Discount Rates, Terminal Multipliers and CEN

[Snoopy]

Discounted cash flow valuations involve calculating the net present value of projected cash flows.

The cash flows are discounted at a "discount rate", which reflects the risk associated with the cash flow stream.

Where cash flows stretch out many years into the future, the terminal or continuing value is normally a high proportion of share price value. Accordingly the "terminal multiplier" becomes the critical determinant in the valuation.

In my efforts to sort out the 'true value' of Contact Energy I have been crunching a few numbers. However, since it seems my valuation will be ultimately largely determined by what "discount rate" and "terminal multiplier" I use, I thought I would throw the question open to the forum.

What "discount factor" and "terminal multiplier" should I use in the case of CEN? Please justify your answer if you can.

TIA

SNOOPY

discl: hold CEN

PS It is unlikely there is a definitive answer to this question, so I am hoping for a range of opinions.

[star]

SNOOPY

The discount rate should use weighted average cost of capital (WACC).
WACC= (D/A) * (1- tax rate%)*cost of debt +(E/A)* Cost of equity.

Cost of equity = Risk free rate + company's equity beta * Equity risk premium

The cost of debt is the cost of borrowed funds. where the firm raises debt finance by issuing bonds, the cost of debt is the yield to maturity. Where the information on cost of debt is difficult to obtain, it is often proxied by cost of borrowing faced by the company from the same industry or by the firms with a similar credit rating.

The equity risk premium is the extra retun investors require to induce them to hold market fortfolio rather than risk free assets.

I have a PriceWaterhouseCoopers publication which provides beta and WACC estimates for selected companies in New Zealand. CEN's WACC is 6.9% where risk free rate is 5.7%, risk premium is 7.5%, D/A for CEN is 28% and beta is 0.48.

Hope this helps.

[Snoopy]

quote:Originally posted by star

SNOOPY

The discount rate should use weighted average cost of capital (WACC).
WACC= (D/A) * (1- tax rate%)*cost of debt +(E/A)* Cost of equity.

Cost of equity = Risk free rate + company's equity beta * Equity risk premium


Hi star,

I appreciate you filling in the figures for one of the 'classic' answers that I was expecting.


quote:
The cost of debt is the cost of borrowed funds. where the firm raises debt finance by issuing bonds, the cost of debt is the yield to maturity. Where the information on cost of debt is difficult to obtain, it is often proxied by cost of borrowing faced by the company from the same industry or by the firms with a similar credit rating.


That makes sense, although past arguments I have read along this line refer to working out the current government bond rate, and then adding a 'margin of safety' to that to work out the cost of company debt.

Any comments on that approach?


quote:
The equity risk premium is the extra retun investors require to induce them to hold market portfolio rather than risk free assets.

I have a PriceWaterhouseCoopers publication which provides beta and WACC estimates for selected companies in New Zealand. CEN's WACC is 6.9% where risk free rate is 5.7%, risk premium is 7.5%, D/A for CEN is 28% and beta is 0.48.


I'll add a few more figures from the latest CEN half year annual report.

Total Assets = $3.8b

made up of total liabilities = $1.4b
and shareholders equity of $2.4b

That means D/A = 1.4/3.8= 0.37
and E/A = 2.4/3.8= 0.63

From your figures I can work out the cost of equity as 9.3%.

You didn't give the cost of debt directly. But if the overall WACC is 6.9%, then you can work backwards through the formula athat you quoted and that gives a cost of debt of 4.15%.

That seems very low. Do you agree with this result?

SNOOPY

[Dimebag]

Hi Snoopy

Be careful to use the market value of equity and debt when calculating WACC, not the book value. For CEN this is about $3.5b for equity, so will increase the WACC marginally.

Dimebag

[star]

SNOOPY

There are three things we have to be careful when apply WACC model:

1. Debt means interest bearing debt only. Also if there is any cash on hands or term investments, they need to be deducted from Debt. Trade payables, provisions, accruals,tax payables and deferred tax should not be included in the calculation of debt unless they will accumulate interest. In CEN's case, Debt = borrowings (1.19b)+ loan from related party (39m)-short term deposit (34.69m)= 1.133b

2. Equity is the market value of equity as Dimbag said. PriceWaterHouseCooper used 31 March 04's market value.

3. A= D+E as defined above, not the net assets as at balance sheet.

Also there is one thing which makes NZ's application of cost of equity different from standard equation -- the DIVIDEND IMPUTATION TAX SYSTEM which creats more compensation for shareholders. PriceWaterhouseCooper applied revised equation to reflect the impact of dividend imputation:

Cost of equity = risk free rate (1-tax rate)+ beta*[expected market return -risk free rate(1-tax rate)]

To get CEN's WACC of 6.9%, I did the following exercise:

If risk free = 5.7%, standard market equity return = 13.2% (5.7%+ 7.5% premium), beta = 0.48, then the cost of equity is 8.32%

If D/A = 0.28, E/A =0.72 Re=8.32%, Rd=4.85%
then WACC= 0.28*4.85%*(1-0.33)+0.72*8.32% =6.9%

Hope I answered you query.

[Barrel Scraper]

Hi snoopy

I have to admit that most of this is still the classic condom to me and goes right over my head, however... would there be any benefit in digging out the projected cash flows CEN had at the time of IPO ? noting that edison mission were prepared to pay $5 for a cen share then or that a CEN share listed at I believe $3.10 ?
Perhaps you could derive a suitable "discount factor" or "terminal multiplier" by using those SP figures and working backwards?

