Equity Valuation

Jan Viebig, CFA, is a Managing Director at DWS Investment GmbH in Frankfurt, Germany, where he manages two long / short equity hedge funds. With EUR 142 billion under management, DWS is the largest asset manager in Germany. DWS is part of Deutsche Asset Management (DeAM). Jan holds a Diploma and a PhD degree in Business Administration from the University of the Armed Forces in Munich and a Master of International Management (Post-MBA) degree from Thunderbird, School of Global Management. He is a lecturer at the University of Bremen. His research interests are in the field of hedge funds and equity valuation. Thorsten Poddig has studied business administration, economics, and computer sciences. He received his PhD degree at the University of Bamberg. His work on concepts in Artificial Intelligence and its application to decision theory and decision making in business administration was followed by analyzing, modeling and forecasting financial markets with neural networks at the University of Freiburg.  Since 1996, he has been Professor of Business Administration and Finance at the University of Bremen. His research interests cover all aspects of asset management, including financial market modeling and forecasting, portfolio optimization and asset allocation, equity valuation, capital market theory and empirical finance.Armin Varmaz studied business administration and economics. In his PhD thesis he analyzed the profitability, the competition and the efficiency in the German banking sector, using panel data approaches and data envelopment analysis. Since 2006 he has been a post-doctoral research fellow at the University of Bremen. His main interests and research experience include valuation theory, optimization in economics and empirical finance. He is currently working on advanced quantitative methods for analyzing, modeling and simulating long-term developments in financial markets.

• Foreword xiiiPreface xviiAcknowledgments xxiiiAbbreviations xxvPart I Discounted Cash Flow (DCF) Models 1Jan Viebig and Thorsten Poddig1 Introduction 32 The Fundamental Value of Stocks and Bonds 53 Discounted Cash Flow Models: The Main Input Factors 113.1 Analytical balance sheets and free cash flow discount models 113.2 The dividend discount model 143.3 The free cash flow to the firm (FCFF) model 213.3.1 Stirling Homex: why cash is king! 213.3.2 FCFF during the competitive advantage period 273.3.3 Weighted average cost of capital (WACC) 353.3.4 Terminal value calculation 45References 49Part II Monte Carlo Free Cash Flow to the Firm (MC-FCFF) Models (Deutsche Bank/DWS) 53Jan Viebig and Thorsten Poddig4 Introduction 555 Standard FCFF Model 575.1 Net revenues 595.2 Cost structure and operating income 635.3 Reconciling operating income to FCFF 665.4 The financial value driver approach 715.5 Fundamental enterprise value and market value 765.6 Baidu’s share price performance 2005–2007 796 Monte Carlo FCFF Models 856.1 Monte Carlo simulation: the idea 856.2 Monte Carlo simulation with @Risk 886.2.1 Monte Carlo simulation with one stochastic variable 886.2.2 Monte Carlo simulation with several stochastic variables 986.3 Disclaimer 103References 105Part III Beyond Earnings: A User’s Guide to Excess Return Models and the HOLT CFROI® Framework 107Tom Larsen and David Holland7 Introduction 1098 From Accounting to Economics – Part I 1139 From Economics to Valuation – Part I 11510 Where Does Accounting Go Wrong? 11711 From Accounting to Economics: CFROI 11911.1 The basics 11911.1.1 Return on net assets (RONA) or return on invested capital (ROIC) 12011.1.2 Return on gross investment (ROGI) 12111.1.3 Cash flow return on investment (CFROI) 12111.2 CFROI adjustments using Vodafone’s March 2005 annual report 12311.2.1 Gross investment 12311.2.2 Non-depreciating assets 13111.2.3 Project life 13511.2.4 Gross cash flow 13711.3 CFROI calculation for Vodafone 14011.4 A comment on goodwill 14112 From Accounting to Economics: Economic Profit 14512.1 The basics 14512.2 Caveats 14712.3 EP adjustments using Vodafone March 2005 annual report 14812.3.1 Balance Sheet 14812.3.2 Net operating profit after tax (NOPAT) 15312.3.3 Economic profit 15312.3.4 EP or CFROI? 15413 From Economics to Valuation – Part II 15713.1 General rules 15713.2 Market value added 15713.3 CFROI 15713.4 A word on debt 15813.5 Valuation 15913.5.1 CFROI valuation: general framework 15913.5.2 Understanding project returns 15913.5.3 The residual period 16113.5.4 CFROI residual period approach 16413.5.5 Economic profit valuation: general framework 16513.6 Valuation of Vodafone 16713.7 EP or CFROI? 