Disney for much of the last two decades has been a firm run by Michael Eisner and for Michael Eisner. The board that he hand-picked has gone along with all of his major decisions ranging from buying Capital Cities/ABC to entering new businesses. Some of these decisions have clearly been good ones, and some not, but the absence of shareholder oversight over management is troubling.
Disney is a firm where insitutional investors clearly are dominant, with more than 70% of the outstanding stock held by instiutions and less than 10% held by insiders. (Source: Yahoo! Finance) The largest investor in the firm is a mutual fund - Investment Company of America - and sixteen of the top seventeen investors are institutions. I would expect the marginal investor in Disney to be a well-diversified institutional investor.
Since the marginal investor is well diverisifed, I would look at only market risk while estimating the cost of equity, and I have measured this market risk with a market beta. Since the regression beta had a large standard error (0.27 on a beta estimate of 1.40), I have used a bottom-up beta estimate, breaking Disney down into the following businesses:
|Business||Estimated Value||Comparable Firms||Unlevered Beta||Division Weight||Weight*Beta|
|Motion Picture and TV program producers||
|High End Specialty Retailers||
|TV Broadcasting companies||
|Theme Park and Entertainment Complexes||
|REITs specializing in hotel and vacation properties||
Source: 10-K, Weights are based upon operating income from each business
Using Disney's current market values of equity ($50.88 billion) and debt ($11.18 billion), we estimate a bottom-up levered beta of 1.25 for Disney. Using a treasury bond rate of 6.08% and a risk premium of 6% yields a cost of equity of 13.85%:
Cost of Equity= 7% + 1.25 (5.5%) = 13.85%
In conjunction with Disney's after-tax cost of borrowing of 7.5%, estimated based upon their rating of AA , we estimate a cost of capital for Disney as a firm of 12.22%
Cost of Capital = 13.85% (0.82) + 4.80% (0.18) = 12.22%
We used a 36% marginal tax rate to compute the after-tax cost of debt.
Disney's typical project varies by division from very long term, capital intensive investments in theme parks to short-term investments in movies and TV programs. While we do not have the breakdown of Disney's project returns by division, we can measure Disney's return on capital as a firm. In 1996, Disney earned $5,559 million as pre-tax operating income on a book value of capital invested of $19,031 (estimated as the book value of debt and equtiy at the beginning of 1996). The after-tax return on capital based upon these numbers is 18.69%.
Return on Capital = EBIT (1-t)/ Average BV of Capital from 1995 to 1996 = $5,559 (1-.36)/ (19,031) = 18.69%
Relative to the cost of capital of 12.22%, Disney seems to be earning excess returns of 6.47% and a positive EVA.
EVA = (.1869 - .1222) ( 19,031 million) = $1,232 million
This may also help explain why Disney's stock was a good investment between 1992 and 1996, when it earned 1.81% more than expected each year. (This was estimated using the intercept from the return regression for the period, and was compared to the riskfree rate (1-beta))
What might account for Disney's excess returns? The firm clearly has signficant
competitive advantages in the theme park and the creative content business
(especially Disney studios) in the form of a brand name that will be difficult,
if not impossible, to replicate. The theme park business is also capital intensive
and there are competitors who can match its experience or expertise (Universal
Studios is closest...) To maintain its excess returns, Disney should do the
1. Build on the businesses where its brand name is most potent - products for children. Computer softward, DVDs of old Disney movies, child-oriented resorts etc. The recent Disney venture into cruise lines seems to be a logical outgrowth of this strategy.
2. Establish clear brand name advantages in businesses where there is no clear advantage currently. Neither Touchstone Studios nor Capital Cities/ABC has been able to establish a clear competitive advantage, though "Who wants to be a millionaire?" has given a temporary lift to the latter. Focusing Capital Cities/ABC on more family oriented fare might be one way in which Disney could build on its reputation elsewhere.
As noted above, Disney's current financing mix is 18% debt and 82% equity. Its debt is a mix of long and short term debt, with a weighted maturity of 3 years. About 10% of the debt is floating rating debt, and about 5% is foreign currency debt. Looking at the factors in the trade off on borrowing:
|Tax Benefit||Disney has a marginal tax rate of about 40%. It has an effective tax rate of 43.58%.|
|Added Discipline of Debt||Disney is a widely held firm. While institutional stockholders own a significant percentage of the firm, no individual stockholder or institution is large enough to have much say in management. The firm has significant cash flows and should gain from the use of debt.|
|Bankruptcy Risk||Some of Disneys earnings are volatile, but a significant portion of the cash flows are stable (especially cash flows from theme parks). The bankruptcy risk should be low, given this factor and the size of the company|
|Agency Costs||The agency costs are likely to be large for borrowings by the creative content and broadcasting divisions, where it is difficult to track the funds. It is likely to be smaller in the real estate, retailing and theme park divisions.|
|Future Flexibility||The need for financing flexibility is increasing as the media business changes technologically and becomes more global.|
While Disney's existing capital structure is 18% debt and 82% equity (see cost of capital above), its cost of capital is minimized at a 40% debt to capital ratio.
|Debt Ratio||Cost of Equity||AT Cost of Debt||Cost of Capital|
If Disney moves to a 40% debt ratio, with a 11.64% cost of capital, its value as a firm can be expected to increase by about $8.5 billion and its stock price by $12.55. (This is based upon the assumption that the savings from moving to the optimal will increase 7.13% in perpetuity.
