The Warehouse Group (WHS) is a New Zealand’s largest listed retailer. The company has been the subject of takeover speculation. Last week the company downgraded its profit guidance. We decided to have a look at the company using the Valuecruncher interactive tool.

WHS Valuation

Our assumptions of revenues for the next three years are NZ$1.745 billion in 2008 increasing to NZ$1.825 billion in 2010 – a compound annual growth rate of 2.3% (2008-10). We have projected flat EBITDA margins of 10% to 2010.

We have used a terminal growth rate of 3%. This is based on a New Zealand long-run economy growth rate. If you have a more optimistic or pessimistic view of the growth for WHS this will impact the valuation.

We have used a WACC (discount rate) of 8.5 %. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). PricewaterhouseCoopers December 2007 cost of capital report gives WHS a calculated WACC of 8.2%.

We used a terminal capital expenditure number of NZ$60 million. In our opinion capital expenditure should stabilise around this number.

WHS Valuation

Our analysis incorporates the cash and debt on the WHS balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of NZ$4.13 which is very close to the current share price of NZ$4.10.

Based on our analysis, WHS shares look about right. Our key assumptions are around terminal growth and WACC (discount rate). Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Forget being identified as a company with a share price at a 52-week low – this week General Motors (GM) were identified as a company with a share price at a 53-year low. Goldman Sachs issued a “Sell” rating expressing concerns about the broad auto sector and suggesting GM may need to raise capital. The broad auto sector issues can be summarised by this quote from a CIBC economic report on oil prices – “Over the next four years, we are likely to witness the greatest mass exodus of vehicles off America’s highways in history. By 2012, there should be some 10 million fewer vehicles on American roadways than there are today—a decline that dwarfs all previous adjustments including those during the two OPEC oil shocks.” Any forecast growth for GM isn’t coming from the US market.

GM Valuation

GM’s revenues decreased from US$195.3 billion in 2004 to US$181.1 billion in 2007 – a (2.5%) compound annual growth rate. Our assumptions of revenues for the next three years are US$173.75 billion in 2008 growing to US$190.25 billion in 2010 – a 4.6% compound annual growth rate (2008-10). We have projected EBITDA margins of 4.5% in 2008 then a flat 5.5% moving forward. We have used a terminal growth rate of 3%. We calculated this terminal growth rate based on year three growth of 3.5% dropping to a 3% stable growth rate by year 10. Our view is that this growth is coming from outside the US market – GM has approximately 60% of sales from international (i.e. non-US) markets. We used a terminal capital expenditure number of US$8.5 billion. We have used a WACC (discount rate) of 9.5%.

Valuecruncher Valuation GM

Our analysis incorporates the cash and debt on the GM balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$10.49 which is 9.2% below the current share price of US$11.55.

GM presents an illustration of the sensitivity of key inputs for a discounted cash flow (DCF) model like we use here at Valuecruncher. There are a range of key assumptions where small changes can make significant changes to the valuation. The most significant of these in our model is the EBITDA margin in 2010. If GM can get the EBITDA margin to 6.0% in 2010 (we are projecting 5.5%) then, with all other assumptions constant, we produce a valuation of $26.03 (125% above the current share price). However if we reduce the EBITDA margin to 5.0% in 2010 we place a zero valuation on the GM shares. This doesn’t make the analysis less valuable – it simply illustrates the areas where there are opportunities and risks associated with the on-going GM financial performance.

Based on our analysis the current valuation looks slightly overvalued – but very sensitive to the assumptions identified (especially EBITDA margins). If GM can beat the numbers identified then there is potentially significant upside – if they can’t then the future could look bleak. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

This week Oracle announced better than expected financial results but gave a conservative outlook moving forward. We decided to have a look at some projected financial numbers using our on-line valuation tool.

ORCL Valuation

Oracle grew revenues from US$11.8 billion in 2005 to US$22.4 billion in 2008 – a 24% compound annual growth rate. Our assumptions of revenues for the next three years are US$25.75 billion in 2009 growing to US$31.5 billion in 2011 – a 12% compound annual growth rate. We have projected EBITDA margins to be flat at 40%. We have used a terminal growth rate of 4%. We calculated this terminal growth rate based on year three growth of 8.6% dropping to a 3% stable growth rate by year 10. We used a terminal capital expenditure number of US$600 million. We have used a WACC (discount rate) of 10.5%.

Valuecruncher Valuation ORCL

Our analysis incorporates the cash on the Oracle balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$24.14 which is 12.7% above the current share price of US$21.42.