Appreciating of course that EM paid a premium for control and based on their current financial predicament might not be the most savvy energy companies on the block. Therefore the listing price might be more appropriate.

[Snoopy]

quote:Originally posted by star



1. Debt means interest bearing debt only. Also if there is any cash on hands or term investments, they need to be deducted from Debt. Trade payables, provisions, accruals,tax payables and deferred tax should not be included in the calculation of debt unless they will accumulate interest. In CEN's case, Debt = borrowings (1.19b)+ loan from related party (39m)-short term deposit (34.69m)= 1.133b


Thanks for clarifying. I have had a look back at p15 of the CEN 2004 half yearly report (the balance sheet). The $1.19b total long term liability figure you quote already includes the loan from the related party.

Furthermore the balance sheet contains some short term debt (loan from a related party and bank o/d) on which the company will also be paying interest. Since the distinction between short term debt and long term debt is IMO to a large extent arbitrary, my feeling is that these debts should also be included. By my calculations the debt of CEN as at 31st March 2004 was:

$1129.6m + $39.1m + $4.5m +$3.5m -$34.7m = $1,142m



quote:
2. Equity is the market value of equity as Dimebag said. PriceWaterHouseCooper used 31 March 04's market value.


Thanks to you and Dimebag for pointing this out.

The closing market price of CEN was $5.59 on 31st March 2004.

There were 576,633,982 shares on issue. That gives a market value for CEN of $3,223m. That market value, of course, includes all the interest bearing debt as well. That means the market value of what is left is:

$3.223m - $1,142m= $2,081m


quote:
3. A= D+E as defined above, not the net assets as at balance sheet.


Righto, so I can now calculate D/A

1142/3223= 0.35

and E/A

2081/3223= 0.65

Ther are somewhat different to your figures of 0.28 and 0.72, even with taking into account our differences in estimating the interest bearing debt. Where have I gone wrong?


quote:
Also there is one thing which makes NZ's application of cost of equity different from standard equation -- the DIVIDEND IMPUTATION TAX SYSTEM which creates more compensation for shareholders. PriceWaterhouseCooper applied revised equation to reflect the impact of dividend imputation:

Cost of equity = risk free rate (1-tax rate)+ beta*[expected market return -risk free rate(1-tax rate)]

To get CEN's WACC of 6.9%, I did the following exercise:

If risk free = 5.7%, standard market equity return = 13.2% (5.7%+ 7.5% premium), beta = 0.48, then the cost of equity is 8.32%


[5.7(1-0.33)+ 0.48(13.2-5.7(1-0.33)]= 8.32%

I agree with you. Looks like I'm getting somewhere :-).



quote:
If D/A = 0.28, E/A =0.72 Re=8.32%, Rd=4.85%
then WACC= 0.28*4.85%*(1-0.33)+0.72*8.32% =6.9%


Your cost of debt is only 4.85%? From page 53, Note 18 of the last annual report:

"The interest rate on Contact's borrowing, for the year ended 30 September 2003 ranged from 5.31% to 8.82% (2002 4.85% to 11.42%). The net weighted average interest rate after taking into account the effect of hedging instruments and interest income was 6.96% (2002 7.08%)."

I would have use

[Coaster]

Snoopy, I think the reason you are getting different ratios is that you are using the market value of equity as a proxy for market value of assets.

A = D + E
A = $1.142b + $3.223b = $4.365b

D/A = 0.262
E/A = 0.738


Watching in the West
Coaster

[Snoopy]

quote:Originally posted by Coaster

Snoopy, I think the reason you are getting different ratios is that you are using the market value of equity as a proxy for market value of assets.

A = D + E
A = $1.142b + $3.223b = $4.365b

D/A = 0.262
E/A = 0.738


Hmmm, those figures are a lot closer to the ones that Star was using than mine. Thinking about it, the debt of CEN is a negative asset. If it wasn't there CEN would be worth more. So perhaps you are right Coaster. The debt needs to be added back onto the market value to get a true 'market asset value' of the CEN business.

SNOOPY

[star]

SNOOPY

CEN's WACC of 6.9%, D/A of 28% is published in a PriceWaterHouseCoopers' report. I only explained it from my understanding.

As for cost of debt, I trust they already analysed all the terms and conditions of each borrowing agreement. You may argue cost of debt is too low. But the weight of debt is only 28%, after tax, the contribution of debt to WACC is still small.

As the market value of equity changed, I would suggest you use the discount rate of 7.2%-7.5% for CEN's discounted cash flow valuation.

I look forward to seeing your results.

Cheers

Star

[Snoopy]

quote:Originally posted by Barrel Scraper



I have to admit that most of this goes right over my head


Hi Barrel Scraper,

There is an excellent 'pdf' on this subject, which can download.

http://www.intranet.management.mcgill.ca/mic/

education/EconomicModelV16.pdf

Rest assured you will not be the only person reading this topic watching it sail over your head. But this is one areqa where I believe it is worth persisting and building up a working knowledge of 'Weighted Average Cost of Capital'. it is quite an important 'buzz phrase'.


quote:
, however... would there be any benefit in digging out the projected cash flows CEN had at the time of IPO ? noting that edison mission were prepared to pay $5 for a cen share then or that a CEN share listed at I believe $3.10 ?
Perhaps you could derive a suitable "discount factor" or "terminal multiplier" by using those SP figures and working backwards?


