Equities Analysis: Module 3

Why should we even value a company?

The quote made above by Benjamin Graham, who was a teacher of Warren Buffet, was trying to get at the idea of the difference between “price” and value”. As Warren Buffet would say:

Price is what you pay, and value is what you get – Warren Buffet

The 2 key reasons to value a company are:

  • It allows us to obtain a clearer picture to determine intrinsic values (we are value investors!)
  • To identify mispriced opportunities so we can profit from undervaluation, and steer clear of overvalued companies

Can you think of any more?

Introduction to Valuation by Aswath Damodaran

DCF values a business as the sum of all the cash flows it will generate, discounted to the present value at a rate that reflects the riskiness of the cash flows.

How can we value a business?

Cash flows are the bread and butter of trying to determine the intrinsic value of a company. While it is incredibly difficult to conclude an exact value, the following cash flow types can assist investors and analysts in discovering the fundamental building blocks of a company.

  1. Dividends: actual cash flow distributions to equity holders (i.e. shareholders)
  2. Free cash flow to equity (FCFE): available cash flows to shareholders only
  3. Free cash flow to the firm (FCFF): available cash flows to both debt and equity holders

Cash flows = operating cash flows – cash reinvestment
Discount rate: is the required rate of return for the investors and is a function of the riskiness of the cash flows.
Dividend Discount Modelfocuses on stable dividends (we will explore this further in module 4)
Example
You own a cafe which is expected to generate $10,500 in 2015, and cash flows are expected to grow 5% each year. Assuming a discount rate (r) of 10% and that all cash flows are generated at the end of the period, what is the PV of cash flows generated in the first 5 years (t)?Now, let’s assume that this cafe continues to operate indefinitely. How do we value this business if the cash flows continue? We use a perpetuity formula in mathematics

DCF: Two Stage Approach

In practice, you will often have explicit forecasts for a few years (usually 5 years), and then you’ll have to make simplifying assumptions beyond this period for cash flows.

  • Stage 1: Explicit forecast period discounted to present value
  • Stage 2: All cash flows beyond the forecast period in a perpetual growth stage

Take a look at the four key columns below. These are the essential aspects of fundamental valuation.
Hint: OPEX = operating expenses; IBL = interest bearing liabilities; Net debt = cash – total debt

Cost of Equity: The CAPM Equation

As you can see from the above diagram, the cost of equity is a critical component of determining the appropriate discount rate. To determine this, the capital asset pricing model (CAPM) is used to describe the relationship between systematic risk and expected return for assets – which in our case, is securities (i.e. shares).
Time value of money and risks are factored into consideration.

3. Financial performance

When we drill into each segment, we see the revenues, costs, EBIT and EBITDA results individually. To determine the group financial results, we must roll up the revenues into one line and the costs into another. After doing so, we build out the profit and loss statement, balance sheet, cash flow statement and subsequently, determine the valuation.
For this module, we will start by building up the historical profit and loss statements first, derived from the key drivers, with as much detail as possible. Segmental revenues, costs and EBIT figures should add up to the total group numbers reported in the annual reports. Sometimes we will choose to emphasise EBITDA over EBIT as it may be a better representation of underlying profit as as different companies have different depreciation and amortisation costs. Remember that numbers in a model don’t mean anything unless you have a story, context or meaning behind it.
For SWM, all the individual segments should total to the final group figures below. This is an approach which derives the total amounts from first principles, allowing future forecasts to be auto-populated easily. In 2017, Seven West Media reported:

  • Revenue of $1673.6m
  • EBITDA of $306.7m
  • EBIT of $261.4

Your turn: Once you have identified the historical performance, take note and discuss the historical trends and views around each division to determine how the company is tracking at a group level, in line with the strategic pillars.

4. Future outlook and forecasts

After looking at the historical performance, we want to gather the tools and resources to forecast appropriately. There are a number of ways to determine your predictions, incorporating both top down and bottom up approach (as touched upon in Module 1).
Analysts often prefer a bottom up approach when conducting fundamental forecasts, drilling into each division / segment, line by line. A top down approach is then used as a sense-checking mechanism. Of course, depending on the sector, this may not always be possible
For our purposes with SWM, we will take a number of angles:

1. Company Guidance
For most company results and announcements, management releases outlook comments and guidance around key metrics. These form the frameworks of an analyst’s forecasts. Note that, some companies scatter outlook comments across their announcements / releases so you may have to dig around for your selected company!
For SWM, management released a series of outlook commentary as seen below. These are incorporated into forecasting models:
2. Third party research
Guidance comments are only released at major announcements and results so analysts must also have their own way of tracking ongoing changes and trends. Also, we can’t just rely on management commentary because we need to have our own independent opinion. That is why a series of independent research and third party consultations are required.
For TV, we triangulate the data with official industry bodies such as:

  • CEASA data (Commercial Economic Advisory Service of Australia) for total ad revenues
  • OzTAM data for ratings shares data by segments
  • KPMG FreeTV data for revenues shares data by segments
  • SMI Data for agency ad expenditure

Your turn: For your own individual stock, come up with a list of industry sources which can help you value the business and understand the market. A good place to start is to dig into the annual reports and company releases of the selected company and their peer comparables. Then read existing broker reports and understand their source of information and research.

3. Broker Forecasts
To ensure that you can justify your forecasts, it is crucial to determine where you sit relative to the rest of the market. The most common metrics to check against are:

  • Revenues
  • EBITDA
  • EBIT
  • NPAT
  • EPS
  • DPS

One way to set out the updates is an excel layout below which can be updated when a catalyst occurs in the market which changes analyst views, e.g. the company makes an acquisition, or delivers a set of results.

Your turn: Have a go at setting out a template for your own company stock and use the UNSW Bloomberg Terminal to find the data. You can do this in the following steps:

  1. Log into the terminal and computer
  2. Launch the Bloomberg software and log in using the provided username and password details at the desk
  3. Search the company ticker name (“SWM AU EQUITY”) in the top bar
  4. Add “EEB” to the end of the search function to find the best analyst estimates in the market
  5. Take a screenshot and update your excel template according to each bank

We collate all of the above data first and then proceed to forecast line by line performances. See if you can use the information / approach for your own selected stocks and come up with your own independent forecasts as you work through the task items below.
At our next F2F workshop and in the next few modules, we will go through more detail about forecasting and valuation. Stay tuned!