Schema cf

#27 Cod. 20137

Corporate FinanceGeneral concept on Value and its implication:_____________________________________________________1

Understand the company positioning in the market_________________________________________________________1

What we need to do to boost value creation:______________________________________________________________4The cycle of business and the perfect owner theory_____________________________________________________________________4M&A Transaction________________________________________________________________________________________________4Disinvest from business____________________________________________________________________________________________6Capital structure_________________________________________________________________________________________________7

How to implement value enhancing strategies and how to ensure management to recognize them:__________________8Governance & compensation scheme________________________________________________________________________________8Information gave by the market and managerial implication_____________________________________________________________10

Valuation methodologies are based on several variants:____________________________________________12

DCF Model_________________________________________________________________________________________12WACC Estimation:_______________________________________________________________________________________________12OFCF Estimation:________________________________________________________________________________________________13Final remark and ending procedure_________________________________________________________________________________18The CAPM approach needs:_______________________________________________________________________________________18

Multiples model_____________________________________________________________________________________20

Economic Profit (EVA) Model__________________________________________________________________________22

APV Model:_________________________________________________________________________________________23

Equity DCF Model [Used for banks]:_____________________________________________________________________23

Special valuation case:________________________________________________________________________________23Emerging market valuation:_______________________________________________________________________________________23High growth industry_____________________________________________________________________________________________25Cyclical industry valuation both from a managerial prospective and a financial one___________________________________________25Bank industry___________________________________________________________________________________________________25Insurers:_______________________________________________________________________________________________________26

General concept on Value and its implication:

Value is a broad measure well expressed by cash flow trend, and it reassumes the healthiness of a company, since it represents the interest of all the stakeholders, granting prosperity to all the community/business. Furthermore it is a long time measure used to assess fundamental driver for stock price and it is not biased by short term deviation which are consequence of bubbles. Measure of value creation, expressing the firms’ competitive advantage, are ROIC spread and Growth1. There is a direct link between future cash flow and competitive advantage, the higher the second the higher will be the first. This relation is the reason behind the value reasoning, in fact increasing value is equal to ask the business to increase its competitive advantage. The investment

rate is given by IR=growthROIC

=Net Investement

NOPLAT it clearly shows the relationship between cash flow and value

Understand the company positioning in the market

The first task to be performed when valuing a firm is to define if there is any competitive advantage and its weakness and strength compared to benchmark peers and their cause. We could implement several models/scheme to properly address the value sources: The first three to be presented are qualitative models and they are focus on understanding the positioning of the firms’ goods (the first),

the firm’ market placement with a dynamic approach (the second one) while the last one is a qualitative representation on where the competitive advantage has been manifested:

The Porter Model outline the mixtures of internal and external factor to define profitability:1. The less intense is the rivalry in its industry the better, higher margin are possible; 2. The less danger of potential entrants & the higher the barriers to entry; the higher is the retentions of extra profit

o Tangible barriers – anything that would put a potential entrant at a competitive disadvantage after entry i.e.

1 Note that an higher growth is positive only in the case of a positive spread between ROIC and WACC otherwise the company will increase the value destruction, however investing in growth will lower the ROIC, since the marginal value contribution of new added project will decrease as well [many companies decide to not invest due to the fear of decreasing their ROIC]

1

#27 Cod. 20137

Scale-based cost advantages, scope-based cost advantages: when fixed costs can be shared among different products,

Knowledge-based cost advantages: when experience is an important factor in knowing how to do things efficiently,

Financial resources: when firms are able to fight off new entrants by cutting prices as a result of hav-ing significant financial resources available,

Favored access to particular resources: when existing firms control resources that are useful or es-sential to efficient operation (For example, airlines may control landing slots at favorable times.),

Favored access to distribution channels: when existing firms can more easily reach the customers Customer goodwill and reputation: when a firm has built up a loyal customer base, but new en-

trants have to win those loyal customers away or convince new customers who were not buying the product to do so

Customer lock-in: when customers tend to continue with the original firm because of issues such as compatibility with existing equipment, economies in maintenance & repair, etc.

Legal & political restrictions: when firms are protected against entry by legal restrictions such as government certification or licenses (Existing firms may also encourage the government to ban for-eign competitors from entering the industry.)

o Psychological barriers – beliefs on the part of potential entrants that, if they enter, firms already in the busi-ness will react aggressively, and are even willing to incur short-term losses, to force out the new entrant

Fighting off an entrant or two is one way for a firm to gain a reputation for being willing & able to fight off new entrants.

Maintaining excess capacity for production or distribution Keeping patents & products on the shelf ready for use if needed can also send a strong signal

3. The less numerous and less aggressive the firms that sell substitute products, and the more numerous and more ag-gressive the firms that sell complementary products;

o If there are many good substitutes for a product, the elasticity of demand for that product will be high. This will limit the ability of the firm to raise prices and will consequently lower potential profits.

4. The weaker the bargaining power of clients/customers; o The client industry is highly concentrated. (The firms buying the product are in an industry in which there are

just a few companies and they are large.)o One particular client industry buys a very large share of the products o The item is not essential to the clients; there are lots of possible substitute in the clients’ production process.o The cost of the item is a large fraction of the clients’ costs/budget. The client is then likely to resist attempts

to push up prices.5. The weaker the bargaining power of suppliers

o The supplier has a franchise or patent on a particular item that is required by firms in the industry.o The supplier is not restrained by any clause substitutes for its product.o The supplier industry is concentrated and the firms are not aggressive rivals with each other

Another technique to represent the competitive positioning is the SWOT analysis: It divides the success mixture in internal factor: Strength and weakness: related to brand, management or any other

variables related to the goods or firms’ business model And those who are external: Opportunities and threats, such as geographical barrier, market evolution or any variables

related to macro change in the society/ countries Consequence and reasons of the presence of competitive advantage is measured by the firm's profitability: it can be above or

below the industry average. This is a consequence of: Price premium side:

Innovative product are difficult to copy or are protected by patent Quality: the customer are willing to pay more for a better goods Brand: differently to quality the costumer are willing to pay more even if there is no quality difference Client lock-in: clients are unable or unwilling to change goods

Cost and capital efficiency side: o Innovative business method: hard to be copy since it isn’t directly observable o Unique resource, Economies of scaleo Scalable product: any new clients have a low margin cost (common in IT industry)

The higher profitability can be preserved in the long term only if it is sustainable

2

#27 Cod. 20137

Other possible schemes to be use are those inside the quantitative family. These models consist of computing specific value driver measure, which are ROIC and Growth:

o High ROIC companies should search for higher growth, and the opposite strategy should be pursued by low or negative ROIC-WACC spread companies, those companies should operate on their efficiency and value creation before looking to growth

We should reorganized the financial statements in effort to have a clean measure of total invested capital and its related after-tax operating income, needed to compute ROIC

To better understand ROIC, we can decompose the ratio as follows

ROIC=

(1−t )∗EBITARevenues

∗Revenues

IC As the formula demonstrates, a company’s ROIC is driven by its ability to (1) maximize profitability, (2)

optimize capital efficiency, or (3) minimize taxes We can further decompose ROIC as much as we want, if you are working inside a company or if the com-

pany releases operating data, you should link operating drivers directly to ROIC. All this work will give you a better insight2

It is hard to retain for long period high level of ROIC. There are several empirical research to demonstrate those trends divided by company quintile

ROIC is easier to preserve than growth rate by continuing introducing new product and by pursuing inno-vation, there is an empirical evidence that best player will be able to preserve those advantages

Any goods portfolio will go toward a common base line after tot years Every sector has a typical average ROIC level, however there is a large range within the same sector and

the difference among industries Nowadays the trends are positive for Health care equipment and Aerospace defense, while it is trending

down for Auto, Tracking, Advertisement and health care facilities Size do not matter

o Organic Growth can be pursue by introducing new product, expanding the market share, while the inorganic one by acquisi-tion, all of them show a marginal decreasing value contribution

The ability to grow cash flows over the long-term depends on a company’s ability to organically grow its revenues Calculating revenue growth directly from the income statement will suffice for most companies. However

the year-to-year revenue growth numbers sometimes can be misleading. It is also useful to decompose the Growth rate using the information on the business characteristic to as-

sess subunits/divisions expectation Growth compared to ROIC is harder to sustain, even if both ultimately depends on the underling product’s life cy-

cle, since market dimension is caped and mature growth rate is basically the economic underling. Hence, the three prime culprits affecting revenue growth are:

Introduce new product: higher3 value creation but longer and harder to implement; Expand the market size: it can be made by attracting new customers or by pushing the existing one to

buy more Increase its own market share: it isn’t a long term strategy, any movement in the market will trigger a

reaction form the competitors. It is a winner strategy only for big players which are bale to force out smaller competitors entirely

Mergers and Acquisitions. When one company purchases another, the bidding company may not restate historical financial statements; this will bias one-year growth rates upwards. There could be two types

o Bolt-on where the bidder will acquire small business to increase its portfolio or filling gap distri-bution channel

o Large acquisition where the bidder try to acquire same size business, those strategy shows poorer value creation and are focus only on the cost side, revenue do not increase

It is hard to grow since the base level on which growth it’s computed increase over time, hence the firms should introduce new products at an increasing rate. Some empirical papers show:

Big company has lower growth High “g” business will rapidly loss power There is an higher dispersion value in the market than ROIC Business tends to grow at an higher rate than home economy due to:

2 We can desegregate by units, by division, by stores, which can be divided in # transaction and in amount of transaction, where # transaction by square feet/store and transaction/store 3 However this measure doesn’t account of the risk of the project, there is no risk correction [fuzzy comparison]

3

#27 Cod. 20137

o Based sample(public company are better than other)o Growth is usually carry out in other economyo Outsourcing strategy do not increase GDP, but business in that high specialized sector will grow

The last angle to be understand, besides the value/competitive advantage side, is the intrinsic risk beard by the company, since future cash flow are affected by the strategies that have granted to achieve those market positioning (any policy aiming to enhance this units will in-crease both the cash flow, but even the risk/volatility of these flows).

o Companies must decide between the tradeoff of bearing too high risk (survivorship is challenged) and higher profit/margin, and they must internally decide which risk is going to be hedged, considering the marginal cost against its benefit, which are granted by the more favorable market judgment on more stable cash flow

o To understand if the business is sustainable, to assess the aggressiveness of a company’s capital structure, we examine: Liquidity – the ability to meet short-term obligations. We measure liquidity by examining the interest coverage

ratio defines as: EBITDA / interest measures the ability to meet short-term financial commitments using both profits, as

well as depreciation dollars earmarked for replacement capital. EBITA / interest ratio measures the ability to pay interest without having to cut expenditures intended to

replace depreciating equipment. Leverage – the ability to meet long-term obligations. Leverage is measured by computing the market-based debt-

to-value ratio The use of leverage magnifies the effect of operating performance. Specifically, with a high leverage ratio

(a very steep line), the smallest change in operating performance, can lead to enormous changes in ROE The higher the leverage ratio (IC/E), the greater the risk, since fixed asset are financed by redeemable

What we need to do to boost value creation:

After understating the firm’s competitive advantage and market positioning we should study how to Boost value creation, we should aim to solve the weakness discovered in the preliminary phase to increase either ROIC or Growth depending on their relative value. We will speak about the perfect owner theory which will allow us to understand how properly run a business by identifying when we need to reallocate/allocate re-sources and how to set up a proper capital structure depending on the business’s life cycle .