I still have the copy of the investment statement prepared for the IPO of Contact Energy, so thanks for the suggestion. Of couirse Contact is a rather different animal now, compared to what it was then.


quote:
Appreciating of course that EM paid a premium for control and based on their current financial predicament might not be the most savvy energy companies on the block. Therefore the listing price might be more appropriate.



It is surprising how easy it is to spot a smart business deal with hindsight!

SNOOPY

[Halebop]

Thanks Snoopy I'll read this with interest. I must admit I don't know much about WACC but because it relies upon market value right or wrong I intuitively assumed it would be skewed by market conditions which to me doesn't seem ideal.

I shall read and learn.

http://www.intranet.management.mcgill.ca/mic/education/EconomicModelV16.pdf

[Snoopy]

quote:Originally posted by star

SNOOPY

CEN's WACC of 6.9%, D/A of 28% is published in a PriceWaterHouseCoopers' report. I only explained it from my understanding.


And I appreciate it, because your understanding was rather better than mine.


quote:
As for cost of debt, I trust they already analysed all the terms and conditions of each borrowing agreement. You may argue cost of debt is too low. But the weight of debt is only 28%, after tax, the contribution of debt to WACC is still small.


And I may be wrong, or they may be wrong or perhaps we are all wrong. The problem with a long relatively complicated formula like WACC is that there is a tendency by many to believe the number it spits out.

I have the opposite philosophy. The more complicated a formula is, the less I trust it. I haven't forgotten the 'garbage in, garbage out' lessons from my computer course days. So I intend to put *every* input to that WACC formula under scrutiny. I know that changing a single input can seem like a small thing, but any mistake will be multiplied greatly in a discounted cash flow analysis


quote:
As the market value of equity changed, I would suggest you use the discount rate of 7.2%-7.5% for CEN's discounted cash flow valuation.


I get

WACC=0.262(1-0.33)[6.96%]
+ 0.738[ 5.7(1-0.33) + 0.48(13.2-5.7(1-0.33)]

=1.22 +6.14 = 7.36%

That is quite close to bang in the middle of your suggested range 'star'.

SNOOPY



.

[Snoopy]

quote:Originally posted by Snoopy
WACC=0.262(1-0.33)[6.96%] + 0.738[5.7(1-0.33) +0.48(13.2-5.7(1-0.33)]


I wanted to put a few thoughts on paper down on this formula, with reference to the numbers put forward for Contact Energy in particular.

Like Halebop I am distinctly uneasy about a fomula that uses current and past market data to create a value that is relevant into the future.
Is it likely to give skewed results as Halebop asserts?

If the share price goes up this will increase the WACC as the 'equity' portion of the formula inceases in value relative to a static 'debt cost of capital'. This kind of makes sense. The higher a share price goes the greater the chance it will eventually fall.as valuations 'revert to the mean'. Our WACC fomula gives us a greater number, the higher the share price is. That means that in order to jusify investing in a share when the share price is high, you must reasonably expect a high return, which makes sense.

Why then, is it considered a good idea to increase the cost of capital yet more, depending on share price historic volatility? For that is what introducing the factor of 'Beta' into the equation does. Would someone please explain to me, why we should even consider a 'Beta'
factor in this WACC equation?

SNOOPY












.


[/quote]

[Halebop]

You know it's serious reading when you can't do it without a calculator and three different windows open on you PC...

[Snoopy]

quote:Originally posted by Halebop

You know it's serious reading when you can't do it without a calculator and three different windows open on you PC...


Well here is something you can do without a calculator.

How many months of data does it take to calculate a Beta for CEN?

I've read conflicting reports, anything from 3 months to 5 years. With only three months of data the time period might be 'abnormal' and give you a false result. With 5 years of data, the information could be outdated and no longer relevant. So what figure is used in the published figures?

Are there any published figures for specific companies? My search for information on NZ companies' Beta' hasn't turned anything up.
My feeling is the Beta figure we have been quoted for CEN of 0.48 is quite low. But how does 0.48 compare to other utility companies?

One article I read suggested that the risk premium applied to shares over and above the risk free premium reflects the weakness of private sector investments spreading risk. Power is sold to importers and exporters, private residents and industry. So the spread of risk could hardly be greater. Anyone think there will be a decrease in the price of power? Not much risk there either then. I'm hard pressed to think of a lower risk company than CEN. So why should the expected rate of return be so much higher than government bonds? Wouldn't a Beta of, say 0.2, be much more reasonable for a company like CEN?

SNOOPY

[Snoopy]

Still working on my CEN valuation.

I just read Contact's own take on their future.

http://www.positive-energy.co.nz

My interpretation of where they are going is the gas way. And with new owner Origin Energy heavily involved in exploration of oil and gas, including our own Kupe field, I see nothing in the change of controlling ownership to vary that view.

By my reading of the "positive energy" website, Contact would be sympathetic to building a new coal powered station as well. However, given that the coal fields are far from the largest power markets and given that coal produces more CO2 per MW of power, coal doesn't look as attractive to Contact as gas.

