Financial Valuation Concepts Points to Consider Financial valuations are often the end result of a financial modeling exercise,

, and a good financial analyst will ensure a rigorous approach, grounded in sound knowledge of valuation concepts, is taken to calculating and performing financial valuations when building a financial model. Some points to consider whenever performing a financial valuation: How much can the key assumptions change without altering the decision? Are the assumptions realistic? Sales growth, operating margins, capital expenditure, discount rate, etc. Be realistic about synergies. Often synergies are manufactured to justify a deal. Avoid hockey stick forecasts where a dramatic turnaround for an underperforming company is forecast. This is often not the case in real world business situations, where gradual changes are most common, and sharp turnarounds considered a rare upside. What could go wrong that would invalidate the decision? How likely is that to occur? Search for mental blindspots such as off-balance sheet items. What if a key executive was ill? Avoid short cuts Use the nine-step DCF process! Financial Valuation Concepts Discounted Cash Flow When a financial analyst is required to conduct a financial valuation on the business or company being forecasted by the financial model, a commonly used valuation technique in a financial modeling exercise is the Discounted Cash Flow (DCF) method. The DCF method uses a nine step process to value a business enterprise: 1. Forecast Free Cash Flow (FCF) 2. Estimate the Weighted Average Cost of Capital (WACC) 3. Use WACC to discount FCF 4. Estimate terminal value (as known as residue value) 5. Use WACC to discount terminal value 6. Estimate total present value of FCF 7. Add value of non-operating assets 8. Subtract value of liabilities assumed 9. Calculate value of common stock Real Options (Strategic Options) in Financial Modeling The traditional, financial results led approach to assessing the viability of a project or business in a financial modeling exercise continues to work very well today, however, a more strategic approach to decision making has also emerged to complement the traditional process.

Real options (or strategic options) are opportunities embedded in projects or investments that are likely to exist and have a material economic impact on cash flow and risk. The recognition of real options embedded in a project will result in the projects strategic net present value (NPV) to differ from its traditional NPV, as follows: Strategic NPV = Traditional NPV + Value of real options We highlight a number of the most common categories of real options which can occur in when performing financial modeling on a project or investment. Abandonment Option The option to terminate or abandon a project before the end of its planned lifespan. This option allows executives or project owners to minimize or avoid monetary losses on projects that turn financially unsuccessful. A good financial modeler who explicitly recognizing the abandonment option when evaluating a project often increases the NPV. Flexibility Option The option to incorporate a greater degree of fluctuation / flexibility into a companys operations, especially manufacturing & production. It generally includes the opportunity to design the manufacturing & production process to accept multiple inputs, use flexible manufacturing techniques / technologies to create a range of outputs by reconfiguring the same set of plant and equipment, and purchase and retain excess capacity in capital intensive industries subject to wide fluctuations in output demand and long lead times in building new capacity from the ground up. A financial modeling and analysis exercise that recognizes this option embedded in a capital expenditure should be able to increase the NPV of a project. Growth Option The option to develop follow on businesses or projects, expand in new or existing markets, retool or increase plants, etc, that would not be possible without the on going existence of the project that is being evaluated for implementation. If a project being considered has the potential to open new avenues for growth if successful, then recognition of the cash flows from such opportunities should be included in the financial model of the initial decision making process. Growth opportunities embedded in a project often increases the projects NPV. Timing Option The option to determine when various actions related to a project are implemented. This option recognizes the companys opportunity to postpone or delay acceptance of a project for one or more time periods, or to either accelerate or slow down the process of implementing a project in response to new information, or to discontinue a project temporarily in response to changes in the competitive landscape or general market conditions. As in the case of the other type of real options, the explicit recognition of timing opportunities in a financial model can improve the NPV of a project that fails to recognize this option in an investment decision.

The Concept Of Free Cash Flow (FCF) Free cash flow (FCF) is equal to the after-tax operating earnings of the company plus noncash charges less investments in working capital, plant, property and equipment (or PP&E), and other assets. FCF is the cash flow generated by a company that is available to all providers of capital, both debt and equity. The table illustrates how free cash flow can be derived from financial statements or results of a financial modeling and financial valuation exercise. 2008 2009 Revenue Operating Expenses EBIT Taxes Net Operating Profit plus Depreciation Gross Cash Flow (A) Change in Working Capital Capital Expenditure Include in Other Assets Gross Investment Total (B) FREE CASH FLOW (A - B) 1,200 1,380 240 144 30 174 9 72 3 84 90 276 166 33 199 18 83 10 111 88 2010 1,587 349 (140) 209 37 246 21 95 2 118 128 2011 1,746 384 (154) 230 41 271 16 105 3 124 147 2012 1,920 422 (169) 253 46 299 17 115 3 135 164

