Lecture 10. Empirical issues in valuation: cost of capital, terminal value, growth rates

Transcription

1 Lecture 10 Empirical issues in valuation: cost of capital, terminal value, growth rates

2 Learning objectives for today How to get the cost of capital right: what potential choices there are and how they can be defended How to get the terminal growth rate right: how much can a company grow into eternity and what does your assumption on growth mean to dividend reinvestment ratio Get a perspective on growth: revenue growth is very hard to sustain, whereas ROIC/ROA/ROE can be sustained at reasonable levels for long periods Elias Rantapuska / Aalto BIZ Finance 2

3 Today we will focus on getting the remaining important numbers right Cost of capital Terminal value Growth Elias Rantapuska / Aalto BIZ Finance 3

4 Is there really a risk-free rate? Finance theories always embrace the concept of risk-free rate, but what is really the risk-free rate? For an investment to be risk-free: No variance in return No default risk No reinvestment risk Options for risk-free rate: Counterarguments Option 1 (preferred): use government-bond yield equal to your forecast horizon, netted out from default risk Option 2: use longest maturity government bond you can find with reasonable liquidity, netted out from default risk Option 3: use 12-month interbank lending rate, such as the 12-month Euribor Option 4: use a very short interbank lending rate, such as the 1-month Euribor Coupons have reinvestment risk; long-term yields n/a Reinvestment risk Interbank-rate has default risk; reinvestment risk High reinvestment risk (but almost zero default risk) Elias Rantapuska / Aalto BIZ Finance 4

5 Aggressive risk-free rate may constitute up to 20% of value Where r f hits valuation % 26 21% 26 7% Option 1 Option 2 Option 3 Option 4 1 month Euribor 12 month Euribor 10-year govt bond 5-year govt bond Elias Rantapuska / Aalto BIZ Finance 5

6 WACC: a refresher Weighted average cost of capital Cost of equity Cost of debt Market value of equity Required rate of return on equity Market value of debt Required rate of return on debt Tax rate Elias Rantapuska / Aalto BIZ Finance 6

7 Cost of debt is the easy part Debt is a contractual claim: cost of debt is relatively easy to calculate with reasonable accuracy Method 1 (preferred): take total interest expense and divide by book value of gross interest bearing debt Method 2: look at notes for description of all bonds, loans, and credit facilities. Take value-weighted average (you will only account for largest bonds and loans) Method 3: take current cost of debt from the market by observing spread over risk-free rate. This approach answers the question: what would be the cost of debt if company if completely refinanced now? Elias Rantapuska / Aalto BIZ Finance 7

8 Cost of equity is the difficult part Why and how do we need a model to calculate cost of equity? Risk has to be compensated with return Finance scholars do not really know how much and what risk is compensated, but at least they have given a try Single factor models, such as CAPM Multifactor models, such as FF3FM, Pastor- Stambaugh, and Carhart-momentum Buildup methods (e.g., currency, control, marketability, size, idiosyncratic risk) Ad-hoc methods (e.g., bond yield plus premium, index return plus premium etc.) Elias Rantapuska / Aalto BIZ Finance 8

9 Single-factor models: CAPM is an old friend Assumptions of CAPM are a good starting point for multifactor models: Investors are riskaverse Investors have mean-variance optimized their portfolio Investors only care about market risk ER ( ) R [ ER ( ) R], Where i F i M F E(R i ) = Required return on equity for security i R F = Current expected risk-free return i = Beta of security i E(R M ) = Expected return on the market portfolio E(R M ) R F = Equity risk premium Elias Rantapuska / Aalto BIZ Finance 9

10 Beta estimation involves multiple practical choices Choice of Market Index DJ Eurostoxx 50 most available, MSCI indices have more constituents Length & Frequency of Data Weekly data for liquid firms, monthly data for thinly traded firms with 3-5 years of data Adjusted Betas Betas move towards 1.0 over time Thinly Traded and Private Firms Use bottom-up beta approach (aka Hamada correction, more also on final lecture) Adjust comparable betas for leverage Elias Rantapuska / Aalto BIZ Finance 10

11 Multifactor models incorporate additional risk(?) factors Fama and French Pastor- Stambaugh where SMB = The return to small stocks minus the return to large stocks size = The sensitivity of security i to movements in small stocks HML = The return to value stocks minus the return to growth stocks where value = The sensitivity of security i to movements in value stocks LIQ = The return to illiquid stocks minus the return to liquid stocks r r mkt size value i RF i RMRF i SMB i HML, mkt size value liq i RF i RMRF i SMB i HML i LIQ, liq = The sensitivity of security i to movements in illiquid stocks Elias Rantapuska / Aalto BIZ Finance 11

12 Buildup-methods: add your favorite additional risk factors Riskfree rate Return on equity Equity risk premium (beta) Other risk discounts Other risk premiums Some risk-premiums: Small firm (SMB) Market/book (HML) Momentum (UMD) Liquidity (LIQ) Control premium/discount Diversification/opaqueness Idiosyncratic risk Country risk Elias Rantapuska / Aalto BIZ Finance 12

