Equity Valuation: Models from Leading Investment Banks Edited by Jan Viebig Thorsten Poddig Armin Varmaz John Wiley & Sons Equity Valuation For other titles in the Wiley Finance series please see www.wiley.com/finance Equity Valuation Models from Leading Investment Banks Edited by Jan Viebig Thorsten Poddig and Armin Varmaz Copyright © 2008 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): [email protected] Visit our Home Page on www.wiley.com All Rights Reserved. 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Library of Congress Cataloging in Publication Data Viebig, Jan, 1969– Equity valuation : models from leading investment banks / Jan Viebig, Thorsten Poddig, and Armin Varmaz. p. cm. — (The Wiley finance series) Includes bibliographical references and index. ISBN 978-0-470-03149-0 (cloth : alk. paper) 1. Stocks—Mathematical models. 2. Portfolio management—Mathematical models. 3. Valuation—Mathematical models. 4. Investment analysis—Mathematical models. I. Poddig, Thorsten. II. Varmaz, Armin. III. Title. HG4661.V54 2008 332.63!221—dc22 2008002738 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 978-0-470-03149-0 (HB) Typeset in 10/12pt Times by Integra Software Services Pvt. Ltd, Pondicherry, India Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire Contents Foreword xiii Preface xvii Acknowledgments xxiii Abbreviations xxv Part I Discounted Cash Flow (DCF) Models 1 Jan Viebig and Thorsten Poddig 1 Introduction 3 2 The Fundamental Value of Stocks and Bonds 5 3 Discounted Cash Flow Models: The Main Input Factors 11 3.1 Analytical balance sheets and free cash flow discount models 11 3.2 The dividend discount model 14 3.3 The free cash flow to the firm (FCFF) model 21 3.3.1 Stirling Homex: why cash is king! 21 3.3.2 FCFF during the competitive advantage period 27 3.3.3 Weighted average cost of capital (WACC) 35 3.3.4 Terminal value calculation 45 References 49 Part II Monte Carlo Free Cash Flow to the Firm (MC-FCFF) Models (Deutsche Bank/DWS) 53 Jan Viebig and Thorsten Poddig 4 Introduction 55 5 Standard FCFF Model 57 5.1 Net revenues 59 5.2 Cost structure and operating income 63 vi Equity Valuation 5.3 Reconciling operating income to FCFF 66 5.4 The financial value driver approach 71 5.5 Fundamental enterprise value and market value 76 5.6 Baidu’s share price performance 2005–2007 79 6 Monte Carlo FCFF Models 85 6.1 Monte Carlo simulation: the idea 85 6.2 Monte Carlo simulation with @Risk 88 6.2.1 Monte Carlo simulation with one stochastic variable 88 6.2.2 Monte Carlo simulation with several stochastic variables 98 6.3 Disclaimer 103 References 105 Part III Beyond Earnings: A User’s Guide to Excess Return Models and the HOLT CFROI® Framework 107 Tom Larsen and David Holland 7 Introduction 109 8 From Accounting to Economics – Part I 113 9 From Economics to Valuation – Part I 115 10 Where Does Accounting Go Wrong? 117 11 From Accounting to Economics: CFROI 119 11.1 The basics 119 11.1.1 Return on net assets (RONA) or return on invested capital (ROIC) 120 11.1.2 Return on gross investment (ROGI) 121 11.1.3 Cash flow return on investment (CFROI) 121 11.2 CFROI adjustments using Vodafone’s March 2005 annual report 123 11.2.1 Gross investment 123 11.2.2 Non-depreciating assets 131 11.2.3 Project life 135 11.2.4 Gross cash flow 137 11.3 CFROI calculation for Vodafone 140 11.4 A comment on goodwill 141 12 From Accounting to Economics: Economic Profit 145 12.1 The basics 145 12.2 Caveats 147 12.3 EP adjustments using Vodafone March 2005 annual report 148 12.3.1 Balance Sheet 148 12.3.2 Net operating profit after tax (NOPAT) 153 12.3.3 Economic profit 153 12.3.4 EP or CFROI? 154 Contents vii 13 From Economics to Valuation – Part II 157 13.1 General rules 157 13.2 Market value added 157 13.3 CFROI 157 13.4 A word on debt 158 13.5 Valuation 159 13.5.1 CFROI valuation: general framework 159 13.5.2 Understanding project returns 159 13.5.3 The residual period 161 13.5.4 CFROI residual period approach 164 13.5.5 Economic profit valuation: general framework 165 13.6 Valuation of Vodafone 167 13.7 EP or CFROI? 171 13.8 A final word 173 Appendix 1: Vodafone Financial Statements and Relevant Notes for CFROI Calculation 175 Appendix 2: Additional Notes from Vodafone Annual Report for EP Calculation 185 References 191 Part IV Morgan Stanley ModelWare’s Approach to Intrinsic Value: Focusing on Risk-Reward Trade-offs 193 Trevor S. Harris, Juliet Estridge and Doron Nissim 14 Introduction 195 15 Linking Fundamental Analysis to the Inputs of the Valuation Model 199 16 Our Valuation Framework 203 17 Linking Business Activity to Intrinsic Value: The ModelWare Profitability Tree 211 18 ModelWare’s Intrinsic Value Approach 219 19 Treatment of Key Inputs 231 20 The Cost of Capital 233 20.1 Risk-free rate 233 20.2 Equity risk premium 234 20.3 Beta-estimation 234 21 Summary and Conclusions 237 Appendix 239 References 251 viii Equity Valuation Part V UBS VCAM and EGQ Regression-based Valuation 253 David Bianco 22 Introducing “EGQ” – Where Intrinsic Methods and Empirical Techniques Meet 255 23 A Quick Guide to DCF and Economic Profit Analysis 257 23.1 Powerful analytical frameworks, but not a complete solution 257 23.2 Dynamics of economic profit analysis 257 23.3 “Unadulterated EVA” 258 23.4 Value dynamic 1: ROIC 258 23.5 Value dynamic 2: invested capital 259 23.6 Value dynamic 3: WACC 260 23.7 Value dynamic 4: the value creation horizon 261 23.8 Combining all four value dynamics: EGQ 261 23.8.1 EGQ vs. PVGO 261 23.8.2 The search for the ultimate valuation methodology 262 24 Regression-based Valuation 263 25 UBS Economic Growth Quotient 265 25.1 The EGQ calculation 265 25.2 EGQ special attributes 265 25.2.1 A complete metric 265 25.2.2 Not influenced by the current capital base 265 25.2.3 Limited sensitivity to the assumed cost of capital 266 25.2.4 Comparable across companies of different size 266 25.2.5 Explains observed multiples on flows like earnings or cash flow 267 26 UBS EGQ Regression Valuation 269 26.1 Intrinsic meets relative valuation 269 26.2 EGQ regressions: relative valuation theater 270 26.3 EGQ regressions: a layered alpha framework 271 26.4 Y-intercept indicates cost of capital 271 26.5 Slope vs. Y-intercept indicates style 271 26.6 Emergent valuation 272 26.7 Why regress EGQ vs. EV/NOPAT? 272 26.8 Think opposite when under the X-axis 273 27 Understanding Regressions 275 27.1 Key takeaways 275 27.2 The line – what is the relationship? 276 27.2.1 Slope (beta) 276 27.2.2 y-intercept (alpha) 277 27.3 The explanatory power or strength of the relationship 277 27.3.1 Correlation coefficient (R) 277 27.3.2 Coefficient of determination (R-squared) 277