The cycle of business and the perfect owner theory

The scope of this theory is to explain and justified how ownership matter in creating value. The main idea is that any goods/business has a life cycle and each of these phases should be run by a specific type of shareholder/management. Hence the best owner is not static, it is dynamic moving from large institution to venture capital: First phases are suitable for founder to stimu-late entrepreneurship, When the company starts to develop there will be the entrance of angel or venture, providing more capital and manage-rial skills; Go public to rise more money, and create governance control to align managers interest with investors; Go in M&A or fusion to in-crease in size & Go in private equity transaction to reconstructing or refocusing the business Executive have to think about their business as a portfolio of different asset, where any of them have an economic cycle, so to obtain the

maximum value they need to be managed using specific skills that can provided by specific owners’ class, such as:o Unique links with other businesso Distinctive skills (managerial or functional)o Better governance, for a specific time there is the best business form o Better insight and foresight (be able to capitalize on innovation)o Influence on critical stakeholder (it is crucial in emerging market)

Hence, the correct approach is to create a corporate strategic team focus on constructing the perfect portfolio by4:o Determining the market value of the company as whole and comparing it by the management expectation to see if there

exist any gapo Identifying and valuing new opportunity internallyo Evaluating if it is the case to disinvest form some businesso Identifying potential acquisition or other initiatives; the best investment for high performing management is usually a com-

pany in a financial distress or poor returno Value how much the company may gain from a changing in the capital structure

The tool used to maximize the value creation are: M&A, Disinvestment and capital structure strategies led by this theory

4 Remember that the diversification for a company is not a source of value, investor can do the same with lower cost, and hence conglomerate strategy doesn’t add value. the manage-

ment doesn’t have confidence to properly finance the different business to anticipate cycle and they don’t use their more stable cash flow to increase leverage compared to their peers, moreover the different division usually performs less than standing alone business line due to lack of focus

4

#27 Cod. 20137

M&A Transaction

M&A are an important element in a dynamic economy, in fact it is the best (and sometimes the only) way to sensibly reallocate resources. M&A aims to create value both for the whole economy and for the investors; in fact better ownership is more probable to increase the profitability of the business itself. Since Value “amount” creation in M&A is not sure and it must be share between the bidder and the target and the usual pay-ment methods consists of an up-front premium payment to the target by the bidder, we can easily assess that this value distribution is favoring the target shareholders5. M&A deal shows some peculiar features: they happen in waves [a pre signal the beginning of the phase is the lowering of the interest rate, allowing big leverage buyout]; Favorable elements to the bidder are: if the acquirer has strong performance, low transaction premium and being the sole bidder helps. There are some myths on success or failing: size relative to target, accounting magic (like change in EPS dilution) and the relationship between SIC code of the players. There are several possible value source in the M&A transaction, they can be classified as synergy and control one, here there is a list:

o Improving the target performance by working on possible improvement on the revenue side either by reducing cost or by managing the company more efficiently

o Consolidate or remove excess capacity from the market (even less tangible like reducing sale force, not only factories)o Create market access to geographical area (sometimes it is a prerequisite)o Acquire new technologies more quickly and cheaper than develop them internallyo Roll up strategy, when a business as a group can realize substantial cost savings or achieve higher revenue than the individualo Consolidate to improve competitor behavior, meaning create oligopoly, which is hard both because of country legislation

against monopoly and because of the difficulty bear by companies to avoid new entrance in the marketo Enter into a transformational merger, to totally modifying the underlying business, refocusing the businesso Buy cheap business in down economy and restructuring them o Pick winners early and develop them, by exploit the so called cash slap problem, meaning bigger company have more avail-

able cash to be implemented in costly project retain by the target who cannot implement them due to cash constrain o Tax benefits (loss on the target or specific benefits that cannot be exploit by the actual owner, or by write up asset, increas-

ing future depreciation) together with all the other financial benefits: Lower capital cost, Better capital structure and Differ-ent seasoning evolution [use of internal cash flow]

The synergy component is estimated by looking after possible operating and financial improvements (higher cash flow or lower discount rate) achievable only thanks to the merger with an industrial partner.

o Estimating cost saving must be structured using a disciplined methodologies, meaning we should allocate any improvement to a specific items, being clear and focus on how to achieve it. It is crucial to involve the experienced line management, and to compare the combined result with the comparable benchmark to avoid unrealistic plan

o Estimating revenue improvement must consider the possible loss of clients and value manger in the operation and the possi-bility to incur in additional cost to uniform the business model. Be explicit about where any revenue growth is going to be obtained. This estimation is harder

o Estimating Financial synergies is worked out by trying to assess the ex-post firm structure, valuing the additional valueo A final comment on the implementation and timing:

It is important to understand that any value source are not be on the table forever after the merger, hence it is cru-cial to capture all of it as soon as possible

The M&A transaction must be led by a detailed plan to be implemented at day one Empirical result shows that companies are quite good in assessing the cost saving, while they are too optimistic on

the revenue improvement side The control component is related to the possibility to increase value by properly/efficiently manage the business, this kind of value is totally

linked to the target own business and should be paid entirely to the target. How to value this lack of efficiency:o At first we should estimate the as-usual value (business run by the old management). Then we will perform another valuation

assuming to solve all the inefficiency, the difference (if any) with the base value is the control valueo A final comment on the implementation of this strategy: Even if it is an “easy task” to improve management efficiency it is

rare/hard to run an M&A transaction lead by this motivation, since the target management will strongly react against this operation and it’s not obvious that target shareholder will accept the bidder offer, so since the legislation on defensive tactics is quite open it is hard to run hostile takeover, unfortunately this is a decrement for the whole economy (lack of value en-hancement)

There are different ways to pay, each of those present different advantage and disadvantage:

5 Proved by empirical results which demonstrate that the winner part is always the target (however the overall aggregated value is higher than before)

5

#27 Cod. 20137

o Cash payment6 [assuming no financial constrain for the buyer] can result in a lower premium compared with stock one and can testify the bidder’s confidence on the deal, since in case of future loss (due to misleading valuation) there is no possible ex post correction on the price paid, furthermore there is a tax issue since the old investor must paid tax on capital gain

o Stock payment (the Bidder will exchange own stock (newly issued) with those of the Target one) is a little bit more expensive, but there is the sharing of risk, so if you are not confident enough confident this method is the better, otherwise cash.

o There are other mean of payments to solve specific problems: Vendor loan: sometimes Bidder doesn’t have enough resource (multimedia case), hence the Target can help by

providing a loan (usually really cheap condition) Convertible: it is a compromise between cash and equity Earn-out7: it is more complicated and it is a sort of postponed payment related to the Target performance without

issuing equity. It is a good compromise The Target will lock in a base value, and will participate in the upper side The transaction can be speed up thanks to this clause The parties must decide how will be settled the compensation and the measurements of performance8 It is possible to hedge this risk by using a collar option to avoid downside by forgo the upper side. This

may be good for the Target to reduce the volatility Squeeze-out: the option to force minority with less 5% if the OPA reach 95% to sell Sell-out right: sell the reaming 10% at the same condition

o Some final comments The concept of accretive: it is a misleading one and it doesn’t put in evidence the economic ratio behind the lower

market multiple of the target (something must be wrong), that problem can drop the bidder value down, or by the presence of some distortion on the P/E

The synergy sharing process depends on the bargain power of the bidder (the synergy can be achieve only by him) on the offer typology (private placement or auction) and on relative dimension

Defensive tactics allowed for Target are country/area specific. There is the conflict of two principles: the efficiency of the market and the protection of national or valuable situation. In EU the new Takeover bid clearly define which tactics can be implement by Targets and Bid-ders, here there is a list of the most famous and used one:

o White knights the Target will ask to another firm, which is consider friendly, to bid for the transactiono Golden parachute or silver one the Target grants to top management big compensation in case of hostile takeover, this

rules is usually set to protect executive that will be fire after the transaction o Poison pillow the board will issue new stock at discount to increase the cost for the Biddero Crown jewel the Target will sell all the valuable asset to other and will cash out o Labor agreements they can hamper the Bidder possibility to effectively change production

Disinvest from business

Even if divestures create value and there are several empirical evidence that companies employing balanced portfolio approach perform better than companies that rarely disinvest, this procedure is undergo only due to external pressure not for a proactive program, and tends to happen in wave as M&A, and nowadays public ownership transaction has become the principal mean for disinvesting. This behavior is mainly due to two circumstance: The management typical adverse perception of divesture due to the general idea that disinvest means failing, furthermore reduc-ing the size of the company is a negative prospective for Executive salary and maybe difficult to find an alternative investment, in fact either 1)holding cash will lower the performance, or 2)repaying debt will be the same of invest at the debt cost, which is usually by far lower than asset return or 3)buying back stock can be problematic as well since the market can react negatively (the company doesn’t have future project) However this strategy allows companies to create value form these sources of value:

o Disinvest form a underperforming business avoids the direct costs of bearing deteriorating resultso The subsidiary can be more competitive or better managed under other ownershipo There is the possibility to take advantage of asymmetric informationo The possibility to focus on the core businesso Problems solved by divesture:

There could be the case of an incompatible culture or of a possible conflict of interest with the subsidiary business The parent could not have the experience and skill to develop properly the business Underperforming business brings down the value of the entire corporation

6 Do not do this for high growth companies 7 It can be set on the overall business (warrants) or just to the Target one (contingent payment), each of them have its own advantage and cons 8 There could be problems on monitoring, external events and rise of conflict of interest. That’s way it is crucial to properly address all the possible situations/problems

6

#27 Cod. 20137

To properly set up a disinvest strategy a company must spend regular and dedicated session for exit review meeting, forcing the manage-ment to evaluate all businesses:

o The first step is to understand the entity of synergies and shared asset, services and system, in this way the management can understand which is the cost of the operation

o The mixture of different type of business allows to reduce the operating risk, and this will grant an higher financial capacity o If the operation is undergo is really important to understand and well define the legal aspect of the operation to avoid any

slow down during the transaction or unpleasant surprise after the transactiono Consider the market valuation to discover if there is a significant mismatch between intrinsic value and current valuation (ex-

ploiting asymmetric info). In a sense liquidity in the market allows divesture to be more attractive Type of transaction can be private or public, the first one is better if you can identify a proper bidder, not all the transaction bring a cash

proceeds, many create long term value by giving new share to existing shareholder:o Equity curve out: in this way the parent doesn’t give up control on subsidiary, to maintain same synergies

However, the separation is typically irreversible, due to possible dilution of parent ownership, hence it is important that parent executive need to plan a full separation since the beginning of the transaction

The risk of unclear governance is present in this type of transaction, and this can destroy the benefits that were supposed to happen. Any subsequent reacquisition is typical a negative sign and empirical research shows that any blend strategy doesn’t grant positive return for the shareholders

o Spin off: the parent gives up the control of the subsidiary, which shares will be divided through parent shareholders, allowing the maximum strategic flexibility for the subsidiary9. Sometimes this transaction is done with a two-step: at first a partial IPO followed by the spin off, this typology allows the existence of a market for the parent shareholder in the case they want to liquidate their stake

o Split off is an offer to parent shareholder to exchange their shares with those of the subsidiary, so the equity will be divided o Tracking stock is a new possibility that allows the parent to retain control, but create severe problem of governance, in fact

the board will be the same Each entity will liable to all the group debt, hence there is no financial advantage, furthermore empirical research

have proven that there is no value creation for this transactiono IPO is the way the new share are issue in the market to new investorso Joint venture and Trade sale are the private transaction

Capital structure

Consequences of the capital structure and the typical tradeoffs in defining the optimal structure10:o Tax savings is granted by the possibility to reduce the taxable income, and therefore increase the value of the company.

