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Financial Valuation of companies. Financial Valuation of companies. Objectives of the course: Unterstand the commonly used techniques in valuation of companies Be able to estimate a spread of values of a company Pr Dr Dominique Thévenin Associate Professor Grenoble Ecole de Management

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Financial valuation of companies

Financial Valuation of

companies


Financial valuation of companies

Financial Valuation of companies

  • Objectives of the course:

    • Unterstand the commonly used techniques in valuation of companies

    • Be able to estimate a spread of values of a company

  • Pr Dr Dominique Thévenin

    Associate Professor

    Grenoble Ecole de Management

    [email protected]


Summary

Summary

  • 1. Asset Pricing: general rules

  • 2. Patrimonial valuation methods

  • 3. Analogy valuation methods

  • 4. Discounted methods

  • 5. WACC issues and statistical approach of CAPM

  • 6. Specific cases: techno companies, convertible bonds


Summary1

Summary

  • Course documents

    • Slides,

    • Exercices and small cases,

    • Cases

  • Required tools

    • Simple calculator, or PC Excel

    • Linear regression, statistics

    • Boursorama, yahoo finance, google finance

    • Bloomberg, www.infancials.com,

  • Course Book

    • Bryley & Meyers ( en)

    • Vernimen (Fr)


1 general rules about asset pricing

1. General rules about asset pricing

Financial ressources

investment

operations


1 1 overview on interest rates

1.1 Overview on interest rates

  • Interest rate

    • Expected inflation

    • Report of consumption

    • Time (liquidity)

    • Risk premium

  • Short horizon interest rate

    • Decided by Central Banks

    • In the context of monetary policy

  • Long Horizon interest rate

    • Market rate cointegrated with short rates

2% (2010 €)3% ( pastaverage)

1-2% (5-15 years)0% - 4 -6%

1% € 2007-2010,0,25% yen, $, 2010


1 2 overview asset pricing

1.2. Overview: asset pricing

  • Value of an asset = transaction price = price

    • that the owner estimates to be enough.

    • that the investor should pay when buying this asset,

    • What you pay = what you get

    • = sum of the future cash flows that you receive as long as you hold this asset

    • = Discounted future cash flows

  • Certain or safe cash flows: bonds

    • P°= present value of future cash flows @ right risk rate


Overview asset pricing

Overview: asset pricing

  • Uncertain cash flows:

    • Speculative pricing : discounted expectedcash flows

    • Interest rate = adjusted to the risk of the asset

    • P° moves in response to rates fluctuations and cash flow revisions

  • Real assets

    • P° sensitive to expected selling price, rents, and interest rates

  • Stocks

    • P° sensitive to dividends, profits, selling price and interest rates


Overview of asset pricing bonds valuation

Overview of asset pricing: bonds valuation

  • The bondholder receives fixed subsequent payoffs.

  • Exemple : 500 € in fine bond @ 3%, maturity 10 years.

  • What is the value of this bond if market rate is ?

    • 5%

    • 8%

    • 12%

    • 2%

    • 1%


1 3 valuation of a company

1.3 Valuation of a company

  • Firm = set of assets holded by shareholders

    • Shares are assets themselves

  • Value of a company = value of all of its assets

  • = Debt Value + Equity value

  • Creditors = money suppliers = stakeholders. Thus the good issue is the value of Equities.

  • Equity Value = Assets value – Debt Value

    • Direct valuation: valuate equities from dividends or profits

    • Indirect valuation: valuate assets and substract the debt


Valuation of a company

Valuation of a company

  • Assets oh the company = set of

    • projects, investments in process, (no growth situation)

    • growth opportunities ( few are disclosed)

  • Value of the assets =

    • PV of the future cash flows of all the projects

    • + PV of growth opportunities

    • Discounted at the weighted cost of capital


Main methods to valuate

Main methods to valuate

  • Book value, or patrimony approach

    • Financial statements provide information about patrimony

    • information about past profitability

    • Information about competitors

  • Analogy approach

    • Duplicate the valuation from similar firms

  • Financial or discounted approach

    • The value of an asset or a security = present value of expected cash flows = sum of discounted expected cash flows. ( part 3)


2 book value approach

2. Book value approach

  • A1: value of equities = book value of equities

    • Simple: just read it in the financial statements !

    • Assets are valuated according rules and regulations.

      • Continental Europe focuses on safety principle,

      • with historical costs: does not reflect their market value. Far from reality.

    • Distinguish some liabilities from equities is not trivial

      • Convertible bonds ?

      • Options on stocks ?

    • Consolidated datas are not always safe

    • IFRS regulation improves the valuation of listed companies


2 1 book value approach

2.1. Book value approach

  • A2: net reevaluated assets :

    • Valuate every asset in the balance sheet at its market value

    • Are all assets liquid ?

