VALUATION: Valuation, discount rate, discount rate, growth rate and project selection

1. VALUATION: Valuation, discount rate, discount rate, growth rate and project selection LECTURE 3

2. Business Valuations $55? $45? $35? 1

3. Learning Goal We know the cost of everything but the value of nothing.

4. Lecture outline • Introduction • Value creation • Valuation models • Discount rates • Growth rates • Project selection

5. Value creation • Firms make various value-increasing decisions • New venture • New project • Product innovation • Process innovation • Need to value those projects/ventures well for better management • Lecture 5 looks at valuation of Technologies/IP

6. Valuation Framework • Gather latest information/data • Estimate expected revenue growth (past rates, mkt. rates, other factors ) • Sustainable operating margin (CVP analysis) • Reinvestment (plough-back rate = g/ROC) • Risk parameters (discount rates) • Start-up valuation (EPS) • Project selection

7. Many different valuation methods……. 5

8. Many different valuation methods……. 5

9. In general • Cost approach (accounting book) • Income approach (Present value or discounted cash flow(DCF); • Market approach • Example: • Valuing a second hand car • Accounting valuation vs. DCF valuation

10. 1. Cost Approach • measures the future benefits of ownership by quantifying the amount that would be required to replace the future service capability of the asset • assumes that the cost of replacement commensurate with the value of the service that the asset can provide during its productive life

11. 1. Cost Approach 1. Research and Development Expenditures: • involves the capitalisation of R&D or product launch expenses • has the double effect of reducing expenses in the income statement and building up the asset side of the balance sheet • capitalisation of R&D expenditure is to recognise its future benefit and therefore should be amortised against future sales

12. 1. Cost Approach Research and Development Expenditures: empirical evidence has failed to ‘find significant correlation between research and development expenditures and increased future benefits as measured by subsequent sales, earnings, or share of industry sales’.

13. 1. Cost Approach Research and Development Expenditures: The professional practice is to take a conservative approach to R&D expenses and to remove intangible assets unless there is a history of profits and sales as justification (i.e. brand names)

14. 1. Cost Approach 2. Tobin’s q • combines the market value and the replacement cost methods for valuing assets in a way very similar to the market-to-book (M/B) value ratio • expectations of future profits are the basic determinant of investment activity and these expectations are supposed to be reflected in a firm’s market value

15. 1. Cost Approach 2. Tobin’s q Compare Tobin’s Q with 1.

16. 1. Cost Approach Tobin’s q • market value of the firm exceeds the value of its existing capital when investors’ perceive its expected earnings as high or increasing • firm can be worth less than its existing capital when its prospects are considered uncertain or low • investment in new real capital is profitable if q exceeds one

17. 1. Cost Approach Tobin’s q • Firms with high q ratios are normally those with attractive investment opportunities or a significant competitive edge, as would the case with most technology start-ups • Tobin’s q ratio differs from the M/B ratio • q ratio utilises market value of the debt plus equity • It also uses the replacement value of all assets instead of the historical cost value

18. 1. Cost Approach • 3. Adjusted Net Assets Method - One of the Cost Approaches • The balance sheet is restated from historical cost to market value • A valuation analysis is performed for the fixed, financial, other assets, and liabilities • The aggregate value of the assets is “netted” against the estimated value of existing and potential liabilities to estimate the value of the equity • This value represents the minimum, or “floor,” value the company at liquidation

19. Income Approach:Discounted cash flows method • Focuses on the income-producing potential of the asset • The value of the asset can be estimated from the present worth of the net economic benefit generated over the life of the asset • The DCF approach captures the essence of the time value of money and risk.

20. Discounted cash flows method The present value of all future cash flows discounted at a rate that reflects the time value of money and the certainty of cash flows. =

21. Discounted cash flows method • Value of firm =

22. Nice Idea But… Who knows what future cash flow & discounts rate to use? The complexity of modeling an enterprise is daunting!

