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4.ADiscountforComplexity:AnExperiment

CompanyA CompanyBOperatingIncome $1billion $1billionTaxrate 40% 40%ROIC 10% 10%ExpectedGrowth 5% 5%Costofcapital 8% 8%BusinessMix Single MultipleHoldings Simple ComplexAccounting Transparent OpaqueWhichfirmwouldyouvaluemorehighly?

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MeasuringComplexity:VolumeofDatainFinancialStatements

Company Number of pages in last 10Q Number of pages in last 10KGeneral Electric 65 410Microsoft 63 218Wal-mart 38 244Exxon Mobil 86 332Pfizer 171 460Citigroup 252 1026Intel 69 215AIG 164 720Johnson & Johnson 63 218IBM 85 353

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MeasuringComplexity:AComplexityScore

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DealingwithComplexity

¨ InDiscountedCashflowValuation¤ TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirm

baseduponthefirm’sstatementsabouttheirvalue.¤ TheConservativeAnalyst:Don’tvaluewhatyoucannotsee.¤ TheCompromise:Adjustthevalueforcomplexity

n Adjustcashflowsforcomplexityn Adjustthediscountrateforcomplexityn Adjusttheexpectedgrowthrate/lengthofgrowthperiodn Valuethefirmandthendiscountvalueforcomplexity

¨ Inrelativevaluation¤ Inarelativevaluation,youmaybeabletoassessthepricethatthemarket

ischargingforcomplexity:¤ Withthehundredlargestmarketcapfirms,forinstance:PBV=0.65+15.31ROE– 0.55Beta+3.04Expectedgrowthrate– 0.003#

Pagesin10K

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5.Becircumspectaboutdefiningdebtforcostofcapitalpurposes…

¨ GeneralRule:Debtgenerallyhasthefollowingcharacteristics:¤ Commitmenttomakefixedpaymentsinthefuture¤ Thefixedpaymentsaretaxdeductible¤ Failuretomakethepaymentscanleadtoeitherdefaultorlossof

controlofthefirmtothepartytowhompaymentsaredue.¨ Definedassuch,debtshouldinclude

¤ Allinterestbearingliabilities,shorttermaswellaslongterm¤ Allleases,operatingaswellascapital

¨ Debtshouldnotinclude¤ Accountspayableorsuppliercredit

¨ Bewaryofyourconservativeimpulseswhichwilltellyoutocounteverythingasdebt.Thatwillpushupthedebtratioandleadyoutounderstateyourcostofcapital.

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BookValueorMarketValue

¨ Youarevaluingadistressedtelecomcompanyandhavearrivedatanestimateof$1billionfortheenterprisevalue(usingadiscountedcashflowvaluation).Thecompanyhas$1billioninfacevalueofdebtoutstandingbutthedebtistradingat50%offacevalue(becauseofthedistress).Whatisthevalueoftheequitytoyouasaninvestor?a. Theequityisworthnothing(EVminusFaceValueofDebt)b. Theequityisworth$500million(EVminusMarketValueofDebt)

¨ Wouldyouranswerbedifferentifyouweretoldthattheliquidationvalueoftheassetsofthefirmtodayis$1.2billionandthatyouwereplanningtoliquidatethefirmtoday?

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Butyoushouldconsiderotherpotentialliabilitieswhengettingtoequityvalue

¨ Ifyouhaveunderfundedpensionfundorhealthcareplans,youshouldconsidertheunderfundingatthisstageingettingtothevalueofequity.¤ Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitemreflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.

¤ Youshouldnotbecountingtheseitemsasdebtinyourcostofcapitalcalculations….

¨ Ifyouhavecontingentliabilities- forexample,apotentialliabilityfromalawsuitthathasnotbeendecided- youshouldconsidertheexpectedvalueofthesecontingentliabilities¤ Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expectedvalueofliability

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6.EquitytoEmployees:EffectonValue

¨ Inrecentyears,firmshaveturnedtogivingemployees(andespeciallytopmanagers)equityoptionorrestrictedstockpackagesaspartofcompensation.Iftheyareoptions,theyusuallyarelongtermandonvolatilestocks.Ifrestrictedstock,therestrictionsareusuallyontrading.

¨ Theseequitycompensationpackagesareclearlyvaluableandthequestionbecomeshowbesttodealwiththeminvaluation.

¨ Twokeyissueswithemployeeoptions:¤ Howdooptionsorrestrictedstockgrantedinthepastaffectequity

valuepersharetoday?¤ Howdoexpectedgrantsofeitherinthefutureaffectequityvalue

today?

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TheEasierProblem:RestrictedStockGrantsAswath

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¨ Whenemployeecompensationtakestheformofrestrictedstockgrants,thesolutionisrelativelysimple.

¨ Toaccountforrestrictedstockgrantsinthepast,makesurethatyoucounttherestrictedstockthathavealreadybeengrantedinsharesoutstandingtoday.Thatwillreduceyourvaluepershare.

