Example of Applying the Discounted Cash Flow Valuation Technique for an Actual Corporate Valuation

Transcription

1 Example of Applying the Discounted Cash Flow Valuation Technique for an Actual Corporate Valuation Overview: The objective of this paper is to present a detailed example of the application of the discounted cash-flow technique of corporate valuation to value the equity of the merged SBC-Pacific Telesis entity. This valuation exercise was performed by Kyle Martin. Valuation of the Merged Entity Based on the DCF Approach This section summarizes the details of the DCF procedure used to compute the value of the merged SBC/PacTel entity. I place the more confidence in the valuation results derived using this DCF technique than the results generated using the comparable/multiple technique. The specific details of the valuation analysis will now be presented. The body of this section focuses on the determination of each of the components of the DCF computation shown in Equation 7.0.a below. Specifically, the free cash flows to all investors, the weighted average cost of capital (WACC), and the terminal value (TV). Company Value CFt CFt CFn TV 2... n ( 1WACC) ( 1WACC) ( 1WACC) ( 1 WACC) n Equation 70.. a The next section focuses on the determination of the cash flows available to all investors. 7.1 Computation of Free Cash Flows Available to All Investors This section will address the methodology employed to compute the free cash flows available to all investors. In order to arrive at a base case projection of the cash flows, the historical cash flows for SBC and Pacific Telesis were analyzed independently. These cash flows were next merged to arrive at a base case. Next, the projected proforma cash flow statements were developed for the next ten years ( ) by applying the projected growth rate profile determined in section 6.0. Then, a higher level of refinement was achieved by factoring into the cash flows 1) Cost savings resulting from the merger and 2) Reduction in cash flows to investors due to the New Regulatory Framework (NRF) whereby rate

2 payers and shareholders divide excess earnings of the regulated telephone utility, 3) Reduction in cash flows available to investors due to the California Public Utilities Code Section 854(b)(2) which requires that the ratepayers receive at least 50 percent of the economic benefits of a merger of California public utility. 7.1 Calculation of Cash Flows Computation of Pre-Merger Cash Flows The individual pre-merger (base case) cash flows for SBC and Pacific Telesis were computed independently. These results are presented in Exhibit a and b respectfully. The data used in these cash flow computations were taken from the 1995 and K SEC reports. These cash flows were then combined as shown in Exhibit c. Exhibit a Stand-Alone SBC Entity Operating revenues $11,772 $12,670 $13,898 Less: Operating expenses Cost of services and products $3,747 $3,806 $4,135 Selling, General and Administrative $3,225 $3,657 $3,967 Depreciation and Amortization $2,038 $2,170 $2,240 Total operating expenses $9,010 $9,633 $10,342 Operating Income (EBIT) $2,762 $3,037 $3,556 Taxes on EBIT (2) ($967) ($1,063) ($1,245) Change in Deferred Taxes NOPLAT $1,795 $2,561 $2,013 Depreciation and Amortization (3) $2,038 $2,170 $2,240 Gross Cash Flow $3,833 $4,731 $4,253 Increase in Working Capital ($547) $332 ($488) Investing Activities Capital Expenditures (4) $2,350 $2,336 $3,027 Investments in Affiliates $22 $16 $29 Purchase of short-term investments $325 $704 $1,005 Proceeds from short-term investments ($390) ($587) ($816) Dispositions Acquisitions Net Cash Used in Investing Activities $3,348 $3,007 $3,442 Free Cash Flow to Investors $1,032 $1,392 $1,299

3 Exhibit b Stand-Alone Pacific Telesis Entity Operating revenues $9,042 $9,588 Less: Operating expenses Total operating expenses $7,031 $7,390 Operating Income (EBIT) 2,011 2,198 Taxes on EBIT (2) -1,253-1,316 Change in Deferred Taxes 0 0 NOPLAT Depreciation and Amortization (3) 1,864 1,870 Gross Cash Flow $2,622 $2,752 Increase in Working Capital ($2,058) $1,178 Investing Activities Capital Expenditures (4) $2,961 $2,753 Net Cash Used in Other Investing Activities $0 $0 Net Cash Used in Investing Activities $2,961 $2,753 Free Cash Flow to Investors $1,719 ($1,179) In order to create proforma cash flow statements for the years 1997 through 2006, certain ratios were taken and applied to the future cash flows. Specifically, The combined entity total operating expense were 68.17% and 67.54% in 1995 and 1996 respectfully. For the future cash flow statements, operating expenses were computed at the 1996 rate of 67.54% of revenues. Taxes were computed at the combined tax rate for SBC and PacTel which was 33.6% in The changes in deferred taxes line item were found in the 10K reports. For the future years, we assumed that changes in deferred taxes would average out to zero.