23. Step 1: Estimate Cash flows • Cash flows are pre-financing, i.e., independent of the capital structure of the firm. • Do not take out interest expense from cash flows

24. Estimating Cash flows CFt = EBITt*(1 - T) + DEPRt – CAPEX - WKt + othert Where • CF = Cash flow; • EBIT = Earnings before interest and taxes; • T = Corporate tax rate; • DEPR = Depreciation; • CAPEX = Capital Expenditure; • WK = Increase in working capital, and • other = Increases in taxes payable, wages, payable, etc.

25. Cash flow Industry based understanding Cash flow Time Time Cash flow diagram for an airline company Cash flow diagram for a newsletter company

26. Cash flow Multiple cash flow curves Harvest This occurs when after the first project, the firm has options to introduce related products/services to the market. This presents new growth opportunity to the company. Time Growth option Invest

27. Cash flow projection Time Projection vs. reality Scenario 1 original projection Cash flow Scenario 2 More time & money, succeeded Reality Time Scenario 3: More time & money, failed

28. Need to understand the industry • Group discussion exercise • The following common sized Financial statements were taken from 4 companies in 4 different industries. Could you please match the numbers to the companies? • Utility • Banking • Grocery • Pharmaceutical

29. Step 2: Estimate growth rate and discount rate • Using CAPM to work out the cost of equity • Need risk free rate (note the matching principle) • Firm beta (leveraged vs. unlevered) • Market risk premium • Note on beta. • Use this as the discount rate for all equity firm

30. Estimating accounting beta The private firm’s accounting earnings can be used to regress against changes in earnings for a market equity index such as the S&P/ASX 200 to estimate an accounting beta. Earningsf =  + S&P/ASX200 +  where Earningsf = the change in earnings of the firm; = the intercept or constant; = the beta of the market equity index; S&P/ASX200 = the market equity index, and  = the random error term.

31. Bottom-up Betas This method involves breaking down betas into their business risk and financial leverage components to enable us to estimate betas without having to rely on past prices on a technology start-up Unlevered Betas (u): The systematic risk of a firm assuming that it is 100% equity financed and has no debt. L U = [1 + (D/E)]

32. Bottom-up Betas • Levered Betas (u): Where the firm’s capital structure consists of both equity and debt financing. L = U [1 + (D/E)] • The use of operating income (i.e. EBIT) would yield an unlevered beta while using the net income would yield the equity or levered beta. • The limitations with this type of beta are the distortion of data caused by accounting adjustments and the lack of a long time series for earnings given the short history of most technology start-ups

33. Cost of Debt • The best practices for estimating the cost of debt are to use the marginal borrowing rate and a marginal tax rate or the current average borrowing rate and the effective tax rate. • The after-tax cost of debt, Kd(1 – T), is used to calculate the weighted average cost of capital.

34. WACC as the discount rate Note: Weight of Debt and Weight of Equity are based on Market value

35. Venture Capital Rates of Return The required rates of return for venture capital at different development stages are illustrated below (Smith and Parr 2000): Venture Capital Rates of Return Stage of Development Required Rate of Return (%) Start-up 50 First Stage 40 Second Stage 30 Third Stage 25

36. Venture Capital Rates of Return The pharmaceutical industry provides a specific industry example, Hambrecht & Quist (Smith and Parr 2000) Development StageRequired Rate of Return (%) Discovery 80 Pre-Clinical 60 Clinical Trials – Phase I 50 – Phase II 40 – Phase III 25 New Drug Application 20 Product Launch 17.5 – 15

37. Growth Rates Damodaran (2002) suggests three ways of estimating growth for any firm as follows: ·        Historical growth rate ·        Market analysts’ estimates ·        Firm’s fundamentals

38. Valuing cash flows with the CCF method • All equity (unlevered firm)

39. Valuing cash flows with the CCF method (cont.) • Leveraged firm • Tax shield advantage when debt is taken as interest payment are tax deductible. • Value of tax shield, TS (time period t)

40. Valuing cash flows with the CCF method (cont) • The tax shields are discounted to PV to get PVTS • Assuming D stays constant for simplicity • WACC can be used as a discount rate

41. Valuing cash flows with the CCF method (cont)

42. Practice with NSK case • Please work out the value of NSK company basing on the information of NSK and comparable companies provided in the case.

43. Next class • Valuation with market based approach. • Case: Tutor Time (A) (p. 131)