At this debt ratio, however, Disney's rating drops below BBB and it can be vulnerable to a drop in operating income.We would argue that Disney's constrained optimal debt ratio of 30% (based upon the rating constraing of BBB) still suggests that the firm has significant excess debt capacity. We do not believe that Disney is a potential takeover target, because of its market capitalization (>$60 billion) and its positive stock price performance (Positive Jensen's alpha). Given the quality of its projects (as evidenced by the EVA estimated in the last section), we would recommend that Disney use its debt capacity to invest in new projects and expand its businesses.
We would recommend different types of financing for Disney's
Creative Content: Short-term, dollar-denominated debt, with coupons tied to movie box-office receipts
Retailing: Operating leases ; if possible, tie lease payments to foot traffic in store
Broadcasting: Network rating-sensitive dollar-denominated bonds; Ratings whose coupons are tied to network ratings
Theme Parks: Long term, floating-rate debt (in a mix of currencies, reflecting mix of tourists)
Real Estate: Mortgage Bonds
Disney also has bought back stock at irregular intervals. Between 1992 and 1996, Disney returned about $217 million less than it could have, when dividends are compared to free cash flows to equity:
|Year||FCFE||Dividends + Stock Buybacks|
To make a judgment on how much we would trust Disneys management to use this cash wisely, and how willing stockholders would be to allow this policy of paying less in dividends than is available in free cash flow to equity, to continue, we scored incumbent management on three dimensions, each of which we have analyzed earlier in this report. The first dimension is corporate governance, where we look at whether incumbent management has been willing to listen to stockholders and put their interests above their own. On this test, Disneys top management fails the test. The second dimension is stock price performance, where we look at the performance of Disney stock, relative to its peer group and the market, after adjusting for risk. On this measure, Disney has delivered excess returns of about 1.81% a year between 1992 and 1996 to its stockholders and has earned itself some leeway on dividend policy. The final dimension is investment policy, where we analyze whether the investments Disney has made historically have measured up in terms of delivering returns to equity investors that exceed the required rate of return. Again, as our earlier analysis of return on capital and EVA shows, Disney passes the test with a return spread of 6.47% and an EVA of $1,232 million.
In summary, Disney has earned itself some flexibility on dividend policy as a result of its strong stock price performance and returns on its projects. The perception on the part of stockholders that incumbent management is not responsive to their needs, and Disneys recent acquisition of Capital Cities (which at $ 18.5 billion dwarfs all other investments that Disney has made), suggest that Disney will operate on a short leash. A year or two of disappointing earnings and stock price performance could very well make a restive group of stockholders into a rebellious group, demanding more stock buybacks and dividends.
Summary of Valuation
We valued Disney as follows:
The present values of the free cash flows to the firm and the present value of the terminal value are computed, and the sum is reported below:
Value of Disney = $ 57,817 million
If we subtract out the market value of existing debt of $ 11,180 million from this firm value, we arrive at the value of equity for Disney to be $ 46,637 million. The value of equity per share is computed by dividing by the number of shares outstanding:
Value of Equity per Share = $46,637/ 675.13 = $ 69.08
Thus, the valuation suggests that Disney was overvalued at $ 75.13 per share.
Summary of Assumptions for Valuation
|Length of Period||
||Forever after 10 years|
|Revenues||Current Revenues: $ 18,739; Expected to grow at same rate a operating earnings||Continues to grow at same rate as operating earnings||Grows at stable growth rate|
|Pre-tax Operating Margin||29.67% of revenues, based upon 1996 EBIT of $ 5,559 million.||Increases gradually to 32% of revenues, due to economies of scale.||Stable margin is assumed to be 32%.|
|Return on Capital||20% (approximately 1996 level)||Declines linearly to 16%||Stable ROC of 16%|
|Working Capital||5% of Revenues||5% of Revenues||5% of Revenues|
(Net Cap Ex + Working Capital Investments/EBIT)
|50% of after-tax operating income; Depreciation in 1996 is $ 1,134 million, and is assumed to grow at same rate as earnings||Declines to 31.25% as ROC and growth rates drop:
Reinvestment Rate = g/ROC
|31.25% of after-tax operating income; this is estimated from the growth rate of 5%
Reinvestment rate = g/ROC
|Expected Growth Rate in EBIT||ROC * Reinvestment Rate = 20% * .5 = 10%||Linear decline to Stable Growth Rate||5%, based upon overall nominal economic growth|
|Debt/Capital Ratio||18%||Increases linearly to 30%||Stable debt ratio of 30%|
|Risk Parameters||Beta = 1.25, ke = 13.88%
Cost of Debt = 7.5%
(Long Term Bond Rate = 7%)
|Beta decreases linearly to 1.00; Cost of debt stays at 7.5%||Stable beta is 1.00.
Cost of debt stays at 7.5%
The Valuation of Disney