Valuation class

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Valuation-What do we mean?

What is valuation? How do we come up with a value? Art or Science? Price versus Value http://pages.stern.nyu.edu/~adamodar/

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Business Valuation

Using the additive rule, the intrinsic value of a company is the present value of expected free cash flows from existing and future projects.

Since the value of the whole firm (debt and equity) and the value of the shareholder’s equity can both be measured, be sure what you measuring.

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The Fair Market Value Balance Sheet

Current AssetsCurrent Liabilities(excluding current

long-term debt)

Long-TermDebtProperty, Plant,

and Equipment

Intangible AssetsStockholders’

EquityGoodwill and

Going Concern

Net Working Capital

Market Value of Invested Capital(L-T Debt + Equity)

Net AssetValue or Enterprise Value (Equity plus Net Debt)

Just as total assets equals total liabilities plus shareholders’ equity in accounting, in finance:

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Business Valuation: Definitions of Value

Fair Market Value (Price)

The fair market value of an asset is generally defined

as the cash price at which the asset would change

hands between a hypothetical willing buyer and a

hypothetical willing seller, if the asset were offered for

sale on the open market for a reasonable period of time,

and both the buyer and the seller were adequately

informed of the relevant facts with neither being under

any compulsion to act.

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Investment Value (Intrinsic Value)

The investment value is the value of the asset to a

specific owner or prospective owner. Accordingly, this

type of value considers the owner’s or prospective

owner’s knowledge, abilities, expectations of risks,

earning potential, synergies and other factors.

Business Valuation: Definitions of Value

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Valuation Methodologies Cost approaches

Accounting book value (Sum of Assets)Adjusted book value (Replacement Cost)

Market approachesComparable public guideline companiesComparable transactions

Income approachesDividend and Earnings modelsDiscounted cash flow models

Free Cash Flow, Equity Cash Flow, Capital Cash Flow and APV

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The value of individual assets and liabilities are restated to reflect their market value.

Typical adjustments include those for: Inventory under-valuation (LIFO)Bad debt reservesMarket value of PP&E Intangible Assets like patents and brand Investments in affiliatesTax loss carry-forwards

Cost Approach: Adjusted Book

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Two general approaches Comparable Multiples Analysis Comparable Transactions Analysis

Identify publicly-traded companies engaged in similar business activities with risk/return characteristics similar to those at the subject company. Infer value from the prices of the securities at these publicly-traded firms.

Research merger and acquisition data to look at transaction values of similar companies in the industry.

Caveats: Achieve consistency between numerator and denominator Normalize Financial Statements (non-recurring items,

depreciation) Equity value to equity income- PE Multiples Invested capital value to invested capital income-EV Multiples

Market Approaches

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Infers value from the prices of comparable publicly-traded securities or comparable merger and acquisition transactions

Requires extensive analysis of:

» Products

» Markets

» Sales growth

» Profit margins

Comparable Multiples Analysis

» Geographic scope of operations

» Financial structure

» Financial and Operating Trends

» Quality of Management

» Equity Value Multiples Price/Earnings Price/Book Value

» Enterprise Value Multiples EV/Revenues EV/EBITDA EV/EBIT

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Income Approach:

The Enterprise Value of a business (EV) equals the present value of the free cash flows that the assets are expected to provide investors over time (FCFF) discounted by the asset’s expected return (discount rate)

PLUS the present value of the tax shield the assets are capable of supporting

PLUS the value of any non-operating assets (excess cash)

(EBIT) x (1 - Average Tax Rate) Profits From Opns. After Tax (NOPAT)+ Depreciation and Amortization- Capital Expenditures- Additions to Working Capital Free Cash Flows from the Firm (FCFF)

+ PV of Tax Shield

+ PV of Non-Op. Assets (excess cash)

= DCF Enterprise Value

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What is a Tax Shield?

It is the value of the capability of the assets of the business to take on debt.

Since interest payments are deductible for tax purposes, having debt reduces tax liability which increases cash flow and therefore increases the value of the assets.

If two businesses have the same FCF but only one has assets that can be leveraged then it should be worth more to the owner.

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What is a Non-Operating Asset ?

Excess Cash- Substantially more cash than required to operate the business.

Marketable Securities – Publicly traded securities that can be quickly turned into cash.

Patents not currently in use. Strategic Investments not generating cash

flow.

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Surgeon and Butcher

The “surgeon” can use a tool of the “butcher” in order to simplify the calculation.

FCFFT,t = NOPATt + (DEPt - CAPEXt +/- WCt )

Is Equivalent to:

FCFF = NOPAT +/– (Net Asset Intensity)*(Change in Sales)

Where Net Asset Intensity is defined as the net amount of investment in working capital and PPE as a percentage of sales required to operate the business.

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Asset Intensity

Sales 1000 % 1100 +100

AR 150 15% 165

Inv 100 10% 110

Net PPE 100 10% 110

AP (50) (5%) (55)

Other ST Liab.