4 Exhibit c Combined SBC/PacTel (Pre-Merger) Operating revenues $21, % $23, % Less: Total operating expenses Total operating expenses $16, % $17, % Operating Income (EBIT) 5, % 5, % Taxes on EBIT (2) -2, % -2, % Change in Deferred Taxes % % NOPLAT 3, % 2, % Depreciation and Amortization (3) 4, % 4, % Gross Cash Flow $7, % $7, % Increase in Working Capital ($1,726) -7.95% $ % Investing Activities Capital Expenditures (4) $5, % $5, % Net Cash Used in Other Investing Activities $ % $ % Net Cash Used in Investing Activities $5, % $6, % Free Cash Flow to Investors $3, % $ % Notes (1) The Method for Determining Free Cash Flow to Investors is Described in Cornell Chapter 5 and in Copeland Ch. 6 (2) Total Federal, State, and Local tax rate = 33.6% for Combined SBC/PacTel Entity (3) Taken for FY. '95 and '96 10K Forms' Consolidated Statements of Cash Flow We elected to use the average of 72.5% of CAPEX in years 1-10 (4) CAPEX includes construction expenditures; The 1996 CAPEX/Sales of 21% For years 1-10 we used the ave. '95 and '96 rate of 24.5% of Revenues Development of Proforma Cash Flows for 1997 through Cash Flows with Growth Incorporated and Cost Savings Excluded After the combined historical cash flow statements were derived, we next built up proforma cash flow

5 statements for the years 1997 through 2000 under the initial case of growth in revenue without cost savings. Below, cash flows with both cost savings and revenue growth benefits incorporated will be presented. The assumptions discussed above were employed in the development of these cash flows. Additionally, as a starting point, the projected corporate growth rate profile developed in Section 6.2 was employed. Projections were developed under three scenarios: Expected, Conservative and Optimistic. Our projections indicate that the merged entity s expected revenue will grow at 9.9 percent per year for the next five years and will stabilize at 4 percent growth in year 10 and beyond. We made the assumption that the growth rate will decrease linearly from 9.9 percent to 4% as follows: 8.72%, 7.54%, 6.36%, 5.18%, 4.0%. Conservative and Optimistic growth rates of 8.7 percent and 10.3 percent were also tested. Computations for the expected cash flows are presented in Figure a. These cash flows were discounted at the WACC was computed to be 10%. A detailed discussion of the WACC computation is presented subsequently. Using these cash flows with only the growth element incorporated the value of the merged entity is $ billion (Exhibit a). Recall that these cash flows do not include cost savings which arise from the merger. In the next section the overall contribution to the value of SBC will be addressed by integrating the cost savings associated with the merger into the DCF valuation analysis Cash Flows with both Growth and Cost Savings Incorporated In section 5.2, cost savings resulting from the merger were analyzed in detail. In this section, the impact of these savings on overall cash flow and hence SBC s corporate valuation will be addressed. These savings arise primarily from the telephone company and yellow pages operations. The savings were forecast to be $259.4 million in 1999, $518.8 million in 2000 and $1,037.6 million in For the years beyond 2001, we projected that the savings would grow at the same rate as telephone company growth. For this growth rate, we used 6%. In order to incorporate these savings into the DCF valuation, we added a line beneath the operating costs as a Savings Add Back. The DCF valuation which incorporates savings is shown in Exhibit b. Please note, that the operating expenses shown in Exhibit a were for SBC/PacTel before the effects of savings were incorporated. Using this methodology enables us to quickly determine the additional contribution to the overall corporate valuation which is attributable to Cost Savings. The value of SBC with savings incorporated is $ billion versus $72,745 without savings. The bottom-line is that the savings due to the merger increase the value of the merged entity by $3.97 billion.

6 7.2 Determination of the WACC The objective of this section and many sub-sections is to summarize the methodology used to determine the post-merger weighted average cost of capital (WACC) for the merged SBC/PacTel entity. The WACC is expressed in Equation 7.2.a below. WACC w k 1 w k Equation 72.. a d d c e e The body of this section is devoted to deriving the values of parameters used in this WACC equation. The definition of these parameters is as follows: w k d d Target weight of debt The cost of debt Target Market Value of Debt Target Market Value of Debt Equity w k c e e Corporate tax rate Target weight of equity = Cost of Equity Target Market Value of Equity Target Market Value of Debt Equity We will begin the WACC computation by determining the cost of equity, k e.

