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Financial Valuation of companies

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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

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

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)

1.1 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

- Value of an asset = transaction price = price
- that the owner estimates to be enough.
- that the investor should pay when buying this asset,

- P°
- 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

- 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

- 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

- 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

- 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

- 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

- 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

- 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 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 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: Renault

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

- 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

- 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

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

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

- Strong differences even in the same industry!

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. Discountedapproaches4. 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

- 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

- « 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

- Economic cash flow including
- Discount the free cash flows value of assets

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

- Memscap: high tech company at Grenoble.
- IPO: january 2001 valuated by Société Générale Owen
- Subsequent DCF are published:

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

- = 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. 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. 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. 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

- 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

- 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 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

- 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

- 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

- 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

- 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

- 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

- Thus we get the derived equation of CAPM approach
Where beta = sensitivity of stock / market = cov (stock, market)/market variance

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

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 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

- Growth opportunities
- Single cash flow sequence doesn not reflect correctly
- Many stages with uncertain cash flow
- Many stages where decisions can change a project

- Single cash flow sequence doesn not reflect correctly
- Decision trees
- Real options

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

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

- 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

- 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 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

- 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

- 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

- 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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