Valuation measurement and value creation l.jpg
This presentation is the property of its rightful owner.
Sponsored Links
1 / 44

Valuation Measurement and Value Creation PowerPoint PPT Presentation


  • 160 Views
  • Uploaded on
  • Presentation posted in: General

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

Download Presentation

Valuation Measurement and Value Creation

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Valuation measurement and value creation l.jpg

Valuation Measurement andValue Creation


Valuation situations l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 continued19 l.jpg

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 continued20 l.jpg

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 l.jpg

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 l.jpg

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 l.jpg

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 valuation24 l.jpg

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 l.jpg

    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 l.jpg

    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 d27 l.jpg

    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 d28 l.jpg

    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 l.jpg

    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 l.jpg

    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”


    Slide31 l.jpg

    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 l.jpg

    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 l.jpg

    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 approach34 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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 l.jpg

    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)


  • Login