Valuation. Contents. Introduction – Fundamentals of Where Value Comes From Discounting and IRR Review Overview of Alternative Valuation Methods Valuation Using Multiples Valuation Using Discounted Free Cash Flow Valuation Using Projected Earnings and Equity Cash Flow Case Studies.
Every major decision a company makes is in one way or another derived from how much the outcome of the decision is worth. It is widely recognized that valuation is the single financial analytical skill that managers must master.
Reference: Chapter 4
Reference: Folder on Yield Spreads
Financial theory dictates that the CAPM should be used to compute the WACC, that the un-levered beta should be used to estimate equity returns, that options pricing models should be used for credit spreads, debt capacity and covenants.
Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk.
Practical Market Information
Practical market information can be used to gauge required equity returns, required credit spreads, required financial ratios to achieve investment grade rating and other issues.
Consider Investment Alternatives A and B, where A has a higher project IRR than B. Assume A has a return of 11% and B has a return of 9%.
Project A or Project B would be selected through assessing the return on the projects relative to the weighted average cost of capital for each project. If the WACC for A is 10% and for B is 9.5% then A is selected. One must computed beta for each investment.
Compute the distributions in cash flow of project A and project B to equity holders. If the standard deviation is lower for project B, then assess the risk relative to the return.
Compute the achieved rate of return from the ability to raise debt and then assess the return earned on equity. If the return on equity is greater for B then A, select project A.Measurement of Risk in Financial Models
Fundamental parameters are almost impossible to measure
Differences in Beta, Rm and Terminal Growth have an Immense Effect on the Value of the Investment
If only we could measure these things
Case 1: 15% Volatility; 40% Mean Reversion; 4.5 Long-run Marginal Cost
Case 2: 25% Volatility; 10% Mean Reversion; 4.0 Long-run Marginal Cost
The probability of earning below the risk free rate is about 5%
The probability of earning below the risk free rate is about 55%
Let Bankers Assess the Risk – That is Their Job
Project BComparison of Approaches: Which Investment would you Select
Project A has a higher rate of return relative to its cost of capital, but Project B has a higher equity return
Discount Rate is WACC
Reference: Private Valuation; Valuation Mistakes
Equity Cash Flow and Value of Equity :
Dividends less Equity Issued
Value of Equity
PV of Cash Flows at
Cost of Equity
Debt Cash Flow and Market Value of Debt :
Net Interest plus Net Debt Payments
Value of Debt
PV of Cash Flows at
Incremental Cost of Debt
Free Cash Flow:
EBITDA – Op Taxes – Cap Exp – WC Chg
Value of Enterprise
PV of Cash Flows
Despite that fact that all we have to do is forecast cash flow and then determine the risk associated with those cash flows, valuation is a huge topic. Some Key issues in valuation analysis include:
Investors cannot buy a house with earnings or use earnings for consumption or investment
The short term
Based on best estimate of likely outcome
Much of valuation involves implicitly or explicitly making growth estimates – High P/E comes from high growth
Reference: Level and persistence of growth rates
For immature companies, the reaching of equilibrium will exceed the standard five year forecast
Extending the forecast forces one to make assumptions for more than one year which become very speculative
Some suggest a fade growth period to address this issueTerminal Value and Growth
A study by Chan, Karceski, and Lakonishok titled, “The Level and Persistence of Growth Rates,” published in 2003. According to this study, analyst “growth forecasts are overly optimistic and add little predictive power.”
EBIT x (1-tax rate) (NOPLAT)
Competitive position such as pricing power and cost structure affects ROIC
In financial terms, value comes from ROIC and growth versus cost of capital
P/E ratio and other valuation come from ROIC and Growth
Economic profit is the difference between profit and opportunity cost
This implies that there are three variables – return, growth and cost of capital that are central to valuation analysis
Once you have a good thing, you should grow
What is the economic reason for getting here and how long can the performance be maintained
Throwing good money after bad
Give the money to investors
Try to get out of the business
Earnings are a good indicator of value; but not always as shown by the recent increases which resulted from share buybacks
Strong Returns plus growth resulted in increased price; when return fell, the price fell
GM had low growth and low returns and the stock price did not increase.
Will the ROIC move to WACC because of competitive pressures
Evidence suggests that ROIC can be sustained for long periods
Consider the underlying economic characteristics of the firm and the industry
What is the expected change in ROIC
When ROIC moves to sustainable level, then can move to terminal value calculation
Examine the ROIC in models to determine if detailed assumptions are leading to implausible results
Migration tableROIC Issues
See the appraisal folder in the financial library
Valuation with high
See the article on private valuation
Evaluate how much of the equity value that you own
(1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)nDebt (Bond) Valuation
Case exercise to illustrate the effect of discounting (credit spread) on the value of a bond
(1+k)1 (1+k)2 (1+k)3 (1+k)nEquity – Dividend Discount Valuation and Gordon’s Model
Vt = E(FCFt +1) + E(FCFt +2) + E(FCFt +3) + ... + E(FCFt +n) + ...
