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Valuation methods

Comparable multiples
P/E multiple
Market to Book multiple
Price to Revenue multiple
Enterprise value to EBITDA multiple
Discounted Cash Flow (DCF)
NPV, IRR, or EVA based methods
WACC method
CF to Equity method

Understanding Value
In the context of valuing companies, it is important to
understand what we mean by value.
From an economic perspective, value is the present
value of future free cash flows (FCF) expected to be
produced by the company, discounted at the weighted
average cost of capital (WACC) that reflects the risk of
the cash flows.
For a definition of free cash flow, see cash flow template
For an understanding of the WACC, see conceptual
diagram later

Understanding Value
This value, is often called the Economic
Value or Market Value of the company.
Let us first clearly understand the differences
Economic value of the company
Accounting or book value of the company

Understanding Value: Book Value
Consider a company whose balance sheet is shown on
the next page.
The important points to note are:
Fixed assets represent the investment in property, plant
and equipment, minus the depreciation
Cash is cash on hand
Accounts receivable is the amount due from customers. It
is an interest free loan to customers.
Accounts payable is the amount owed to suppliers. It is an
interest free loan from suppliers.
Accrued expenses are amounts owed to employees,
government, etc. It is also an interest free loan.
Financial investments include holdings in other companies.

Understanding Value: Book Value

Accounting Balance Sheet

Fixed assets $1500 Current liabilities
Current assets Short-term debt $150
Cash $200 Payable $320
Marketable securities
$150 Accrued expenses $80
& financial investments
Inventory $350 Noncurrent liabilities
Receivable $400 Long-term debt $1000
Equity $1050
$2600 $2600

Understanding Value: Book Value
Finally the Shareholder funds in an accounting balance
sheet (called the book value of equity) is the amount
of equity capital invested in the company. This includes
The original equity capital invested when the company was
Additional equity invested in the company through
subsequent external equity financings minus any equity
Profits reinvested in the company.
It is important to understand that the value of equity in
the accounting balance sheet is NOT what the
shareholders can obtain if they sold the company and
paid off all the debt.
Understanding Value: Book Value
Before we relate the accounting balance sheet to
economic values, we slightly reconfigure the
accounting balance sheet.
The cash on hand is decomposed into operating cash
and excess cash.
Operating cash is the cash required for working capital
It is determined by the companys cash budgeting process.
Excess cash is cash that is not required for working
capital purposes.
It is presumably kept for strategic reasons
In this example, we assume that $25 cash is required for
operating purposes.
Remaining cash ($175) is Excess cash.

Understanding Value: Book Value
Marketable securities and financial
investments are taken out of current assets
which is now re-labeled as current operating
If there are any interest-bearing current
liabilities, they are left on the sources side of
the balance sheet.
Remaining items are re-labeled as current
operating liabilities.

Understanding Value: Book Value
Accounting Balance Sheet: Reconfigured
Uses Sources
Fixed assets $1500
Excess Cash $175
Marketable securities &
financial investments
Current operating assets
Operating cash 25
Working capital

Inventory $350
Receivable $400
Current operating liabilities Short-term debt $150
Payable ($320) Long-term debt $1000
Accrued expenses ($80) Equity $1050
$2200 $2200

Understanding Value: Book Value
The total capital (on which a return must be
provided) raised by the company is $2200:
Short-term debt = $150
Long-term debt = $1000
Equity = $1050
Note that accounts payable and accrued
expenses are not included as they are not
interest-bearing liabilities.

Understanding Value: Book Value
This capital is used to
Acquire fixed assets = $1500
Invest in working capital = $375
Acquire financial holdings in other companies and
invest in excess cash and marketable securities
(possibly for future investment needs) = $325
Note that working capital is the difference
between current operating assets and current
operating liabilities.

Understanding Value: Economic Value

Using the reconfigured accounting balance sheet

as a model, we can now create an economic
balance sheet.
The main difference is that
Values in the accounting balance sheet represent
what has been invested.
Values in the economic balance sheet represent the
current value of what has been invested.
The goal of companies is to ensure that the
economic value exceeds the accounting value!!