7 7.2.1 Computation of the Cost of Equity Two techniques in order to determine the cost of equity these were as follows: CAPM Approach DCF Approach for Cost of Equity The CAPM approach will first be addressed Determining the Cost of Equity using the CAPM Approach The cost of equity was computed initially using the CAPM approach which entails using equation a below: k r E r r Equation a e f m f where, r f Risk free Rate = Systematic Return of Equity E r m Expected Return of the Market E r r Market Risk Premium m f The next several sections are devoted to the determination of these constituent parts of the CAPM expression Computation of Beta There are several techniques which can be used to compute betas. For the SBC valuation, we employed the following three techniques to determine beta: Computation of Beta based on comparables

8 Regression Analysis Published Beta Estimates The following sub-section describes the details of how beta was computed based on comparable companies Computation of Beta based on Comparables One method for determining the beta of the merged entity is to compute the beta based on comparable companies in the industry. This methodology was employed in this project. The specific details will now be presented. The first step entailed finding comparable companies in the telecommunications industry. Because SBC is considered a Regional Bell Operating Company (RBOC), data from other RBOCs were used. Additionally, SBC has many similar characteristics to the independents which include GTE, ALLTELL and Cincinnati Bell, so data for these companies were also used. Finally, because SBC is now migrating into the long-distance market, data on AT &T, MCI and Sprint were also used. Once the comparable companies were selected, Value Line was used to determine the betas and capital structures (debt and equity) of these companies. This data was then compiled into a spreadsheet. The betas were next unlevered using Equation a below. Unlevered 1 P E Levered D 1 c E Equation a Where D is the market value of debt, E is the market value of common stock equity and P is the value of preferred. SBC and PacTel did not have any preferred in their capital structure. The average corporate tax rate used was 37 percent. The next step required averaging all the unlevered betas. This average was [Exhibit a ] However, we felt that it would be more appropriate to perform a weighted average. We applied a weight of.60 to the RBOC average of 0.75, a weight of.30 to the Independent average beta of 0.73 and a weight of.10 to the long-distance company average beta of The weighted average beta turned out to be 0.76.

9 The final step entailed relevering the betas with merged company s capital structure. Specifically, the combined debt book value of $13.26 billion was used as a close approximation to the market value of debt. Additionally, the current market value of SBC stock on May 22, 1997, $55.375, was multiplied by the current 921 million shares outstanding after the merger. The debt/equity ratio of 0.26 was employed in the relevering. The relevered beta for the merged entity becomes Determination of Beta Using Regression Analysis The objective of this section is to describe the techniques employed to determine the Beta of SPC using regression analysis. Method: The general concept employed was to run a regression of SBC s stock returns against the return of the market. The S&P 500 was used as a proxy for the market. SPC Communications stock prices were collected from June 6, 1990 through April 18, This search yielded 1,733 data points. The stock returns were computed by taking the closing stock price on day (t+1) and subtracting the closing price of the previous day. The percent return was computed by dividing this difference by the closing price on day t. This computation is shown in Equation 1-a below. Stock Return = [P t+1 - P t ]/P t The same basic equation was used to compute the returns on the market (S&P 500). The plot of the line generated by the regression analysis is shown in Figure 1 below. Prior to running the regression it was necessary to make sure that all the dates correlated. Note, for certain dates, only one of the (S&P or SBC) prices were available. The objective of the regression is to obtain the coefficients and for the regression line which is in the form: Y = + X

10 where, Y = Return (%) on SBC Stock X = Return (%) on the market. Here, the proxy for the market was the S&P 500 The regression analysis yielded the following: = 6.2 X = It is not surprising that the Beta for SBC is less than 1.0. Typically for large telecommunications companies, their betas are less than 1.0. In order to get a better understanding of the behavior of SBC s Beta as a function of time, the same regression analysis can be run for the periods of and Additionally because the computed value of the pre-merger SBC beta of 0.91 agrees very closely with our computations of beta for SBC on a stand-alone basis (0.87), we make the assumption that a similar regression analysis for the Pacific Telesis entity will yield results close to the 0.94 beta which we computed by relevering the industry average unlevered beta with the Pacific Telesis capital structure Computation of the of the Risk Premium (Return of the Market Less the Risk Free Rate) The Risk Free Rate There are several measures of the risk-free. The important point in using the CAPM equation is to select the same type of risk-free security for both the risk-free rate and for the risk premium. We will be consistent and use Treasury Bond returns. Because most of the published averages combine both the 10 and 30 year Treasury Bond returns, we will elect to use the 20 year Treasury Bond taken directly from the Wall Street Journal s Treasury Yield curve for a 20 maturity. This yield was 6.8% on May 21, We will use this 6.8% as the risk-free rate in our application of the CAPM equation Arriving at the Risk Premium An area which requires caution when using the CAPM equation lies in the choice of the risk-free rate and the risk premim, [E(Rm) - Rf]. Specifically, it is imperative to be consistent between which risk-free rate