However there is an important consideration to be made: usually taxation on interest income is higher than on capital gains for investors, hence with a 100% debt funding the investor tax rate could be higher

o Reduction of corporate overinvestment: debt can help impose discipline on mangers; therefore the management is forced to pay back the debt interest expense before making another investment. This is quite crucial for highly fragment ownership

o Cost of business erosion and bankruptcy: highly levered company could forgo good investment opportunity or reduce R&D (loss of flexibility), moreover they can lose client, employers and suppliers due to the risk of a financial distress

o Cost of investor conflicts may become crucial, the two main investors categories can have different view on how to run the business (different risk appetite, moral hazard problem)

o Besides all this consideration there isn’t any analytical formula for the optimal choice, because every business have different needs and characteristic, which will require different level of flexibility and robustness form the financial side

The tools used by firms to finance their business are (form the most preferred to the less one): Internal resources, in other world reinvest-ing the income; issuing debt, which is the more common practice. There exist several possible instruments to be issue; & issuing equity which is the last resort because it can cause the share price to fall. Some empirical data:

o Firms ends to react to regain their target capital structure after a change only after two years rather than immediately after each change; continuously adjustment are too costly and impracticable

o Firms are likely to issue equity when they are overleveraged compered to their target How to set an effective capital structure:

9 The subsidiaries show the higher performance improvement (empirical test)

10 Debt leverage matter less than we have expected, in fact firm’s structure is usually set up more in a negative way, by trying to avoid losing value more than achieving higher value with a prospective attitude The cost of an error is more costly than any possible advantages. Market surveys have proven that the firms prefer a rating range between A+ and BBB-, for structure outside this range the loss of value or the cost are too high in fact among this range the value of the tax shield difference is really slim

7

#27 Cod. 20137

o Look at the peer group is a good approach; at least firms are not giving away any competitive advantage derived by the capi-tal structure. This problem is quite severe when competitors can use their financial robustness to start a war of price

o Credit rating analysis is suggested when peer group is far away from their optimal structure due to wave change in the mar-ket. In doing this the executives must understand the key driver in rating:

The size is an external factor and it is determinant only for blue chips segment, it is a prerequisite to achieve high rating (above AA)

Coverage ratio gives a measure on how many times the firm is able to repay interest by using cash flow. It is more relevant together with the underling volatility of the revenues (risk proxy measurement)

Leverage ratio measures the same thing of coverage, but over different time horizons (long term), hence it is complementary to the first

Solvency is not critical, besides for financial distress prospective The Credit spread doesn’t increase linearly according to the default probability, in fact there is much more differ-

ence in the default probability between BBB and B than between AAA and BBB Another approach to value rating is the market based one, it consists on extrapolate from the current price the im-

plied risk, instead of computing the firm ratios. This methodologies is a nice measure because consider all the infor-mation, but it is sensible to short term fluctuation

o Cash flow analysis is the best one to understand the specific needs of the own business in terms of flexibility and robustness For any capital adjustment on the short term Management is facing a signal problem and a transaction cost, the first one is difficult to esti-

mate, while the second is clear since it is an explicit costo Commonly the higher transaction cost is associated with the IPO, followed by SEO, Bond convertible and bond.o The signal problem is the typical reaction of the market to management action, besides any other consideration:

Dividend cut is a really strong negative signal, so any change in the dividend policy must be carefully taken Issuing equity is taken as an executives’ belief about overvaluation of stock price Issuing debt gives less negatively signal Redeeming excess fund is controversial, it is a positive signal because the company is able to produce extra cash,

but it could the case of losing future benefit due to lack of investment opportunity Share repurchase is a better choice if the management doesn’t want a long term commitment and furthermore this

strategy do not force the investors to choose between capital gains or dividends Debt repayment have different drawback the market will think that stock are overvalue (otherwise the company

should have buy it), that future cash flow are not enough to repay debt or a lack of investment opportunity. It is different in the case of financial distress, in this situation it is a positive signal

Increase dividend must be undertaken consciously, any increase must be sustainable (long term commitment). In general it is viewed as positive by investors, however can be a signal for future low return (less Investment)

Business plan must represent all the Management issues regarding the long term horizon, hence it should determine:o At first we have to estimate the surplus and deficit, and this is crucial, in fact CFO spend more time on it to grant enough

flexibility and robustness o Estimate expected operating and investment cash flow, so that is possible to plan the requirement of capital for the capital

expenditure and acquisitiono Analyze exposure to business risk to understand any possible fluctuation to assess the robustness requiremento Make assumption on unexpected investment opportunity, to assess the flexibilityo Project as-if financing surplus or deficit assuming not changing structureo Set target capital structure, management help themselves with setting controlling ratio, (enforce them if there are any

covenants on past debt). It must follow the business cycleo Decide the tactical measure to implement in order to move toward the target (short term tactics)

Create value from financial engineeringo Derivate instruments can transfer some risk to a third party, but management must be aware of their complexity and they

have to avoid erroro Off balance sheet is a good instrument to raise fund without affecting the balance sheet outlook, however the market is

aware of it, hence it must be used to create special vehicles to boost or securities asset to receive debto Hybrid financing like convertible bond must be understand by management, in fact given up ownership for a low coupon can

be a misleading strategy

How to implement value enhancing strategies and how to ensure management to recognize them:

When we have recognized some possible initiatives we need to assess a proper internal management organizational scheme to implement them. We need to work simultaneously on the governance, compensation and market relationship side. At first we will describe an innovative gover-

8

#27 Cod. 20137

nance scheme proposed by McKinsey to deal with increasing complexity then we will reconcile governance with compensation, enlarging our discussion to market linked instruments. The second section is entirely dedicated on Market information stream both from a management prospective (how to deal with investors and how to avoid mistake) and from an investors one (try to understand the stock price movements)

Governance & compensation scheme

Firms have to face continuously with decision, trade off and operational issue on how to value performance and consequently decide how to al-locate resources. Therefore is crucial to define a new approach which works on several variables: It is crucial for a company to ensure that all decision affecting value are consistent with objectives, to ensure this it is important to develop a

reliable management performance system to see clearly the impact of those decisions The ultimate solution proposed by Mc Kensey is Value Manager which is an useful tool to make easier the decision process in case of trade

off, helping in defining priority among actions and in setting priorities (ensuring multi-dimensional improvements) and to better allocate time resource, in fact 40% of time resource is dedicated to this task, and moreover one of the main role of the CFO is to properly implement those performance measurement ; this situation has been steam up by a greater external pressure/scrutiny on companies and by the in-creasing business complexity

Choose the right metrics to ensure value creation and organizational health:o First of all we should identifying value drivers by dividing from internal (controllable) factor and those who are external (take

as given) and by focusing on the first one: Short term driver are: sales (market share, price premium), operating cost and capital (working capital) productivity

index/ratio Medium-t: Commercial (brand, pipeline, customer satisfaction), cost structure (ability to have to manage its cost

relative to competitors) and asset health Long term: define and measure the opportunities and the threats it is a more qualitative milestones

o Secondly develop a value drivers tree diagram11 to increase the company insight (be company specific12); we can assess the difference by characteristic, ROIC-growth profile, so that it is possible to understand where company is doing well and where not. To create BU we need to identify:

The overhead cost to be allocate in the center cost units which must be value separately: To properly compare BU with peer that don’t have those cost To assess how much resources are dragged by overhead

Do not off-set internal transactions, but rather left them in the FCF The BU’s debt cost, in case of miss reconciliation allocate the difference as a corporate item The BU’s NOPLAT and IC and reconcile them with the company’s one

o Thirdly we need to ensure the ability of the company of retaining valuable human resource by providing a good work envi-ronment (value, satisfaction)

o Lastly chose effective targets, that need to be both realistic and challenging Use benchmark from competitors or other cells/ Business units parameters, often senior executives will bench-

mark performance not against BU’s peer, but rather to other BU within the firm, even if they have different fea-tures

Set range is better than single point by dividing the target in base and in stretch one Organizational support for corrective action:

o Buy-in to performance management at all levels: it means to involve all management level by enforcing the perception of value creation in all the communications, link value creation with reward process

o Properly define target, be specific (explain interrelation) and motivatingo Fact-based performance reviews13: using more than financial report to make decision, use brain storming or meeting to dis-

cuss of the problem to better inform all the parts

The compensation is a crucial element, highly linked with Organizational and Governance. We are going to describe the TRS relation with salary. At first we need to address that short term movement are meaningless, and that there exists a possible distortion in using TRS, which is the treadmill. Management shouldn’t pay attention on short term movement, as a general rule management should start to be worry for any movement

greater than 2% daily or 10% quarterly not justified by peers’ co-movement

11 The higher is the disaggregation the better, under those simple rules: Each cells should be enough big to be independent and should not share too many activity or link (limited synergy)

with other cells12 By branch, by division/geographical area, by custom types13 It’s common practice to use scorecards, since they allow fast and easy comparison between units, however it is important to address the unique characteristic of each units

9

#27 Cod. 20137

Market expectation translates themselves into value creation and can easily become a treadmill, which means that successful company al-ready discount extremely future positive return, so it becomes really hard to further improve those expectations, and (hence) the market price. An appropriate reward will aim to long term/sustainable growth pursuing :

o Stock based stripping out broad macro or industry effectso Postpone bonus compensation o Long term company health metrics like ROIC, Growth measure relative to peerso Use more holist system, less matho Harnessing the power of non-financial incentives like career progressiono Understand the market expectation to properly set up stock linked compensation to overcome the treadmill problems, thus frus-

trating the management

Information gave by the market and managerial implication

Now we will speak about the relation between stock price and their intrinsic value. At first we will understand the source of TRS by decompos-ing it, using two possible ways: The traditional decomposition defines the TRS as the linear summation of % increase in earnings, % change in P/E and dividend yield. This

methodology has three limits:o Not all type of earnings lead to value creationo The dividend yield can be increased without affecting future earnings, just modifying the payout ratioo It doesn’t consider the financial leverage of the company

The McKinsey approach consists on breaking down the TRS into 4 parts, it will allow management to have a better insight14:o Value generating from revenue growth net of capital required to sustain that growo What TRS would have been without the growth parto Change in P/E or other earnings multiple between period o The impact of leverage on TRS

It isn’t always a good measure of intrinsic value; however it has been proven by many papers the existence of the relationship between key value drivers and stock price, thus TRS

o ROIC strong relationshipo Growth high relations only for company with a positive ROIC spread, the higher the higher the impact of go Expectation initial expectation plays a big role in assessing the TRS, and any change in expectation has big market effecto There are empirical evidences of the existence of long term reversal and short term momentum. The first one is a direct con-

sequence of overreaction, while the second of under reaction. However there is no evidence against efficiency, in fact those movements are unpredictable; hence the abnormal return of these strategies is still close to zero15

o For company with low growth could be hard/impossible to recognize the ROIC contribution by using earnings multiple (com-mon practice), hence it is suggest to use capital multiples

valueearnings

=

valuecapital

∗1

ReturnOnCapitalAs we can see the earnings multiple is rescaled by the return ratio

Now we will dedicate ourselves on defining why market efficiency is important and how it is granted. It is possible to speak of efficiency since on the long run the stock market follow underling valuation/criterions; this is allowed by the presence of informed investor which has the highest long-t influence. Efficiency in the market will ensure that market price stays linked to ROIC and growth rate measures. There are several surveys to show the

strong relation between ROIC spread and stock return, this is strong proof on the fact that the noise component usually creates distortion only in the short term.

They can be classified into three classes: Intrinsic investor rigorous due diligence, they drive stock price; Traders bet on short term movements, they don’t have any view on the stock; & Mechanical investors use math to develop models or replicate index. Those class of investor look at what drives the stock value

As a general rule Management should keep in mind that substance always prevails on form; hence either management or technical trading artificial policy don’t allow any excess return:

o On Managers’ side- the attitude to use account to manage earning doesn’t have any effect on the valuation Smooth or less volatile earnings don’t provide any extra return

14 The growth component (first one) is computed as the increase of earnings, this measure minus the period investment gave us the Growth of TRS from performance. The zero-growth component is the past earnings over past equity value (it is a return). The multiple contribution is a short term benefit a company cannot increase TRS by exploiting this variable 15 If management is aware of any deviation it is rational to expect to see them to implement tactics to exploit those deviations by repurchasing program.

10

#27 Cod. 20137

Treatment of goodwill doesn’t show any market impact, the market totally anticipated the decision and the lower benefits

Different accounting standard doesn’t lead to different values (inventory, stock option, ...)o On Technical trading side- those factors are irrelevant

The decision of be traded in more the one stock doesn’t grant any extra return, however it isn’t true for emerging country firm, which will have a benefit of being listed in a more liquid market

Belonging in an index doesn’t give any extra return (there is a small evidence of a positive trend) and be delisted doesn’t affect long term return

Stock Split has a positive impact due to the positive signal impact, the management is confident of future perfor-mance, and this operation reduce the capital constrain, furthermore this operation is the consequence of past posi-tive performance

In same eras/case some situation can bring the market to systematically trade far away from intrinsic value: small free float, or any kind of barriers which is lowering the market efficiency.

o The emotion and mispricing in the market are rare and not long lasting; they are caused by the predominance of irrational-ity from some individuals or group of investors.

