4000 words Company Valuation Paper Company: Pirelli

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Dear Students,

Hope you are doing well, and that the dissertation writing goes well.

Approximately two weeks ago, I sent you an email consisting of information on the way in which you can structure the dissertation. This email is an extension to the previous email, consisting of a detailed information on the following:

(a) how to calculate the WACC

(b) how to calculate the perpetual growth rate

(d) how to use the relative valuation model (if you decide to apply this),

(e) how to do the sensitivity analysis

(a) The computation of the WACC

Firstly, remember that the WACC is computed by applying the following formula:

WACC = rd * (D/D+E) + re (E/E+D) * (1-tax rate)

Let's observe how you can calculate each of these items.

Computation of rd:

rd = interest payments / total debt

where the interest payments can be found in the statement of comprehensive income and where the total debt can be found in the balance sheet.

You shall use the average of the tax rate across the past 5 years (i.e. between 2016 - 2020). Specifically, take an average of the tax rates across the past 5 years - 2016 to 2020 - and use this as the tax rate until 2026 (keeping it constant). Here is how you can do this:

(i) tax rate in 2016 = tax paid in 2016 / profit before tax in 2016

(ii) tax rate in 2017 = tax paid in 2017 / profit before tax in 2017

(iii) tax rate in 2018 = tax paid in 2018/ profit before tax in 2018

(iv) tax rate in 2019 = tax paid in 2019 / profit before tax in 2019

(i) tax rate in 2020 = tax paid in 2020 / profit before tax in 2020

Then, take an average of the tax rates across these 5 years (and use this average as the tax rate for the remaining 5 years to 2026).

Computation of re:

re = rf + beta * market risk premium

Let's observe how you can derive each of these parameters - rf, beta and market risk premium - in detail.

Let's start off with the market risk premium. The first method in which you decide on the market return to use is to see the countries in which "your company" operates in (and therefore use the relevant stock indexes). Specifically, if it operates in:

(a) Country X

(b) Country Y

Then, you can use the (a) stock index in Country X in which your company's market capitalization is mostly concentrated, (b) stock index in Country Y in which its market capitalization is mostly concentrated and (c) stock index in Country Y in which its market capitalization is mostly concentrated.

Then, observe the sales in each of these countries, and take a weighted average of the above stock indexes (using the sales figures in each of the countries X, Y and Z) to determine the 'market return'.

Otherwise, a second method is to merely use the stock index of the Country in which you company's operations are mostly concentrated in. For example, assuming that it operates in Countries X, Y and Z... If your company holds most of its operations in Country Y, then use the stock index of Company Y (in which its market capitalization is mostly concentrated). Assuming, for example, that its operations are mostly concentrated in Italy, then you can use the "FTSE MIB" index as a proxy for the market return.

Overall, the first method is more accurate.

The same holds for the 'rf' rate; i.e. using the first method, you can find a weighted average -using the sales figure - of the 'rf' of the countries in which your company operates in (otherwise, using the 2nd method, you can obtain the figure directly from bloomberg (or another terminal) using merely ONE of the countries in which it has holdings and preferably the one with the largest holdings). And, again, similarly to the computation of the 'rm', the 1st method is preferred.

For the computation of the beta, again, there are two methods that you can choose from. The first method involves taking the value of the beta (of your company) directly from Bloomberg. Or, alternatively, a 2nd method involves using 4 comparable firms of your company. Specifically, for this 2nd method, you shall firstly extract the asset beta of each of these competing firms and THEN apply the steps shown in the attached handout (note: I have attached a handout on the email, which explains in detail how to calculate the value of beta of your company using this 2nd method).

Computation of D and E:

Note that the Debt (D) & Equity (E) that are used in the formula of the WACC (above) are the target debt and equity of the company; hence, they are not the values of Debt and Equity today. Rather, they are the target debt and equity (that is, the debt and equity in year 2030, which is the final year of your forecasting cycle).

As a first step, you need to compute the value of Debt and Equity today. After you compute the value of debt and equity today, you shall then proceed to the target debt and equity in 2030 (assuming that this will be the last year in your forecasting cycle).

Let's begin with the debt and equity today:

Debt today = this is the total debt given in the balance sheet

Equity today = this is the market capitalisation found on bloomberg

However, the WACC formula requires the target debt and equity:

Target debt (i.e. debt at 2026): you need to adjust this year's debt - upwards or downwards - depending upon what you expect to happen in the future. For instance, if you expect overtime the company to undertake more investments, then, presumably, you would expect an increase in its overall debt levels. Similarly, if the annual report says that the company expects to face some financing risks, again this would suggest that it is expected that the company would have high levels of debt. On the other hand, if the report says that the company aims to reduce its refinancing risks in the subsequent years, then you would expect to have less debt levels overtime. Overall, I would recommend you to observe every single year - 2021, 2022, 2023... etc - in isolation, until you reach the target debt in the final year of your forecasting period (i.e. 2026).

