Key Concepts
- Diluted Shares Outstanding
- Dealing with Equity Issued to Employees
- Loose Ends and Minor Tweaks
- Mid-year Discounting
- Cash
- Cross Holdings
- Estimate MV Debt
- Dual Class Shares
- Levered Free Cash Flows
- Sensitivity Analysis
- Final Thoughts on Valuation
Shares Outstanding
What is the right shares outstanding to divide equity value by?
- Shares outstanding?
- Diluted Shares outstanding?
- Issue is how to deal with equity granted to employees.
Forms of Equity Grants
- Restricted Stock Units (RSUs)
- Employee Options
Restricted Stock Grants
How to incorporate into valuation?
- Past: Include in shares outstanding (even if not vested, Why?)
- Future: Estimate value as % of revenue. Forecast and include in compensation expense.
Options
A right to buy a share at a fixed price over a period of time
Approaches to incorporating into valuation:
- Treasury Approach
- Treasury with a Twist Approach
- Option Value Approach
Option Terminology
(Note all compensation options are call options)
- Exercise or strike price: Price at which you can buy the stock.
- In-the-money: If the strike price is less than the current stock price.
- Exercise: Invoking the terms of the option contract, i.e., buying the stock.
- Unexercisable: Options that have been granted to the employee but not yet vested. The employee cannot exercise the option until it vests, i.e., becomes exercisable.
WRONG! Diluted Share Count Approach
- Adjust the denominator (shares outstanding) for shares if options are exercised
- Look at in the money options and adjust shares by number of in the money options
- Issue?
- Fails to consider that exercising options will bring cash in.
DON'T DO THIS!!!
Treasury Approach
- Follow the diluted shares approach for shares
- Add the value received from the exercise of options to the equity value
- Ignores the time premium on the options
Treasury with a Twist Approach (Our method)
- Use the proceeds to buy back the stock at the current price
- Adjust the shares for the options exercised AND the shares repurchased
- Equity value remains unchanged. Why?
- Still ignores time premium
Option Value Approach
Value the options and subtract from equity value
- Use existing option value model (ex. Black Scholes) to value employee options
- Subtract from Equity Value
- Divide by existing shares (don't mess with share count)
- Issues:
- Option models not designed for employee options.
- Employee options are long-term, not liquid, exercised early, dilutive, and have vesting schedules.
- Note: can multiply by (1-tax rate) as options give tax break
Options Outstanding vs Exercisable
- Options outstanding includes unexercisable options, i.e., options that have not ye vested.
- Why might it be appropriate to include unexercisable options? (Think about modeling assumptions you've likely made)
- Similar logic applies to performance based equity grants.
Basic Example
You have calculated the equity value of GoNuts4Donuts at $150 million. The latest share count is 15 million. Your boss says "Ok, well this firm is valued at $10/share!" (10 million if you work at MSCNBC/NYT!). You know this is wrong since the firm has the following equity grants: 2 million options outstanding with an exercise price of $6 and 1 million unvested RSUs. You have also calculated the value of the options using Black Scholes at $7.80 a share. The stock is currently trading at $12/share. What is the new value per share under the Treasury Method? Treasury with a Twist Method? Option Value Method?
Solution
Treasury
$Value/Share=\frac{150M+(2M*6)}{15M+2M+1M}$
$Value/Share=9$
Treasury with Twist
$Value/Share=\frac{150M}{15M+2M+1M-\frac{2M*6}{12}}$
$Value/Share=8.82$
Option Value
$Value/Share=\frac{150M-(2M*7.80)}{15M+1M}$
$Value/Share=8.40$
Mid-year Discounting
When do cash flows occur?
When do we assume they occur?
- Solution is to discount as if they occur on average in the middle of the year
- $\frac{FCFF_1}{1+WACC^{0.5}}+\frac{FCFF_2}{1+WACC^{1.5}}+...$
- In Excel. Multiply the NPV by $(1+WACC)^{0.5}$
Cash
- Best practice: Keep it out of valuation!
- Ex. Do not include interest income from Cash
- Add cash back at the end
Premium/Discount Cash
- Cash itself is not the issue!
- When is cash bad (discount)?
- Probability that company will waste cash
- Think of activist investors?
- When is cash good (premium)?
- In markets where access to capital is of concern.
- More likely in foreign countries
- Think of start-up ex. Lyft vs Uber
Cross Holdings
Holdings in another company
- Minority passive: I/S shows dividends, B/S shows original investment
- Minority active: I/S income from cross holding, B/S original investment plus retained earnings
- Majority active: financial statements are consolidated. (act like you own 100% until...Minority interest (non controlling interest) under Equity)
How to deal with Cross Holdings
- Figure out the accounting method!
- Add in value of minority passive or minority active
- Subtract value of non-controlling interest
What is the value of Company A if you use consolidated financials to come up with a $1 billion value for the FCFF and the firm has $300 million in debt and $100 million in cash?
Company A holds a passive 10% of Company B who has a MV of 500 million. They also a hold 60% of company C that has been fully consolidated with a book value of $ 40 million. What is the value?
