Firm Valuation

 How is value measured? Choose methodology Apply reasonable assumptions Value is something subjective contingent on: For what? (liquidation, restructuring, continuity...) For whom? (buyer/seller, controlling/minority...) In what context (sector, country...)

An adequate valuation methodology...

Accounts for a firms capacity to generate future CFs Accounts for an initial forecast period (5, 10..years) Allows calculation of continuing value (beyond forecast period) Considers time value of money

Valuation Methods
Relative Valuation
Comparable transactions Multiples from publicly-listed firms

Discounted cash flows

Relative Valuation

1. Comparable transactions
Provide a value reference based on historical transactions that have taken place.

2. Publicly traded firms as comparables

Provide a wealth of information Provide market-driven measures of value

Determining comparability
Same industry is not always enough Size, capital structure, credit status Management experience Nature of competition, maturity of business, earnings behavior

Once comparability has been determined

From comparable firms, find ratios between value and income statement variables. Knowing target firms income statement variables, use ratios from comparables to find targets economic value.

A simple example
Assume that, on average, purchase transactions of pharmacies reach 4 times annual sales. Thus, if we wish to acquire a target whose annual sales are $900,000 then we should pay 4 x $900,000 = $3.6 mill

Enterprise value 4 Annual sales

Enterprise Value = Market Value of Equity+ Debt Non-operating cash

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Choosing multiples
In general, there is a tendency to assume that an equally or value-weighted average of same-industry firms will suffice as benchmark. Practitioners prefer median instead of mean values. However, if our target is on the highest or lowest end of sample, then multiples should be chosen more selectively than the median.

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Why use ratios from comparables?

Easier to share with clients Avoids a lot of number-crunching and assumption-making

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Understanding the implications

DPS1 P0 ; rE - g Dividing each side by EPS and assuming stable growth... DPS 1 g P EPS Payout 1 g E rE - g rE - g

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When choosing multiples

Are definitions consistent? (PE ratio) Are the numerator and denominator consistent? (P/EBITDA) How are outliers handled? How are negative values handled? (PE) Understanding implications

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Some widely used multiples

Price/Earnings ratio (PE ratio) Equity value/FCFE Enterprise value/Sales Enterprise value/EBIT Enterprise value/EBITDA Note: Forward looking earnings figures have been found to work better

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Why Enterprise Value?

Enterprise Value = Market Value of Equity + Debt Non-operating cash

Unlike the PE ratio, it takes into account that an acquirer will also have to take over the targets debt. Recognizes that the presence of cash is an implicit cost reduction, since it goes to the acquirer.
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Discounted Cash Flow Method

Of the available valuation tools, a discountedcash-flow analysis delivers the best results
McKinsey on Finance

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The relevant Cash Flows

Operating CFs
Not affected by financing decision Generated by use of firms assets

Free CFs
Available to all providers of funds (s/hs and b/hs)

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Free Cash Flow

EBIT
Minus: Plus: Minus: Minus: EBIT taxes EBIT x (1-t) Depreciation Operating Cash Flow Additional investment in working capital Investment in Fixed Assets (or Capex) Free Cash Flow
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Working Capital
How much do firms tend to hold as WC? 1%, 4%, 15% of sales Historically, how much cash was held by companies? 4 to 6% of sales Can WC be negative? How does this affect our valuation?

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Capex
This component may not follow a stable behavior. Thus, last years value may overestimate or underestimate Capex We may need to normalize Capex

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FIRM VALUE =

PV of CF from firms operations

+
PV of non-operating assets

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FIRM VALUE =
PV of CFs from operations

PV of residual CFs from operations

+
PV of non-operating assets

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EQUITY VALUE = PV of CFs from operations

PV of residual CFs from operations

+
PV of non-operating assets

Value of interest-bearing debt

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Steps
1. Forecast FCFs for all providers of funds 2. Estimate residual value at end of forecast period 3. Discount forecasted FCF and continuing value at WACC 4. Add any value of non-operating assets 5. To find value of equity, subtract value of debt

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Step 1: Forecast Period

FCFs must be explicitly calculated on a year by year basis until
Firm reaches stability and thus FCF can be considered as growing at a constant rate Firm is liquidated In general, the forecast period does not exceed 10 years.