Based on our analysis the current valuation looks slightly undervalued. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

We are revisiting a prior piece of analysis we completed on Google (GOOG). It has been a popular piece of analysis and we wanted to update the analysis using our on-line valuation tool.

GOOG Valuation

Google grew revenues from US$3.2 billion in 2004 to US$16.6 billion in 2007 – a huge 73% compound annual growth rate. Our assumptions of revenues for the next three years are US$22.5 billion in 2008 growing to US$34.5 billion in 2010 – a 27% compound annual growth rate. Year-on-year revenue increases have slowed from 92.5% in 2005 to 56.5% in 2007. We are projecting revenue growth to continue to slow – 35.6% in 2008, 26.7% in 2009 and 21.0% in 2010.

We have projected EBITDA margins at a flat 40%.

We have used a terminal growth rate of 6.5%. We calculated this terminal growth rate based on year three growth (2009 to 2010) of 21% dropping to 18.5% in 2011 and then to a 5% stable growth rate over the next ten years.

We have used a WACC (discount rate) of 10.5%. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). We think this WACC of 10.5% is reasonable but recognise that the actual number could be as low as 10% or as high as 12-12.5%.

We used a terminal capital expenditure number of US$4.25 billion.

Our analysis incorporates the cash on the Google balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$481.94 which is 11.1% below the current share price of US$542.30.  Our valuation is based on the current share price - it isn’t a target price for the future.

Valuecruncher Valuation GOOG – Base Case

We then created three separate scenarios:

1. Growth – where Google’s current dominance of on-line search and advertising is enhanced and revenues grow faster than anticipated in the base case. This scenario holds all the inputs from the base case constant except that we have increased the terminal growth to 7.0% – based on 2011 growth of 20% decreasing to 5% over ten years – and lifted EBITDA margins to 42.5%. This scenario has a valuation of US$590.39 per share. This is 8.9% above the current share price and 22.5% above our base case valuation.

Valuecruncher Valuation GOOG – Growth

2. Disruption – where Google’s current market dominance is reduced by changes in the competitive landscape. This scenario holds all the inputs from the base case constant except that we have decreased the terminal growth to 5.5% – based on 2011 growth of 15% decreasing to 4% over ten years – and dropped EBITDA margins to 37.5%. This scenario has a valuation of US$363.22 per share. This is 33.0% below the current share price and 24.6% below our base case valuation.

Valuecruncher Valuation GOOG – Disruption

3. Black Swan – where Google’s internal activities create a new growth business similar in value to Salesforce.com. The new business grows from US$250 million in revenues in 2009 to US$1.5 billion in 2012 and from $250m in losses to 50% EBIT margins in the same period. To reflect this we have increased 2009 revenues by US$250 million and 2010 revenues by US$500 million. We have reduced the 2009 EBITDA to 39%. We have also lifted the terminal growth to 6.65%. This scenario has a valuation of US$507.85 per share. This is 6.4% below the current share price and 5.4% above our base case valuation. Google creating a new business of the value of Salesforce.com adds just under US$26 to our base case share price.

Valuecruncher Valuation GOOG – Black Swan

Valuecruncher greatly respects Google’s current market dominance in search and on-line advertising. However – we can see both a situation where Google maintains this dominance and more advertising spend moves from traditional media to on-line and conversely one where new methods of discovery on-line disrupt Google’s current dominant position. We do not have a perspective on which of those might occur – but it is worth considering the impact of both scenarios from a valuation perspective. These are scenarios 1 and 2.

Our third scenario looks at the valuation impact if one of the internal Google R&D activities produces a material new business unit (say US$1.5 billion of revenues by 2012 at 50% EBIT margins). The value of this new business unit is ~US$8.1 billion in the valuation – comparable to the current enterprise value of a Salesforce.com.

Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Shares of 3M have dropped 7.8% for the quarter through June 23 – with the S&P500 down only 0.4%. We thought it was time to have an objective look at 3M using the interactive Valuecruncher valuation tool.

3M Valuation

3M grew revenues from US$16.3 billion in 2002 to US$24.5 billion in 2007 – 8.4% compound annual growth rate. Our assumptions of revenues for the next three years are US$26.5 billion in 2008 growing to US$29.5 billion in 2010 – 6.4% compound annual growth rate. We have projected EBITDA margins remaining flat at 26.5%.

We have used a terminal growth rate of 2.5%. We calculated this terminal growth rate based on year three growth (2009 to 2010) of 5% dropping to a 2% stable growth rate over the next ten years.

We have used a WACC (discount rate) of 9%. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). We think this WACC of 9% is reasonable but recognise that the actual number could be as low as 7.5-8.0% or as high as 10%.