(960) (1,104) (1,238) (1,362) (1,498) (96) (110)

Financial Valuation Concepts The Internal Rate of Return (IRR) The internal rate of return (or IRR) is a common financial valuation metric used by financial analysts to calculate and assess the financial attractiveness / viability of capital intensive projects or investments. As the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case. So what exactly is the IRR? The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a

discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments. All projects or investments with an IRR that has been calculated in a financial modelingexercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted. When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC. Modified Internal Rate Of Return (MIRR) The modified IRR (MIRR) is said to reflect the profitability of a project or investment more realistically than an IRR. The reason why this is so is because the IRR assumes the cash flow from an investment or project to be reinvested at the IRR, whereas the modified IRR assumes that all cash flows to be reinvested at the investors / firms cost of capital. The MIRR is used extensively in real estate financial analysis due to the nature and timing of cash flows and investments for real estate investments. Dividend IRR The ongoing financial returns to investors who own and retain the equity of a business or project is essentially by way of financial / cash dividend payouts. As equity investors are typically last in rank in the cash flow waterfall, and therefore face the greatest risk of not being paid should the investment turn sour when compared to holders of other forms of ownership in the same investment, equity investors would therefore expect the highest return. The dividend IRR is therefore used extensively by equity investors to calculate and measure the discount rate at which the present value of cash dividend payouts equal the present value of equity investments. Capital Budgeting and the Pros and Cons of IRR and NPV Capital budgeting is an executive decision making technique that all good financial analysts should be familiar with, in order to ensure that their financial modeling and analysis skill set remains relevant and practical to business realities. Capital budgeting is essentially an assessment on whether a capital investment into a project or business asset is worth undertaking from a financial attractiveness perspective. A good financial analyst should recognize that superior capital budgeting ability is reflected through a sound procedure that evaluates, compares and selects between 2 or more alternatives of an investment / capital expenditure that delivers satisfactory cash flows and rates of return. There are 2 primary capital budgeting metrics that have been traditionally used for this process: the net present value (NPV) and the internal rate of return (IRR), along with a secondary derivative of the IRR the modified internal rate of return (MIRR). If 2 or more investments are compared using the NPV method, a discount rate that fairly reflects the risk of each of the investments under consideration should be chosen. It would be realistic for a financial analyst to assess different projects at different discount rates

because the risks of each project generally differs. However, a good financial analyst would always keep mind that the result of an NPV based capital budgeting assessment can only be as reliable as the discount rate that is chosen. If the discount rate chosen for the NPV assessment of an investment is unrealistic, the decision to accept or reject the investment would therefore be unreliable. Like the NPV method to capital budgeting, the IRR method also uses cash flows and recognizes the time value of money. Whilst being easy to compute and understand, the IRR method does have some drawbacks. The main problem with the IRR method is that it often gives unrealistic rates of return. Assume we are assessing the financial attractiveness of an investment with a hurdle rate of 10% and the IRR is calculated to be 30%. An immediate assumption that financial analysts may infer from the IRR of 30% is that the investment is financially attractive and should be immediately accepted. However this is far from the reality, as an IRR of 30% assumes that there is an opportunity to reinvest future cash flows at 30%, rather than an actual return of 30%. If proven, historical business performance and general economic conditions indicate that a 30% return is an exceeding high rate for future re-investments, there would be reason for a good financial analyst to suspect that an IRR of 30% is unrealistic. Simply speaking, an IRR of 30% can be considered too good to be true. Hence, unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject an investment. A good financial analyst should also be aware that the IRR method may entail more problems than a financial modeler may anticipate. Another problem with the IRR method is that the IRR method may give rise to different rates of return. Assume a situation where there are 2 discount rates (i.e. 2 IRRs) that make the present value of an investment equal to the initial investment. In this case, a financial analyst would struggle to choose between the 2 rates as a decision factor for comparison with the cutoff rate. However, in practice, the IRR method is considered more popular and straightforward than the NPV approach for financial management and decision making, especially for business executives without an advanced level of financial knowledge. Generally speaking, to balance to trade offs between the NPV method and the IRR method, a good financial modeler would rely on both the NPV and the IRR when performing a capital budgeting assessment. If the IRR results of an assessment returns a very high value, a financial modeler must question whether such an impressive IRR is possible to maintain by looking at past and existing benchmarks, as well as future business opportunities, to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If not, a good financial analyst would reevaluate the financial attractiveness of the investment by the NPV method, using a discount rate that is well researched and proven to be realistic and viable.