The big question mark over gas is whether Contact can secure a long-term supply to power both existing and drawing board gas powered electric power stations. My gut feeling is that NZ is not short of gas, and it is the artificially low gas price from the Maui field that has choked off efforts to find new commercial gas fields that makes us think that gas in NZ is scarce. Contact won't be leaving gas supplies to chance, so my reading of the issue is that they will undertake a two pronged strategy to obtain security of supply.

Finding a new local gas field is the preferred solution for Contact Energy. To that end I predict an exploration and development program that will cost Contact $100m per year every year from FY2005 to FY2008 inclusive. For insurance against this policy failing, Contact will also build a Liquid Natural Gas to Natural Gas conversion plant which will cost a total of $600m, spread out over a FY2006, FY2007 and FY2008. That means they could ship in liquefied gas from Australia and Indonesia. This type of plant is much less likely to be made commercially redundant than a coal fired station that faces the full wrath of Kyoto and has to be shut down prematurely.

Combining all this with comments from Origin energy that power prices may have to rise another 10% from today's level to make construction of new power stations economic, and I think I have enough information to run my discounted cash flow model. Following on from the 10% rise I will assume a 2.5% annual rise in price cost and profit after that year as the power price continues to rise in line with inflation.

If you think I have got my future vision of CEN wrong, now is the time to speak up. I am happy to run alternative scenarios.

SNOOPY

[CAM]

quote:Originally posted by Snoopy



By my reading of the "positive energy" website, Contact would be sympathetic to building a new coal powered station as well. However, given that the coal fields are far from the largest power markets and given that coal produces more CO2 per MW of power, coal doesn't look as attractive to Contact as gas.



There is a large coal field in Huntly, which is rather close to major energy markets. I understand they are getting organised to ramp up production from this mine with talk of them opening up a section that has been closed for some time. But this could be for the export market...not sure. I also think it has something to do with the Govt wanting higher coal reserves to avoid possible black outs.

Solid Energy may have some more info on this option.

Admittedly coal is not as environmentally friendly but if demand increases and supply dosn't it might well be a future option. I am sure the Government of the time will not want any outages as its not good for the votes (as well as the economy), especially when combined with electricity higher prices.

[maxine]

Snoopy, as noone else seems to have addressed some questions you have raised I am going to. I hope they are relevant and useful, and I don't find myself accused of teaching you to suck eggs.

I don't have time this evening to be succinct so I shall ramble.

You want to value CEN shares. Fine.

You have decided to do this by determining an NPV. Fine in theory, and we might go later into what the alternatives tend to be and their merits.

You have realised that terminal value assumptions (you call it a terminal value multiple, which is fine) and discount rate are central to the answer you get.

So a few posters enter into a discussion as to discount rate for a DCF on CEN....

...and you all elect to use the Capital Asset Pricing Model (CAPM, pronounced "cap - M") to arrive at a WACC.

All well and good and very trad text book.

I will accept this construct and post within it.

1. The cash flows should already be probability weighted for diversifiable risk. That means that the discount rate does not seek in anyway to compensate for uncertainty in relation to specific firm performance. If a company projects cash flow of $10 million in a given year this might be a best guess, but it might be asymetric about that: a big project will either succeed or fail, so you model the cash flow with a probability weighted outcome, not just expect your discount factor to allow for the risk of the project failing.

2. The Beta used is not specific to the Company. It is generally taken to be an "Industry Beta", and in the US investors derive "Beta Books" for whole sectors. This is impossible for New Zealand because statistically we don't have a telecoms equity sector or an electricity equity sector and so forth, so in a practical sense CAPM is basically impossible in NZ (BTW CAPM is basically completely bogus anyway, even in the US...but it is still widely used, and it there is no generally accepted less bogus approach....go figure).

To give you some more background on this you rightly seem to identify a nifty little circularity in the WACC phlospohphy. Namely, unless you realise that the relevant cost of equity is not company specific but sector specific, you have the crazy situation where successful companies pay high returns to shareholders thereby increasing investors expected returns, thereby increasing their cost of equity and cost of capital (and for the confused manager, possibly even persuding him or her that they therefore cannot justify further investment with such a high wacc.....while some useless company destroys value, ends up with a low wacc, and decides therefore they should consume more capital. You can see therefore why the cost of equity is sector derived.

The sector philosophy is based on the CAPM attitude that in applying DCF the cost of equity should reflect undiversifiable (or systemic)risk....or if you like generic market risk.....but argues that one can generalise about the market risk for common types of investments.

In case you don't actually know what a Beta is, it is generally described as a measure of "market risk". Mathematically it is simply the covariance between a share's return and the market divided by the variance of the market return....so it assumes that if a share goes up faster than the market when the market goes up, it will go down faster than the market when the market goes down....which some readers might htink sounds like a pretty doddgy assumption. It also assumes that a share that goes down when the market goes up, will go up when the market goes down.

Now on top of all that, one is then asked to assume that you can calculate Betas for a basket of stocks in a sector and that they will be similar, and therefore you can average them to get a sector beta, and you can use this in your CAPM calc to derive market risk premium, and from that derive WACC.

Note of course that aside from the wacc calculation leverage within individula shares also changes market volatility, so unless you think a sector has common gearing you are expected to adjust for that too.

Even

[Snoopy]

quote:Originally posted by maxine


I don't have time this evening to be succinct so I shall ramble.


