«Equity Valuation LinkedIn Corp José Miguel de Figueiredo Bettencourt Moreira da Silva Student Number: 152414022 Instructor: José Carlos Tudela ...»
José Miguel de Figueiredo Bettencourt Moreira da Silva
Student Number: 152414022
Instructor: José Carlos Tudela Martins
23rd March, 2016
Dissertation submitted in partial fulfillment of requirements for the degree of MSc in
Finance, at Universidade Católica Portuguesa, 23rd March, 2016.
LinkedIn Corp Equity Valuation
Para atingir maior robustez foi executada uma análise de sensibilidade incluindo análise
de cenários múltiplos, com o fim de testar várias projecções de receitas, e variações em variáveis específicas.
Por fim, foi efectuada uma comparação com um relatório da J. P. Morgan para comparar os resultados desta dissertação com o de um banco de investimento. A conclusão final da dissertação foi de recomendar Venda sobre o LinkedIn, pois esta apresentou um preço de fecho no dia 1 de Dezembro de 2015 de $ 249,82. Em contraste a J. P. Morgan apresentou uma recomendação de Compra com preço alvo de $ 300.
LinkedIn Corp Equity Valuation Preface This dissertation marks the culmination of my academic pursuits in the areas of Economics and Finance. I am extremely grateful to all the people I’ve met throughout my academic path who’ve in some way contributed to my past, present and future success.
I’d like to express a note of gratitude to my family who’ve supported me throughout my endeavors always striving to fuel my academic and professional interests.
To my friends and colleagues who I’ve met during university, and to the ones who’ve accompanied me even longer I express my sincerest appreciation. A special note to Ricardo Carvalho who pushed me in the toughest moments of the dissertation and Guilherme Neves for the debates in all maters statistical and mathematical.
Last but definitely not least, I must thank my thesis coordinator Professor José Carlos Tudela Martins, who pushed me to explore deeper into the subject of valuation and always provided prompt and valuable feedback to my doubts.
LinkedIn Corp Equity Valuation Contents Investment Note
1 Literature Review
1.1 Discounted Cash Flow Valuation
1.1.1 Free Cash Flow
1.1.2 Equity Cash Flow
1.1.3 Adjusted Present Value
1.1.4 Economic Value Added
1.2 Dividend Discount Model
1.3 Relative Valuation
1.4 Contingent Claim Valuation
1.5 Liquidation and Accounting Valuation
2 Industry Overview
2.1 Global Overview
2.2 Porter’s Five Forces Analysis
2.2.1 Rivalry between competitors
2.2.2 Threat of Substitutes
2.2.3 Threat of New Entrants
2.2.4 Bargaining Power of Buyers
2.2.5 Suppliers’ Bargaining Power
2.3 Company Overview
2.4 SWOT Analysis
2.5 Future Expectations
3.1.2 Operating Expenses
3.1.3 Capex and Property, Plant and Equipment (PP&E)
3.1.5 Working Capital
3.1.8 General Assumptions
4.1 Multiples Approach
4.2 Adjusted Present Value Approach
4.2.1 Unlevered Cost of Equity
4.2.2 Discounted Cash Flows
4.2.3 Terminal Value
4.2.4 Unlevered Firm Value
4.2.5 Tax Benefits from Debt
4.2.6 Expected Bankruptcy Costs
4.2.7 Enterprise Value
4.2.8 Equity Fair Value
5 Sensitivity Analysis
5.1 Expected Bankruptcy Costs
5.2 Cost of Equity and Growth Rate
5.3.1 Cost of Equity
5.3.2 Cost of Equity and Stable Growth
5.4 Multiple Scenario Approach
6 Comparison with Investment Note
6.2 Discount rate and stable growth rate
6.4 Overall comparison summary
Appendix 1 – Reported Income Statements 2006-2014
Appendix 2 – Reported Balance Sheet 2009-2014
Appendix 3 – Forecasted Net Working Capital 2015-2025
Appendix 4 – Forecasted Base Case Revenue 2015-2025
Appendix 5 – Forecasted Bad Case Revenue 2015-2025
Appendix 7 – Forecasted Balance Sheet 2015-2025
Appendix 8 – Forecasted FCFF Base Case 2015-2025
Appendix 9 – Forecasted FCFF Bad Case 2015-2025
Appendix 10 – Forecasted FCFF Good Case 2015-2025
Appendix 11 – Forecasted Operating Expenses 2015-2025
Appendix 12 – Forecasted Long-Term Debt 2015-2025
Appendix 13 – Forecasted Operating Leases 2015-2025
Appendix 14 – Sensitivity Analysis Tables
Appendix 15 – Debt Rating and Default Probability Tables
1 Literature Review The cornerstone of finance lies in valuation. It is of the utmost importance for a company to be able to assess the return its decisions will bring to its stakeholders. Similarly, it is the role of a portfolio manager to find undervalued companies to present high yields to its clients.
Regardless of its central role in finance, valuation is not a straightforward subject. In fact, it is a very volatile topic, (Demirakos, Strong, & Walker, 2004) explore the different models used by analysts and one of their conclusions is that they “tailor their valuation methodologies to the circumstances of the industry”. Yet, even when using the same methodologies for the same company two analysts can come up with very different results depending on the assumptions undertaken by each of them.
Therefore, the challenge presents itself, which are the optimal methodologies to use in order to correctly assess the value of LinkedIn?
In this chapter I will look at the different methods of valuing a company. (Damodaran A.
, 2006) states there are 4 general approaches to this subject: discounted cash flow valuation, liquidation and accounting valuation, relative valuation and contingent claim valuation.
My goal will be to delve into each of these methods pointing out their strengths and weaknesses with the final intent of choosing the best methods to value LinkedIn.