Do not worry much about the resulting debt that you end up using (i.e. do not worry if it deviates slightly from your classmates). The important thing is the rationale behind your decision to increase or decrease the current debt to the target level (hence, the examiner will be looking for the rationale behind your adjustments; positive or negative adjustments).

Target Equity (i.e. equity at 2026): you need to adjust this year's equity - upwards or downwards - depending upon what you expect to happen in the future. For instance, if the annual report says that it wishes to increase its shareholdings, then you would expect the equity to increase. Similarly, if the annual report says that the company wishes to expand its external financing, then, again, perhaps you would expect an increase in its equity from the increasing issuance of shares. Alternatively, if you come across information that says that the company is inclined to improve the power of its current shareholders, then perhaps you would expect some share repurchasing and, hence, a reduction in the equity levels... Like above, make sure to observe every single year - 2021, 2022, 2023,... etc - in isolation (i.e. increase the equity in the year appropriate and decrease it in in the year appropriate, after considering the given information, until you reach your target equity level in the final forecasting year).

This is the end of the WACC calculation.

(b) The computation of the perpetual growth

Here, you can use the 'World Bank' database and see what the economic growth rate is in 2020 and adjust it accordingly - upwards or downwards - for each of the next 5 years, until you see what the - forecasted - economic growth rate is in 2026 (and this will be used as the 'perpetual growth rate' in 2026).

(c) The computation of the terminal value

The perpetual growth rate (from (b) above) can be used to determine the terminal value in 2026 (which also needs to be discounted to the present, amongst the free cash flows found for each of the years 2021, 2022, 2023, 2024, 2025 and 2026). The formula to apply for the terminal value is the following:

Terminal Value = [ FCFF in 2026 * (1 + perpetual growth rate) ] / (WACC - perpetual growth rate)

After you find the 'terminal value', you need to discount this back to the present (which is 2021), alongside the 'free cash flows' between 2021 - 2026 using the WACC.

(d) The relative valuation model:

Here is the way in which you can conduct the relative valuation:

(a) Pick 3-5 comparable firms (i.e. 3-5 competitors) --> here, I take the assumption that you select 5

(b) compute 3 multiples for each of the competitors; (a) P/E multiple, (b) P/S multiple, (c) P/CFO multiple, (d) or any others you want to choose - you can choose any multiples you want

compute the average of P/S multiple (across all 5 comparable firms)

compute the average of P/CFO multiple (across all 5 comparable firms)

(d) THEN, you need to calculate the

average P/E * average earnings (across the competitors)

average P/S * average sales (across the competitors)

average P/CFO * average CFO (across the competitor)

(e) you will sum the average of these (from note (d)) and divide these by 3

(f) find the number of shares outstanding --> from bloomberg (or any other terminal)

(g) divide (e) / (f) --> this will give you the intrinsic value of the firm

Note: As you can see, in step (b) you need to compute the multiples. There are two methods in which you can do this:

1st method: the first method involves taking merely the 2020 data (much quicker)

2nd method: the second method involves taking the data for over one year in the past for each of the multiples (for instance, over 2016 - 2020) and THEN find an average of each multiple across these years --> this is done in step (b) above --> once you find the average for each multiple across, for instance, the past 5 years, you proceed normally with step (c) to step (g).

Overall, I would have chosen the 2nd step (but, of course, you can take the 1st one if you prefer) --> maybe, you can even comment a bit on the multiples (and the consequential intrinsic value derived from these) --> for instance, you might wish to compare multiples one to another (or you might wish to say which multiples drive the intrinsic value downwards and/or upwards etc.).

(e) How to do the sensitivity analysis

The sensitivity analysis is essentially a synonym to a "what-if" analysis. Specifically, after you construct your valuation models (specifically, your Discounted Cash Flow model), you need to come up with a couple of hypothetical scenarios to see how your results would diverge.

Remember that, in this kind of project, you are dealing with 'forecasting'. Hence, these 'forward-looking assumptions' many not necessarily hold true and, therefore, the scenario analyst (in this case, yourself) needs to incorporate several different performance possibilities into your financial model.

My recommendation is that you adjust TWO variables:

1st: the weighted average cost of capital (WACC)

2nd: the perpetual growth rate

Specifically, you can adjust the WACC by +/- 1 basis point (that is 1 basis point upwards and downwards) AND you can also adjust the perpetual growth rate by +/- 0.5 basis points (that is, 0.5 basis points upwards and downwards)

THEN, you would come up with the following scenarios:

+1 WACC & +0.5 perpetual growth rate

+1 WACC & -0.5 perpetual growth rate

-1 WACC & +0.5 perpetual growth rate

-1 WACC & -0.5 perpetual growth rate

And, then, you can compare these to your INITIAL results found in the discounted cash flow model (in the preceding section BEFORE the adjustments made in WACC and the perpetual growth rate).