Excellent Maxine. A most useful ramble if I may say so. I'm going to heavily shorten your post, not because the points aren't useful, but because I don't want to turn this thread into a 'ramblathon'.


quote:
1. The cash flows should already be probability weighted for diversifiable risk. That means that the discount rate does not seek in anyway to compensate for uncertainty in relation to specific firm performance. If a company projects cash flow of $10 million in a given year this might be a best guess, but it might be asymmetric about that: a big project will either succeed or fail, so you model the cash flow with a probability weighted outcome, not just expect your discount factor to allow for the risk of the project failing.


I hear you, but am not keen on the probability approach. As you said yourself a new power station will either meet its operational targets or not or be some way in between. The outcome of any investment is an unknown but fixed number that will come out in the wash of time.

So my preference is to go through a range of scenarios. Consider if this happens or if that happens. What return does investing in a company today yield if 'scenario 1' happens, 'scenario 2' happens or some other scenario happens.? I know that you could draw up some kind of probability function to incorporate all scenarios. I suspect that this exercise would be a complete waste of time though. I wouldn't like to guess the probability of a particular scenario occurring, would you? GIGO.


quote:
2. The Beta used is not specific to the Company. It is generally taken to be an "Industry Beta"


Is this what Price Waterhouse Cooper do in New Zealand? Star seemed to imply the figure quoted for CEN was company specific.


quote:
To give you some more background on this you rightly seem to identify a nifty little circularity in the WACC philosophy.


I notice that both Star and Dimebag suggest I use 'market equity' when working out the WACC. On rereading my notes I see this approach best correlates with the market movement predicted with 'Betas'.

However, you could use 'balance sheet equity' if you wish to decouple your calculation from the manic whims of Mr Market. That would allow you to use a company specific information rather than sector information. It's easier too as you only need grab the figures from the annual report, and not worry about Mr Market at all.


quote:
In case you don't actually know what a Beta is, it is generally described as a measure of "market risk".


You mean market volatility ;).

I don't accept that market risk and market volatility are the same thingl.


quote:
(Beta) also assumes that a share that goes down when the market goes up, will go up when the market goes down.


Is this the so called 'n

[star]

SNOOPY

Beta is a measure of company's specific risk compared to the overall market risk.

A company's beta should be close to its sector range. But to use sector/industry average beta to value a company is only a short cut, the result would not be as accurate as by using the company's specific beta.

CEN's beta of 0.48, PWC 0.86, TPW 0.67 and Horizon 0.40 are listed in PriceWaterHouseCoopers' report. I also have an article disclosed a few major US listed companies' beta provided by Standard and Poor, value Line and Bloomberg. If you are interested I can post it here next time.

There is a gap between the theory and practice in application of WACC and discount cash flow model. That is why for the same stock, different investment bank can have different valuation. But Snoopy, as we discussed before, 7.36% discount rate for CEN is a very reasonable estimate.

Yes, the lower beta, the lower risk, and the lower required return. If two companies have the same amount of cash flows, any other thing being equal, the company with lower risk and required return should have higher value and higher share price.

[maxine]

Snoopy, for the record I agree with the points you make...so we are aligned. I completely agree with your points about scenarios and lumpy cashflows for example. I'm not sure I have understood your comments about balance sheet derived numbers enabling you to ignore Mr Market...but thats ok.

The one exception is that my aside which relates that some people observes that contrary to theory "low volatility" utilities shares have a higher than predicted discount rate BECAUSE they areseen by the market to have a constrained upside. That bit seems to have got lost in translation. Note, this is not always true, and not always the explaination....but it makes sense to me and seems to happen in practice at least in some parts of the macro market cycle.

Star: If you are saying that a company valuation using DCF with a CAPM derived wacc should use a company specific beta I disagree, and stand by what I posted....but then I think the whole approach is generally lame, and basically invalid in the NZ market environment anyway....so theres not much point in you and I argueing over it.

Cheers to you both.

[Snoopy]

quote:Originally posted by maxine
[br I'm not sure I have understood your comments about balance sheet derived numbers enabling you to ignore Mr Market...



The link I gave to a pdf file on the economic model goes into this.

I reproduce an excerpt below that might explain things.

quote
----------

The Mechanics of the Economic Model p14

Empirical research (Bowman 1980) has shown that market betas (the centerpiece of the CAPM) are more correlated with market value capital structures.
In theory, a higher debt-to-equity ratio (market value) should result in a
higher beta for the firm. Bowman tested four measures of debt-to-equity ratio:

D(book)/ E(book)

D(book)/ E(market)

D(market)/ E(book)

D(market)/ E(market)

against a firm’s beta to find out which one was most closely
associated to it. The results showed that beta was most correlated with

D(book)/ E(market)

D(market)/ E(market)

Because the market value of equity is most of the time far greater than debt, whether we use book or market value of debt makes little difference (especially when market interest rates are stable). Therefore, in light of these findings, we believe that using the market value capital structure to calculate the WACC is most appropriate for comparison with the ROIC. In many cases, especially for technology companies, the WACC will be equal to the cost of equity.

--------------

The guts behind what I am saying is that both debt and equity have both a 'book' value and a 'market' value. The book value of equity is easy to obtain. Generally it is the initial paid up capital of the company plus the retained earnings, although it isn't so clean in the case of Contact - a fact I will return to later. You can look up the book value by studying the annual report.