Understanding Value: Economic Value

Economic Balance Sheet

Free CF @ WACC $2500 Short-term debt 150

Excess Cash $175 Long-term debt $1000

Marketable securities &

$150 Equity $1675
financial investments

$2825 $2825

Enterprise value

Understanding Value: Economic Value

Fixed assets and working capital in the accounting

balance sheet have been replaced by the present value
of the free cash flow they are expected to generate in
the future ($2500).
This figure is just an assumed number.
This is the economic value of the operations of the
company and is often called Enterprise Value.
Excess cash and marketable securities are usually
valued the same as in the accounting balance sheet as
their values are unlikely to be different.
Financial investments should be valued at market
It is assumed in this example that the market and book
values are the same.

Understanding Value: Economic Value

The total value of the company is:

Enterprise Value + Excess cash + Marketable securities
+ Financial investments
In this example it is assumed the economic value
of the debt is the same as in the accounting
balance sheet.
This is more likely to be true for short-term debt.
The value of the long-term debt is more sensitive to
changes in interest rates.
If the interest rates had increases since their issue,
their value would decrease from the face value.

Understanding Value: Economic Value

In general, liabilities also include, in addition to debt,

obligations to other parties such as
Legal and environmental liabilities
Liabilities to employees such as pension
The value of equity is the difference between the total
value of the company and all its liabilities.
It is also called the market capitalization and is equal to the
share price times the number of shares outstanding.
This is the current value of the equity, i.e., what the
shareholder will receive if they were to sell the
company off at its current value and payoff all the

Constructing Economic Value
Balance Sheet

If a company is publicly traded, it is easy to construct

the right side of the balance sheet:
Debt values can be obtained from the accounting balance
Equity value can be calculated by multiplying the share
price by the number of outstanding shares.
Value of items such as excess cash, marketable
securities, and financial investments can be obtained
from the accounting balance sheet and market prices
of these items.
The enterprise value can then be calculated as the

Multiples: P/E
If valuation is being done for an IPO or a takeover,
Value of firm = Average Transaction P/E multiple EPS of
Average Transaction multiple is the average multiple of
recent transactions (IPO or takeover as the case may be)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of
This method can be used when
firms in the industry are profitable (have positive earnings)
firms in the industry have similar growth (more likely for
mature industries)
firms in the industry have similar capital structure
See next page

P/E and leverage
Gordon growth model: P0 = D1/(re g)
P0 = Stock price today
D1 = Expected next-year dividend per share
re = Cost of equity
g = Expected dividend growth rate
Assume constant payout ratio
K = Payout ratio = D1/ EPS1
P0 = K EPS1/(re g)
Simple algebra yields P0/EPS1 = K /(re g)
As leverage increases, re increases, decreasing P/E

Multiples: Price to book
The application of this method is similar to that of
the P/E multiple method.
Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each dollar
of equity invested.
This method can be used for
companies in the manufacturing sector which have
significant capital requirements.
companies which are not in technical default (negative
book value of equity)

Multiples: Enterprise Value to EBITDA
This multiple measures the enterprise value,
that is the value of the business operations (as
opposed to the value of the equity).
In calculating enterprise value, only the
operational value of the business is included.
Value from investment activities, such as
investment in treasury bills or bonds, or
investment in stocks of other companies, is

Value to EBITDA multiple: Example
Suppose you wish to value a target company using the
following data:
Revenue = $800 million
COGS = $500 million
SG&A = $150 million
All from continuing operations only
Excludes any non-operating income such as interest and dividend
Excludes interest expenses
Depreciation (from CF statement) = $50 million
Cash in hand = $25 million
Marketable securities = $45 million
Sum of long-term and short-term debt held by target =
$750 million

Value to EBITDA multiple: Example
You collect the following data about a recent takeover
in the same industry
Selling price = $40 a share (40 shares)
Cash on hand = $50 million (all assumed Excess Cash)
Marketable securities = $200 million
Market value of financial investments = $120 million
Short-term debt = $200 million
Long-term debt = $1100 million
From continuing operations
Revenue = $1000 million
COGS = $650 million
SG&A = $120 million
Depreciation = $70 million