    • Are all assets profitable ? (useless assets)

    • Does every asset fully reflect future earnings ?

      • Brands, licences, specific assets ?

    • Some elements do not exist in assets and financial statements

      • Know how, human capital, specific assets, growth opportunities

    • On the other side:

      • dissimuated liabilities


2 1 book value approach1

2.1. Book value approach

  • Listed companies: IFRS

  • Assets and liabilities are valuated at their « fair value »  A2 approach

    • Only some untangible assets are valuated at the fair value: acquired brands and licences, financial investments, etc.

    • Goodwills are controversy

  • IFRS are sometimes contrevorsy, but the induced valuations are closer to market valuations

  • Nevertheless, the difference between market and book values are large


2 book value approach1

2. Book value approach

  • A3: the goodwills:

    Idea: valuate assets that accounting systems are not able to do, but generate profits.

    Untangible assets, know how, human ressources,…

    These additionnal value = Goodwill.

    But methodologies suggest hazardous formulas:

    No cash, no discount, no risk and no expectations!

    The Goodwill valuation approach has no backgroud

    But Goodwill exists : ex post, GW = Price of a firm – Book Value…


Example hermes

Example: Hermes


Example renault

Example: Renault


3 the multiples

3. the « multiples »

  • Underlying idea: markets evaluate identical firms at the same price.

  • Consider the PER: Market price /net income

    • Price Earning Ratio indicates how many times of annual profit you pay a company

    • PER Air liquide = 18  the price of the share = 18 times its annual net profit

  • The current net profit is commonly seen as the main reference to measure the profitability of a company.

    • the PER shows the expected growth of the profits

    • PER 6-8 = low growth

    • PER 10 = maturity

    • PER > 20 = growing company


The multiples

The multiples

  • Consider now the links between economic variables of the firm: income, sales, net assets, book value

    • Net profit = Sales x net margin in%

    • Sales = invested assets x turn over speed

  • Links between 1 economic variable and the market price are established

    • A « multiple » = market price / economic variable

  • there are links between market valuation and most economic variables.

    • Multiples are very closed among an industry, because companies run the same business model


Multiples

multiples

  • But the debt will infer. Thus separate these indicators

    • Market cap / net income, variables related to equities,

    • Enteprise value / variable limited to economic variables

  • Where Enteprise value = market cap + debt


Multiples1

multiples

Ev commonly means market value of assets = market cap + debt

P:S, P:EBIT are often computed on market cap and not Ev . Please pay out


Examples

examples


The multiples1

The multiples

  • The use of the multiples if non listed company

    • Look for listed similar companies on a market

    • Compute main multiples

    • Duplicate the multiple to unlisted companies, or analyse the place of a company among its competors

  • Advantages

    • simple, easy

  • Cons

    • Difficult to build samples of similar companies

    • What else if no earnings…

    • What else if the maket price is very volatile

    • Book datas are delayed in regards to market datas


Example 2006

Example 2006

  • Strong differences even in the same industry!


4 discounted approaches

Value of equities = value of assets – value of debt.

Assets = sum of investment projects

Assets value = present value of future economic cash flows, discounted @ the cost of capital.

 Infer equities

Value of equities = present value of the future cash flows to shareholders

 equities value = (economic cash flow – cash flow to bondholders) discounted @ the cost of equities

4. Discountedapproaches


4 discounted approach

4. Discountedapproach

  • Exemple: a company produces cheese and generate a stable and infinite EBITDA = 20 M. The balance sheet shows 50 M debt at 6% interest. Income tax = 30%, and shareholders require a 9% return.

  • 1. Estimate the value of its equities,

  • 2. Estimate the WACC and the value of its assets


4 1 the dcf method

4.1. The DCF method

  • DCF = Discounted Cash Flows.

    • Translate strategy into a stream of future economic cash flows.

    • Discount @ wacc

  • DCF gives the value of assets


4 1 dcf

4.1.DCF

  • « free cash flow » table

    • Economic cash flow including

      • operating flows after tax (NOPAT + depréciations)

      • + Delta Net Working Capital

      • - investment required to maintain operations possible

      • No interest or debt flows (except if you compute cash flow to shareholder)

    • Techniques

      • Assume depreciations = investment (roll over)

      • Cash flow every year as long as the visibility is correct

      • Troncate the subsequent flows at the end: « terminal price »

        • Assume a multiple

        • Or assume a long term growth rate

  • Discount the free cash flows  value of assets


4 1 dcf1

4.1. DCF

  • Advantages

    • Translate a strategy into datas

    • Specific DCF if diversified company. Then consolidate. ( SOTP = sum of the part)

  • Cons

    • Few visibility over long period

    • DCF is very sensitive to the « terminal price »

    • Requires to know the WACC


Example memscap

Example: Memscap

  • Memscap: high tech company at Grenoble.

