Equity Valuation 101 The Question Behind the Question

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Equity Valuation 101The Question Behind the
Question

• Vincent Catalano, CFA
• Managing Partner
• Outer Drive Associates, LLC

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Whats It All About, Alfie?

• Wall Street Analysts want to know
• Whats Real and Whats Not
• Senior Corporate Management IROs want to know
• The question behind the question

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Valuation Models

• Methodologies
• Discounted Cash Flow
• Cash Flows, Growth Rates, Discount Rates
• Comparables
• P/E ratios

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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

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Discounted Cash Flow Model(Show me the real
money)

• Free Cash Flows
• Net Income
• Depreciation
• - Capex
• /- changes in working capital
• Free cash flows

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DCF Model Example

• NI 200m
• Depr. 100m
• - Capex - 50m
• /- WC changes 60m
• Free cash flows 310m

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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)

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Sustainable Growth Rate Example

• ROE 20
• Retention Rate 50
• (1 - dividend payout ratio)
• Sustainable growth rate 10

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Discount Rate Example

• Risk free rate 5
• beta 1.2
• Excess return on mkt. 7
• (exp. ret. on mkt - risk free rate)
• (12 - 5)
• Discount rate 13.4
• (rfr b(exp. ret. on mkt. - rfr)

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Basic DCF Example

• FCF 310m
• g 10
• k 13.4
• 310m ? (13.4 - 10) 9,119m
• (FCF div. by k - g)

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Digging a Little Deeper(Get busy living or get
busy dying)

• Dupont Formula
• Net Profit Margin profitability
• Asset Turnover Ratio efficiency
• Financial Leverage leverage or risk

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Digging a Little Deeper

• Dupont Formula
• Net Profit Margin x Asset Turnover Ratio x
  Financial Leverage Return on Equity
• For Example
• NPM 10
• AT 2.5
• FL .8
• ROE 20

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Digging a Little Deeper

• Trend Analysis this year last year
• NPM 10 15
• AT 1.5 2.0
• FL 1.3 .67
• ROE 20 20

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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

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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

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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

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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

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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

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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

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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

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Conclusion(I want the truth. You cant 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

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Therefore...

• Understanding your market will lead to
  understanding
• The Question Behind the Question

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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.  Its 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.