OTOH the market value of the equity of the company is connected to the share price. When new shares are issued in a company it will normally be at a discount to the market value (the book value is not a consideration). Equate' raising new capita'l with 'selling new shares on the market'. I haven't read Bowmans 1980 study, but it is no surprise to me that the market value of the company is a better indicator of the cost of capital (ability to raise new capital) than the book value.

Similarly you could take the debt figures on the balance sheet and go out and find what it would cost to refinance that debt today. This would be the 'market value' of the debt. If the company concerned had capital notes issued, then the 'market interest rate available' on those capital notes would be a good proxy for this. But in general the market value of a company's debt is more difficult to obtain than the market value of a company's equity: the latter being derived from the prices quoted daily on the sharemarket.

My suggestion of using

D(book)/ E(book)

flies in the face of Bowmans research results. But since I have a healthy disrespect for 'Beta' anyway this doesn't bother me.

If you accept that Mr Market is always right about the share price then my approach doesn't make sense. But if we assume that Mr Market may be right, but is just as likely to be be manic depressive or irrationally exhuberant then I think my suggestion of using

D(book)/ E(book)

starts to make more sense.

[quote]quote:
The one exception is that my aside which relates that some people observes that contrary to theory "low volatility" utilities shares have a higher than predicted discount rate BECAUSE they are seen by the market to have a constrained upside. That bit seems to have got lost in translation. Note, this is not always true, and not always the explaination....but it makes sense to me and seems to happen in practice at least i

[maxine]

Snoopy, sort of....it is not exactly my argument because one can't arbitrarily say A should be high just because one has decided (rationally) that cost of equity should be high. (high because no blue sky)

Rather, I observe that CAPM, which correctly differentiates between diversifiable and systematic risk and which "rewards" low volatility and counter cyclical shares, does not penalise "no blue sky" situations...so the fault, if you like, is that CAPM doesn't account for my "no blue sky equity cost premium".

So you have got my point re "no blue sky" = higher cost of equity....I just wouldn't try and arrive at that higher cost of equity through redefining A, Beta or B.....probably some academic has demonstrated that a "C" can be derived which adjusts CAPM for other factors.....others might rightly argue that your case of scenarios for cashflow (or mine of probability wieghting cash flows) should fully account for the "no blue sky", in the ennumerator, and accordingly no adjustment in the denominator is called for.

Now I think of it that is probably a more proper way of dealing with it (and may well already have been factored into all your numbers), and introduces no need to manipulate the CAPM derived cost of equity.

By the way, how many angels can dance on the head of a pin?

[Snoopy]

quote:Originally posted by maxine


Snoopy, sort of....it is not exactly my argument because one can't arbitrarily say A should be high just because one has decided (rationally) that cost of equity should be high. (high because no blue sky)


Why not? If we accept the cost of equity model is of the form

Cost of Equity= A + (Beta)B

What is 'A' if not an arbitrary value assessing the average level of risk above the the risk free rate of return? Perhaps you might argue it is a 'rationally selected value based on maket expectations' and not an 'arbitrary value', but I cannot see any difference myself.

After all, I can subjectively select 'an A' to reflect the share specific risk of Contact Energy if I choose to do so. How does this selection process differ from that used to select 'A' in the WACC, Cost of Equity model?


quote:
Rather, I observe that CAPM, which correctly differentiates between diversifiable and systematic risk


You have gone over my head here. I do not understand what you mean by 'diversifiable risk' in relation to a single share, like Contact Energy. Can you explain please?

I presume 'systematic risk', refers to the general risk that might be expected by investing in shares of a particular type within 'a pre-defined market'.(?)


quote:
and which "rewards" low volatility


I understand this bit. The CAPM rewards shares with a low price volatility by giving them a low Beta.


quote:
and counter cyclical shares,


You lost me again. How does the CAPM reward counter cyclical shares?
The only way you can know a share is 'counter cyclical' is to compare where a share price is now, compared to where it was in another (higher) point in cycle. As far as I am aware neither 'A' nor 'B' nor 'Beta' vary at all in the business cycle. So how can the CAPM model reward counter cyclical shares if it cannot even identify what part of the cycle they are in? I do not understand.


quote:
does not penalise "no blue sky" situations...so the fault, if you like, is that CAPM doesn't account for my "no blue sky equity cost premium".


But often a share that doesn't have a great upside risk, doesn't have a great downside risk either. Does not the CAPM model deal with this kind of share rather well?


quote:
So you have got my point re "no blue sky" = higher cost of equity....I just wouldn't try and arrive at that higher cost of equity through redefining A, Beta or B.....probably some academic has demonstrated that a "C" can be derived which adjusts CAPM for other factors.....


If 'A' provides an overall assessment of the quality of earnings (or implied risk required to earn that quality of earnings), and '(Beta)B' provides a factor which adjusts for the variability of a particular share owner's expectations (the vascillating share price), then I cannot see any space for a 'C'. Why can you not incorporate 'C' into 'A'?

[maxine]

Hi Snoopy, I will respond to your questions....but please appreciate that I am not interested in an intellectual pissing match on this topic, and I really don't have a problem with your perspective...so only read my answers if you feel like it.

1. I thought your "A" was the risk free rate.....a la CAPM basics, so given a CAPM approach I (pedantically perhaps) didn't want to go on record saying "just bump up A"....'cos knowing how this board works someone else would have jumped up and down saying it was methodologically flawed to say the "risk free rate" was elevated because of a share specific or asset class specific "no blue sky"....but yes of course you can make A whatever works for you.