What is the issue?
Value needs to be intrinsic!!!
Perfect World
Assume the value of company A is $750 million using only the parent financials. You separately value company B and C at $250 million each using their intrinsic value. What is the value of company A?
Ideal Solution
- Value the company without cross holdings (using unconsolidated financial statements)
- Value the equity (intrinsically) of each cross holding individually
- Add each of the values of cross holdings (value times % held) to value of the company.
More Realistic Alternative
- For majority holdings (under full consolidation): Multiply the BV of minority interest by the Price-to-Book ratio for the industry of the subsidiary and subtract from enterprise value of parent
- For Minority holdings: Multiply the BV of holdings by the Price-to-Book ratio for the industry of the subsidiary and add to the enterprise value of the parent
Even More Realistic Alternative
- For majority holdings (under full consolidation): Subtract the book noncontrolling (minority) interest from enterprise value of parent
- For Minority holdings: Add the book asset value of holdings (marketable securities or Investments) to the enterprise value of parent
MV of Debt
- Wait what?
- Can estimate (treat as gigantic bond):
- Treat debt amount as face value
- Interest expense is coupon
- Discount at cost of debt
- Use average maturity
This will be similar to BV for healthy companies.
What about distressed companies?
Estimate MV of Debt
A company has a BV of debt of $1 billion and shows an interest expense of $132 million. The average maturity on the debt is 4 years and you estimate the cost of debt to be 8.2%. What is your best estimate for the MV of debt?
N=4; YTM=8.2%; PMT=132M; FV=1,000M
Answer: $1,164.87 million
Dual Class Stock
Multiple share classes (A, B, etc) with different voting rights and potentially different cash flow rights.
How do we value dual class shares?
Apply a premium to the voting class shares (5-10%). Adjust for difference in cash flow rights directly.
Dual Class Example
On 1-800-Flowers.Com Inc's most recent filing it states "The number of shares outstanding of each of the Registrant's classes of common stock as of January 31, 2020: Class A Common Stock of 35,753,963 and Class B Common Stock of 28,542,823 share" Voting rights are 10-1 (B-A) and Class B is not publicly traded. If you value the equity at $1.2 billion and place a 5% premium on voting shares, what is the value per share? (assume no dilutive securities outstanding)
Dual Class Answer
$Value/NonVoting Share=\frac{1200}{35.754+28.543*(1.05)}$
$Value/NonVoting Share=18.26$
Levered Free Cash Flows or FCFE
Cash flows after financial obligations
$FCFE=NonCashNI+DA-Investments$
$-(Debt Repaid - Debt Issued)$
Discount using Cost of Equity
Example
You have been asked to value a firm with expected annual after-tax cash flows, before debt payments, of $100 million a year in perpetuity. The firm has a cost of equity of 12.5%, a market value of equity of $600 million and a market value of debt of $400 million. If the debt is perpetual and the after-tax interest rate on debt is 6.25%.
What if the MV if of equity was $800 million?
Answer1
$WACC=\frac{400}{1000}6.25+\frac{600}{1000}12.5=10$
Using unlevered cash flows:
$Value of Firm=\frac{100}{.1}=1000$
$Value of Equity=1000-400=600$
Using levered cash flows:
$FCFE=100-(400*.0625)=75$
$Value of Equity=\frac{75}{.125}=600$
Answer2
$WACC=\frac{400}{1200}6.25+\frac{800}{1200}12.5=10.42$
Using unlevered cash flows:
$Value of Firm=\frac{100}{.1042}=960$
$Value of Equity=960-400=560$
Using levered cash flows:
$FCFE=100-(400*.0625)=75$
$Value of Equity=\frac{75}{.125}=600$
Will you get same answer?
- Issue arises because we use MV of Equity in WACC
- Problem gets compounded with growth (need to keep debt ratio fixed)
- Need to iterate through to get cost of capital (also constant debt rate)
Sensitivity Analysis
How does our valuation change when we change our assumptions?
- What are key drivers?
- Best and worst case scenarios?
- Reasonable range?
Excel Tools
- Data Tables
- Vertical
- Horizontal
- Two-way
- Scenario Manager
- Allows multiple inputs to be varied at once
Example: Data Table
Example: Scenario Manager
Some Valuation Notes
- Good valuation is at the intersection of the numbers and the story
- Bad valuations come when you are at one end or the other.
- Key story (number) drivers
- Company history
- The markets and its growth
- Competitors it faces (and will face)
- Macro environment
Valuation Steps
- Survey the landscape
- Create a narrative for the future
- Simple, focused, and grounded
- Common sense check the narrative
- Is it possible? plausible? probable?
Is it?
- Impossible
- Growth rate greater than economy
- Bigger than total market
- Profit margin>100%
- Depreciation without capex
- Implausible
- Growth without reinvestment
- Profits without competition
- Returns without risk
- Improbable
- High Growth and low risk
- High Growth and low reinvestment
- Low risk and high reinvestment
More steps
- Connect narrative to key drivers of value
- Be ready to modify narrative as information (events) updates