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Estimating the Growth Rate to Use in Terminal Value Calculations

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Estimating the Growth Rate to Use in Terminal Value Calculations HCVI Henley Centre for Value Improvement Testing IPO Pricing Two Contrasting Telecomm Illustrations Roger W. Mills* Henley Discussion Paper Series (HCVI HDP No. 7, June 2005) * The author wishes to express his thanks to Mr Teo Cocca, University of Zurich, for his assistance with the analysis of Swisscom ISBN 1 86181 236 1 Henley Centre for Value Improvement (HCVI) Henley Management College Greenlands Henley-on-Thames Oxon RG9 3AU Tel: + 44 1491 418762 Fax: + 44 1491 571574 Email: [email protected] Website: www.henleymc.ac.uk/hcvi ©Roger Mills 2 Henley Discussion Paper Series HCVI HDP No. 7 Abstract In this paper a framework that can be used for challenging the assumptions used in IPO pricing is described and illustrated using IPO discounted cash flow valuations of Jordan Telecom and Swisscom that were produced by analysts. The framework makes use of information about comparable businesses that is applied in challenging key assumptions using Market Implied Competitive Advantage Period (MICAP) analysis. Typically, IPOs are valued using a variety of methods and within the valuations there will often be a discounted cash flow (DCF) estimate in some form, about which great care has to be exercised by the reader in terms of understanding the implicit and explicit assumptions used. Conventional wisdom in estimating the value of businesses with long-term growth potential is to use a two stage model, where the first stage represents a time period in which growth is assumed to be captured in the explicit growth in individual cash flows over a finite time period. The second stage is assumed to be a perpetuity thereby avoiding the need to forecast the growth in individual cash flows; instead a composite growth rate, ‘g’, for free cash flows can be assumed. The selection of a growth rate has a significant impact upon the value and the higher the growth rate the higher the value . A major concern typically arises about the impact of the g on the resulting value and, therefore, how it might be estimated in any meaningful way. At the end of the day, the user of investment research needs to be able to establish confidence with the assumptions used and the problem is that within corporate finance there is limited evidence of any readily available framework ©Roger Mills 3 Henley Discussion Paper Series HCVI HDP No. 7 In this paper a framework for challenging perpetuity with growth assumptions is proposed with reference to the case of Jordan Telecom. The use of this company has the advantage that it is a relatively recent issue in a sector often beset by forecasting challenges and, most importantly, it draws upon information predominately available in the investment research report itself. Thereafter, the outcome is contrasted with that for Swisscom, for which the same framework was applied. These two IPO valuations had markedly contrasting results, but the analysis provided here illustrates how the framework can be applied to help ensure that the right questions about IPO pricing are being asked. ©Roger Mills 4 Henley Discussion Paper Series HCVI HDP No. 7 Introduction As we have just seen with Google, the valuation and pricing of an in Initial Public Offer (IPO) is always a difficult and contentious issue1. Trying to gauge market sentiment and setting a price that does not spell disaster in terms of the desired objectives is a real challenge2. Typically, IPOs will be valued using a variety of methods and within the valuations there will often be a discounted cash flow (DCF) estimate in some form, about which great care has to be exercised by the reader in terms of understanding the implicit and explicit assumptions used. In very simple terms, the key components within a DCF valuation typically include assumptions about: the generation of the cash flows, both in the period for which explicit and detailed estimates are made and the period beyond (often referred to as the continuing, terminal, or residual value); the discount rate to use, i.e. the cost of capital; the method to use for valuing the time period beyond the explicit cash flow forecast; and the time horizon to use for the explicit forecast A number of academics and practitioners have identified many errors that can be made in undertaking DCF valuations3. Furthermore, behavioural finance which has its roots in the pioneering work of psychologists Daniel Kahneman and Amos Tversky has traced the mistakes that humans commit when making decisions to four common causes that include self-deception as characterised by such effects as over-optimism and over-confidence 4,5. Over-optimism and over-confidence may often be encountered in DCF valuations in estimating the growth in free cash flows within the explicit