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Step 2: Continuing Value at T

Value of operations beyond forecast period
FCFT (1 g) Continuing Value T WACC - g WACC g
T 1

FCF

g is the expected growth rate of FCFs under perpetual conditions.

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Importance of continuing value

Percentage of total firm value using an 8-year forecast period
Tobacco: 56% Sporting Goods: 81% Skin Care: 100% High Tech: 125%

Copeland, Koller & Murrin 2000

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Assumptions regarding determinants

Earnings reflect a normalized trend consistent with the last year in forecast period. Operating costs are assumed stable. Growth rate needs to consider general economic growth

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More on g
Many argue that g should reflect the expected nominal growth of the economy. Does this mean that, in the end, all firms will be applied the same g? Can we use a g that is smaller than economic growth? Can we use a negative g? How long is the transition period from the forecast period to stability conditions?

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Step 3: Discount at WACC

Weights Cost of equity (CAPM) Cost of Debt (CAPM, Debt ratings)

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Is CAPM adequate for any type of firm?

CAPM assumes a diversified investor. This may not be the case. May have to adjust beta. In addition, small firms with high PE ratios seem to generate higher returns than those explained by CAPM For foreign investments, a country risk measure may be necessary

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CAPM adjustments
Adjustment for lack of diversification
BetaTotal BetaMarket R2

Size premium (2-4%). Liquidity adjustment (some sources suggest discounting firm value by as much as 30%)

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Country Risk
Default spread x (Sigma for equity)/(Sigma for debt)

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Step 4: Add non-operating assets

Financial assets Property not related to operations Other investments (acquisitions)

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Additional adjustments: Valuation levels

1. Value as controlling s/h + Liquidity 2. Value as minority s/h + Liquidity 3. Value as minority s/h + Illiquidity

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Why are adjustments needed?

When market multiples of comparable firms are used, we are implicitly assuming liquidity. Is this always the case? When we insert optimal financing and synergy expectations, this assumes we will control over both decisions. Is this always the case?

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Discounts
Discounts are multiplicative and not additive. On average, court rulings and other sources imply a 25% to 45% minority discount. Most marketability discounts fall in the 30% to 40% range.

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Thus,
Shareprice Minus minority discount of 35% : $10.00 $6.50

Minus marketability discount of 30% : $4.55

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Other discounts
Key person discount:20-25% Portfolio discount: 10 to 15% Voting versus non-voting shares:5 to 10%

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A question
How much is the minority position of a private firm potentially worth?

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Valuing new firms

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Where do get the information for valuation?

Current financial statements Historic financial statements Information from comparables

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Fine-tuning new firms

Negative Values
Impact on growth estimates Survival implications

Revenues versus Earnings Adjusting Operating Income (EBIT)

Capitalizing R&D Operating Leases

Multiple WACCs

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Risk-free rate
The risk-free security should have no default or reinvestment risk. Thus, we should use a government zero-coupon bond. Since deal with CFs in different time periods, we would need zeros with 1 year, 2 yearetc maturities. A more practical approach is to estimate Duration of our CFs and use this to determine the T-bond maturity we are looking for.

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MRP
Using historical averages assumes history repeats itself. This may be complicated to assume, especially for new firms. Using the implied MRP by solving for it from market values may be more adequate.

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Beta
Try to use bottom up betas. Are regressions based on historical information a correct reflection of our reality?

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Growth
Historical growth may be a problem Analyst estimates generally cannot provide longterm growth prospects Perhaps a fundamental analysis Use Reinvestment rate=(Cap expenditure Dep+change in WC)/EBIT(1-t) Return on Capital = EBIT(1-t)/Cap Invested Growth = Reinvest. Rate x Ret on Capital We can also use revenue growth, estimate operating margins and get to an earnings growth estimate.
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Other valuation approaches

1. Adjusted present value (APV): VL = Vu + PV of tax shield - BC, where Vu is the PV of FCFs discounted at Re of unlevered firm. Equity Value= VL Value of debt 2. Directly valuing Equity: Equity value= PV of CF for equity holders (FCE) discounted at Re of levered firm, where CFE= NI-(Capital investment-Depreciation)- Inv. in Working Capital- Principal payments+New debt issues

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Expected growth (of EBIT)

g EBIT Reinvestment Rate x Return on Capital where, Capex - Depreciation noncash WC Reinvestment Rate EBIT1 - t EBIT1 - t Return on Capital Invested Capital

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