Modelling and Valuation of real sector companies - Fastovets.… · Modelling and Valuation of real...
Transcript of Modelling and Valuation of real sector companies - Fastovets.… · Modelling and Valuation of real...
Modelling and Valuation of real sector companies
Pitfalls and best practices
Konstantin Fastovets
Main topics
1. General thoughts on valuation & forecasting2. Modelling structure3. Modelling detail4. The valuation method5. Other common pitfalls6. Relative valuation
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General thoughts on valuation & forecasting
• Valuation offers a method or a tool rather than a number• Any output is conditional on a number of assumptions• It is how those assumptions
• If you disagree with the market try to have an explanation for why the market is wrong
• Other participants are lacking the information that you have• Other participants do not have resources dedicated to the same kind of analysis
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Modelling structure
• Separate operations, financials, valuation, and, definitely, assumptions into a different sheet each
• Try to match columns (years)• Color code, use comments• To determine a proper structure start off by looking at the operating segments. Pay special attention to divisions that generate the bulk of the EBITDA
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Modelling structure
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Remember – EBITDA is generated by total sales, not only external ones
Modelling structure
• Treat each operating segment as a separate business • This way you do not need to keep track of whether one segment sold enough raw materials to a different one (where your model can unbalance)
• Internal and external sales can alternate from year to year • Unlike revenues or costs, EBITDA is additive
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Modelling detail
• How detailed should your model be?
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Modelling detail
• How detailed should your model be?• Pros of detailed models:
• They reflect business processes more closely• Assumptions are broken down into more pieces (COGS as a whole vs each component)• They give the impression of being more correct, because they took longer to build
• Cons of detailed models:• They are hard to update• Valuation drivers can get lost in the detail• The extra detail is not always impactful or can be projected in a meaningful manner
• The answer: ideally, it should contain all useful and impactful detail on which opinions can be formed
• Example – modelling farming costs
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Modelling detail
If you adopt a 20/80 approach you only really care about operating segments that generate a meaningful amount of EBITDA
• In this example – 79% of EBITDA has been generated by the coal and power generation division
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Modelling detail
• Working with limited information• Examples are abundant in Ukraine• Usually you have a problem with costs and breaking them down
• Information on sales volumes and prices is often available
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Modelling detail
• Working with limited information• Examples are abundant in Ukraine• Usually you have a problem with costs and breaking them down
• Information on sales volumes and prices is often available
• The answer – use margins on per operating segment basis• Margins allow you to estimate costs. In absence of a better approach bulking everything together actually works quite well
• Costs/t=Price/t‐EBITDA/t• In the short term costs are fixed – this is an excellent way to forecast near‐term earnings• You can adjust costs based on information that is available to you (example – iron ore into steel)
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Modelling detail
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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
MHP farming EBITDA/ha, $
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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
MHP poultry EBITDA/kg, $
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Metinvest steel EBITDA/t, $
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Ferrexpo pellets, EBITDA/t
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One remarkable characteristic of margins is that in the absence of structural changes on the market they tend to be mean‐reverting. This also works in absolute terms
Modelling detail
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2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Kernel bulk oil, $/t
new players entering
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Kernel grain trading, $/t
new players entering
• When you’ve got structural changes, profits will reflect that and the price/cost spread will adjust accordingly.
• You can think of profits driving prices and costs rather than vice versa
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The modelling method
• Is there any difference between the discounted FCF and FCE approaches? • What is the meaning of WACC?• Errors are introduced when the WACC is used incorrectly
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The modelling method – deriving the WACC
EECF1 Ke
ECF1 Ke 1 Ke ⋯
EECF1 Ke
ECF1 Ke 1 Ke ⋯
E 1 Ke ECF ESubtracting the tax shield from FCF is mostly a convention
CFd D Kd D DSource: “WACC: Definitions, Misconceptions, and Errors” by Pablo Fernandez
Start off with:
Therefore:
The same logic goes for:
Derive what the discount rate for FCF needs to be for the following to hold
where
EV 1 Ke EV 1 WACC FCF
Intertemporal form
EV E D
We are proving:
FCF ECF D D D Kd 1 T
where
Since
[1]
[2]
[5]
Combine [1], [2], and [5]:
[3]
[4]
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The modelling method – deriving the WACC
Now plug in FCF and CFd definitions ([3] and [4]) to get:
Which simplifies to:
Solving for WACC:
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2019 2020 2021 2022 2023 2024 2025 TVECF before change in debt 150 100 75 0 85 95 100ECF after change in debt 150 0 175 100 185 195 100Tax rate 2% 3% 4% 5% 6% 7% 10%Kd (interest rate) 8% 8% 8% 8% 8% 8% 8%Debt, bop 200 200 100 200 300 400 500After tax interest expense 16 16 8 15 23 30 36Change of debt 0 ‐100 100 100 100 100 0FCF 166 116 83 15 108 125 136Ke 20% 20% 20% 20% 20% 20% 20%Equity, bop 582 548 658 614 637 579 500 500WACC 17% 17% 18% 17% 16% 15% 14%EV (discounted FCF), bop 782 748 758 814 937 979 1000 1000EV (equity + debt), bop 782
Terminal FCF growth rate 0.0%Equivalent ECF growth rate 0.0%Terminal Ke 20%Terminal Kd 8%
Terminal WACC 14%
D/E need to be assumed fixed
The modelling method – WACC use example
• Implications if you want to use WACC:• You will have to calculate the fair value of equity first• The cost of debt has to equal the cash interest rate (i.e. fair value and
balance sheet value of debt need to match!)• You have to assume a fixed D/E ratio – setting a terminal growth rate
on FCF implies growth rate of debt, which means that the equivalent FCE growth rate is actually much higher. In this example 3.0% translates into 5.5%
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The modelling method
• How to determine a proper cost of equity?• Does the CAPM work well?