11 is used. If the risk premium is taken as the difference between the return of the market (e.g. S & P 500) and Treasury bonds, then it is necessary to be consistent by selecting as the risk-free rate the rate of return on Treasury bonds. For the SBC valuation, we elected to use the post-war average premiums of the S & P 500 over Treasury Bonds as shown in Table a below. This average is 8.6%. Note, because the premium is taken over Treasury bonds, we must be consistent and use Treasury Bond returns as our risk-free rate in applying the CAPM. This 8.6% average agrees well with the average of 7.78 percent from Kaplan and Rubak s research a Average Premium over Treasury Bonds 1950s 20.8% 1960s 7.10% 1970s 1.80% 1980s 4.70% Average 8.6% Table a Computation of Market Risk Premium [E(R m ) - R f ] Computation of the Expected Inflation Rate The forecasting period was chosen to be ten years beyond which it is assumed that the company will reach a steady state condition. The definition of steady state is that time at which the following conditions prevail: The company earns a constant rate of return on all new capital invested during the continuing-value period. The company earns a constant rate of return on its base level of invested capital. The company invests a constant proportion of its earnings back into the business each year. Incorporating Expected Inflation into Cash Flow Forecasting The expected rate of inflation, E(), can be calculated using the following formula: E ( ) 1 Nominal Interest Rate 1 real a Steven N. Kaplan and Richard S. Ruback, The Valuation of Cash Flow Forecasts: An Empirical Analysis, The Journal of Finance, Volume. L. No. 4, September 1995, p. 1082

12 For a nominal interest rate, we used which would be applicable over the valuation period of the company which was assumed to be ten years. Thus, the ten year U.S. Treasury Strip interest rate was used. This rate of 6.86 percent was taken from the Wall Street Journal on May 2, We estimated the real rate of inflation, real to be 3 percent which is in the 2-3% range of the long-term growth in GDP as recommended by Copeland. 1 Applying the above equation, the expected rate of inflation over the next ten years is 3.75% which is computed as follows: E( ) % Applying the CAPM to determine the Cost of Equity We can now use the parameters we just derived in the CAPM expression to arrive at the cost of equity. Specifally, we will apply Equation a from above. k r E r r 68% % % e f m f The cost of equity, ke, can also be determined using the DCF technique. This method will be addressed in the following section Determining the Cost of Equity Using the DCF Technique The cost of equity was also estimated using the spreadsheet shown in Exhibit a. The cost of equity is determined by inputting the current stock price, the latest dividends and the appropriate growth rates. Because our explicit forecasting period is ten years, we employed the 5 year linear convergence spreadsheet for the 10 year period. The reason for doing this is as follows: This spreadsheet is set up such that in years 1 through 5 ( ), we use the projected 9.9% growth rate. For years 6 through 10, the growth rate is linearly decreased until the steady-state growth rate of 4% is achieved. Specifically, the year 6 through 10 ( ) growth rates were 8.7%, 7.5%, 6.4%, 5.2% and 4.0%. These were the actually growth rates 1 Copeland, Tom, Koller, Tim, Murrin, Jack; Valuation - Measuring and Managing the Value of Companies. 1996, Library of Congress, p. 220

13 applied in generating the proforma cash flows. One area of caution in running this DCF Cost of Equity computation: It is necessary to use the combined SBC and Pacific Telesis dividends. SBC s total dividends in 1996 were $1.72 and Pacific Telesis dividends were $1.59. Entering the combined total dividends paid of $3.31 into the spreadsheet and running the Goal Seek routine to adjust the discount rate such that the total present value of the cash flows equals the current market price of stock, $55 3/8, yields the cost of equity: 12.5 percent. For the determination of the WACC, we elected to use the average cost of equity found by averaging both the CAPM (14.37%) and DCF (12.5%) approaches. This cost of equity is percent Computation of the Cost of Debt and Total Debt In the following two sub-sections we will discuss the steps taken to arrive at the cost of debt and the total amount of corporate debt currently held by the merged SBC/PacTel entity Computation of the Cost of Debt In determining the Cost of Debt, we calculated a weighted average yield for the debt issued by both Pacific Telesis and SBC. To determine the yield on the companies existing debt, we referred to the Standard & Poor s 1997 Corporate Bond Guide which listed all corporate bonds issued by the two companies as well as the credit rating of these bonds, their price and their yield to maturity. We calculated a cost of Debt of 7.2% for the combined debt of Pacific Bell, Pacific Telesis, Southwestern Bell Cap and Southwestern Bell Telephone. Our calculations are shown in Exhibit a Value of Corporate Bonds and Total Debt The market value of the companies corporate bonds was $8, Billion as indicated in the 1997 S&P Corporate Bond Guide. The book value of the listed debt was $8,905 Million and the difference between book and market value was $221 Million.. The companies have a significant amount of debt not listed in the S&P guide. Exhibit a lists the two companies long-term debt and short-term debt as presented