Long term Reversal may be due to investor overreaction on good news Momentum may be explain by some friction in the market, meaning investors are slow to correct their valuation

o The market will give too much attention on last result, overvaluing the last industry developso There is an intrinsic market asymmetry which reduces efficiency. Short position are much riskier than long one, hence there

is less corrective trade on the negative side, furthermore there exist limit on short selling16

What information is important to know what to be sent to the market and which doesn’t? Any significant gap between intrinsic value and stock price is a disadvantage to all the company’s stakeholders: too high valuation can lead to short term tactics aiming to maintain that unsustainable level, while too low can reduce morale and create concern in the board. Management from big corporation usually react to this problem by spending lots of time dealing with investors with an ad hoc way, but it is highly suggested to implement systematic approach, so that the management can communicate better and in a less time consuming mode. There are three areas in the communication field to be addressed: Understand if there is any discrepancy with the market communication, what are the market beliefs and implicit forecasting assumptions.

Often the executive doesn’t have a clear touch with reality, in fact they may not aware that their company is already valued at an high pre-mium and the implied hp are incredibly aggressive or maybe they don’t understand that their hp are considered over optimistic by the mar-ket that is adopting a waiting strategy (they want numbers)

Understand the investor base and focus the communication to each category. A common fallacy believed by executive is that they can change their price by marketing to different categories of investors, this is not the true

Taylor the communication to those who mostly determine the stock price, which are intrinsic investor, they are not interested in short term tactics, but only in long term strategy

o Transparency is being a must in the principle for accounting, but there is a big room for decision regarding disclosure17

The management should be honest on their communication, any “deviation” won’t last long, moreover the com-pany may gain to be transparent showing their project, it is like showing confidence on their strategy and the inca-pability of the competitor to replicate it

Since intrinsic investors are sophisticated, company should give more detailed information avoiding aggregate data, as a rule of dumb they should disclosure for each business units down to the level of earnings before tax

Final note: Sometimes successful firms doesn’t disclosure their plan, exploiting their success as long as it lasts & Use the same metric from quarter to quarter, avoid any kind of account magic

o Guidance on future business evolution are useful, but there are some comments: EPS evolution is not a good guidance; sophisticated investor doesn’t look at these numbers. Firms doesn’t suffer

any loss when they stop to communicate EPS evolution and doesn’t gain any extra earnings premium (paper) Guidance on the short, median a long term on value driver are highly suggested, so that the investors can make

their valuation

16 The so-called noisy trader risk, big short sell may hamper the efficiency the market favoring irrational behavior17 In some business like commodity is more important to disclosure production data not the revenue one, since the last one is influenced by external factor (better dealt by investors)

11

#27 Cod. 20137

Valuation methodologies are based on several variants:

Some general statements on valuation: A valuation isn’t an objective search of “true” value; in fact all valuations are biased. The only question is how much and in which direction; we can assess that the direction and the magnitude are directly proportional to whom is paying and how much they are paying you. Hence, there isn’t any good valuation even if valuation models are quantitative, actually it is not true that the more quantitative a model, the better the valuation: One’s understanding of a valuation model is inversely proportional to the number of inputs re-quired for the model, that’s why Simpler valuation models do much better than complex ones. Any kind of research, no matter how good they are, is affected by firm-specific as well as market wide information and it will age quickly as new information is available. There exist five well known frameworks18: enterprise DCF value, equity cash flow, economic profit, APV and Capital cash flow. In theory, each framework will gener-ate the same value. In practice, the ease of implementation and the interpretation of results the better It is suggested the first one.

DCF Model

DCF is the most accurate and the most flexible method for valuing project, division or companies. It requires four elements: WACC, OFCF, Contin-uing value and non-operating asset valuation. Here we will discuss about all the estimation issues and some suggestion on how set up a proper framework to judge all possible issues.

WACC Estimation:

WACC will be used to discount the cash flow and it represents the cost of capital computed as the blended rate of return for all sources of capi-tal, specifically debt & equity. When performing Enterprise DCF, make sure to choose the cash flows19 and discount factor consistently. Since free cash flows are the cash flows available to all investors, the discount factor for free cash flow must represent the risk faced by all investors To estimate the cost of equity, we must determine the expected rate of return of the company’s stock. Since expected rates of return are

unobservable, we rely on asset-pricing models that translate risk into expected return. The three most common asset-pricing models differ primarily in how defining risk factors.

o The capital assets pricing model (CAPM) states that a stock’s expected return is driven by how sensitive its returns are to the market portfolio. This sensitivity is measured using a term known as “beta.”

o The Fama-French three-factor model defines risk as a stock’s sensitivity to three portfolios: the stock market, a portfolio based on firm size, and a portfolio based on book-to-market ratios.

o The Arbitrage Pricing Theory (APT) is a generalized multi-factor model, but unfortunately provides no guidance on the ap-propriate factors that drive returns.

To Estimate the cost of debt (kd) we need to check:o If the firm trades bonds in the market and those bonds are liquid we can compute the implicit yield to maturity (YTM), in fact

although YTM represents a promised yield, it is a good approximation for expected return for investment grade companies. o In the other case we will compute the yield-to-maturity indirectly by adding a default premium (based on company’s rating)

to the risk free. Yield to maturity is not an expected return. It is the return earned if the obligation is paid on time and in full. Since distressed companies have a significant chance of default20, the yield-to-maturity is a poor proxy for expected return. In order to be compensated for default risk, lenders charge a premium over the default-free benchmark rate to risky cus-tomers21.

Regardless of the maturity structure for the company’s debt, use a long-term risk free rate when estimating a com-pany’s cost of capital. Using short-term debt yields ignores the fact that future debt will have different yields

o One alternative for computing expected return is the CAPM22. Since most bonds don’t trade enough to generate a reliable beta, however, we can compute index betas instead

o The tax shield can simply be computed (1-t) as proxy To develop a target capital structure for a company:

o Estimate the company’s current market-value-based capital structure, if the company is not listed used an iterated formulao Review the capital structure of comparable companies to place the company’s current capital structure in the proper context

18 A distinction between models: you can either value the cash flows generated by the company’s economic assets, or value each financial claim separately (debt & equity) 19 It must be denominated in the same currency as free cash flow and in nominal terms when cash flows are stated in nominal terms; basically if any risk it is accounted in the numerator the risk premium associated to that risk must be eliminated from the denominator 20 Professional firms, such as S&P and Moody’s, rate the default risk of most bonds, Once a bond rating has been identified, convert the rating into a yield to maturity21 The higher the chance of default, the higher the premium will be.22 Empirical paper shows that high yield debt has only a slightly higher beta than investment grade debt, as an example if the market risk premium equals 5%; this difference translates to only a 50 basis point differential in expected return!

12

#27 Cod. 20137

Industries with heavy fixed investment in tangible assets tend to have higher debt levels. High-growth industries, especially those with intangible investments, tend to use very little debt.

o Review management’s implicit or explicit hp on how financing the business and on its implications for the targeted capital structure.

However, a time-varying WACC is appropriate if (1) the yield curve is sharply increasing or decreasing or (2) if significant changes are ex-pected in any of the following: the capital market weights for debt and equity, the cost of debt or the tax rate. For complex capital structure is better to specifically model the tax shield with an APV model

OFCF Estimation:

1. The second step in DCF is to forecast the Operating cash flow by forecasting each balance items, however before doing that we need to collect and rearrange/understand infoo When analyzing historical performance, keep the following in mind:

Look back as far as possible (at least 10 years). Long term horizons will allow you to evaluate company and industry trends and whether short-term trends will likely be permanent

Disaggregate value drivers, both ROIC and revenue growth, as far back as possible. If possible, link operational per-formance measures with each key value driver.

Identify the source, when there are radical changes in performance. Determine whether the change is temporary or permanent, or merely an accounting effect.

o Understanding a company’s past is essential to forecast its future. Using historical analysis or analyzing operating and financial trends, we can test if the company is able to create value over time and to compete effectively within the company’s industry

o A good historical analysis will focus on the drivers of value: return on invested capital (ROIC) and growth. ROIC and growth drive free cash flow, which is the basis for enterprise value.

Rearranging the accounting statements, Digging for new information in the footnotes, Making informed assumptions where needed

o Before you begin forecasting individual line items, you must determine how many years to be forecasted and how detailed your forecast should be. [as a general rules]

A detailed 5 to 7 year forecast, which develops complete balance sheets and income statements with as many links to real variables (e.g., unit volumes, cost per unit), the explicit forecast period must be enough long to reach a steady state, defined by the following characteristics

The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.

The company earns a constant rate of return on new capital invested. The company earns a constant return on its base level of invested capital. In general, we recommend using an explicit forecast period of 10 to 15 years perhaps longer for cyclical

companies or those experiencing very rapid growth Using a short explicit forecast period, such as 5 years, typically results in a significant undervaluation of a

company or requires heroic long-term growth assumptions in the continuing value Sometimes above the detail forecast it is added a simplified forecast, which is focused on few important variables,

such as revenue growth, margins, and capital turnover, if we believe on company’s higher growth compared to the terminal value hp

Value the Terminal years by using a perpetuity-based formula, such as the key value driver formulao At first we should find the NOPLAT and Invested capital from the historical trend, so that we will have an insight on the com-

pany performance. Usually account measure are not reliable: ROE mixes operating performance with capital structure , making peer group analysis and trend analysis less mean-

ingful. ROE rises with leverage if ROIC is greater than the after-tax cost of debt. ROA measures the numerator and denominator inconsistently (even when profit is computed on a pre-interest ba-

sis). For instance, ROA double counts implicit financing charged by suppliers – in the numerator as part of COGS and in the denominator as part of total assets.

o The valuation spreadsheet can easily become complex. Therefore, you need to design and structure your model before start-ing to forecast, here there is a possible scheme to be followed:

Prepare and analyze historical financials. Before forecasting future financials, you must build and analyze historical financials. In many cases, reported financials are overly simplistic. When this occurs, you have to rebuild financial statements with the right balance of detail.

13

#27 Cod. 20137

Build the revenue forecast23. Almost every line item will rely directly or indirectly on revenue. You can estimate fu-ture revenue by using either a top-down (market-based) or bottom-up (customer-based) approach. Forecasts should be consistent with historical evidence on growth.

Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, deprecia-tion, interest income, interest expense, and reported taxes.

Forecast the balance sheet: invested capital and non-operating assets. On the balance sheet, forecast operating working capital, net property, plant, & equipment, goodwill, and non-operating assets.

Forecast the balance sheet: investor funds. Complete the balance sheet by computing retained earnings and fore-casting other equity accounts. Use cash and/or debt accounts to balance the cash flows and balance sheet.

Calculate ROIC and FCF. Calculate ROIC to assure forecasts are consistent with economic principles, industry dy-namics, and the company’s competitive advantage. To complete the forecast, calculate free cash flow as the basis for valuation. Future FCF should be calculated the same way as historical FCF.