¨ Toaccountforexpectedstockgrantsinthefuture,estimatethevalueofthesegrantsasapercentofrevenueandforecastthatasexpenseaspartofcompensationexpenses.Thatwillreducefutureincomeandcashflows.

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TheBiggerChallenge:EmployeeOptions

¨ Itistruethatoptionscanincreasethenumberofsharesoutstandingbutdilutionperseisnottheproblem.

¨ Optionsaffectequityvalueatexercisebecause¤ Sharesareissuedatbelowtheprevailingmarketprice.Optionsgetexercisedonlywhentheyareinthemoney.

¤ Alternatively,thecompanycanusecashflows thatwouldhavebeenavailabletoequityinvestorstobuybackshareswhicharethenusedtomeetoptionexercise.Thelowercashflows reduceequityvalue.

¨ Optionsaffectequityvaluebeforeexercisebecausewehavetobuildintheexpectationthatthereisaprobabilityofandacosttoexercise.

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Asimpleexample…

¨ XYZcompanyhas$100millioninfreecashflows tothefirm,growing3%ayearinperpetuityandacostofcapitalof8%.Ithas100millionsharesoutstandingand$1billionindebt.Itsvaluecanbewrittenasfollows:

Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valuepershare =1000/100=$10

¨ XYZdecidestogive10millionoptionsatthemoney(withastrikepriceof$10)toitsCEO.Whateffectwillthishaveonthevalueofequitypershare?a. None.Theoptionsarenotin-the-money.b. Decreaseby10%,sincethenumberofsharescouldincreaseby10millionc. Decreasebylessthan10%.Theoptionswillbringincashintothefirmbutthey

havetimevalue.

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I.TheDilutedShareCountApproach

¨ Thesimplestwayofdealingwithoptionsistotrytoadjustthedenominatorforsharesthatwillbecomeoutstandingiftheoptionsgetexercised.Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Valuepershare =1000/110=$9.09

¨ Thedilutedapproachfailstoconsiderthatexercisingoptionswillbringincashintothefirm.Consequently,theywilloverestimatetheimpactofoptionsandunderstatethevalueofequitypershare.

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II.TheTreasuryStockApproach

¨ Thetreasurystockapproachaddstheproceedsfromtheexerciseofoptionstothevalueoftheequitybeforedividingbythedilutednumberofsharesoutstanding.

¨ Intheexamplecited,thiswouldimplythefollowing:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Numberofdilutedshares =110Proceedsfromoptionexercise =10*10=100Valuepershare =(1000+100)/110=$10

¨ Thetreasurystockapproachfailstoconsiderthetimepremiumontheoptions. Thetreasurystockapproachalsohasproblemswithout-of-the-moneyoptions.Ifconsidered,theycanincreasethevalueofequitypershare.Ifignored,theyaretreatedasnon-existent.

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III.OptionValueDrag

¨ Step1:Valuethefirm,usingdiscountedcashfloworothervaluationmodels.

¨ Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthevalueofequity.Alternatively,skipstep1andestimatetheofequitydirectly.

¨ Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)ofotherequityclaims:¤ ValueofWarrants=MarketPriceperWarrant*NumberofWarrants

:Alternativelyestimatethevalueusingoptionpricingmodel¤ ValueofConversionOption=MarketValueofConvertibleBonds- Valueof

StraightDebtPortionofConvertibleBonds¤ ValueofemployeeOptions:Valueusingtheaverageexercisepriceand

maturity.¨ Step4:Dividetheremainingvalueofequitybythenumberof

sharesoutstandingtogetvaluepershare.

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ValuingEquityOptionsissuedbyfirms…TheDilutionProblem

¨ Optionpricingmodelscanbeusedtovalueemployeeoptionswithfourcaveats–¤ Employeeoptionsarelongterm,makingtheassumptionsabout

constantvarianceandconstantdividendyieldsmuchshakier,¤ Employeeoptionsresultinstockdilution,and¤ Employeeoptionsareoftenexercisedbeforeexpiration,makingit

dangeroustouseEuropeanoptionpricingmodels.¤ Employeeoptionscannotbeexerciseduntiltheemployeeisvested.

¨ Theseproblemscanbepartiallyalleviatedbyusinganoptionpricingmodel,allowingforshiftsinvarianceandearlyexercise,andfactoringinthedilutioneffect.Theresultingvaluecanbeadjustedfortheprobabilitythattheemployeewillnotbevested.