17113.8 A final word 173Appendix 1: Vodafone Financial Statements and Relevant Notes for CFROI Calculation 175Appendix 2: Additional Notes from Vodafone Annual Report for EP Calculation 185References 191Part IV Morgan Stanley ModelWare’s Approach to Intrinsic Value: Focusing on Risk-Reward Trade-offs 193Trevor S. Harris, Juliet Estridge and Doron Nissim14 Introduction 19515 Linking Fundamental Analysis to the Inputs of the Valuation Model 19916 Our Valuation Framework 20317 Linking Business Activity to Intrinsic Value: The ModelWare Profitability Tree 21118 ModelWare’s Intrinsic Value Approach 21919 Treatment of Key Inputs 23120 The Cost of Capital 23320.1 Risk-free rate 23320.2 Equity risk premium 23420.3 Beta-estimation 23421 Summary and Conclusions 237Appendix 239References 251Part V UBS VCAM and EGQ Regression-based Valuation 253David Bianco22 Introducing “EGQ” – Where Intrinsic Methods and Empirical Techniques Meet 25523 A Quick Guide to DCF and Economic Profit Analysis 25723.1 Powerful analytical frameworks, but not a complete solution 25723.2 Dynamics of economic profit analysis 25723.3 “Unadulterated EVA” 25823.4 Value dynamic 1: ROIC 25823.5 Value dynamic 2: invested capital 25923.6 Value dynamic 3: WACC 26023.7 Value dynamic 4: the value creation horizon 26123.8 Combining all four value dynamics: EGQ 26123.8.1 EGQ vs. PVGO 26123.8.2 The search for the ultimate valuation methodology 26224 Regression-based Valuation 26325 UBS Economic Growth Quotient 26525.1 The EGQ calculation 26525.2 EGQ special attributes 26525.2.1 A complete metric 26525.2.2 Not influenced by the current capital base 26525.2.3 Limited sensitivity to the assumed cost of capital 26625.2.4 Comparable across companies of different size 26625.2.5 Explains observed multiples on flows like earnings or cash flow 26726 UBS EGQ Regression Valuation 26926.1 Intrinsic meets relative valuation 26926.2 EGQ regressions: relative valuation theater 27026.3 EGQ regressions: a layered alpha framework 27126.4 Y-intercept indicates cost of capital 27126.5 Slope vs. Y-intercept indicates style 27126.6 Emergent valuation 27226.7 Why regress EGQ vs. EV/NOPAT? 27226.8 Think opposite when under the X-axis 27327 Understanding Regressions 27527.1 Key takeaways 27527.2 The line – what is the relationship? 27627.2.1 Slope (beta) 27627.2.2 y-intercept (alpha) 27727.3 The explanatory power or strength of the relationship 27727.3.1 Correlation coefficient (R) 27727.3.2 Coefficient of determination (R-squared) 27727.4 Reliability or confidence in the quantified relationship 27827.4.1 Standard error (of beta) 27827.4.2 t-Statistic 27827.5 Regression outliers 27827.5.1 Influence outliers 27827.5.2 Leverage outliers 27827.6 Beware of outliers in EGQ regressions 27928 Appendix Discussions 28128.1 EGQ’s muted sensitivity to assumed WACC 28128.2 EV/IC vs. ROIC/WACC regressions 28228.3 PE vs. EPS growth regressions or PEG ratios 28428.4 Return metrics: ROIC vs. CFROI 28528.5 Accrual vs. cash flow return measures 28628.6 ROIC vs. CFROI 28628.7 Adjusting invested capital important, but not for EGQ 288References 291Part VI Leverage Buyout (LBO) Models 293Jan Viebig, Daniel Stillit and Thorsten Poddig29 Introduction 29530 Leveraged Buyouts 29731 IRRs and the Structure of LBO Models 30132 Assumptions of LBO Models 30733 Example: Continental AG 31733.1 Background 31733.2 LBO modeling approach – appropriate level of detail 31833.3 Key LBO parameters 31833.4 Step-by-step walk through the model 32034 A Word of Caution 329References 333Part VII Valuation 101: Approaches and Alternatives 335Aswath Damodaran35 Introduction 33736 Overview of Valuation 33937 Discounted Cash Flow Valuation 34137.1 Essence of discounted cashflow valuation 34137.2 Discount rate adjustment models 34137.2.1 Equity DCF models 34337.2.2 Firm DCF models 34437.3 Certainty equivalent models 34537.4 Excess return models 34637.5 Adjusted present value models 34637.6 Value enhancement in the DCF world 34737.6.1 Determinants of value 34737.6.2 Ways of increasing value 34938 Liquidation and Accounting Valuation 35538.1 Book value-based valuation 35538.1.1 Book value 35638.1.2 Book value plus earnings 35638.1.3 Fair value accounting 35738.2 Liquidation valuation 35838.3 Value enhancement in the accounting world 35839 Relative Valuation 36139.1 Steps in relative valuation 36139.2 Basis for approach 36139.3 Standardized values and multiples 36239.4 Determinants of multiples 36339.5 Comparable firms 36539.6 Controlling for differences across firms 36539.7 Value enhancement in the relative valuation world 36640 Real Option Valuation 36940.1 Basis for approach 36940.2 The essence of real options 37040.3 Examples of real options 37140.4 Value enhancement in the real options world 37241 Closing Thoughts on Value Enhancement 375References 377Part VIII Final Thoughts on Valuation 379Armin Varmaz, Thorsten Poddig and Jan Viebig42 Introduction 38143 Valuation in Theory: The Valuation of a Single Asset 38343.1 Certain cash flows 38343.2 Uncertain cash flows 38443.3 Risk premia 38643.4 Certainty equivalents and utility-based valuation 38843.5 Risk neutral probabilities 39144 Outlook: The Multi-asset Valuation and Allocation Case 39545 Summary 399References 401Index 403