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Valuation Measurement and Value Creation. Valuation Situations. We encounter valuation in many situations: Mergers & Acquisitions Leveraged Buy-outs (LBOs & MBOs) Sell-offs, spin-offs, divestitures Investors buying a minority interest in company Initial public offerings

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Valuation Measurement and Value Creation

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Valuation Measurement andValue Creation


Valuation Situations

  • We encounter valuation in many situations:

    • Mergers & Acquisitions

    • Leveraged Buy-outs (LBOs & MBOs)

    • Sell-offs, spin-offs, divestitures

    • Investors buying a minority interest in company

    • Initial public offerings

  • How do we measure value?

  • Why do we observe these situations? How can managers create value?


Business Valuation Techniques

  • Discounted cash flow (DCF) approaches

    • Dividend discount model (DDM)

    • Free cash flows to equity model (FCFE - direct approach)

    • Free cash flows to the firm model (FCFF- indirect approach)

  • Relative valuation approaches

    • P/E (capitalization of earnings)

    • Enterprise Value/EBITDA

    • Other: P/CF, P/B, P/S

  • Mergers and acquisitions

    • Control transaction based models (e.g. value based on acquisition premia of “similar” transactions)


Discounted Cash Flow Valuation

  • What cash flow to discount?

    • Investors in stock receive dividends, or periodic cash distributions from the firm, and capital gains on re-sale of stock in future

    • If investor buys and holds stock forever, all they receive are dividends

    • In dividend discount model (DDM), analysts forecast future dividends for a company and discount at the required equity return


Dividend Discount Models (DDM)

  • The value of equity (Ve) is the present value of the (expected) future stream of dividends

    Ve = Div1/(1+r) + Div1(1+g2)/(1+r)2 + Div1(1+g2)(1+g3)/(1+r)3 +...

  • If growth is constant (g2 = g3 = . . . = g) , the valuation formula reduces to:

    Ve = Div1/(r - g)

  • Some estimation problems:

    • firms may not (currently) pay dividends

    • dividend payments may be “managed” (e.g., for stability)


Dividends: The Stability Factor

Dividend changes: Publicly traded U.S. Firms

Factors that influence dividends:

  • Desire for stability

  • Future investment needs

  • Tax factors

  • Signaling prerogatives

Source: A. Damodaran, Investment Valuation, Wiley, 1997


Discounted Free Cash Flow Equity (FCFE) Approach (“Direct” Method)

  • Buying equity of firm is buying future stream of free cash flows (available, not just paid to common as dividends) to equity holders (FCFE)

  • FCFE is residual cash flows left to equity holders after:

    • meeting interest/principal payments

    • providing for capital expenditures and working capital to maintain and create new assets for growth

      FCFE = Net Income + Non-cash Expenses - Cap. Exp.

      - Increase in WC - Princ. Payments

  • Problem: Calculating cash flows related to debt (interest/ principal) & other obligations is often difficult!


Valuation: Back to First Principles

  • Value of the firm =

    value of fixed claims (debt) + value of equity

  • How do managers add to equity value?

    • By taking on projects with positive net present value (NPV)

  • Equity value =

    equity capital provided + NPV of future projects

  • Note: Market to book ratio (or “Tobin’s Q” ratio) >1 if market expects firm to take on positive NPV projects (i.e. firm has significant “growth opportunities”)


Valuation: First Principles

  • Total value of the firm

    = debt capital provided + equity capital provided

    + NPV of all future projects project for the firm

    = uninvested capital +

    present value of cash flows from all future

    projects for the firm

  • Note: This recognizes that not all capital may be currently used to invest in projects


Discounted Free Cash Flow to the Firm (FCFF) Approach (“Indirect” Approach)

  • Identify cash flows available to all stakeholders

  • Compute present value of cash flows

    • Discount the cash flows at the firm’s weighted average cost of capital (WACC)

  • The present value of future cash flows is referred to as:

    • Value of the firm’s invested capital, or

    • Value of “operating assets” or “Total Enterprise Value” (TEV)


The DCFF Valuation Process

  • Value of all the firm’s assets (or value of “the firm”)

    = Vfirm = TEV + the value of uninvested capital

  • Uninvested capital includes:

    • assets not required (“redundant assets”)

    • “excess” cash (not needed for day-to-day operations)

  • Value of the firm’s equity

    = Vequity = Vfirm - Vdebt

    where Vdebt is value of fixed obligations (primarily debt)


Total Enterprise Value (TEV)

  • For most firms, the most significant item of uninvested capital is cash

    Vfirm = Vequity + Vdebt = TEV + cash

    TEV = Vequity + Vdebt - cash

    TEV = Vequity + Net debt

    where Net debt is debt - cash (note: this assumes all

    cash is “excess”)


Measuring Free Cash Flows to the Firm (FCFF)

  • Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim

    FCFF = EBIT  (1 - tax rate)

    + Depreciation and amortization (non cash items)

    - Capital Expenditures

    - Increase in Working Capital

  • What is working capital?

