marketable Securities & Non-operating assets = $299,901.00 Value of Firm = $2,906,611.26 Market Value of outstanding debt = $13,181.52 Market Value of Equity = $2,893,429.74 Value of Equity in Options = $89,955.01 Value of Equity in Common Stock = $2,803,474.74 Market Value of Equity/share = $11.31 Valuation Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 13 COACH, INC. For Discounted Cash Flow Valuation we have used Three-Stage-Growth model. The main assumptions are highlighted below. Based on these assumptions, the value of the company’s stock came out as slightly overvalued. High-Growth Period - Revenues growth is 30% - Bottom-up Beta is 1.04 - High-Growth period is 5 years - Pretax Operating Margin is 30% - 3% Debt Financing - Working Capital/Revenue is 40% - Marginal Tax Rate is 35% Stable Period - Revenue growth rate is 4% - Capital Expenditures are 120% of the Depreciation - Pre-Tax Operating Margin is 20% - Bottom-up Beta is 1.00 - 20% Debt Financing Terminal Value 20,650,144,755$ Base 1 2 3 4 5 EBIT (1- t) 313,319,796 $ 392,832,662 $ 491,854,466 $ 614,934,413 $ 767,595,426 $ 956,508,950 $ + Depreciation 42,854,000 $ 55,710,200 $ 72,423,260 $ 94,150,238 $ 122,395,309 $ 159,113,902 $ - Capital Expenditures 67,700,000 $ 88,010,000 $ 114,413,000 $ 148,736,900 $ 193,357,970 $ 251,365,361 $ - Change in WC (6,854,000) $ 158,532,720 $ 206,092,536 $ 267,920,297 $ 348,296,386 $ 452,785,302 $ = FCFF 295,327,796 $ 202,000,142 $ 243,772,190 $ 292,427,454 $ 348,336,379 $ 411,472,189 $ 6 7 8 9 10 1,114,141,625 $ 1,237,333,856 $ 1,306,624,551 $ 1,307,931,176 $ 1,236,589,476 $ 198,574,150 $ 237,494,683 $ 271,693,918 $ 296,689,758 $ 308,557,349 $ 275,146,052 $ 298,926,744 $ 322,707,435 $ 346,488,127 $ 370,268,818 $ 486,593,271 $ 479,937,931 $ 421,718,521 $ 308,229,381 $ 146,341,950 $ 550,976,451 $ 695,963,864 $ 833,892,513 $ 949,903,426 $ 1,028,536,056 $ Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 14 Going through a sensitive analysis of the most significant inputs, we have noticed that the most important parameters are the growth rate during the high growth period and pre-tax operating margin in perpetuity. The assumptions we have made for these two variables are the most feasible due to the company’s significant current growth and growth potential and due to the nature of the company’s product lines. Coach is selling brand-name products at a high margin, resulting in high operating margin. Value of Firm 10,843,917,352$ + Cash and marketable securities = 434,443,000$ - Value of Debt 728,885,692$ Value of Equity 10,549,474,660$ - Value of Equity options issued by firm -$ Value of Equity per Share 55.84$ -100% -80.0% -60% -40.0% -20% 0.0% 20% 40.0% 60% 80.0% Growth Rate in High Growth Period 30% 1.0$ 1.2$ 1.7$ 2.5$ 4.9$ 12.4$ 34.0$ 90.2$ 222.3$ 508.3$ 10% 13% 16% 19% 22% 25% 28% 31% 34% 37% Pre-Tax Op. Margin in perpetuity 20% 26.8$ 35.5$ 44.2$ 52.9$ 61.7$ 70.4$ 79.1$ 87.8$ 96.6$ 105.3$ 2.25% 2.50% 2.75% 3.00% 3.25% 3.50% 3.75% 4.00% 4.25% 4.50% Growth Rate in Stable period= 4.0% 45.2$ 46.4$ 47.7$ 49.0$ 50.5$ 52.1$ 53.9$ 55.8$ 58.0$ 60.3$ 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt to refinance in Stable Growth periodLength of Growth Period= 20% 50.3$ 55.8$ 63.0$ 72.6$ 86.1$ 106.6$ 141.5$ 214.2$ 458.3$ 0% 20% 40% 60% 80% 100% 120% 140% 160% 180% Cap Ex / Depreciation= 120% 73.5$ 70.6$ 67.6$ 64.7$ 61.7$ 58.8$ 55.8$ 52.9$ 50.0$ 47.0$ 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 Beta= 0.99 63.0$ 61.5$ 60.0$ 58.6$ 57.1$ 55.8$ 54.4$ 53.1$ 51.8$ 50.6$ Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 15 RELATIVE VALUATION AXA Given the nature of AXA business, the appropriate ratio to use is the Price to Book value. A simple matrix plot of the ROE and PBV of 20 comparable firms, shows that AXA is positioned the down left box meaning that it has a low PBV which is due to its low ROE. ROE P B V 6050403020100-10-20 6050403020100-10-20 5 4 3 2 1 0 5 4 3 2 1 0 Matrix Plot of PBV vs ROE Regressing PBV against ROE and expected 5 years growth in earning of 20 comparable firms (European companies in the multi line insurance industry) gives the following equation: Ln PVB = 2.58 + 0.562 ln Growth + 0.250 ln ROE Predictor Coef SE Coef T P Constant 2.5794 0.6256 4.12 0.001 Growth 0.5621 0.2148 2.62 0.018 ROE 0.25033 0.07336 3.41 0.003 S = 0.350709 R-Sq = 53.8% R-Sq(adj) = 48.3% It is important to notice that to run this regression, I only used firms with positive return on equity. Based on this equation with an R squared of 53.8%, the appropriate PBV of AXA based on the regression is: ln PVB = 2.58 + 0.562 (ln 1.3%) + 0.250 (ln 9.5%) PVB = 0.64 Comparing to the current PBV of 1.34, AXA seems overvalued. The factors that account for low price to book value for AXA include low ROE comparing to an industry return of 11.9% and low expected growth on earning comparing to the average of comparable firms. AXA Valuation – Fundamentals & Relative Approaches for a Sample of Seven Companies 16 XM SATELLITE RADIO HOLDINGS Given the fact that XMSR is one of the two companies (Sirius is the other one) that have a distinctly different business model than other entertainment/broadcasting companies as well as the fact that XMSR is an early-stage high-growth company (while the entertainment/broadcasting industry consists of predominantly mature companies), valuation against comparables makes little sense. Nevertheless, I conducted regression analyses (see below for results) of 22 radio holding companies, XMSR and Sirius. I regressed the companies’ EV/Sales ratio (since XM does not have positive earnings) against their Pre-tax Operating Margins. Despite a 99% R- squared, the regression is useless, as XMSR and Sirius are the two outliers (see graph). Moreover, the regression equation does not make any sense, as increasing operating margin results in lower EV/Sales multiple. Therefore, using the regression equation to evaluate XMSR relative to comparable companies is an exercise in futility. It’s important to note that regressing XMSR against internet, wireless and cable TV comparables produces similar results. This is not surprising as both XMSR and Sirius command a premium in the equities market based solely on the very high growth expectations. The regression equation is EV/Sales = 7.04 - 9.36 Pre-tax O