2. From this information we will compute the projection for the future cash flow. o One critical component of financial forecasting is your estimate of revenue growth, as almost every line item will rely directly

or indirectly on revenue, so any error in the revenue forecast will be carried through the entire model. You can estimate revenue using either a top-down (market-based) or bottom-up (customer-based) approach

Extend short-term revenue forecasts to long-term Estimate new customer wins and turnover Project demand from existing customers Estimate market share and pricing strength based on competition and competitive advantage Estimate quantity and pricing of aggregate worldwide market

o With a revenue forecast in place, next forecast will be the individual line items related to the income statement. To forecast a line item, use a three-step process:

Decide what economically drives the line item. For most line items, forecasts will be tied directly to revenue. Estimate the forecast ratio. Since cost of goods sold is tied to revenue, estimate COGS as a percentage of revenue. Multiply the forecast ratio by an estimate of its driver. For instance, since most line items are driven by revenue,

most forecast ratios, such as COGS to revenue, should be applied to estimate the needed variable. When forecasting balance sheet items, use the stock method. The relationship between balance sheet accounts

and revenue (the stock method24) is more stable than that between balance sheet change and change in revenues (the flow method25).

o The last five line items: excess cash, short-term debt, long-term debt, a new account titled newly issued debt, and common stock. Some combination of these line items must make the balance sheet balance. For this reason, these items are often re-ferred to as “the plug.” Simple models use newly issued debt as the plug, while advanced models use excess cash or newly issued debt, to prevent debt from becoming negative.

Step 1: Determine retained earnings using the clean surplus relation, forecast existing debt using contractual terms, and keep equity constant.

Step 2: Test which is higher, assets excluding excess cash or liabilities and equity, excluding newly issued debt.

23 To ground our historical analysis, we need to separate operating performance from non-operating items and the financing to support the business. To prevent non-operating items

and capital structure from distorting the company’s operating performance, we must reorganize the financial statements following this rules:o NOPLAT. The income statement will be reorganized to create NOPLAT, which represents the after-tax operating profit available to all financial investors.

If the company has no tax credits, operating taxes can be computed by multiplying the adjusted EBITA by the tax rate If the company has tax credits, multiplying operating profits by statutory tax rate will overstate the company’s tax burden. In this case, start with

reported taxes and remove any taxes related to non-operating items and financial structure Many financial analysts prefer to compute NOPLAT using cash taxes and treat deferred tax accounts as equity equivalents. To do this, computed

reported operating taxes and subtract the increase in deferred tax liabilitieso Capitalizing R&D If a company has significant long-term R&D, do not subtract the annual R&D expense. Instead, capitalize R&D on the balance sheet and sub-

tract an annualized amortization of this capitalized R&D.o Capitalizing Operating Leases If a company has significant operating leases, capitalized the operating lease on the balance sheet and adds back lease-based inter-

est to operating profit. Convert the remaining rental expense to depreciation.o Excluding Recognized Pension Gains & Losses. Pension gains & losses booked on the income statement are usually hidden within cost of goods sold. Remove

any recognized gains or losses from NOPLAT. Unrecognized gains do not flow through the income statement, so no change is required for unrecognized gains.o Invested Capital. The balance sheet will be reorganized to create invested capital, which equals the total capital required to fund operations, regardless of type

(debt or equity).o The reported tax rate can be misleading because companies can defer certain taxes for many years. In fact, a growing profitable company could defer a portion

of its taxes forever! Deferred taxes arise for a number of situations including: Accelerated depreciation schedules Pension accounting Goodwill amortization

24 Basically compute the line as a % of the revenue (direct method)25 Basically compute the change of the items as a % of the & of the revenues over time (indirect method)

14

#27 Cod. 20137

Step 3: If assets excluding excess cash are higher, set excess cash equal to zero and plug the difference with newly issued debt. Otherwise, plug with excess cash.

3. When forecasting you are likely to come across three additional issues: o Nonfinancial operating drivers. In industries where prices or technology are changing dramatically, your forecast should in-

corporate operating drivers like volume and productivity. Consider the airline industry, where labor and fuel has been rising as a percentage of revenue – but for different

reasons. Fuel is a greater percentage because oil prices have been rising. Conversely, labor is a greater percentage because revenue per seat mile has been dropping.

o Currency Changes. Foreign revenues must be consolidated into domestic financial statements. If foreign currencies are rising in value relative to the company’s home currency, this translation, at better rates, will lead to higher revenue.

o Changes in accounting policies. When a company changes its revenue recognition policies, comparing year-to-year revenue can be misleading (examples provided in slides)

o Fixed versus variable costs. The distinction between fixed and variable costs at the company level is usually unimportant be-cause most costs are variable. For individual production facilities or retail stores, this is not the case, most costs are fixed.

o Inflation. Often, the cost of capital is estimated using nominal terms. If this is the case, forecast in nominal terms. Be careful, however, high inflation will distort historical analyses.

4. Estimate a Continuing/terminal Value by forecasting cash flows in the long-term future, using a perpetuity that focuses on the company’s key value drivers, specifically ROIC and growth. A thoughtful estimate of continuing value is essential to any valuation because continuing value often accounts for a large percentage of a company’s total value. 56% to 125% of total value.o Although many continuing-value models exist, we prefer the key value driver model. The key value driver formula is superior

to alternative methodologies because it is based on cash flow and links cash flow to growth and ROIC

value=NOPLA T t+1∗(1− g

ROIC)

WACC−g

If RONIC=WACC I C0+E Pt

WACC−gwhere E Pt=I C0(ROIC−WACC )

Continuing value can be highly sensitive to changes in the continuing value parameters While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it

only affects the distribution of the company’s value between the explicit forecast period and the years that follow In the formula, if you assume RONIC equals WACC. It implies that new projects don’t create value and existing projects

continue to perform at their base-year level. By computing alternative approaches, we can generate insight into the timing of cash flows, where value is created

(across business units), or even how value is created (derived from invested capital or future economic profits). Regardless of the method chosen, the resulting valuation should be the same

o Other Methods: Liquidation Value and Replacement Cost Liquidation values and replacement costs are usually far different from the

value of the company as a going concern. In a growing, profitable industry, a company’s liquidation value is probably well below the going-concern value.

Exit Multiples (such as P/E and EV/EBITA) Multiples approaches assume that a company will be worth some multiple of future earnings or book value in the continuing period. But multiples from today’s industry can be misleading. Industry economics will change over time and so will their multiples!

o A common error in forecasting the base level of FCF is to assume a constant re-investment rate, which implies that NOPLAT, in-vestment, and FCF will grow at the same rate

The assumption that RONIC equals WACC is often faulty because strong brands, plants and other human capital can gen-erate economic profits for sustained periods of time, as is the case for pharmaceutical companies, consumer products companies and some software companies.

Many analysts’ errors are due to excessive caution when estimating continuing value because of uncertainty, but to offer an unbiased estimate of value, use the best estimate available. The risk of uncertainty will already be captured by the weighted average cost of capital. An effective alternative to revising estimates downward is to model uncertainty with scenarios and then examine their impact on valuation

Several estimation approaches are available, but recommended models (such as the key value driver and economic profit models) explicitly consider:

Profits at the end of the explicit forecast period - NOPLATt+1 The rate of return for new investment projects - RONIC Expected long-run growth - g

15

#27 Cod. 20137

Cost of capital - WACC A large continuing value does not necessarily imply a noisy valuation. Other methods, such as business components and

economic profit can provide meaningful perspective on how aggressive (or conservative) the continuing value is. Common pitfalls to avoid: naïve extrapolation to determine the base year cash flows, purposeful over-conservatism

(RONIC = WACC).5. Value all the non-equity26 and debt claims. In today’s increasingly complex financial markets, many claimants have rights to a

company’s cash flow before equity holders - and they are not always easy to spoto Traditional debt instruments:

Investment Grade Debt - Publicly Traded If the debt is relatively secure and actively traded, use its market value Investment Grade Debt - Privately Held If the debt is not traded, discount the promised payments and principal

repayment at the yield to maturity to estimate current value. Book value is a reasonable approximation if interest rates and default have not significantly changed since issuance.

Companies in Financial Distress For companies in financial distress, the value of the debt will be at a significant dis-count to its book value and will fluctuate with the value of the enterprise. To value equity, create multiple perfor-mance scenarios and deduct the full value of debt under each scenario. Weight each scenario by probability of oc-currence

o Debt equivalents such as operating leases, pensions, specific types of provisions Because operating leases are a form of secured debt, operating leases should be capitalized as part of invested cap-

ital and as a debt-equivalent liability. It is the most common form of off-balance-sheet debt. Remember when valu-ing a company that under certain conditions, companies can avoid capitalizing leases as debt on their balance sheet (however payments must be disclosed in the footnotes).

Asset value= Rent

kd +1

assetLife Unfunded retirement liabilities should be treated as debt-equivalents. They can make a significant difference when

calculating equity value, especially for older companies. Although total shortfall is not reported on the balance sheet (only a smoothed amount is transferred to the balance sheet), it should be considered as an offset against enterprise value.

Pension liabilities are concentrated in the automotive, aerospace, airline, oil and gas, and utility sectors. The amount on the balance sheet does not include (1) all of the capital gains and losses on the fund assets, nor (2) re-cent changes to the fund’s liabilities.

Some retirement assets and liabilities may be hidden within other balance sheet entries. Thus check the company’s footnotes

Retirement liabilities are designated as either defined-contribution or defined benefit. o Defined-contribution plans do not generate unfunded liabilities since the company is only com-

mitted to make fixed contributions.o Defined-benefit plans can produce unfunded liabilities since the company is committed to pro-

vide specific benefits to employees irrespective of the actual performance of the plan’s funds Ongoing operating provision are included in the CGS, hence we do not need to account for them Long-term operating provisions (e.g. plant-decommissioning costs) are typically recorded at a discounted value,

hence the book value can be directly used Non-operating provisions (e.g. restructuring charges) are generally recorded at a non-discounted value, but are

near term in nature. So we can use book value as proxy Contingent liabilities (e.g. pending litigation) should be valued by estimating the associated expected after-tax cash

flows and discounted at the cost of debt; examples are lawsuits and loan guarantees, which are usually reported in the footnotes.

o Hybrid claims such as employee stock options and convertible bonds Employee options: Each year, many companies offer their employees compensation in the form of options. Since

options give the employee the right to buy company stock at a potentially discounted price, they can have great value. There exist several Option valuation models: the one using option-valuation models such as Black Scholes or the other using advanced binomial (lattice) models.

Under US GAAP and IFRS, the notes to the balance sheet report the value of all employee stock options outstanding as estimated by option-pricing models. This value is a good approximation only if your esti-mate of share price is close to the one underlying the option values in the footnotes.

26 Equity is a residual claimant, receiving cash flows only after the company has fulfilled its other contractual claims.

16

#27 Cod. 20137

Exercise value approach: This method provides only a lower bound for the value of employee options. It assumes that all options are exercised immediately and thereby ignores the time value of options.

Convertible bonds valuation: If the market price is near your estimate of share price, if the convertible bonds are actively traded,

deduct their market value, but only if estimated stock price is near the traded stock price, as the value of convertible bonds depends on your estimate of equity value.

If the market price differs from your estimate of share price,o Convertible valuation approach: The value of convertible bonds can be estimated using an ad-

justed Black Scholes convertible bond pricing model.o Conversion value approach: This common approach assumes that all convertible bonds are im-

mediately exchanged for equity and ignores the time value of the conversion option. The ap-proach works well when the conversion option is deep in the money.

Preferred stock. Although the name denotes equity, preferred stock in well-established companies more closely resembles unsecured debt.