13 Ad-hoc models are, well, ad-hoc Bond Yield plus Risk Premium Method Useful if firm has public debt YTM on long-term debt + risk premium Admittedly ad-hoc, but in practice: How much precision do you think your best model will have in estimating cost of equity? Percentage right? First decimal right? Second decimal? Are we even sure empirical finance research with R 2 s of 2-3% yield enough confidence to warrant a complex model of equity returns? Elias Rantapuska / Aalto BIZ Finance 13

14 Well, what about the equity risk premium? Equity premium discussion is one of the most heated and important debates in finance A practitioner needs a number, not a debate Historical estimates Forward-looking estimates Macroeconomic buildup (identity) models Elias Rantapuska / Aalto BIZ Finance 14

15 Historical equity risk premium estimates Number of markets Finnish data from Nyberg and Vaihekoski would indicate equity premium (over bonds) of 5.17% Geometric historical equity premium relative to bonds Source: Dimson, Marsh, Staunton (2008); Nyberg and Vaihekoski (2011) Elias Rantapuska / Aalto BIZ Finance 15

16 Using historical equity risk-premiums: issues Length of Sample Period Balancing long-term and short-term considerations Geometric vs. Arithmetic Mean Both have been used and can be defended Ask the department strongman for the right answer Choice of Risk-Free Return On-the-run long-term Treasuries Survivorship Bias Using returns from surviving firms artificially inflates estimates of return Losers get kicked out from broad indexes and winners are included. Return momentum biases results Strings of Unusual Events Like Russian revolution of 1917 Maybe the world has changed and risk-premium permanently reached a lower plateau Elias Rantapuska / Aalto BIZ Finance 16

17 Forward-looking estimates: ask the market what do they expect Gordon growth model estimates D/P + earnings growth rate risk free rate Note resemblance to Ibbotson-Chen introduced later Survey estimates Ask analysts, economists, or heaven forbid, professors Circular reference warning Elias Rantapuska / Aalto BIZ Finance 17

18 Macroeconomic models are also buildup methods, but based on fundamentals ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC R F 1 If equity riskpremium is in nominal terms, having inflation assumes that real assets will retain their real value 2 Growth in real earnings = labor supply + labor productivity (or real GDP growth) 3 Growth in P/E = expectation on change in valuation levels (assume zero with lack of better information) 4 Dividend yield plus repurchase of shares plus reinvestment to other companies Source: Pinto et al., pages 55-57; Ibbotson and Chen (2003) Elias Rantapuska / Aalto BIZ Finance 18

19 Using the Ibbotson-Chen approach to compute equity premium (1/2) Yield on treasury bonds 3.8% Yield on Treasury inflation-protected securities 1.8% Expected growth in labor productivity 1.5% Expected growth in labor supply 1.0% Expected growth in the P/E 0.0% Expected dividend yield 2.7% Return from reinvestment of income 0.1% Elias Rantapuska / Aalto BIZ Finance 19

20 Using the Ibbotson-Chen approach to compute equity premium (2/2) Treasury Bond Yield Expected Inflation 1 TIPS Yield Expected Inflation 1 2.0% Real earnings growth Labor productivity Labor supply growth 1.5% 1.0% 2.5% 3.5% estimate for equity premium 4 Expected income Dividend yield Reinvestment return 2.7% 0.1% 2.8% Elias Rantapuska / Aalto BIZ Finance 20

21 Today we will focus on getting the remaining important numbers right Cost of capital Terminal value Growth Elias Rantapuska / Aalto BIZ Finance 21

22 Terminal value: the important and often neglected part of valuation Public firm has no finite life. Value is therefore: Value = t= CF t t=1 (1+r) t Estimating value up to infinity is not possible in theory and not meaningful for very long periods either. We need terminal value Value = t=n t=1 CF t Terminal Value (1+r) t (1+r) N Often 80-90% of the total firm value comes from the terminal value and analysts routinely overlook it Elias Rantapuska / Aalto BIZ Finance 22

23 Terminal value: five questions we are going to answer 1 How to estimate terminal value? 2 When should stable growth period start? 3 How much can net income really grow in the long-term, in theory? 4 How to set reasonable growth rate in stable growth, in practice? 5 What about capital expenditure and reinvestment in stable growth? Elias Rantapuska / Aalto BIZ Finance 23

24 How to estimate terminal value? Terminal value Liquidation value Stable growth Multiple approach What do you need to assume Competitive advantage will fade away The company will be taken over for a nominal price, end up in bankruptcy or ceases operations Going concern Stable growth into eternity Either maintains or loses competitive advantage Most often used method Company operates as going concern Company performs in line with peers used in multiple valuation Elias Rantapuska / Aalto BIZ Finance 24

25 Stable growth discounts cash flows from eternity Terminal value = Cash flow (Dividend/FCFE/FCFF) Discount rate - g This little fellow will turn your estimates around even with small changes Elias Rantapuska / Aalto BIZ Finance 25