  • IPO: january 2001  valuated by Société Générale Owen

  • Subsequent DCF are published:


4 2 discounted approaches dividends or fundamental approach

4.2.Discountedapproaches:dividends or fundamentalapproach

  • Price of a stock = present value of the cash flows to shareholders

    • Dividends and capital gains: D1 and (P1-P0) if cash flo to shareholders are restricted to dividends

  • If D1 and P1 are estimated, the required return to shareholders wellknown,


4 2 dividends

4.2. dividends

  • = present value of inifinite dividend stream

  • If you introduce a long term growth rate: Gordon-Shapiro model.

    • Dividend and growth rate are not independant

    • Growth rate has to be < return rate

  • Reverse the model and get

    • Required return = dividend yield + growth rate

  • Fundamental and Gordon Shapiro models have a weak explainatory power:

    • < 40% in US stocks

    • 60% in France


4 2 dividends1

4.2. dividends

  • Limits of Gordon Shapiro model

    • Valid with mature companies

    • Irrelevant with growing companies

      • Troncate the model into growing period and maturity

    • ROE often irrelevant (delayed) to estimate g with( way 2)

    • Irrelevant if the dividend policy is unstable


4 2 dividends2

4.2. dividends

  • 3 ways to estimate the growth rate?

    • Try to translate the strategy into sustenable long terme growth rate

    • Link payout ( Dividend / Earnings) = b, and growth

      • (1-b) * Earnings are retained and invested

      • Ceteris paribus,

        • the book equities increase by (1-b)*ROE

        • Earnings and Dividends increase by (1-b)*ROE

      • g = (1-b)*ROE

      • g is the requested growth to get the same ROE

    • Observe subsequent dividends over time, and run an exponential regression t / t-1


4 2 dividends3

4.2. dividends

  • Exercice: look at a listed company

    • Compute b, ROE,

    • infer growth rate,

    • Compute dividend yield

    • Infer the cost of equities

    • Download the dividends over the past 10 years

    • Regress and infer g


4 3 growth and stock price

4.3. growth and stock price

  • Growth of sales and earnings should show a long term link

  • g = 0: b = 100%, dividends = earnings. P0= earnings / r  PER = 1/r, or r = 1/PER

  • If g>0: additionnal cash flows and earnings  Price moves up  PER moves up

    • r = 15% g = 0% b=100%  PER = 6.67

    • R = 15% g =10% b=40%  ROE =16.66%  PER = 8

    • r = 15% g =10% b=50%  ROE =20%  PER = 10


Financial valuation of companies

  • French market 2006: average PER = 16 (13 in 1993)

    • PER were historicaly high 1998-2002. Earnings had to grow !

    • Dec 2009: <10

  • Growing company : PER > 20 - 25


4 4 discounted approach bates model

4.4 Discountedapproach: Bates Model

  • Mix DCF + PER approaches

    • Firm is growing at g over n years, and retained earnings (1-b) are constant over time.

    • PERn reflects moderate growth.

    • PER0 can be estimated as follows:

    • Value of equities = PER0 x Net Income0


Bates

Bates

  • Advantages

    • Valid for growing companies

    • Simple

    • Possible to run Bates with a multiple of NOPAT, and gives the value of assets

  • Limits

    • Positive Net income is required

    • Constant % dividend payout ( possible to input b=0%)

    • Requires to know the cost of equities


Bates example google

Bates: example Google

  • Google sept 2011

    • Cost of equities 10,3% ( beta 1, rf 1,8%, market 8,5%)

    • Net income 2010/2011 = 9013 M$

    • Market cap = 174 000 M$  PER°=19,3

    • b = 0 assumed for a long time

    • Forecasts = PER 2013 = 10,8

    •  implicit growth rate = 47% over 2 years.


Conclusion about valuation methods

Conclusion about valuation methods

  • Patrimonial approaches reflect the past

    • Correct if real assets

    • Avoid a priori Goodwills

  • Financial approaches are founded on expectations. They price growth opportunities.

    • It ensures volatility when expectations are revised.

    • Sensitive methods to hypothesis

  • Strong links with strategy

  • Financial approaches requires to estimate first the cost of equities, and/or the cost of capital !

  • Strong links with capital structure


5 discount rate

5. Discount rate

  • Discounted methods (part 4) require to know the discount rate

    • Cost of equities, or

    • WACC.

  • Cost of equities and WACC depend on the D/E leverage ratio

    • D/E ratio includes the market values and not the book values

  • Risk of « circular » estimation of discount rate


5 1 cost of equities and capm

5.1 Cost of equities and CAPM

  • Stock return = risk free + risk premium

  • Stock risk = systematic risk + specific risk

    • Systematic risk = risk generated by the stock market on our stock

    • Specific risk = risk that can be eliminated by diversification of the portfolio owned by the shareholder

  • Only systematic risk is paid to shareholder

    • This risk = Market risk smoothed or incréased by the sensitivity of the stock in response to the market fluctuation


5 1 capm

5.1 CAPM

  • Thus we get the derived equation of CAPM approach

    Where beta = sensitivity of stock / market = cov (stock, market)/market variance


5 1 capm1

5.1 CAPM

  • How to estimate the cost of equities of a listed company ?