(1+k)1 (1+k)2 (1+k)3 (1+k)nEquity Valuation - Free Cash Flow Model
Terminal value is after the last period cash flow and must use mid year period x (1+g)^1.5
Precise discounting with mid year period
Objective – does not require discount rate of terminal value
Simple – does not require elaborate forecast
Flexible – can use alternative multiples and make adjustments to the multiples
Theoretically correct – consistent with DCF method if there are stable cash flows and constant growth – FCF/(k-g).
Valuation depends on opinions of others and not the underlying drivers of value.
Too simple: Does not account for prospective changes in cash flow
Accounting Based: Depends on accounting adjustments in EBITDA, earnings
Timing Problems: Changing expectations affect multiples and using multiples from different time periods can cause problems.Advantages and Disadvantages of Multiples
There are reasons similar companies in an industry should have different multiples because of ROIC and growth – this must be understood
In the long-term P/E ratios tend to revert to a mean of 15.0
Theory of growth and multiples – depends on long-term growth more than short-term growth. Also depends greatly on the cost of capital.
Comparison of equity value (P) to EBITDA compares value after debt to income before interest – favors companies with less debt
Sample should have similar WACC and growth rates and therefore be in the same industry and have the same kind of risks. Note difference in size and difference in company profile.
The red bars from the DCF valuation are compared to market date
Which multiple best reflects value for the various companies – note the EV/EBITDA is most stable
When you compute the terminal value using
CF x (1+g)/(k-g)
Compute the implied
EV/EBITDA from the data
Also compute the implied P/E and the implied EV/EBITDA when computing the DCF
Market crashed after very high PE in 2000
Low P/E when long-term interest rates where high
Note how multiples cover the cycle in a commodity business
Demonstrates that the multiple in the merger is consistent with other transactions
Note that the median is presented before the mean
Median P/E Multiples: Public vs. Private Deals
Source: Mergerstat (U.S. Only)
Disclaimer: Data is continually updated and is subject to change
Median Transaction Multiples by Deal Size
Source: Mergerstat (U.S. Only)
Disclaimer: Data is continually updated and is subject to change
Exercise: Data table with alternative parameters to investigate P/E and EV/EBITA
Theoretically Valid – value comes from free cash flow and assessing risk of the free cash flow.
Operating and Financial Values – explicitly separates value from operating the company with value of financial obligations and value from cash
Sensitivity – forces an understanding of key drivers of the business and allows sensitivity and scenario analysis
Fundamental – not biased by optimism or pessimism in the market
Assumptions: Requires WACC assumptions and residual value assumptions. There are major problems with WACC estimation and the long-term growth assumption.
Forecasting Problems: Complex forecasting models can easily be manipulated
Growth: The residual value depends on a number of assumptions which can easily distort value
Real Options: Discussed aboveAdvantages and Disadvantages of DCF
Treatment of other investments depend on definition of free cash flow. Here, income from other investments must not be in free cash flow
Note how investments are added and debt is deducted in arriving at equity value
If the liability is included in operating expenses, then no adjustment may be necessary
Year after explicit period to establish stable cash flows
CFt x (1+g)/
Explicit Forecast Period
EV/EBITDA that Reflects
Long-term Growth Rate and ROIC
PV of Cash
Step 2: PV from Year t to current year
Step 1: PV to year t – End of period t, so Gordon’s method must use t+1 cash flows
Market to Book Ratio that Reflects Long-term ROE
Make sure Cash Flow in period t reflects realistic ROIC, Working Capital that reflects long-term growth and realistic capital expenditures
First, high growth firms with high net capital expenditures are assumed to keep reinvesting at current rates, even as growth drops off. Not surprisingly, these firms are not valued very highly in these models.
Second, the net capital expenditures are reduced to zero in stable growth, even as the firm is assumed to grow at some rate forever. Here, the valuations tend to be too high.
Gordon Dividend Discount Model.
P = D1/(K – G)
The model can be used to compute the cost of capital where:
R = D/P + G
Problem: D is not EPS and G is affected by payout ratio
EPS = $33 million/ 190 million = 17. 3 CENTS
We often talk about free cash flow, sometimes, it is challenging to assess what is "free“ cash flow or not, may wish to elaborate on that rather than just defining free cash flow in a text book term.
The basic point is to keep things consistent. If you define FCF as EBITDA without other income, then the valuation does not include other investments.
On the other hand if FCF is defined using Cash B/4 Financing that includes other income, the other investments are included in the valuation
Terminal value, and the use of a stable growth rate. How do you determine that, what is the rule of thumb and how do you determine which year onwards should be terminal year (i.e. how long should your forecasted period be).
On how to calculate a WACC, rather than just providing the formula of WACC, it would be useful to give instructions on where to find the market premium data, betas and what is the best method vs the most practical method.
Also there is no mentioning of cash revolver and how to calculate it.
Used multiples to demonstrate that the valuation is not plausible
- Takeover King
- Breath of fresh air in the ‘old’ boardroom
Source: Pierpont (Trevor Sykes) Australian Financial Review, 24 May 2002