6. The final step is to value the entire non-operating asset to obtain the EV. It is important to avoid double counting, so consider only flow not included in the EBITA. Non-operating assets can be segmented into two groups, marketable securities and illiquid invest-ments. Given their different accounting treatments, each non-operating asset type must be valued separatelyo Excess Cash and Marketable Securities under US GAAP and IFRS, companies must report such assets at their fair market

value on the balance sheet. Therefore, use the most recent book value as a proxy for the current market value. o Tax Loss Carry-forwards : Create a separate account for the accumulated tax loss carry forwards, and forecast the develop-

ment of this account by adding any future losses and subtracting any future taxable profits on a year-by-year basis. Discount at the cost of debt.

o Discontinued Operations : Most recent book value is a reasonable approximation since assets and liabilities associated with discontinued operations are written down to fair value and disclosed as a net asset on the balance sheet.

o Excess Real Estate and Other Unutilized Assets : Identifying these assets is nearly impossible unless they are specifically dis-closed in a footnote. For excess real estate, use the most recent appraisal value, an appraisal multiple such as value per square meter or discounting of future cash flows.

o Illiquid Investments such as loan to other companies. To value them, use the following methods: If loans were provided on fair market terms and credit risk and general interest rates have not changed since is-

suance, use the reported book value If this is not the case, perform a separate DCF valuation of the promised interest and principal payments discounted

at the yield to maturity for corporate bonds with similar risk and maturityo Minority Interest27 As minority interest is a claim only on a particular subsidiary, we need to assess only the stake in it

If the subsidiary is consolidated we can have two cases: If the subsidiary is publicly listed, deduct the proportional market value owned by outsiders from enter-

prise value to determine equity value. Use the market value for the company’s equity stake. Verify that the market price reflects intrinsic value (i.e. that there is adequate liquidity and free float so that the trad-ing price reflects current information)

If the subsidiary privately held, if financial statements are available you can perform a separate valuation of minority interest using a DCF approach, multiples, or a tracking portfolio depending on the information available if no separate financial statements are available there are three alternatives to value a sub-sidiary with limited financial information:

1. Simplified-Cash Flow-to-Equity Build forecasts for how the key value drivers will develop and discount at subsidiary cost of equity not at the parent company’s WACC

2. Multiples Valuation Build a valuation based on the P/E and/or market-to-book multiple. An appropriate multiple can be estimated from a group of listed peers

3. Tracking Portfolio Approximate its current market value by adding the relative price increase\decrease of a portfolio of comparable over the same holding period.

Nonconsolidated subsidiaries are companies in which the parent company holds a non-controlling equity stake (generally less than 50% ownership). They are accounted for in the following ways:

o Equity Method: For equity stakes between 20 percent and 50 percent, the parent company is as-sumed to have influence but not control. The investment is reported on the balance sheet at historic cost plus profits and additional investment, fewer dividends received. Parent’s portion of subsidiary profit shown on income statement.

27 It exists when a company controls a subsidiary but does not own 100 percent, the investment must be consolidated, and the funding provided by other investors is recognized on the company’s balance sheet as minority interest.

17

#27 Cod. 20137

o Cost Method: For equity stakes below 20 percent, the parent company is assumed to have no influ-ence. The equity holdings are reported on the parent’s balance sheet at historic cost. Dividends re-ceived by parent shown on income statement.

Final remark and ending procedure

Subtract the debt and non-equity claims to find the equity value. To find the value per share we can use two method depending on how options and convertible bonds are valued28:

o Option-based-valuation Divide the total equity value by the number of undiluted shares 29 outstanding . Use undiluted shares outstanding because the value of convertible debt and stock options has already been deducted from the enterprise value. (numerator side)

o Conversion and exercise value method Divide total equity value by the diluted number of shares. Convertible debt and stock options are not incorporated as non-equity claims, but rather through the number of shares outstanding.

Once the model is complete, we should review results to ensure your findings are technically correct, your assumptions are realistic, and your interpretations plausible.

o While you are building a forecast, it is easy to become engrossed in the details of individual line items. But we stress, once again, that you must place your aggregate results in the proper context.

Income available to investors = NOplat + Non-Operating after tax income NI + After tax interest expense = Income available to investors

o Always check your resulting revenue growth and ROIC against industry-wide historical data. If required forecast competi-tors’ historical performance, make sure the company has a specific and robust competitive advantage.

o Finally, do not make your model more complicated than it needs to be. Extraneous details can cloud the drivers that really matter. Create detailed line item forecasts when they increase the accuracy of company’s key value drivers

o The value of operations should be adjusted for mid-year discounting. We often assume that cash flows occur continuously throughout the year rather than in a lump sum at the end of the year. To adjust for this discrepancy, we grow the discounted value of operations at the WACC for six months

o A valuation is based upon forecast assumptions about external markets and competitors as well as internal capabilities of the company. Using multiple scenarios incorporates the uncertainty and risk related to those assumptions. Collectively, the sce-narios should capture the future states of the world that would have the most impact on future value creation and a reason-able chance of occurrence.

Consider the following to review scenario assumptions : broad economic conditions, competitive structure of the industry, internal capabilities of the company, and financing capabilities of the company.

Assign a probability to each scenario considering the above variables to assess historical frequencyo Examining the initial results may uncover unanticipated questions that are best resolved by additional scenarios. In this way,

the valuation process is inherently circular.o After estimating the equity value, perform several checks to test the logic of your results and ensure that you have a good

understanding of the forces driving the valuation. Check the model for consistency and robustness

Are the outcomes consistent with assumptions? Always reconcile your estimation/ratio Does the balance sheet balance in every year? Are the sources of cash equal to the uses of cash? Does the

sum of invested capital plus non-operating assets balance with the sources of financing? If the projected returns are above the WACC, is the value of operations above the book value of invested

capital (as it should be)? Analyze the patterns of key financial and operating ratios.

Are the patterns intended and reasonable? Is a steady state reached for the company’s economics by the end of the explicit forecasting period, that

is, when you apply a continuing value formula Perform a sensitivity analysis to assess the impact of individual variable change and to analysis the trade-off and to

check how changes in sector-specific value drivers affect the final valuation. Test whether the final results are plausible.

If the company is listed, compare your results with the market value. Can you justify the difference if size-able?

Perform a sound multiples analysis. Calculate the implied forward-looking valuation multiples and com-pare these with equivalently defined multiples of traded peer-group companies. Make sure that you can

28 Those methods generate a different results29 The number of shares outstanding is the gross number of shares issued, less the number of shares in treasury.

18

#27 Cod. 20137

explain any significant differences from peer group in terms of the company’s value drivers and underly-ing business characteristics or strategy.

The CAPM approach needs:

Estimate the risk-free rate30: look at government default-free bonds. For simplicity, most valuation analysts choose a single yield to matu-rity from one government bond that best matches the entire cash flow stream being valued.

Estimate the market risk premium is arguably the most debated issue in finance. Methods to estimate the market risk premium fall in three general categories31:

o Extrapolate historical excess returns32. If the risk premium is constant, we can use an historical average to estimate the fu-ture risk premium. To overcame the drawback of using historical data, you should:

Calculate the premium over long-term government bonds Use long-term government bonds, because they match the duration of a company’s cash flows better than do short-term rates.

Use the longest period possible if the market risk premium is stable, a longer history will reduce estimation error. Since, no statistically significant trend has been observed, we recommend the longest period possible.

Use an arithmetic average of longer-dated intervals (such as five years) Although the arithmetic average of annual returns is the best predictor of future one year returns, compounded averages will be upward biased (too high). Therefore, use longer-dated intervals to build discount rates.

Adjust the result for econometric issues, such as survivorship bias. Predictions based on U.S. data (a successful economy) are probably too high

o Regression analysis. Using regression, we can link current market variables, such as the aggregate dividend-to-price ratio, to

expected market returns33. Rm=rf + β ln( DP )+ε

o Use DCF to reverse engineer the risk premium. Using DCF, along with estimates of return on investment and growth, we can reverse engineer the market’s cost of capital – and subsequently the implied market risk premium.

P= DK e−g

=ke=earnings∗(1− g

ROE )P

+gWhere we can extrapolate the forward market cost of equity

We use the key value driver formula to reverse engineer the market risk premium. After stripping out inflation, the expected market return (not excess return) is remarkably constant, averaging 7.0%.

Estimate the beta, which measures how much the stock and market move together. Since beta cannot be observed directly, we must esti-mate its value. Estimating beta is a noisy process. The suggest methodology is:

Raw regressions should use at least 60 data points (e.g., five years of monthly returns). Rolling betas should be graphed to examine any systematic changes in a stock’s risk. It should be based on monthly returns. Using shorter return periods, such as daily and weekly returns, leads to systematic biases.

Company stock returns should be regressed against a value-weighted, well-diversified portfolio, such as the S&P 500 or MSCI World Index.

To improve the precision of beta estimation, use industry, rather than company-specific, betas. Companies in same industry face similar operating risks, so they should have similar operating betas.

First, regress each company’s stock returns against the S&P 500 to determine raw β Next, to un-lever each beta, calculate each company’s market-debt-to-equity ratio.

30 For U.S.-based corporate valuation, the most common proxy is the 10-year government bond rate. This rate can be found in any daily financial publication31 None of the methods precisely estimate the market risk premium. Still, based on evidence from each of these models, we believe the market risk premium as of year-end 2003 was approximately 5 percent32 Annual returns can be calculated using either an arithmetic average or a geometric average. The first one is the simple average of observed premium, while the second is a compound-ing average of yearly excess

The arithmetic average of annual returns is the best predictor of future one year returns, but compounded averages will be biased upwards (i.e. too high)

Ra=1T∑ 1+rm

1+r f

−1

To correct for the bias caused negative autocorrelation in returns, we have two choices. First, we can calculate multi-period holding returns directly from the data, rather than com-pound single-period averages. Alternatively, we can use an estimator proposed by Marshall Blume, one that blends the arithmetic & geometric averages

Rg=(∏ 1+rm

1+r f)

1 /t

−1

33 Authors question the power of this tool, in other world the regression estimation quality doesn’t seem better than the simple average

19

#27 Cod. 20137

Determine the industry unlevered beta by calculating the median (or a weighted average with the market cap as weights).

Re-lever the industry unlevered beta is to each company’s target debt-to-equity ratioo Next, recalling that raw regressions provide only estimates of a company’s true beta, we improve estimates of a company’s

beta by deriving an unlevered industry beta and then re levering the industry beta to the company’s target capital structure Because estimates of beta are imprecise, plot the company’s rolling 60-month beta to visually inspect for structural

changes or short-term deviations Simply using the median of an industry’s raw betas, however, overlooks an important factor: leverage. A company’s

equity beta is a function of not only its operating risk, but also the financial risk it takes To improve the estimate we can use some smoothing method to make the beta converging to one, the weights can

be qualitative addressed or computed using a sophisticated formula accounting of the error of the methods used to

regress and volatility in the industry beta σ ε

2

σε2+σ β

2 (1 )+ βraw (1−σ ε

2

σ ε2+σβ

2 )

o The weighted average beta for operating assets (bu - which is called the unlevered beta) and financial assets (btxa) must equal

the weighted average beta for debt (bd) and equity (be). Our goal is to use this relationship to solve for bu

Method 1: Assume btxa equals bu. If you believe the risk associated with tax shields (btxa) equals the risk associated

with operating assets (bu), the risk equation can be simplified dramatically, we are also assuming the bd =0 (risk free) and that Tax shield will fluctuate according to operating asset is constant. Specifically

be=(1+ DE )∗bu

Method 2: Assume btxa equals bd. If you believe the risk associated with tax shields (btxa) is comparable to the risk

of debt (bd), and assuming the bd =0 (risk free) the equation can be arranged for the unlevered cost of equity.

bu=1

1+(1−T m )∗D

E

∗be

Multiples model

Multiples are a relative valuation techniques based on how similar assets are currently priced in the market. It is a useful method for triangulate results with the other methodologies; it can help testing the plausibility of those methodologies and to understand if there is any mismatch with competitors’ valuation. It allows understanding the market view on the strategic positioning of industry players.

Reasons for popularity: Few explicit assumptions, Simpler than DCF and Reflects the current mood of the market. P otential Pitfalls are Inconsis-tent estimate of value when variables such as risk, growth or cash flow potential are ignored, this can result in values that are too high when the market is overvaluing comparable firms, or too low when it is undervaluing these firms; Lack of transparency regarding the underlying assump-tions and Inconsistent choice of numerator and denominator: different time horizon, different unit of measure, double counting and the use of income measure together with balance sheet one (meaning that those numbers refer to different measurement methodology, hence it is incon-sistent putting them all together) A well-designed, accurate multiples analysis can provide valuable insights about a company and its competitors. Conversely, a poor analysis

can result in confusion. To apply multiples properly we need too Create an appropriate peer groupo Use an enterprise value multiple to eliminate effects from changes in capital structure and onetime gains and losseso Use a forecast of profits, rather than historical profitso Enterprise-value multiples must be adjusted for non-operating34 items hidden within enterprise value and reported EBITA

and they must be computed consistently (asset side or equity side multiples) To create and analyze an appropriate peer group:

o Start by examining other companies in the target’s industry. We define an industry using as Potential resources the annual report, the company’s Standard Industry Classification Code (SIC) or Global Industry Classification (GIC)

o Once a preliminary screen is conducted, the real digging begins. You must answer a series of strategic questions. Why are the multiples different across the peer group? Do certain companies in the group have superior products, better access to customers, recurring revenues, or

economies of scale?