    Non-cash current assets - non-interest bearing current liabilities (e.g. A/P & accrued liab.)


Working Capital vs. Permanent Financing

Short- term

liabilities

Short-term

assets

Working

capital

Permanent

Capital

Operating

assets

Permanent

Capital

Long-term

assets

Uninvested

capital

Permanent capital may include “current” items such as bank loans if debt is likely to remain on the books

Key: Treat items as either working capital or permanent capital but not both


FCFF vs. Accounting Cash Flows

Cash Flow Statement, Hudson’s Bay, ($millions, FYE Jan 1999)

Cash flow from operations

Net Income $ 40

Non-cash expenses $ 169

Changes in WC ($116)

Cash provided (used) by investments

Additions to P,P & E ($719)

Cash provided (used) by financing

Additions (reductions) to debt $ 259

Additions (reductions) to equity $ 356

Dividends ($ 53)

Overall Net Cash Flows ($ 64)

Income Statement, Hudson’s Bay

($millions, FYE Jan 1999)

Sales$7,075

Cost of Goods Sold $6,719

EBITDA $ 356

Depreciation$ 169

EBIT$ 187

Interest Expense $ 97

Income Taxes$ 50

Net Income$ 40

Dividends $ 53

Hudson’s Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561)


FCFF Definition Issues

Why is FCFF different from accounting cash flows?

  • Accounting cash flows include interest paid

    • We want to identify cash flows before they are allocated to claimholders

  • FCFF also appears to miss tax savings due to debt

    • Key: these tax savings are accounted for in WACC


An Example

  • $1 million capital required to start firm

  • Capital structure:

    • 20% debt (10% pre-tax required return): $200,000

    • 80% equity (15% required return): $800,000

  • tax rate is 40%

  • firm expects to generate 220,000 EBIT in perpetuity (all earnings are paid as dividends)

  • future capital expenditures just offset depreciation

  • no future additional working capital investments are required

  • What should be the value of this firm?


An Example, continued

  • Let us look first at how the EBIT is distributed to the various claimants:

    EBIT$220,000

    Interest (20,000)$200,000*10%

    EBT$200,000

    tax (80,000)40% rate

    EAT$120,000

    Div. to common$120,000

    Note: The dividend to equity equals 15% of equity capital


An Example, continued

  • The firm here generates a cash flow that is just enough to deliver the returns required by the different claimants.

    • i.e. the NPV of the firms projects = 0

    • Another way to see this:

      • WACC = 0.2 * 10% * (1 – 0.4) + 0.8 * 15% = 13.2%

      • Pre-tax WACC = 13.2% / (1 – 0.4) = 22%

      • EBIT / capital is also 22%, so NPV of future projects for this firm is zero

  • From “first principles”, the value of the firm should equal the invested capital, or $1,000,000


An Example, continued

  • Now consider FCFF valuation of this firm

    • FCFF = EBIT * (1-t) = $220,000 * (1 – 0.4) = $132,000

    • Value = 132,000 / 0.132 = $1,000,000

  • Note: we could have accounted for taxes in cash flow and not WACC

    • WACC without tax adjustment = 14%

    • Adjusted FCFF = EBIT – actual taxes

      = $220,000 – 80,000 = $140,000

    • Value = $140,000 / 0.14 = $1,000,000

  • Key: account for tax benefit, but only once (no double counting)!


Two Stage FCFF Valuation

  • Impossible to forecast cash flow indefinitely into the future with accuracy

  • Typical solution: break future into “stages”

    • Stage 1 : firm experiences high growth

      • Sources of extraordinary growth:

        • product segmentation

        • low cost producer

      • Period of extraordinary growth:

        • based on competitive analysis / industry analysis

    • Stage 2: firm experiences stable growth


Stage 1 Valuation

  • Forecast annual FCFF as far as firm expects to experience extraordinary growth

    • generally sales driven forecasts based on historical growth rates or analyst forecasts

    • EBIT, capital expenditures, working capital given as a percentage of sales

  • Discount FCFF at the firm’s WACC (kc)

FCFF1+ FCFF2 + . . . + FCFFt

VALUE1 =

1+kc (1+kc)2 (1+kc)t


Stage 2 Valuation

  • Start with last FCFF in Stage 1

  • Assume that cash flow will grow at constant rate in perpetuity

    • Initial FCFF of Stage 2 may need adjustment if last cash flow of Stage 1 is “unusual”