    • Risk free is observable at a given date: T-Bonds à 10 years is the most commonly used proxy

    • Market risk premium: often published in financial newspapers.

      • Average of the market premium over time: 3.5% - 4%.

      • Never use 1/PER of the market

    • beta is sometimes published in financial newspaper

      • unsafe


Risk premium over time

Risk premium over time


5 1 capm2

5.1 CAPM

  • How to estimate the beta of a listed company

    • Beta = regression coefficient of Ri = a + beta * Rm

    • Download stock price and stock index, exchange them into returns

      • Week data over 1 year is preferable

    • Regress Ri on Rm and get the beta coefficient

    • Run a Student test to decide if your estimation is acceptable

      • Sophisticated econometric tests should be conducted, due to non stationnary datas

      • Beta reflects the risk of a company, and is not stable over time, or after M&A


5 1 capm3

5.1 CAPM

  • How to estimate the beta of a non listed company

    • Estimate the beta of a listed company

    • Compute market D/E ratio

    • Exchange the beta into the economic beta and duplicate it to the non listed company,

    • Valuate the company under all equity financed hypothesis  value of assets

    • Adjust with the debt

    • Some iterations may be required

      • Avoid to compute the cost of equities and the WACC under book value D/E


6 specific cases 1 techno firms

6. Specific cases. 1. techno firms

  • Growth opportunities

    • Single cash flow sequence doesn not reflect correctly

      • Many stages with uncertain cash flow

      • Many stages where decisions can change a project

  • Decision trees

  • Real options


Real option as investment

Real option as investment

  • R&D = valuate with Black and Sholes model

    • Underlying asset = project itself

    • Maturity = uncertain, unknown

    • Strike = investment ,

    • Volatility = the risk of cash flows = substituate with the standard deviation

  • Options on extension, communication, to give up, to differ, etc

  • All of this opportunities give more and more value

    • The « true value » is revealed with information


Black sholes model

Black & Sholes model

W = value of the call

P0 = price of underlying asset

Px = Stike price

t = maturity

rf = risk free interest rate

Sigma = volatility of the asset

N(.) = cumulative normal law


6 2 convertible bonds

6.2 convertible bonds

  • Convertible bond = a bond including the right to exchange it to stock @ a given exchange ratio

    • Stage 1: classical bond ( coupon …)

    • Stage 2: pay back time

      • No cash, but common stocks,

      • Cash if the value of the stock is low

  • Advantages to the issuer

    • Interest is tax save

    • No cash to payout if exchange

    • Delays the dilution induced by an equivalent capital increase


Example

example

  • Convertible bond issue by ABB April 2002 (968 M$)

  • Issuing price : 1000 $

  • Date : 29 April 2002

  • expiration: 16 Mai 2007

  • coupon : 4,625%

  • Reimbursement price: 1000 $

  • exchange : 87, 7489 actions per 1 bond

  • Exchange period : from 29 April 2002 to 16 May 2007

  • Stock price ABB: 14,218 CHF (8,77$)


6 2 convertible bonds1

6.2 convertible bonds

  • Advantages to the bondholder

    • Receives fixed interest vs random dividend,

    • Receives cash if low performance of stocks,

    • Gets shareholder if high performance

    • = option to get shareholder

  • Finance a company

    • Low markets: convertible bonds,

    • High markets: capital increase


6 2 valuation of a convertible bond

6.2. valuation of a convertible bond

  • In case of take over, initiator buys most of the shares

    • Convertible bonds may create new shares in the future

    •  Buy convertible bonds

  • Value of convertible bond under a take over:

    • Arbitrage bond / share according the exchange ratio

    • + discounted difference between subsequent dividends and coupons


6 3 the case of real assets in companies

6.3. the case of real assets in companies

  • Some companies do not hold real assets but rent.

    • Extend to other assets

  • EBITDA, EBIT, NOPAT, Cash Flow change

    • Multiples change

    • PV of Cash flow ( DCF) change

    • WACC ???

  • Adjust the multiples and DCF, is recommanded


References

references

  • Albouy, Décisions financières et création de valeur, Economica 2003 Fr

  • Sudarsanam: Creating Value from mergers and acquisitions. Prentice Hall 2004 (En)

  • Ottoo, Valuation of growth opportunities, Garland NY, 2000 (En)

  • Bryley & Meyers: principles of corporate finance (en)

  • Vernimen (Fr)


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