1.1 Discounted Cash Flow Valuation Discounted cash flow (DCF) models use future cash flow projections discounted at an appropriate rate to reach the present value for the firm. The models differ between each other through the discount factor and the assumptions taken to reach both the cash flow estimates and terminal value. There are “ten methods: free cash flow; equity cash flow;
capital cash flow; APV (Adjusted Present Value); business’s risk-adjusted free cash flow and equity cash flow; risk-free rate-adjusted free cash flow and equity cash flow;
economic profit; and EVA.”1 Fernandez, P. (2007). Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories. Journal of Management Science, 1 (1), 83-102.
For the purpose of this section I will look over the most important and widely used methods within DCF, focusing on the ones more relevant for LinkedIn.
1.1.1 Free Cash Flow Free cash flow method states that the total value of a company – Equity plus Debt – is obtained from the present value of expected free cash flows (FCF) discounted at the weighted average cost of capital (WACC).
As can be seen in equation (1), FCF is the total cash a company has available after settling the maintenance and expansion of its asset base. It can be calculated from earnings before interest and taxes (EBIT) discounted by the tax rate (T) adding depreciation and amortization (D&A) and discounting the changes in net working capital and capital expenditures (CAPEX).
Equation (2) shows that WACC takes into consideration all forms of capital, given their proportional weight. Therefore, the cost of equity (Re) and the cost of debt (Rd) are proportionally weighted through the percentage of financing that is equity (E/V) and debt (D/V), where debt takes into consideration corporate taxes (T).
Therefore, the value of a firm through the FCF/WACC method is as given by equation (3). The second half of the equation is what is known as the terminal value, which is where the company is expected to be at steady state and to grow at a certain rate (g) in perpetuity.
1.1.2 Equity Cash Flow “In equity valuation models, we focus our attention of the equity investors in a business and value their stake by discounting the expected cash flows to these investors at a rate of return that is appropriate for the equity risk in the company.”2 Therefore, this method consists in regarding the true value of a company in respect to the cash generated towards common equity holders. As can be seen from equation (4) equity cash flow (ECF) is a function of net income (NI), depreciation and amortization (D&A), capital expenditure (CAPEX), change in working capital and net borrowing (NB).
In order to reach the value of the company we need to discount these cash flows by the cost of equity (Ke) which gives us the return demanded by investors from the company.
Equation (5) shows us how to reach this value.
Similarly, to the FCF method, the value of a company through the ECF method is therefore given, as seen in equation (6), by discounting the future cash flows and terminal value by the cost of equity.
1.1.3 Adjusted Present Value “Today’s better alternative for valuing a business operation is to apply the basic DCF relationship to each of a business’s various kinds of cash flow and then add up the present values.”3 The prevalence of WACC is directly correlated to its simplicity of use. However, its simplicity is both its strength and weakness. WACC agglomerates all sources of tax shields into one parameter – 1 minus corporate tax – and how many companies today can simplify their corporate tax structure in such a way? It is very limited in estimating the tax shields and is more appropriate for companies where the capital structure is expected to remain stable. This next model presents itself as a solid way to correct these issues and yield a more solid valuation.
Adjusted Present Value (APV) divides itself into three main sections; present value of cash flows discounted by the unlevered cost of equity (Ke), present value of interest tax shields (ITS) and expected bankruptcy costs (EBC) as can be seen in equation (7).
Therefore, the first step is to calculate the value of the company as if it was fully financed through equity, then adding the ITS and EBC.
Regarding the tax shields “there are several theories regarding which are the fundamental determinants behind this tax shield formula” (Fernandéz, 2007). However, for the purpose of this literature review, I will focus on Myers theory that discounts the costs of financing by the cost of debt (Kd) which is given by equation (8).
Finally, in regards to bankruptcy costs, this can be calculated by simply multiplying the probability of default (PD) by the bankruptcy costs (BC) as seen by equation (9). The Luerhman, T. A. (1997). What's It Worth? A General Manager's Guide to Valuation. Harvard Business Review, 132-142.
issue is the vagueness of the equation itself in regards to probability of default. To answer this issue Damodaran suggests using the corporate bond rate if applicable.
1.1.4 Economic Value Added “The value of a business depends on its return on invested capital (ROIC) and growth.”4 The fundamental theory behind Economic Value Added (EVA) is that the true value of a company can be measured by correctly estimating its surplus value created. This model is derived from the DCF model and is a good measure for the return an investor can expect from financing a company.
Therefore, as can be seen in equation (10), the value of a company calculated through EVA is given by multiplying the difference between ROIC and the cost of capital (Ka) by the total invested capital (IC).
The company’s enterprise value is then reached by adding the “capital invested in assets in place, (plus) the present value of the economic value added by these assets and the expected present value of the economic value that will be added by future investments”5.
The main issues with this model is the fact that it favors assets in place in regards to future growth prospects, thus limiting in certain company analysis.
1.2 Dividend Discount Model The Dividend Discount Model (DDM) is a cash flow based model which uses issued dividends as inputs to value a company’s stock. The model proposed by Gordon et al.
(1956) states that given knowledge of a company’s price, dividend and future growth rate we can reach a valuation showing whether a company is undervalued or otherwise in the markets.
Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and Managing the Value of Companies. John Wiley and Sons.
Damodaran, A. (2002). Investment Valuation, Tools and Techniques for Determining the Value of Any Asset (2nd ed.). New York:
John Wiley & Sons.
The issue with this model is that it requires that a company be expected to issue dividends, which is not the case for LinkedIn and making it unfeasible to use as a means of valuing it. Moreover, it doesn’t take in consideration the effects of investments by the company and requires quite stable conditions in order to lead to solid results, since even small changes in the assumptions can have drastically different values.