      • spike in sales or other items

      • capital expenditures should be close to depreciation

  • Value 1 year before Stage 2 begins =

FCFFt * (1+g)

Kc - g


Stage 2 Valuation

Present value of Stage 2 cash flows (Terminal Value or TV):

Key issue in implementation: Terminal growth (g)

  • rate of “stable” growth in the economy (real rate of return ~1-2% plus inflation)

  • TEV = VALUEt + TV

  • FCFFt * (1+g)

    1

    TV =

    x

    Kc - g

    (1+kc)t


    Discounted FCFF Example

    Assumptions

    YearEBITDepCap ExW/C Change

    1 40 4 6 2

    2 50 5 7 3

    3 60 6 8 4

    Tax rate = 40%

    kc = 10%

    Vdebt = value of debt = $100

    Growth (g) of FCFFs beyond year 3 = 3%


    Discounted FCFF Example (cont’d)

    FCFF = EBIT*(1-t) + Dep - CapEx - Increase in WC

    Year 1 FCFF = 40*(1 - 0.4) + 4 - 6 - 2 = 20

    Year 2 FCFF = 50*(1 - 0.4) + 5 - 7 - 3 = 25

    Year 3 FCFF = 60*(1 - 0.4) + 6 - 8 - 4 = 30


    Discounted FCFF Example (cont’d)

    20 25 30 30*(1+g) 30*(1+g)2

    | | | | | |

    t=0 1 2 3 4 5

    P = Vfirm

    30*(1+g)/(kc-g)

    TEV = 20/(1+kc) + 25/(1+kc)2 + 30/(1+kc)3 +

    [30*(1+g)/(kc-g)]/(1+kc)3


    Discounted FCFF Example (cont’d)

    TEV = 20/(1.10) + 25/(1.10)2 + 30/(1.10)3 +

    [30*(1.03)/(0.10 - 0.03)]/(1.10)3

    = 18.2 + 20.7 + 22.5 + 331.7 = 393.0

    TEV + Cash (unused assets) = Vfirm

    ==> Vfirm = TEV =393.0

    Vfirm = Vdebt + Vequity ==> Vequity = Vfirm - Vdebt

    Vequity = 393.0 - 100.0 = 293.0


    Relative Valuation: Capitalization of Earnings

    • Compute the ratio of stock price to forecasted earnings for “comparable” firms

      • determine an appropriate “P/E multiple”

  • If EPS1 is the expected earnings for firm we are valuing, then the price of the firm (P) should be such that:

    P / EPS1 = “P/E multiple”

  • Rearranging,

    P = “P/E multiple” x EPS1


  • Relative Valuation - Example

    • ABC Company:

      • Next year’s forecasted EPS = $1.50

    • Comparable company: XYZ corporation

      • Next year’s forecasted EPS = $0.80

      • Current share price = $20

      • PE ratio = 20 / 0.80 = 25

    • If ABC and XYZ are comparable, they should trade at same PE

      • Implied price of ABC = 25 * 1.50 = $37.5

    • Note: Analyst prefer “forward looking” ratios but “backward looking” ratios are more readily available

    • Key: Make comparisons “apples with apples”


    P/E Ratios and the DDM

    • Recall the constant growth DDM model; assume payout ratio is PO%

      • D1 = PO * EPS1

    • P/E ratios capture the inherent growth prospects of the firm and the risks embedded in discount rate

    P = D1

    ke - g

    P= PO *EPS1

    ke - g

    P = PO

    EPS1 ke - g

    P/E Motto: Growth is Good, Risk is Rotten


    P/E Ratio Based Valuation

    • Fundamentally, the “P/E multiple” relates to growth and risk of underlying cash flows for firm

    • Key: identification of “comparable” firms

      • similar industry, growth prospects, risk, leverage

      • industry average


    TEV / EBITDA Approach

    • TEV = MVequity + MVdebt - cash

    • EBITDA: earnings before taxes, interest, depreciation & amortization

    • Compute the ratio of TEV to forecasted EBITDA for “comparable” firms

      • determine an appropriate “TEV/EBITDA multiple”

  • If EBITDA1 is the expected earnings for the firm we are valuing, then the TEV for the firm should be such that:

    TEV / EBITDA1 = “EV/EBITDA multiple”


  • TEV / EBITDA Approach

    • Rearranging:

      TEV = “EV/EBITDA multiple” x EBITDA1

    • Next solve for equity value using:

      MVequity = TEV - MVdebt + cash

    • Multiples again determined from “comparable” firms

      • similar issues as in the application of P/E multiples

      • leverage less important concern


    EV/EBITDA Valuation - Example

    • ABC Company:

      • Next year’s forecasted EBITDA = $50 million

      • Shares outstanding = 20 million; value of debt = $50 million; cash = $0

    • Comparable company: XYZ corporation

      • Next year’s forecasted EBITDA = $40 million

      • Current share price = $20; shares outstanding = 10 million; value of debt = $100 million; cash = $0

        • EV = 20* 10 + 100 – 0 = $300 million

        • EV/EBITDA ratio = 300 / 40 = 7.5

    • If ABC and XYZ are comparable, they should trade at same EV/EBITDA

      • Implied EV for ABC = 7.5 * 50 = 375 million

      • Value of equity = 375 + 0 – 50 = $325 million

      • Price per share = 325/20 = $16.25


    Other Multiple Based Approaches

    • Other multiples:

      • Price to Cash Flow:

        P = “P/CF multiple” X CF1

      • Price to Revenue:

        P = “P/Rev multiple” X REV1

    • Multiple again determined from “comparable” firms

    • Why would you consider price to revenue over, for example, price to earnings?


    Merger Methods

    • Comparable transactions:

      • Identify recent transactions that are “similar”

      • Ratio-based valuation

        • Look at ratios to price paid in transaction to various target financials (earnings, EBITDA, sales, etc.)

        • Ratio should be similar in this transaction

      • Premium paid analysis

        • Look at premiums in recent merger transactions (price paid to recent stock price)

        • Premium should be similar in this transaction


    Aside: Why Merge or Acquire Another Firm?

    • Efficiency - “synergistic gains” 

    • Information - “undervalued assets” 

    • Agency problems - “entrenched management” 

    • Market power - “corporate hubris” X


    Aside: Most Mergers “Fail”!

    • Post-merger “success” defined as earnings on invested funds > cost of capital

    • McKinsey & Co. estimates 61% fail and only 23% succeed because:

      • Inadequate due diligence by acquirer

      • No compelling strategic rationale

      • Overpay, or projected synergies not realized


    Some Valuation “Myths”

    • Since valuation models are quantitative, valuation is objective

      • models are quantitative, inputs are subjective

  • A well-researched, well-done model is timeless

    • values will change as new information is revealed

  • A good valuation provides a precise estimate of value

    • a valuation by necessity involves many assumptions

  • The more quantitative a model, the better the valuation

    • the quality of a valuation will be directly proportional to the time spent in collecting the data and in understanding the firm being valued

  • The market is generally wrong

    • the presumption should be that the market is correct and that it is up to the analyst to prove their valuation offers a better estimate

      Source: A. Damodaran, “Investment Valuation: Tools and Techniques for Determining The Value of Any Asset”


  • Value Creation Summary

    • Firms create value by earning a return on invested capital above the cost of capital

    • The more firms invest at returns above the cost of capital the more value is created

    • Firms should select strategies that maximize the present value of expected cash flows

    • The market value of shares is the intrinsic value based on market expectations of future performance (but expectations may not be “unbiased”)

    • Shareholder returns depend primarily on changes in expectations more than actual firm performance

      Source: “Valuation: Measuring and Managing the Value of Companies”, McKinsey & Co.


    Valuation Cases

    • Size-up the firm being valued

      • do projections seem realistic (look at past growth rates, past ratios to sales, etc.)?

      • what are the key risks?

    • Valuation analysis

      • several approaches + sensitivities (tied to risks)

    • Address case specific issues

      • e.g. for M&A: identification of fit (size-up bidder), any synergies, bidding strategy, structuring the transaction, etc.

      • e.g. for capital raising: timing, deal structure, etc.


    Applications

    • We will apply valuation principles in variety of settings:

      • Private sales

        • Graphite Mining, Oxford Learning Centres

      • Mergers & Acquisitions

        • Oxford Learning Centres, Empire Company

      • Capital Raising

        • Tremblay, Eaton’s, Huaneng Power


    Valuation References

    Copeland, Koller and Murrin,1994, Valuation: Measuring and Managing the Value of Companies(Wiley)

    Damodaran,1996, Investment Valuation (Wiley); http://www.stern.nyu.edu/~adamodar/

    Pratt, Reilly and Schweihs, 1996, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Irwin)

    Benninga and Sarig, 1997, Corporate Finance: A Valuation Approach (McGraw Hill) http://finance.wharton.upenn.edu/~benninga/home.html

    Stewart, 1991, The Quest for Value (Harper Collins)

    Harvard Business School Notes:

    An Introduction to Cash Flow Valuation Methods (9-295-155)

    A Note on Valuation in Private Settings (9-297-050)

    Note on Adjusted Present Value (9-293-092)


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