forecast time horizon but, more ©Roger Mills 5 Henley Discussion Paper Series HCVI HDP No. 7 importantly in the period beyond. Conventional wisdom in estimating the value of businesses with long-term growth potential is to use a two-stage model, where the first stage represents a time period in which growth is assumed to be captured in the explicit growth in individual cash flows over a finite time period. The second stage is assumed to be a perpetuity thereby avoiding the need to forecast the growth in individual cash flows; instead a composite growth rate, ‘g’, for free cash flows can be assumed. As a consequence, value from the second stage can be very simply calculated as follows, where FCF (t+1) represents the estimated prospective perpetuity cash flow and WACC the weighted average cost of capital: FCF (t+1) Terminal Value = WACC-g Therefore, to summarise, whereas the first stage of a conventional DCF valuation is typified by the use of explicit forecast assumptions being made for individual line items of the projected free cash flow, g in the second stage often represents a number that is designed to capture in some way the sum total of expectations about individual line items. The deduction of a growth rate in the denominator of the calculation has a significant impact upon the value and the higher the growth rate the higher the value6. As anyone who has worked with such models will know, a major concern typically arises about the impact of the g on the resulting value and, therefore, how it might be estimated in any meaningful way. The user of investment research needs to be able to establish confidence with the assumptions used and the problem is that within corporate finance there is limited evidence of any readily available framework. ©Roger Mills 6 Henley Discussion Paper Series HCVI HDP No. 7 There are many examples of the application of the perpetuity with growth approach illustrated in equation (2), of which a good one was provided in the valuation of Jordan Telecom, the first case study subject of this paper. The background was that in September 2002, the Jordanian government sought to sell 15% of its share capital (37.5 million shares) in an initial public offering (IPO). The IPO was assessed by a number of analysts of which the following is the example that will be used here7: ‘Using the discounted cash flow (DCF) method, we arrived at an estimated fair value for Jordan Telecom in the range of JD618.8-671.9 million, which translates into JD (Jordanian Dinars) 2.48-2.72/sharei. In terms of the 2-stage model discussed earlier, a seven year explicit forecast period was used to estimate free cash flows, which were then discounted to a present value to produce JD272.4 million as the value of stage 1. The value of stage 2, the terminal value, was calculated using two assumptions for the perpetuity growth rate. Based upon a 5% perpetuity growth rate it was JD428.5 million (61.14% of the total enterprise value) and it was JD489.5 million using a 6% perpetuity growth rate (64.25% of the total enterprise value). As with all such perpetuity with growth valuations, the all important question arises, ‘why 5% or 6%?’ The purpose of this case study is to offer a framework for challenging such growth assumptions. It is based upon the tools and techniques of corporate finance and, as with all such frameworks, there are strengths and weaknesses, but our experience has been that the former outweigh the latter. i Assumes 5% and 6% growth in perpetuity assumptions ©Roger Mills 7 Henley Discussion Paper Series HCVI HDP No. 7 In what follows, the framework proposed for challenging the assumptions used in such analysis will be introduced with reference to the case of Jordan Telecom. The use of this company has the advantage that it is a relatively recent issue in a sector often beset by forecasting challenges and, most importantly, it draws upon information predominately available in the investment research report itself. Thereafter, the outcome is contrasted with that for Swisscom, for which the same framework was applied. Proposed Framework for Challenging IPO Pricing The 5 steps outlined in Figure 1 are proposed as a framework to use to interrogate the results from a DCF valuation for an IPO. Figure 1: 5 Step Framework 1. Select comparable businesses with the target company being valued for IPO purposes, obtain a relevant share price for them, up-to-date financials, estimates for cash flow growth and the WACC. The objective here is to obtain estimates of all valuation inputs other than time, so that we can use Market Implied Competitive Advantage Period (MICAP) analysis to solve for the explicit time period implied in the share price, assuming a simple perpetuity in the period beyond. 2. Find the time period for all comparable businesses that equates prospective cash flows based on the assumptions, with the ‘relevant’ share price.
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