Value to EBITDA multiple:
First compute enterprise value at which this comparable company sold.
Equity value = 40 40 = $1600 million
Enterprise value = 1600 + 1100 + 200 250 120 = $2530 million

Economic Balance Sheet

Enterprise value $2530 Short-term debt 200

Excess Cash &

$250 Long-term debt $1100
marketable securities
Market value of financial
$120 Equity $1600

$2900 $2900

Value to EBITDA multiple: Example
Next compute the EBITDA of the comparable company
from continuing operations
EBITDA = Revenue COGS SG&A + Depreciation
EBITDA = 1000 650 120 + 70 = $300 million
Compute the Enterprise value/EBITDA multiple at
which the comparable firm sold
Enterprise value/EBITDA = 2530/300 = 8.43
Compute EBITDA of your target company
EBITDA of target = 800 500 150 + 50 = $200 million
Compute enterprise value of the target
Enterprise value of target = 200 8.43 = $1686 million

Value to EBITDA multiple:
Compute equity value of target company
Equity value = 1686 + 70 750 = $1006 million
Finally, if there are acquisition costs (Investment banking, legal) and
financing costs (bank fees, transaction costs) subtract from equity value
(not done in this example).

Economic Balance Sheet

Enterprise value $1686 Total debt $750

Excess Cash &

$70 Equity $1006
marketable securities

$1756 $1756

Valuation: Value to EBITDA multiple
Since this method measures enterprise value it
accounts for different
capital structures
cash and security holdings
By evaluating cash flows prior to discretionary
capital investments, this method provides a
better estimate of value.
Appropriate for valuing companies with large
debt burden: while earnings might be negative,
EBIT is likely to be positive.
Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.

Mutiples methods: drawbacks
While Multiples methods are simple, all of them
share several common disadvantages:
They do not accurately reflect the synergies that may
be generated in a takeover.
They assume that the market valuations are accurate.
For example, in an overvalued market, we might
overvalue the firm under consideration.
They assume that the firm being valued is similar to
the median or average firm in the industry.
They require that firms use uniform accounting

Valuation: DCF method
This is similar to the technique we used in capital
Estimate expected free cash flows of the target
including any synergies resulting from the takeover
Discount it at the appropriate cost of capital
This yields enterprise value
After calculating enterprise value, equity value of
target is calculated using the same process as

Valuation: DCF method
DCF methods impose stricter discipline on the
acquiring company
They need to specify the value drivers of the
They need to provide estimates of the value
created and their sources
Allows for post-audit of the takeover based on
these benchmarks

DCF methods: Starting data
Free Cash Flow (FCF) of the firm

Template for Free Cash Flow
Less Costs
Less Depreciation
Operating Income

Profits from asset sale


Taxable income
Less Tax
Add back Depreciation
Less Profits from asset sale
Operating cash flow
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
Template for Free Cash Flow
The goal of the template is to estimate cash flows, not profits.
Template is made up of three parts .
An Operating Income Statement
Adjustments for non-cash items included in the
Operating Income Statement to calculate taxes
Capital items, such as capital expenditures,
working capital, cash from asset sales, etc.
The Operating Income Statement portion differs from the usual income
statement because it ignores interest. This is because, interest, the cost of
debt, is included in the cost of capital and including it in the cash flow
would be double counting.

Template for Free Cash Flow
There are four categories of items in our Operating Income Statement.
While the first three items occur most of the time, the last one is likely to
be less frequent.
Revenue items
Cost items
Depreciation items
Profit from asset sales
Cash from asset sale Book value of asset
Book value of asset = Initial investment Accumulated depreciation
Adjustments for non-cash items is to simply add all non-cash items
subtracted earlier (e.g. depreciation) and subtract all non-cash items
added earlier (e.g. Profit from asset sale).