2. "Diversifiable risk" is risk specific to a specific investment. Most (including me) argue that the market does not discount diversifiable risk per se...you can diversify it away, and even better you can achieve a superior risk return performance from a portfolio....and market behaviour very much tends to confirm this: mergers that reduce diversifiable risk in a specific share are not generally seen to result in a lower derived discount rate in the share price....and very much diversified conglomerates carry a conglomerate discount, and investment funds do not trade at a premium to their individual components....the market is happy to diversify its own risk rather than penalise/ reward specific stocks for the "diversifiable risk"....so I don't know if I have explained that very well....it is not at all original or controversial.

As for "systematic risk" I think you presume correctly.

Alternative phrases are "unique risk" and "market risk"

3. "How does the CAPM reward counter cyclical shares?"...not as much as I thought when I typed my last post now I have to actually explain myself, so sorry 'bout that. You have caused my to ponder the impact of counter cyclical shares on classic CAPM derived diversified portfolio assessment....thinking "out loud" it seems that a countercylical share can generally be assumed to have a low Beta even if it has high volatility....this means that you have a volitile asset class with a low CAPM derived cost of equity...which means taken in isoloation you tend to overvalue the stock relative to volatility....but as part of a portfolio maybe you undervalue it.....not sure I have got any of that straight but thanks for making me revisit it.

One area where you and I do have a misunderstanding in relation to this is that I was really meaning to refer to a "counter cyclical share class" from a sector beta point of view. A, B and Beta don't vary during the cycle, but as I mused above, I think a counter cylcical sector versus the market in general will have a low Beta....remember when doing a valuation with a CAPM derived cost of equity I argue the beta used should not be firm specific but a sector beta....although I further observe that there are both philosophical and practical problems with this....

4. "Does not CAPM deal with this kind of share rather well?" CAPM assumes that returns are normally distributed, so the returns distribution is completely characterised by mean and standard deviation, with no skewness or asymetry. The low upside/low downside share you describe conforms with this, so it does deal with it fine....but some shares (and here it is suggested CEN is one of them) have a capped upside....so the returns distribution might be skewed with a tail to the left....alternatively you might argue that CEN does have a fairly normal distribution in practical terms and it is other shares that contribute materially to market performance that actually do have "blue sky" (i.e. their actual returns distribution might be skewed with a tail to the right....with the same result, that the relative value of CEN should be adjusted down versus that one might derive based on the "all returns normally distributed" assumption.

5. I guess the discussion of A, B and C has already been covered under 1 above. You can define A how you like (and in your most recent post, have now done so), but I had

[Snoopy]

quote:Originally posted by maxine

Hi Snoopy, I will respond to your questions....but please appreciate that I am not interested in an intellectual pissing match on this topic,


When I proof read my last post I thought it sounded a bit 'academic' but decided you could probably handle it :-).

I'm not interested in an academic argument for the sake of it either.

My sole purpose in starting this thread was

1/ To get a really good valuation of Contact Energy

However, on realising the effect of the discount rate on this, I realised that I needed to get a *really good* grasp of the discount rate I was using. The most comprehensive way to determine a discount rate, I saw as the one used in the CAPM. So my secondary objective was.

2/ Understand how to derive a suitable discount rate using the CAPM *and* understand the assumptions behind that (because I have a habit of finding some of these assumptions wrong). Then after identifying the problems in this model, finding a way of 'fixing' them. Thanks to you and Star, I think I'm just about there now....

that only leaves

3/ Find a suitable terminal valuation method for the company as it will exist ten years and onwards into the future.

which I will come back to.


quote:
1. I thought your "A" was the risk free rate.....a la CAPM basics, so given a CAPM approach I (pedantically perhaps) didn't want to go on record saying "just bump up A"...


This is just a message board. We aren't answerable to any university professors here. We can 'tune' the CAPM as we like :-)


quote:
.'cos knowing how this board works someone else would have jumped up and down


It's only a message board. Let them jump up and down. They don't know who you are and you don't know who they are, so what difference does it make? Occasionally those that jump up and down can have something useful to say too...


quote:
2. "Diversifiable risk" is risk specific to a specific investment.
<snip explanation>
I don't know if I have explained that very well....it is not at all original or controversial.


Not everyone (including me) on this forum has the same erudite knowledge on the buzzwords thrown around in discussing the CAPM as you do. Thanks for the education.


quote:
t....thinking "out loud" it seems that a countercylical share can generally be assumed to have a low Beta even if it has high volatility....this means that you have a volitile asset class with a low CAPM derived cost of equity


So what you mean by a 'coutercyclical stock' is one that is mature within an industry that has well known cycles. Like Fletcher Building (the building industry) or Colonial Motors (the car retailing industry) for example. Both building and automotive retailing are known to be volatile industries, but neither of the companies mentioned, being market leaders, are likely to stray too far from the performance of the industry as a whole - hence they can be said to be 'low Beta' type companies (?)

[quote]quote:<hr height

[maxine]

Thanks for your response Snoopy.

This seems to have pretty much run its course. My only comment in relation to your last post is that FBU et al are not what I meant by counter cyclical. What I meant by counter cyclical was a stock (or sector) that generally tended to go down when the "market" went up and vice versa. I can't cite examples of this with any authority off the top of my head...maybe property stocks or stocks catering for services used by low income earners, maybe oil or gold related investments....maybe businesses that deal in down sizing and so forth...not sure, but you get the idea.