34 We should use Net enterprise value measure, Gross value – minus all non-operating asset (core operating value)

20

#27 Cod. 20137

Create group of peer classified by ROIC, Growth level and compute the average of those classes to see the markup between top player and follower

o If necessary, compute the median and harmonic mean for sample Multiples are best used to examine valuation differences across companies. If you must compute a representative

multiple, use median or harmonic mean. Harmonic mean : Compute the EBITA/Value ratio for each company and average across companies. Take the recip-

rocal of the average. The multiples can be computed considering

o Current earnings per share generated in the last yearo Trailing earnings per share referring to the last 12 months (4 quarters)o Leading multiples earnings per share expected for the next year

Here there is a list of the main multiples used in the field: The enterprise value multiple (Value/EBITA35) computation starts from assuming value as given by the formula of continuing

value rearranged to focus on drivers of value:

value=NOPLAT∗(1− g

ROIC)

WACC−g Value

EBITA=

(1−t )∗(1− gROIC

)

WACC−g Hence this multiples depends on ROIC, Growth, operating cash tax rate, and WACC This multiples is suggested be used as a starter one, the book provides a chart showing the non-financial multiples distri-

bution (mean around 9, skewed to the right)

EV 0

EBITA1

=1−t

WACC+

ROIC−WACCWACC

∗(1−payout )∗(1−t )

WACC−ROIC∗(1−payout) This is another possible representation, where the first element is the base, the second the excess return and the last is

the reinvestment Net present value P/E ratio drivers formula is:

PEPS

=payout∗(1+g)

r firm−g=

1− gROE

r−gwhere g is assumed constant

It deepens on: Growth, Risk (therefore this multiple is negative correlated with leverage) and Reinvestment needs EV to EBITDA multiple drivers

EV 0

EBITDA=

(1−t )− D∧A∗(1−T )EBITDA

− REINVESTEMENTEBITDA

WACC−G It is positive correlated with leverage, as long as it will decrease the WACC The second element represents the loss on NI due to historical capital expenditure (net of the tax benefits), the third ele-

ment is the absorption for new capital investment P/BV

In the case of g=0 P0

BV 0

= ROEK el

where K el is the cost of equity levered

In the case of stable growth P0=BV 0∗ROE∗PayoutRatio∗(1+g)

r−g It is positive correlated with leverage

EV/SALES is commonly used only for retail industries, since it is imposing an additional restriction: similar operating margins on the company’s existing business. For most industries, this restriction is overly burdensome.

In the case of absence of growth EV 0

SALES0

=ROS0∗(1−t)

WACC

35 The book justified the usage of EBITA instead of EBIT since Amortization represents an accounting feature related to past acquisition and don’t represent future cash flow, hence there is a distortion based on the growing strategy implemented by companies. Note that in case of software amortization we need to clean the measure since those company can report amor-tization on R&D

21

#27 Cod. 20137

o Alternately we can use the formula ValueSales

=

ValueEBITA

∗EBITA

Sales where the second term is the EBITA margin

Price Earnings Growth (PEG) Ratio. Whereas a price-to-sales ratio further restricts the enterprise-to-EBITA multiple, the PEG ratio is more flexible than the enterprise multiple, because it allows expected growth to vary across companies.

PEG= EV multiple100∗Expected EBITA growthrate

o Limits are: The PEG ratio incorrectly assumes 1) a linear relationship between multiples and growth, 2) it controls only for growth not for ROIC, 3) there is no standard time frame for measuring the growth in profits and 4) low growth com-pany would be undervalued using the PEG ratio.

o The valuation analyst must decide to use a one year or a two years or a longer term growth Multiples of operational data. When financial data is sparse, compute non-financial multiples, which compare enterprise value to

one or more operating statistics, such as Web site hits, unique visitors, or number of subscriberso Multiples based on nonfinancial (i.e. operational) data can be computed for new companies with unstable financials or

negative profitability. But to use an operational multiple, it must be a reasonable predictor of future value creation, and thus somehow tied to ROIC and growth.

o Many analysts used operational multiple to value young Internet companies at the beginning of the Internet boom Enterprise Value/Website Hits Enterprise Value/Number of Subscribers Enterprise Value/Unique Visitors

o Non-financial multiples should be used only when they provide incremental explanatory power over financial multiples. o Non-financial multiples, like all multiples, are relative valuation tools. They do not measure absolute valuation levels

Some comments on multiples’ reliability and on possible pitfall1. Use Enterprise-Value-to-EBITA Multiple instead of P/E

A cross-company multiples analysis should highlight differences in performance, such as differences in ROIC and growth, not differences in capital structure. However no multiple is completely independent of capital structure, an enterprise value multiple is less susceptible to distortions caused by the company’s debt-to-equity choice. The multiple is calcu-lated as follows

EnterpriseValueEBITA

= MV Debt+MV EquityEBITA

Consider a company that swaps debt for equity (i.e. raises debt to repurchase equity). o EBITA is computed pre-interest, so it remains unchanged as debt is swapped for equity.o Swapping debt for equity will keep the numerator unchanged as well. Note however, that EV may change due

to the second order effects of signaling, increased tax shields, or higher distress costs2. Conversely, the P/E Ratio can be artificially impacted by a change in capital structure, even when there is no change in enterprise

value, in fact it can be shown, that in a world without taxes, the price to earnings ratio is a function of the unlevered price to earnings ratio, the cost of debt, and the debt to value ratio

PE

=K+K−P Eu

( DV )∗kd∗( P Eu )−1

where K= 1k d

o If P Euis high the ex-post levered P/E will be positively affected, the reverse if P Euis low

o The second problem with the P/E ratio is that it commingles operating and non-operating performance. Each source can have vastly different financial characteristics

Excess cash has a very high P/E ratio (because of extremely low earnings). Mixing excess cash with income from operations usually raises the P/E ratio.

One time non-operating gains and losses such as restructuring costs and other write-offs will also temporarily raise or lower earnings, raising the P/E ratio. Most analysts recognize this problem and make necessary adjust-ments

3. Use Forward Looking Multiples36 when building a multiple: the denominator should use a forecast of profits, rather than histori-cal profits. This practice, unlike backward-looking multiples, is consistent with the principles of valuation—in particular, that a company’s value equals the present value of future cash flow, not past profits and sunk costs

36 Research by Kim and Ritter (1999) and Lio, Nissim, and Thomas (2002) documents that forward looking multiples increase predictive accuracy and decrease variance of multiples within an industry

22

#27 Cod. 20137

4. Adjust for Non-Operating Items, in fact even the enterprise value-to-EBITA multiple commingles operating and non-operating items. Therefore, further adjustments must be made.

Excess cash and other non-operating assets have very different financial characteristics from the core business, exclude their value from enterprise value when comparing to EBITA

The use of operating leases leads to artificially low enterprise value (missing debt) and EBITA (lease interest is sub-tracted pre-EBITA). Although operating leases affect both the numerator and denominator in the same direction, each adjustment is of different magnitude

When companies fail to expense employee stock options, reported EBITA will be artificially high. Enterprise value should also be adjusted upwards by the PV of outstanding stock options

To adjust enterprise value for pensions, add the present value of unfunded pension liabilities to debt plus equity. To re-move gains and losses related to plan assets, start with EBITA, add the pension interest expense, and deduct the recog-nized returns on plan assets

5. EV/EBITDA vs. EV/EBITA multiple. EBITDA is popular because the statistic is closer to cash flow than EBITA, but fails to measure reinvestment, or capture differences in equipment outsourcing.

Many financial analysts use multiples of EBITDA, rather than EBITA, because depreciation is a noncash expense, reflect-ing sunk costs, not future investment.

But EBITDA multiples have its own drawbacks. To see this, consider two companies, who differ only in outsourcing poli-cies. Because they produce identical products at the same costs, their valuations are identical ($150). When computing the enterprise-value-to-EBITDA multiple, we failed to recognize that Company A (the company that owns its equipment) will have to expend cash to replace aging equipment. Since capital expenditures are recorded as an investing cash flow they do not appear on the income statement, causing the discrepancy

5. A multiple analysis that is careful and well-reasoned will not only provide a useful check of your DCF forecasts but will also pro-vide critical insights into what drives value in a given industry. A few closing thoughts about multiples:

Similar to DCF, enterprise value multiples are driven by the key value drivers, return on invested capital and growth. A company with good prospects for profitability and growth should trade at a higher multiple than its peers.

A well designed multiples analysis will focus on operations, will use forecasted profits (versus historical profits), and will concentrate on a peer group with similar prospects.

P/E ratios are problematic, as they commingle operating, non-operating, and financing activities which lead to misused and misapplied multiples.

In limited situations, alternative multiples can provide useful insight. Common alternatives include the price-to-sales ratio, the adjusted price earnings growth (PEG) ratio, and multiples based on non-financial (operational) data

Economic Profit (EVA) Model

The economic profit 37model highlights how and when the company creates value so even if it leads to a valuation that is identical to that of en-terprise DCF it will provide an useful measure for understanding a company’s performance in any single year, whereas free cash flow is not

Economic profit translates size, return on capital, and cost of capital into a single measure. Economic profit equals the spread be-tween the return on invested capital and the cost of capital times the amount of invested capital.

o Economic profit = Invested Capital x (ROIC – WACC) or o Economic profit = NOPLAT - (Invested Capital x WACC)

oCV =

E Pt

WACC+

NOPLA T t+1∗( gRONIC )∗( RONIC−WACC )

WACC (WACC−g ) This approach shows that economic profit is similar in concept to accounting net income, but it explicitly charges a company for all

its capital, not just the interest on its debt.

APV Model:

The adjusted present value (APV) model separates the value of operations into two components: the value of operations as if the company was all-equity financed and the value of tax shields that arise from debt financing

To build an APV-based valuation, value the company as if it were all equity financed. Do this by discounting free cash flow by the unlevered cost of equity (what the cost of equity would be if the company had no debt). To this add the present value of tax shields

The unlevered cost of equity equals the cost of equity as if the firm was financed entirely with equity

37 Not every company has a positive economic profit. In fact many companies earn an accounting profit (net income greater than zero), but can’t earn their cost of capital

23

Value of Operaions=∑t=1

∞ FCFt

(1+ku )+∑

t=1

∞ Tax Shields t

(1+k txa)

#27 Cod. 20137

The cost of capital for tax shields is unobservable. That’s why we use the Modigliani Miller result where the blended cost of capi-

tal for operating assets (ku - which is called the unlevered cost of equity) and financial assets (ktxa) must equal the blended cost of

capital for debt (kd) and equity (ke)

Some practitioners use the unlevered cost of equity, others the cost of debt. To use the APV, we need to discount projected free

cash flow at the unlevered cost of equity, ku. Unfortunately, none of the variables (including ku) on the left side can be observed. Only the values on the right, i.e. those related to debt and equity, can be measured directly

o Method 1: Assume ktxa equals ku. If you believe the risk associated with tax shields (ku) equals the risk associated with

operating assets (ku), the risk equation can be simplified dramatically. Specifically,

o Method 2: Assume ktxa equals kd. If you believe the risk associated with tax shields (ktxa) is comparable to the risk of

debt (kd), the equation can once again be arranged to solve for the unlevered cost of equity.