We used a terminal capital expenditure number of US$1.5 billion.

Valuecruncher Valuation 3M

Our analysis incorporates the cash and debt on the 3M balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$85.16 which is 16.7% above the current share price of US$72.96

Based on our analysis, 3M shares look cheap. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Telecom Corporation of New Zealand (TEL) is New Zealand’s largest company (by market capitalisation). TEL is facing a range of challenges in the New Zealand market as it begins to operate in a more open regulatory environment. We decided to have a look at the company using the Valuecruncher interactive tool.

TEL Valuation

Our assumptions of revenues for the next three years are NZ$5.625 billion in 2008 decreasing to NZ$5.575 billion in 2010. We have projected EBITDA margins decreasing from 33.5% in 2008 to 31.5% in 2010.

We have used a terminal growth rate of 1%. Our view is that TEL will start to see modest growth post 2010 and 1% is a reasonable estimate. This assumption has a significant impact on the valuation. If you believe TEL has better future prospects – this will positively impact the valuation.

We have used a WACC (discount rate) of 10 %. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). PricewaterhouseCoopers December 2007 cost of capital report gives TEL a calculated WACC of 11.3%. In our opinion this is too high. In 2004 PricewaterhouseCoopers calculated a TEL WACC between 9.8% and 10.5% (with 10.1% as the point estimate). In our opinion this 2004 analysis appears more reasonable. The December 2007 cost of capital report gives a New Zealand market WACC of 10.3% – TEL having a WACC 1% higher seems wrong.

We used a terminal capital expenditure number of NZ$750 million. In our opinion capital expenditure should stabilise around this number.

TEL Valuation

Our analysis incorporates the cash and debt on the TEL balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of NZ$3.40 which is 8.85% below the current share price of NZ$3.73.

Based on our analysis, TEL shares look expensive. Our key assumptions are around terminal growth and WACC (discount rate). Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

With GE’s share price hitting a five-year low and analyst coverage turning negative. We thought it was time to have an objective look at the GE numbers using the interactive Valuecruncher valuation tool.

GE Valuation

GE grew revenues from US$134.3 billion in 2004 to US$172.7 billion in 2007 – 8.75% compound annual growth rate. Our assumptions of revenues for the next three years are US$187.5 billion in 2008 growing to US$206.5 billion in 2010 – 6.1% compound annual growth rate. We have projected EBITDA margins increasing from 23.5% in 2008 to 24.5% in 2010.

We have used a terminal growth rate of 2.5%. We calculated this terminal growth rate based on year three growth (2009 to 2010) of 5% dropping to a 2% stable growth rate over the next ten years.

We have used a WACC (discount rate) of 6.5%. The WACC (discount rate) has a material impact on a discounted cash flow valuation (as does the terminal growth rate). We think this WACC of 6.5% is reasonable but recognise that the actual number could be as low as 5.5% or as high as 7.5-8%.

We used a terminal capital expenditure number of US$4.0 billion.

Valuecruncher Valuation GE

Our analysis incorporates the cash and debt on the GE balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$36.16 which is 32.1% above the current share price of US$27.38.

Based on our analysis, GE shares look cheap. Play with our assumptions – what does your analysis say?

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.

Today we look at the valuation of a traditional media company – in this case Time Warner. Traditional media may be an outdated description of a company that includes the AOL operating division and the recently acquired social network Bebo within their ranks. But maybe digital assets are now simply part of traditional media. Time Warner’s other operating divisions include: Cable, Filmed Entertainment, Networks and Publishing.

TWX Valuation

Time Warner grew revenues from US$39.5 billion in 2003 to US$46.5 billion in 2007 – a 4% compound annual growth rate. Our assumptions of revenues for the next three years are US$48.0 billion in 2008 growing to US$52.0 billion in 2010. We have projected EBITDA margins increasing from 22% in 2008 to 25% in 2010. We have used a terminal growth rate of 2%. We calculated this terminal growth rate based on year three growth of 4% dropping to a 2% stable growth rate by year 10. We used a terminal capital expenditure number of US$4.5 billion. We have used a WACC (discount rate) of 8.5%.

Valuecruncher Valuation TWX

Our analysis incorporates the cash and debt on the Time Warner balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of US$15.08 which is very close to the current share price of US$15.19.

Based on our analysis the current valuation looks about right. Play with our assumptions - what does your analysis say?

Over at Clusterstock Henry Blodget thinks that eBay looks cheap. We thought that we would take the opportunity to have a look at eBay using the Valuecruncher interactive tool to analyse the company.