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ValuingEmployeeOptions

¨ Tovalueemployeeoptions,youneedthefollowinginputsintotheoptionvaluationmodel:¤ StockPrice=$10,Adjustedfordilution=$9.58¤ StrikePrice=$10¤ Maturity=10years(Canreducetoreflectearlyexercise)¤ Standarddeviationinstockprice=40%¤ RisklessRate=4%

¨ Usingadilution-adjustedBlackScholesmodel,wearriveatthefollowinginputs:¤ N(d1)=0.8199¤ N(d2)=0.3624¤ Valuepercall=$9.58(0.8199)- $10e-(0.04)(10)(0.3624)=$5.42

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ValueofEquitytoValueofEquitypershare

¨ Usingthevaluepercallof$5.42,wecannowestimatethevalueofequitypershareaftertheoptiongrant:Valueoffirm=100/(.08-.03) =2000Debt =1000=Equity =1000Valueofoptionsgranted =$54.2=ValueofEquityinstock =$945.8/Numberofsharesoutstanding /100=Valuepershare =$9.46

¨ Notethatthisapproachyieldsahighervaluethanthedilutedsharecountapproach(whichignoresexerciseproceeds)andalowervaluethanthetreasurystockapproach(whichignoresthetimepremiumontheoptions)

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Totaxadjustornottotaxadjust…

¨ Intheexampleabove,wehaveassumedthattheoptionsdonotprovideanytaxadvantages.Totheextentthattheexerciseoftheoptionscreatestaxadvantages,theactualcostoftheoptionswillbelowerbythetaxsavings.

¨ Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1- taxrate)togetanafter-taxoptioncost.

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Optiongrantsinthefuture…

¨ Assumenowthatthisfirmintendstocontinuegrantingoptionseachyeartoitstopmanagementaspartofcompensation.Theseexpectedoptiongrantswillalsoaffectvalue.

¨ Thesimplestmechanismforbringinginfutureoptiongrantsintotheanalysisistodothefollowing:¤ Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsasapercentofrevenues.

¤ Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofutureyears,allowingforthefactthatasrevenuesgetlarger,optiongrantsasapercentofrevenueswillbecomesmaller.

¤ Considerthislineitemaspartofoperatingexpenseseachyear.Thiswillreducetheoperatingmarginandcashfloweachyear.

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Whenoptionsaffectequityvaluepersharethemost…

¨ Optiongrantsaffectvaluemore¤ Thelowerthestrikepriceissetrelativetothestockprice¤ Thelongerthetermtomaturityoftheoption¤ Themorevolatilethestockprice

¨ Theeffectonvaluewillbemagnifiedifcompaniesareallowedtorevisitoptiongrantsandresettheexercisepriceifthestockpricemovesdown.

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NARRATIVEANDNUMBERS:VALUATIONASABRIDGE

Tellmeastory..

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Valuationasabridge

The Numbers People

Favored Tools- Accounting statements

- Excel spreadsheets- Statistical Measures

- Pricing Data

Illusions/Delusions1. Precision: Data is precise

2. Objectivity: Data has no bias3. Control: Data can control reality

The Narrative People

Favored Tools- Anecdotes

- Experience (own or others)- Behavioral evidence

Illusions/Delusions1. Creativity cannot be quantified

2. If the story is good, the investment will be.

3. Experience is the best teacher

A Good Valuation

Number Crunchers Story Tellers

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Step1:Surveythelandscape

¨ Every valuation starts with a narrative, a story thatyou see unfolding for your company in the future.

¨ In developing this narrative, you will be makingassessments of¤ Your company (its products, its management and itshistory.

¤ The market or markets that you see it growing in.¤ The competition it faces and will face.¤ The macro environment in which it operates.

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Step2:Createanarrativeforthefuture

¨ Everyvaluationstartswithanarrative,astorythatyouseeunfoldingforyourcompanyinthefuture.

¨ Indevelopingthisnarrative,youwillbemakingassessmentsofyourcompany(itsproducts,itsmanagement),themarketormarketsthatyouseeitgrowingin,thecompetitionitfacesandwillfaceandthemacroenvironmentinwhichitoperates.¤ Rule1:Keepitsimple.¤ Rule2:Keepitfocused.¤ Rule3:Staygroundedinreality.

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TheUberNarrative

InJune2014,myinitialnarrativeforUber wasthatitwouldbe1. Anurbancarservicebusiness:IsawUber primarilyasa

forceinurbanareasandonlyinthecarservicebusiness.2. Whichwouldexpandthebusinessmoderately(about40%

overtenyears)bybringinginnewusers.3. Withlocalnetworkingbenefits:IfUber becomeslarge

enoughinanycity,itwillquicklybecomelarger,butthatwillbeoflittlehelpwhenitentersanewcity.

4. Maintainitsrevenuesharing(20%)systemduetostrongcompetitiveadvantages (frombeingafirstmover).

5. Anditsexistinglow-capitalbusinessmodel,withdriversascontractorsandverylittleinvestmentininfrastructure.

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Step3:Checkthenarrativeagainsthistory,economicfirstprinciples&commonsense

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TheImpossible,TheImplausibleandtheImprobable

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Uber:Possible,PlausibleandProbable

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The Story The Checks (?)

+ Money

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The Impossible: The Runaway Story

The Implausible: The Big Market Delusion

The Improbable: Willy Wonkitis