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The modelling method
• How to determine a proper cost of equity?• Does the CAPM work well? • No, it works poorly because real markets do not fulfill the assumptions under which it is derived
• The overall market needs to be in equilibrium – this implies that everything is already priced correctly
• A special relationship between an asset’s return and the distribution of its returns is only achieved if everyone is holding the same optimal portfolio, which includes all assets present on the market
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The modelling method – deriving the CAPM
In the present of a risk‐free rate a portfolio’s expectedreturn can be expressed as:
The marginal contribution of a risky asset i to the expected portfolio is thus :
Since
The variance of a portfolio’s return in the sum of all entries in the table:
The sum of the entries of the i‐th row and the i‐thcolumn is the total contribution of asset i to portfolio variance:
2 ,
Source: Caltech lecture notes by J. Wang (15.401 – “CAPM and APT”)
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The modelling method – deriving the CAPMThe marginal contribution of asset i to portfolio variance is thus:
The marginal contribution of asset i to portfolio volatility (or standard deviation) is:
In an optimal portfolio the ratio of marginal return to marginal risk must be the same across all included assets (otherwise you should be rebalancing)
Since it is also true for the market portfolio itself:
Rewriting:
Source: Caltech lecture notes by J. Wang (15.401 – “CAPM and APT”) 21
The modelling method
• Empirical evidence shows that the CAPM did not work well over the last 30years even on the US market
Source: Fischer Black, “Beta and return” 22
The modelling method
• So what’s the solution?• Change your approach. The relationship between the cost of equity and the fair equity value is the same as that of a price of a bond to its yield
• You can:• Calculate the implied cost of equity for similar companies on the market and the decide if there should be a premium
• Look at the cost of debt and add a premium• In the end you can only answer the question what a fair equity value (or stock price) is, given a certain cost of equity. Demonstrate different results with different cost of equity assumptions
MHP 2020
DTEK 2024
FIUB 2018
Ferrexpo 2019
Kernel 2022
Oschadbank 2023
Oschadbank 2025
Metinvest 2021
MHP 2024Ukreximbank
2022
Ukreximbank 2025Ukrzaliznutsya
2021
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Corporate Eurobonds Government Eurobonds
The best you can do for bonds is look at spreads
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Other common pitfalls
• Earnings that grow out of nowhere• Make sure capex compensates for D&A• Make sure the company’s investment projects are reasonable in terms of return
• You can model them separately to see their net effect• Check your growth rate, especially if you’re using FCF – you could be generating most of your value from an unknown source
• Using unrealistic price assumptions• Its fine to just assume the current price for commodities and assigning some sort ofinflation to it – otherwise make sure you know why the market is wrong and you’re right
• Forgetting about currency risks.• If the company’s cash flow is mixed in hard currency and the hryvnia, make sure yourdiscount rate reflects that
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Relative valuation
• DCF vs relative valuation – which one is better? • Should you take averages? Maybe weighted averages?
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Relative valuation
• DCF vs relative valuation – which one is better? • Should you take averages? Maybe weighted averages?• No, the two approaches should be telling you the same thing. If they are not, figure out why (maybe one of them simply fails to work correctly).
• The bond analogy is duration
• Common pitfalls:• The peer group does not operate in the same industry, or environment• Financial year periods do not match• Earnings metrics are calculated on a different basis
• The inclusion of JVs into EBITDA• Revaluation effects• Functional vs reporting currency during sharp exchange rate changes
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Relative valuation – an IAS 41 case study
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Relative valuation – an IAS 41 case study
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Q&A
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