EBAY Valuation

Our assumptions are revenues of US$9.0 billion in 2008 growing to US$11.5 billion in 2010. We have used a flat EBITDA margin of 37.5% from 2008. We have used a terminal growth rate of 4.8%. We calculated this terminal growth rate based on year three growth of 12.2% dropping to a 4% stable growth rate by year 10. We used a terminal capital expenditure number of US$800 million. We have used a WACC (discount rate) of 11.5%.

Valuecruncher Valuation EBAY

Our analysis incorporates the cash on the eBay balance sheet – Valuecruncher calculates a net debt number. Our analysis also incorporates Skype within the current eBay structure. It is possible that eBay will decide to sell the Skype business (Yahoo, Google and Microsoft have been suggested as possible acquirers). There may be a higher value owner of Skype than eBay – but until that situation is clarified we have kept Skype where it is.

Our analysis gives a valuation of US$28.13 which is less than 1% below the current share price of US28.38. We don’t agree with Henry Blodget that EBAY looks cheap. Based on our analysis the current valuation looks about right. Play with our assumptions - what does your analysis say?

Continuing on from our look at the terminal growth rate we now turn our attention to the discount rate assumption. The discount rate is one of the key assumptions in the Valuecruncher valuation.

Deciphering the discount rate

Before addressing the technical definition of the Valuecruncher discount rate it is important to understand what the discount rate is designed to capture. The discount rate reflects the required rate of return on the investment. The discount rate consists of two key components, the time value of money and risk.

Time Value of Money

The time value of money assumes that all other things being equal you would prefer have a $1 today as opposed to waiting until tomorrow, next year or retirement. To sacrifice the opportunity to use that $1 today an incentive is required. The time value of money is reflected in the risk free rate component of the discount rate.

Risk

When considering risk in a financial context NYU Professor Aswath Damodaran cites the Chinese symbol for risk which is a combination of the characters for danger (crisis) and opportunity.

This approach recognises that risk represents more than just downside outcomes. Drawing on Damodaran again:

“…risk in finance is defined in terms of variability of actual returns on an
investment around an expected return, even when those returns represent positive outcomes.”

Valuecruncher’s valuation considers the risk associated with the company’s forecast free cash flow.

Games of chance such as roulette have a discrete number of potential outcomes with explicitly defined returns and probabilities. The expected return, variability and therefore risk can be established relatively easily.

The risk associated with a company is the function of countless potential outcomes that reflect a multitude of company specific and macro factors.

Examples of risks associated with Apple’s future cash flows:

• How much will the new 3G iPhone and price point increase sales?
• Will the economic downturn impact on the company’s sales?
• How big will the mobile web be and what will be the iPhone’s role?
• Can Apple continue their successful development of new and improved products?

The impact and likelihood of these factors are not directly observable like the outcomes of the roulette wheel but all contribute to Apple Inc’s discount rate. This makes the process of identifying and quantifying risk one of the major challenges of the valuation process.

A technical definition of the Valuecruncher discount rate

The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital (WACC). The weighted average cost of capital is a combination of the required rate of return of the company’s equity holders (shares/stocks) and debt holders (bonds/loans).

Valuecruncher applies the discount rate to the company’s forecast nominal post-tax free cash flow (FCF). The free cash flow is calculated as a function of Valuecruncher inputs revenue, profitability, capital expenditure, depreciation and tax.

Wake up!! That was meant to be the boring part

Calculating, estimating or guessing the discount rate for companies

As stated the discount rate reflects the required rate of return on both debt and equity. The debt component of the discount rate is relatively easy to estimate based on the lending terms the company enjoys i.e. what interest rate (coupon rate) does the company pay. The required rate of return of the equity component is a more difficult proposition.

Practitioners often draw on mathematical approaches such as the capital asset prising model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return on equity. These like all approaches have their pro’s and con’s. Despite the mathematical fire power inherent in these models a subjective assessment must be made before they are incorporated into the discount rate. This subjective component relates to the relationship between the discount rate and the company’s forecast free cash flows. A discount rate calculated based on historic returns, alternative forecasts or expectations may not be consistent with the forecast free cash flow. Examples of this issue include when companies are shifting their focus (e.g. IBM’s restructuring) or the industry is in the process of dramatic change (e.g. newspapers).

There are extensive resources available online on calculating the discount rate:

• Investopedia
• Damodaran on Valuation (2nd Edition)
  
• Estimated discount rate for New Zealand listed companies - PwC Cost of Capital Report
• Estimated discount rate by industry for the United States - Aswath Damodaran’s discount rate table