Valuing Publicily Traded Equity Securities: Black & Decker

Valuing Publicly Traded Equity Securities:

The Black & Decker Corporation (BDK)

I. Introduction

This teaching note describes the valuation of publicly traded equity securities using the Discounted Cash Flow (DCF) and Price/Characteristic (market comparison) approaches, with a specific spreadsheet example for The Black and Decker Corporation. Free cash flow valuation and comparables (comps) are key tools in fundamental analysis, the process of picking stocks with high expected return based on an analysis of the company. In theory, buying stocks of companies that are undervalued in the stock market will produce high returns as other investors slowly realize the company’s true value and quoted share prices increase to match that value.

Three basic ideas underlie the application of discounted cash flow (DCF) analysis. First, the value of a company is ultimately derived from the cash that can be extracted from that company, and more cash is preferred to less. Second, cash received in the future is not as valuable as cash received today. Third, risky cash flows are valued less than cash flows known with relative certainty.

The process of valuing publicly traded equity using DCF involves three steps. First, condensed financial statements, also called pro-forma statements, are forecasted several years into the future. Second, the forecasted statements are used to calculate free cash flows for the entire firm, which are then discounted by the cost of capital for the firm. Third, the intrinsic value of one share of the common stock is calculated as total firm value minus the market value of the debt, divide by the number of outstanding shares. The resulting intrinsic value of the shares can be compared with the current market price to inform buy and sell decisions. The objective of fundamental analysis in active portfolio management is to buy stocks with a market price that is substantially less than the estimated intrinsic value, and sell stocks when the market price is well above intrinsic value.

Fundamental stock analysts also rely heavily on Price/Characteristics ratios using comparable companies or “comps” to validate buy and sell decisions. Most of these ratios, for example the simple P/E ratio, include the quoted market price in the numerator and some measure of profitability or performance in the denominator. The analyst compares the ratio of the stock in question to the ratio for similar stocks; i.e., companies in the same industry and of similar size and financial leverage. While a comparison or ratios across stocks does not produce an intrinsic value, the comparison does tell the analyst if the stock is expensive or cheap relative to other stocks. This teaching note discusses the DCF approach first and in more detail than the Price/Characteristic method which is often used by analysts as the first step in screening for possible stock purchases or as a “reality check” on assumption for an appraiser of a specific business.

II. Discounted Cash Flow

Step 1: Forecasting Financial Statements

The example used throughout this note is The Black & Decker Corporation, a large U.S. corporation that makes hand held power tools. To begin, financial data for Black & Decker is gathered from a financial web site, such as, www.zacks.com, directly from the Investor Relations section of Black & Decker’s own web cite, www.bdk.com, or from the Securities and Exchange Commission (SEC) at www.sec.gov. This valuation example uses five years of historical data for the income statement and balance sheet to construct forecasted condensed income statements and balance sheets. The condensed statements have much less detail than the formal audited financial statements, but are complete in that the income statement tracks top-line sales to the bottom-line net income, and the balance sheet does in fact balance. These historical financial statements are then used to create forecasted or pro-forma financial statements for five years into the future. In addition to the end goal of determining the stock’s intrinsic value, the forecasting of financial statements has other benefits including: (a) the analyst explicitly forecasts future sales, profitability, and asset utilization, (b) the analyst learns about the sensitivity of cash flows, and ultimately value per share, to these forecasting assumptions, and (c) the analyst calculates the additional financing needed to meet forecasted growth.

Two requirements that financial forecasts must meet are economic plausibility and accounting consistency. Economic plausibility requires realistic assumptions about the firm, the status of the