If the debt is assumed to be constant the formula can be simplify D-Vtxa=D(1-t)

Equity DCF Model [Used for banks]:

The equity DCF model values equity directly by discounting cash flows to equity at the cost of equity, rather than at the weighted average cost of capital. However it is difficult to implement correctly because capital structure is imbedded in the cash flow. This makes forecasting difficult – as cash flows must be defined consistently with the cost of capital. Some drawbacks are: Unlike free cash flow, an increase in debt will (tempo-rarily) increase cash flow to equity, in fact as leverage rises, the cost of equity must be increased. If the offsetting increase is not computed per-fectly, the company will artificially create/destroy value

CV =¿(1− g

ROE )ke−g

Special valuation case:

Emerging market valuation:

The valuation of those economies is getting more and more important thanks to globalization and the presence of a global asset allocation indus-try. This case poses many different difficulties and obstacles: such as Lack of an efficient stock market (illiquidity), no futures market to hedge the currency risk, political and macroeconomic condition is volatile and significant accounting difference. There is no consensus in the practitioners field to solve those issues; McKinsey suggests a triangular method based on a scenario DCF38, a risk premium DCF and a multiple analysis (inter-national and home based). Our presentation is divided in two sections: the first consists of preliminary operations, the second of valuation model The first section is divided into two phases:

o The first step is the reclassification of the historical analysis, you must be aware of the possible accounting differences to depurate ratio or other measure of possible distortion

o The second phase consists of making consistent economic assumptions, aiming to create a set of hp not to obtain the correct one Macroeconomics variable are more volatile in those economy To manage the exchange risk we must consider:

The PPP does hold in the long run, but the short term deviation can be significant, it is important to un-derstand the relative current position to estimate the long term convergence

To hedge the risk you must understand the exposure of the company to this risk, many industry in emerging economy usually trade using foreign currency, hence there is no exposure

If there is a developed and liquid market for futures you can synthetically replicate it by estimating the inflation spread over the next period or use a forward future exchange rate to convert future cash flow

McKinsey suggest to use an international investor approach, meaning not to overestimate risk which can easily be diversified

The second section is divided in several phases on both scenario and premium DCF

38 The scenario approach is preferable because it is more flexible and allows us to understand which events are responsible of the value fluctuation

24

V u

V u+V txa

ku+V txa

V u+V txa

k txa=D

D+Ekd+

ED+E

ke

k u=E

D+Ekd+

ED+E

ke

k u=D-Vtxa

D-Vtxa+ Ekd+

ED-Vtxa+ E

ke

#27 Cod. 20137

o To estimate the Cash flow, As in the normal case, be consistent in developing your case To incorporate the emerging market risk in the cash flow by using the scenario approach, thus the numerator is modified to take into account those risks

Use past data on crisis to have a clue of possible outcome and to compute the Probability based on frequency The Terminal value should not discount any crisis risk, since in any case they won’t last in the long term, hence we

should use the western hp on terminal growth (convergence)o To estimate WACC (global investors prospective39) remember that companies in those economy usually are less exposure to

leverage when you are choosing the capital structure: The risk free rate could not exist in those economy or there is no long term government bond market:

Use the US bond plus an expected inflation spread estimate with the spread between bond denomi-nated in foreign currency and home one

Or use the difference between projected inflation, however in this case you should perform a model analysis and it isn’t sure that this projection is better than the market expectation

To estimate the beta keep in mind that the CAPM is not suggest, hence we should: At first compared the local industry sector index with one of the developed economy to see if there is any

significant markup Secondly regress your target on a developed country index and add back the eventually markup

The market premium cannot be estimate using the spread between local market and government bond (there too many imperfection), therefore it is suggest to use a global market premium

The after tax cost of debt can be tricky in those economies Its cost should not consider any additional spread; credit risk is similar among countries. The correct

methodology is to add on the local risk free the spread computed using the rating approach The taxation in these counties can be really different, therefore it is highly suggested to incorporate any

difference in the tax shield or in the cash flow depending on their link to those items We should allow the model to have different capital cost x each period, and terminal discount factor

should not address any country premium Estimate a country risk premium only if you are not using a scenario approach, and only to triangulate result. This

method consists of adding on the normal cost of capital another spread Use different source, understand the company exposure The country risk premium approach has several drawback:

o There is the possibility to overestimate its valueo It will penalize the cash flow unequally, more the long termo It must be applied only to a normal case to avoid double countingo There is no statistically proves that the emerging market are going to pay drastically higher

premium compared with the developed economieso Different company has different exposure to the country risk, therefore a mechanical usage is

not suggested o An high premium is like assuming a big probability of distress, hence compared the results

with the relative implied probability of distress o After the DCF analysis is time for interpreting the results:

THE Enterprise value can be really different form the current price, the emerging market can significantly deviate from intrinsic value, due to lack of liquidity and information efficiency

Use multiples for both international and home comparable, the international to have an idea on the market expec-tation on the emerging market growth (the premium paid for the higher expectation), the home peer to have in-sight on the relative positioning of the target

High growth industry

This firm typology (early stage) is characterized by high uncertainty, there are many methods starting from scenario DCF to real option, however none of them is better than another, actually some practitioners have even described it as hopeless. McKinsey is suggesting the scenario DCF, since other methods suffer of: multiples: volatility, possible negative value, unique characteristic are not accounted; real option: some input of DCF, but it is more complex and obscure At first we will develop a long term future view, meaning we will imagine a situation in which the company will stabilize its performance

(usually the hyper growth phase may last around 10/15 years)o In doing this we must assess the size of the market (it is new or old), the product and how it satisfies the needs of the client.

Use ratio like average return per clients, penetration ratio…

39 There is no framework for valuing companies with a local prospective

25

#27 Cod. 20137

o We have to understand the price dynamic, new entrance’s occurrenceo Set reasonable boundary40 and define all the key value drivers as well as understand where revenues come fromo Built scenario to deal with uncertainty, remember to weight those scenario with consistent probability taking from historical

examples (transparent hp since they are subjective (no historical evidence) and the final value highly depends on them) Starting form the future we will came back to the present making assumption on how fast the company will reach that level

o Keep in mind the difference between investment and expense (capitalized)

o Consider historical comparable examples trend41 At the end you will come out with the implied IRR, however the uncertainty is here to stay so diversify

Cyclical industry valuation both from a managerial prospective and a financial one

The share behavior for those companies is not totally rational, it seems that the market is not able to predict the cycle:o One reason could be linked with the analyst incentive to avoid valuing down part42, o The price follows a specific model rather than the market consensus (provided by analyst), the market is hoping in the possi-

bility to break the cycle, it seems it is using the following approach: 50% zero foresight, the current level are assumed to be maintain forever 50% detailed foresight, it is a detailed estimation of the cycle

The management behavior seems to mislead the market, in fact their investment strategies are totally counter rational (they invest when they shouldn’t) due to the difficulty to convince board to invest during the down side of a cycle

The proper valuation method is to run a model based on a normalized terminal value in a scenario considering the breaking cycle possibility

Bank industry

Valuing bank is an hard task: 1) accounting principles matter a lots in defining the whole picture (those decisions are subject to management, thus we need both to understand and to assess if those decisions are correct), 2) the leverage exposure is higher than other business, hence this business is more correlated with economy, 3) banks are a multi business industry43, each of those have peculiar characteristic and 4) there is not enough info on bank’s economic.

o Net interest income is the result of the typical role of a commercial bank, transfer surplus (deposit) to who need resource (loan). This activity is made transforming the maturity, therefore this risk must be taken in account to judge value creation

o Fee and commission are the result of providing services. This part of income is the main resource for investment bank, but it is an important source of revenue even for the new model of universal bank

o Trading income is both the property and external trading. The property one has been proved to be incredibly volatile, large loss in a single year can wipe out all the gain of the previously years, while the external is a cyclical business

o Other income is a marginal part of the total revenue for a bank and it consists in a wide range of non-banking activity (insurance, participation, pension product, real estate development and services for third party)

Principle of bank valuation, since we cannot value operation separately form interest expense/income we have to use two possible method the equity DCF and the spread approach:

o The equity cash flow can be computed with two different methods: Starting from NI - the earnings retained in the business + any variation in OCI (other compressive income) Considering all the shareholder cash flow including cash changing hands such as dividend, new issuance

and repurchase stock The perpetuity formula for the terminal value needs some rearrangements: instead of ROIC we will use RONE that

it the return on new equity reinvestment, and NOPLAT is substitute with Net interest income (NII) To Estimate the Ke we need to take care of Changing cost of equity since it is related to the equity capital ratio,

which is strictly correlated with business develop and of leverage risk, but a normal CAPM model fails in doing it There are some pitfall on the equity cash flow method :

The first limit is the incapability to highlight the value creation using NII, thus we should consider: The cost of capital due to regulatory requirement and the Maturity miss match

To forecast future develop we need to consider the capital requirement and to understand the interest rate evolution as well as the operating expense to maintain the presence in the territory

o Spread approach is the net interest income minus all the cost of equity and maturity transformation, this method is useful to understand the bank performance, while DCF is better to have an overall valuation

40 By comparing with other similar company to avoid to aggregate small error and ends up with a big one41 Remember that there a few home run in the history 42 Papers show that EPS estimation are always positive trended43 Nowadays bank industry is getting more and more complex toward a multi business area

26

#27 Cod. 20137

L∗( r l−k l ) (1−t )−TP where k l is the MOR (marginal opportunity rate) and TP the tax penalty, this last variable will ac-

count for the capital structure change Can be useful to make own assumption and estimation on the provision for bad loans, in fact we should check if

the reported quality correspond to the one computed by your own valuation We should compute the tax penalty cost, associated with the holding cost of equity separately, in fact differently

form the DCF this cost is not incorporated into the discount factor We should add the fee component contribution but it is easier to be value, since this business is similar to the cor-

porate one (we can use the same methodologies) and there is no capital absorption This method is better than the NII because it allow us to properly address value creation by addressing the mis-

matched contribution on value creationo To assess properly the risk we should weight each asset using the Basel standard approach, use VAR measure to judge the

market fluctuation impact on the bank balance sheet (trading and fee income) and considering the operating risk is also cru-cial for performance valuation

Insurers:

The Income statement is composed:o Revenue side: Premium income flows from the payments that costumers make for policies. Premium income in any given year is

typically just a tranche of a longer term cash flow, Investment income generated by the time lag between payments of premium and the insurer payments of benefits and claims, Capital gains (or losses) on their investment portfolio and Fee income derived by selling broader range of investment products to costumers

o On the cost side, insurers have several industry specific items: Cost of reinsurance: occurs when an insurers transfer the underly-ing risk to a reinsurer, Benefit and claims: very large components that depend on the type of product sold and Commissions and other policy acquisition costs that incurred to sell policies to costumers. These items can have different accounting treatment un-der national accounting principle and under statutory accounting principle for insurance companies

The Balance sheet:o The main items of the asset side of an insurance company’s balance sheet are : Investment: predominates on the asset side and is

related to the investments of premium income, Separate account assets: funds entrusted to the insurance company to invest on behalf of their costumers and Other typical assets as working capital, fixed assets and goodwill

o The main items of the liabilities side of an insurance company’s balance sheet are : Reserves : the present value of expected bene-fits and claims to be paid out. These reserves are estimated through actuarial guidelines taking into account costumer risks, persis-tence, investment returns and inflation, Debt and equity financing: if debt is straightforward, equity can be more complicated. It can be affected by pension accounting, foreign currency translation and other items

Despite the complexities It is possible to do an informative valuation (example):o For income statement items, the analyst estimates growth in premium and fee income as our main drivers. Investment income is

based on growth in investmento On the expense side analyst forecasts benefits and claims as a percentage of premium and fee income. o For balance sheet analyst can project that investments will grow in line with overall premium and fee income and that reserves in

turn will grow in line with investments. Of course the last assumption can be a simplification because of the sensitivity of reserves to premiums and the life span of the business

Typical multiples are: P/Premiums; P/Embedded Value44 ; P/Book Value; P/Tangible Book Value; P/Net Asset Value

44 Embedded Value (EV): EV measures the value of the insurance company by adding today’s value of the existing business (i.e. future profits) to the market value of net assets (i.e. accumulated past profits).

27