14 in their most recent SEC filings. The Book value of the companies total debt is $13,264 including $136 million in unamortized premium discounts. Due to the small difference between book and market value of debt when compared to the total value of the company, we decided to use book value as a measure of the companies debt Putting it all Together to Compute the WACC Above, we showed the equation (Equation 7.2) which we employed to used to determine the WACC for the merged entity. We need to make a few additional computations and we are ready to enter the parameters computed above to compute the WACC. First we need to arrive at a target capitalization structure. Currently the merged entity has a capital structure which is 21% debt and 79% equity. This current capital structure has a much higher percentage of equity than most of the other telecom companies as shown in Exhibit a where we estimated beta. Thus, we believe that a reasonable target capital structure over the long run would consist of 40 percent debt and 60 percent equity. The last element is the corporate tax rate, c. We will use the combined weighted average tax rate for SBC and PacificTelesis as computed in the combined cash flow analysis. This rate was c = 33.6%. The other parameters computed above were: K d = 7.2% and K e = 13.43%. Entering these values into Equation 7.2.a we arrive at a WACC of 9.97 percent as shown below. WACC w k 1 w k % % % d d c e e

15 7.3 Calculation of the Terminal Value We applied two different formulations for the terminal value; the DCF approach and the ROIC Approach. The formulation we standardized is shown in Equation 7.3.a below. Terminal Value = FCF t+1 WACC - g Equation 7.3.a The terminal value in year 10 becomes $113.8 billion for the anticipated 9.9% growth rate. Then, discounted at the WACC the terminal value contributes $43.87 billion to the entire valuation of the merged entity. The other approach we worked with in determining the terminal value was to use Equation 7.3.b below. We elected not to standardize on this approach because the additional ROIC term was a parameter which we felt could have a relatively high range due to the nature of the rapidly changing telecom market. Terminal Value = NOPLAT t+1 1 WACC g g ROIC Equation 7.3. b Per ROIC: Copeland says that over the long run, the ROIC should be equal to the WACC, for those companies that DO NOT have a competitive advantage. Similarly, he says that ROIC during the continuing value should be equal to ROIC during the explicit forecast period, if the company has unique competitive advantages that will remain in the future. We believe that SBC is not on either extreme. Our approximation for ROIC for the explicit forecast period is 25%. For the continuing value we believe that ROIC will fall in the range of 13% to 20%. W believe that given the conditions of the merger and the monopolistic environment where the company operates, it will be able to maintain many of its competitive advantages in the future.

16 7.4 Summarizing the DCF Valuation Results All of the information contained in this report was either directly or indirectly incorporated into our DCF valuation of the merged SBC entity. We incorporated the element of savings in conjunction with the overall corporate growth profile along with the WACC of 9.97% to arrive at a corporate valuation for the merged SBC/PacTel entity. We ran the analyses under three different growth scenarios. Under each scenario we assumed that SBC s revenues would grow a certain rate for the first five years, then linearly decrease to a terminal growth rate of 4%. The growth rates for the first five years for the three scenarios were as follows; Expected 9.9%, Conservative 8.5%, Aggressive 10.3%. The DCF analysis yielded the entire corporate valuation. The valuation included cost savings as well as the $329 million PV of ratepayer reductions. In order to arrive at the value of equity only, we simply subtract out the total debt of $13.26 billion. The range of valuations are presented in Table 7.4.a below. The valuation of the entire merged company under the expected growth scenario was found to be $76.80 billion. Subtracting the $13.26 billion of debt from the total value gives us the value of equity, $63.63 billion. Dividing the equity value by the 921 million shares outstanding yields our estimate of $69.09 as a fair value for the merged company s stock with a range of between $64.27 and $ Table 7.4.a Summary of DCF Corporate Valuation of Merged SBC/PacTel Entity Total Value of Company (Billion) Equity Value (Billion) Stock Value ($/Shr.) Scenario Growth Rate Conservative 8.50% $72.48 $ Expected 9.90% $76.89 $ Aggressive 10.30% $78.23 $