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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

YearEBIT Dep Cap 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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