2006 M. P. Narayanan 38
Template for Free Cash Flow
There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or
Property, Plant, and Equipment (PP&E))
Working capital
We need to include only additions to capital (both fixed
and working) since the capital originally invested is still
employed in the project.
It is important to recover both types of capital at the
end of a finite-lived project.
Recover the market value property plant and equipment
Cash from asset sale
Recover the working capital left in the project (assume full

Template for Free Cash Flow
What is the FCF template Revenue
actually doing?
Less Costs
See table on the right
Less Tax
The template is longer because
of tax calculations Less increase in working capital
Items on the right are the value Less capital expenditure
drivers Cash from asset sale
You may view this as a Free cash flow (or unlevered CF)
conceptual template

Estimating Horizon
For a finite stream, it is usually either the life
of the product or the life of the equipment
used to manufacture it.
Since a company is assumed to have infinite
Estimate FCF on a yearly basis for about 5 years.
After that, calculate a Terminal Value, which is
the ongoing value of the firm.

Terminal Value
Terminal value can be calculated several ways:
Use the constant growth perpetuity model with a
long-term growth closer to economy growth rates.
Works for mature industries
Estimate a two- or three-stage model,
Higher growth rate(s) in the initial stage(s) (for about 10
A lower long-term growth for the final stage
Use a Enterprise value to EBITDA multiple based
on industry averages to estimate terminal value

One of the issues in the valuation of companies for
acquisition is what WACC to use.
Should we use the target companys WACC or the
acquirers WACC? Or something else?
As always, the answer is it depends.
If a conglomerate is buying a target company, it is
appropriate to use the target companys WACC.
There is likely to be very little interaction between the
target companys operations and that of the acquirer.
If it is a horizontal merger, the WACC of acquirer and
target are likely to be close.
A weighted average WACC may be appropriate (weights
based on the enterprise values of the two parties)

The idea is that if the integration of the target
with the acquirer is minimal, the targets
WACC is appropriate.
If there is substantial integration, but
companies are not in the same industry, it
becomes more difficult to figure out a precise
WACC to value the target.
The issue has to be dealt on a case by case basis.

Valuation of private companies
Private company stocks are very illiquid
Similar to small firms with less liquid stocks, private company
stocks also will sell at a discount. The liquidity issue much more
severe with private companies.
Private company owners are likely to be less diversified.
Therefore, they bear both the market risk and the
company-specific risk, increasing their cost of capital and
decreasing the value of the firm to them.
If you own only GM stock you are bearing the risk of the auto
industry as well risk that is GM-specific (a strike at GM).
If you own all the auto company stocks (GM, Ford, Toyota,
Nissan, Volkswagen, Diamler-Chrysler), you bear only the auto
industry risk.

Valuation of private companies
The typical method of valuing a private company
is to value it as if it is a public company and then
apply a discount for the reasons stated earlier.
Find a pure-play and use its WACC to discount the
cash flows of the private company
Pure-play is a public company that has the same business
risk as the private company
Or, use the multiples of a public company
The trick is to compute this discount. There are
ways to get some handle on this discount.
The discounts are in the 20-40% range

Weighted average cost of capital: Overview

Lenders Stockholders
Required rate = 8% Required rate = 12%

Annual return

Annual return

Equity capital
Debt capital



deduction = $1.12
Annual tax saving

(35% of 3.20)
from interest

Total return = $10.40

Annual return
Total capital


Rate of return on capital

required to payoff the debt and
minimally satisfy stockholders, Operations
i.e., WACC Required rate = 9.28%

Costs of debt and equity
Cost of debt can be approximated by the yield to
maturity of the debt.
If the yield is not directly available, check the bond
rating of the company and find the YTM of similar
rated bonds.
Cost of equity
Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the
assumption that market is efficient, this is the required re.
You need an estimate of future dividend growth rate to do this.
Therefore, works better for firms with a history of dividend

Valuation: CF to Equity method
In the WACC method, we compute
Enterprise value by discounting the free cash flows at
Add value of any financial investments
Subtract value of debt to obtain equity value
In CF to Equity method, we
Compute CF that are available to equity-holders
This is Free Cash Flow less principal and after-tax interest
Discount this at cost of equity and directly compute
equity value

Equity value: WACC method
Value from Value from
Operations investments

Enterprise value Value generated

Value of Debt
Equity value

All are values: CF discounted at appropriate cost of capital

Equity value: CF to Equity method
FCF from CF from
Operations investments

Total CF generated

CF to Debt
(Principal, after-tax
interest) CF to Equity
All are CF

Equity value = CF to Equity @ re