Generally people see FBU as closely linked to building industry cylicality...which in turn is generally in synch with the NZ share market cycles...so it would generally be seen as a cyclical or perhaps market tracking stock.

Betas tend to be compiled using monthly price data over a period of 5 to 10 years (in the US by Valueline and so forth). I doubt the NZ market offers the clean data depth to do this for many shares, but it doesn't tend to reflect day trader type volatility ....so the "mature - predictible earnings" ... share doesn't ipso facto have a low Beta....if it tends to follow the market more or less over the years then it will have a Beta around 1.....

Now you have got me thinking about it, even though I never use CAPM, others might like to post about counter cylical shares as a natural portfolio volitility hedge, and how CAPM driven portfolio theory does or doesn't handle them properly. That is surely enough from me on this topic for now however.

Cheers - M

[stephen]

This has made educational if esoteric reading. Thanks.

[Snoopy]

quote:Originally posted by maxine

My only comment in relation to your last post is that FBU et al are not what I meant by counter cyclical. What I meant by counter cyclical was a stock (or sector) that generally tended to go down when the "market" went up and vice versa. I can't cite examples of this with any authority off the top of my head...maybe property stocks or stocks catering for services used by low income earners, maybe oil or gold related investments....maybe businesses that deal in down sizing and so forth...not sure, but you get the idea.


Like shares in debt collection agencies or perhaps even a store like Cash Convertors? I don't think it works for gold. That goes down in bull, bear and trendless markets ;). When you say 'counter-cyclical' you are talking about the genuine 'negative Beta' company. A 'counter market' entity. I wonder if such a creature really exists in any market anywhere? I have heard of the idea but have never seen an example.


quote:
Now you have got me thinking about it, even though I never use CAPM, others might like to post about counter cylical shares as a natural portfolio volitility hedge, and how CAPM driven portfolio theory does or doesn't handle them properly.


Hmmm, I'd even settle for others identifying even a single real-world negative Beta share!

SNOOPY

[Snoopy]

I'd like to put down a few thoughts on the 'terminal multiplier' bit of this thread which hasn't been addressed yet.

Readers will see that I have posted my CEN valuation on the 'other' CEN thread. You will see that the terminal value represents over half of the value of the business. It is quite easy to value a business using the terminal multiplier method. Simply start with a representative annual earnings figure, multiply this figure by a suitable P/E ratio and there you have it: your residual business valuation.

That sounds like you can pick any figure for a P/E ratio and so value a business with a given earnings at any value you like. It is not that simple. Take the reciprical of your P/E ratio ( E/P ) and then you will have your earnings yield. The maximum sustainable dividend yield is equivalent to the earnings yield so straight away there is your upper limit on P/E.

The (normalised) earnings yield as at 30th September each year, followed by the P/E for CEN since it has listed, is as follows:

1999: 6.1% (net), 9.1% (gross), 16.1
2000: 6.4% (net), 9.6%(gross), 15.8
2001: 6.7% (net), 10.0% (gross), 15.0
2002: 4.9% (net), 7.3% (gross), 20.4
2003: 4.1% (net), 6.1% (gross), 24.4
2004; (est) 4.3% (net), 6.5% (gross), 25.7

The rising P/E over the last few years must to some extent reflect a market view that power company profitability is on the rise. This is as much due to the better matching of wholesale and retail demand by Contact as it is to the expectation of ever rising power prices. Of course, no-one knows for sure what the outlook for power prices will be in ten years time. But on drawing up this table I wonder if the P/E figure that I used in the spreadsheet ( 20 ) on the 'other' CEN thread is a little high. Any comments?

SNOOPY

[Snoopy]

quote:Originally posted by maxine


You have decided to do this by determining an NPV. Fine in theory, and we might go later into what the alternatives tend to be and their merits.


There is more than one way to 'skin a cat' and an alternative method of energy company valuation is to use EBITDA multiples. I quote here from the Grant Samuel valuation report on Contact Energy prepared in May 2001, page 30.

"Capitalising earnings or cash flows is most appropriatefor businesses with a substantial operating historyand consistent earnings trend that is sufficiently stable to be indicative of ongoing earnings potential."

"The choice between EBITDA and EBIT multiples is usually not critical and should give a similar result. EBITDA can be preferred if depreciationor non-cash charges distort earnings or make comparisons between companies difficult. Both BITDA and EBIT multiples are used by analysts in assessing energy stocks. However, market analysts following Contact Energyhave varying views on the treatment of the amortisation of prepaid gas. Grant Samuel has considered both cases although it is more appropriate to consider EBITDA multiples because trading multiples appear to have been calculated on a consistant basis."

So I shall do the same. For Australasian power concerns forecast EBITDA multiples of 8 to 10 were used (from Appendix 1 in the grant Samuel Report). From the CEN 2003 annual report EBITDA for FY2003 was $376.6m.

That implies a company valuation of $3,012b to $3,766b. Divide tohse figures by the number of shares on issue (576.6m) and you get a fair value share price valuation of between $5.22 and $6.53. The mid point of that is $5.88.

This method cannot allow for any one off large capital expenditures that are on the investment horizon. My judgement is that this method would slightly overvalue Contact Energy.

SNOOPY