26 Reminder: sustainable growth rate At sustainable growth rate key profitability and solvency ratios remain constant: Sustainable growth rate (g*) = ROE x (1 Dividend Payout Ratio) Dividend Payout Ratio = Cash dividends Paid / Net Income If planned growth (g) > g* then profitability (ROE) or leverage have to be increased or dividend payout lowered If planned growth (g) < g* then profitability or leverage might decrease or dividend payout ratio should be increased Elias Rantapuska / Aalto BIZ Finance 26

27 How much can net income really grow in the long-term, in theory? Growth is capped by ROE Growth comes from reinvestment Definition 1: Reinvestment ratio = Retained Earnings for net income / Net income Definition 2: Return on Investment = ROE = Net Income/Book Value of Equity If ROE is expected to remain unchanged g NI = Retained Earnings t-1 / NI t-1 * ROE = Reinvested ratio * ROE Proposition 1: The expected growth rate in net income (or FCFF/FCFE) for a company cannot exceed its return on equity in the long term Definition 3: g NI = Reinvestment ratio * Return on invested capital + Growth rate from improved efficiency without reinvestment In stable growth: Efficiency will not deliver growth without reinvestment (it would not be a stable period then, but a perpetual money machine) Reinvestment rate will be a function of your stable growth rate and what you believe the firm will earn as a return on capital in perpetuity: Reinvestment ratio = Stable period g NI / Stable period ROE Proposition 2: reinvestment ratio must be consistent with your forecasted g NI and ROE Elias Rantapuska / Aalto BIZ Finance 27

28 How to set reasonable growth rate in stable growth, in practice? The economy on average grows at GDP growth rate There are high-growing firms in the economy. Therefore, stable growth firms will have to grow slower than the economy unless they have sustainable competitive advantage The stable growth rate can be negative. The terminal value will be lower and you are assuming that your firm will disappear over time. In reality, there are always companies with sustainable competitive disadvantage: think Alitalia, SSAB (Ruukki) and GM If you use nominal cash flows and discount rates, the growth rate should be nominal in the currency in which the valuation is denominated. It is also entirely sensible to argue that the company will not grow in real terms: then use inflation as nominal growth rate: Assume the company only replaces its assets and increases prices in line with inflation Some use risk-free rate as nominal growth rate proxy Your reasonable upper limit: GDP growth. If you go above this, make sure to present a compelling case why the company will sustain competitive advantage for decades in the future Your base case: something between inflation and GDP growth Your lower limit: none really, a negative number will also do if the firm is not able to compete. If the terminal value is negative, consider using liquidation value Note that using e.g., GDP growth as long-term growth rate implicitly assumes that ROE x Reinvestment ratio = GDP growth Elias Rantapuska / Aalto BIZ Finance 28

29 When should stable growth period start? Assume that you are valuing a young, high growth firm, such as Twitter. How long would you expect Twitter to have double digit growth? a. < 5 years b years c years d years e. > 20 years Most growth firms have difficulty sustaining their growth for long periods, especially while earning excess returns Elias Rantapuska / Aalto BIZ Finance 29

30 When should stable growth period start for Twitter? Elias Rantapuska / Aalto BIZ Finance 30

31 What about capital expenditure and reinvestment in stable growth? Capex: Many analysts assume capex = depreciation and no additional working capital needs in stable growth Firms just make maintenance capex to deliver growth. If you make this assumption, what must be then reinvestment ratio and terminal growth rate? Reinvestment ratio: Remember to change your reinvestment ratio to stable period g NI / stable period ROE when you cross over from explicit forecast to terminal value Never put reinvestment ratio to zero, unless you also put terminal growth to zero as well: growth must be finance from somewhere! Elias Rantapuska / Aalto BIZ Finance 31

32 Today we will focus on getting the remaining important numbers right Cost of capital Terminal value Growth Elias Rantapuska / Aalto BIZ Finance 32

33 Competitiveness naturally declines over time Source: McKinsey, Creative Destruction Elias Rantapuska / Aalto BIZ Finance 33

34 Current abnormal revenue growth is hard to sustain US nonfinancial firms grouped by revenue growth into five portfolios Source: McKinsey on Finance 2012 Elias Rantapuska / Aalto BIZ Finance 34

35 ROIC can be sustained, if the company stays competitive Median ROIC and revenue growth for top 500 US publicly listed companies in 1965, 1975, 1985 and 1995 ROIC can be sustained for decades Revenue growth is hard to sustain Source: McKinsey Elias Rantapuska / Aalto BIZ Finance 35

36 Lecture 10: What does all of this mean? With the lack of better information, time, and good argumentation, for cost of capital use the Popular valuation version introduced at the end of Lecture 7: Use long-term historical equity premium Long-term government bond as risk-free rate CAPM beta either from public estimates or by using weekly/monthly observations and a broad market index Average interest paid on gross (interest bearing) debt over a full year as cost of debt For g in the terminal value: ROE x (1 Dividend Payout Ratio) It may also be zero. Competitive advantage will eventually be lost even for the best companies For growth: Be sceptical to every model (including your own which has abnormal revenue growth more than 5 or 10 years) ROA, ROE, and ROIC levels can be sustained, but growth unlikely in stable growth stage Elias Rantapuska / Aalto BIZ Finance 36