(50) (5%) (55)

Net Asset Intensity

250 25% 275

Net Assets Adj. to NOPAT

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Net Fixed Assets vs Depreciation plus CAPEX

Period 1 Period 2 Period 3 Period 4 Period 5

Depreciation - income statement 500 1,000 1,500 2,000 2,500

Gross Fixed Assets 5,000 10,000 15,000 20,000 25,000

Accumulated depreciation - balance sheet 500 1,500 3,000 5,000 7,500

Net Fixed Assets 4,500 8,500 12,000 15,000 17,500

Method One:

Add Depreciation 500 1,000 1,500 2,000 2,500

Subtract CAPEX 5,000 5,000 5,000 5,000

Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)

Method Two:

Change in Net Fixed Assets 4,000 3,500 3,000 2,500

Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)

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Calculating the Terminal Value - PV(TVT)

The present value of the terminal value, PV(TVt), is frequently estimated by “capping” the cash flows at the end of a period for which detailed projections are produced. The constant growth model is typically used to estimate the terminal value.

TVT = FCFT(1+g)/(KT - g)

where:

FCFT – operating cash flow in year T

KT - appropriate cost of capital in year T

g - expected growth rate of the free cash flows (growth of economy)

Note that TVT is in year T dollars. It must be discounted back to year 0 before it is used in equation.

Most DCF valuation models are extremely sensitive to terminal value assumptions

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Since the constant growth model assumes that the cash flows will grow at rate “g” forever, you should try to prepare detailed cash flow projections for a period at least as long as it takes the business to stabilize.

Note that “g” cannot exceed K or the sum of expected inflation and the expected real growth rate of the economy.

Selecting the Terminal Year

CashFlows

Year0 T

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Alternative Terminal Value Can use a multiple of free cash flow

of from 6-10 times.

Cash Flow Multiples Equivalency

Terminal Growth rate

Discount Rate 0% 3% 6%

10% 10.0 14.7 26.5

15% 6.7 8.6 11.8

20% 5.0 6.1 7.6

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EBITDA vs FCF…What Gives??

Equivalent EBITDA

FCF Multiple 5 X 7 X 9 X

Net Asset 0% 8.3 11.7 15.0

Intensity 30% 9.0 12.6 16.2

60% 9.8 13.7 17.6

Assumes EBITDA Margin of 20% EBIT Margin of 10% 40% Tax Rate

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Equivalency:

So: 5 X EBITDA Is the same as;

9.0 X FCF at 30% Net Asset Intensity;And

3% Perpetuity Growth at 15% Discount Rate and 0% Net Asset Intensity

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Cont’d:

Can use comparable ratios as well such as….P/E, EV/Sales, P/Book, EV/EBITDA etc.Can use salvage value if exiting businessSometimes zero for depleting assets like

natural resources.

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Discount RateRequired Rate of Return (Opportunity Cost)

Risk Free RateTreasury Bond (10 year)

+ “Market” Risk Premium + Unique Risk of the Company (Beta)

Variability of Sales and Income Concentration of Sales Cyclicality Market Position

+ Small company risk

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Estimating the Discount Rate CAPM measures the stocks volatility relative

to a stock index (S&P 500) to determine a Beta (covariance) for the company. This beta can be adjusted for capital structure and measures the systematic (market) risk of the company.

This risk premium is estimated by multiplying the firm’s beta times the historical market premium of equities minus the historical risk free rate.

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The Security Market LineExpected

Return(r)

ExpectedMarketReturn(rm)

RiskFree

Rate (rf)

0 .5 1.0 Beta (

r = rf + (rm - rf)

Market Portfolio

Security Market Line

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Historical Market Risk prem.S&P 500 vs 10 Yr Treasury Bonds

Source : Damodaran Online (NYU Prof)

Then: Base Rate = 5% + Beta(4%) + Adjustments

Period Stocks 10 yr Bonds Risk Premium

1928-2012 9.31% 5.11% 4.2%

1962-2012 9.73% 6.8% 2.93%

2002-2012 7.02% 5.31% 1.71%

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Estimating Beta

Return On Share

Return On Market

+= .4

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Return On Share

Return OnMarket

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= 1.6

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Beta is the slope of the regression line

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Using Comparables - Beta

Small businesses do not have “observed” betas and therefore we must use “market comparables” to “estimate” the beta of the firm we are evaluating.

In order to do this we must make some adjustments to the observed Beta’s for the varying degrees of debt.

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Re-Levered Beta

Most public companies we use for comparables have some amount of debt, thus their “beta” is considered to be a “levered beta”.

In order to adjust for the varying levels of debt in our “proxy companies" we “un-lever” the betas in order to put everyone on the same playing field.

We then use the “un-levered” beta to calculate our Expected Return on Assets, which is the discount rate to be used for the Capital Cash Flow Method.

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Adjusting Beta for Leverage

Un-levering and Re-levering betas:

U = L / (1+ VD/VE)(1-T)

L = U * (1+ (VD/VE)(1-T))

Where:L is the levered beta of a comparable company

U is the asset (unlevered) beta (assumes d is 0) L is the relevered beta VD/VE is the market value of debt divided by the market value of

equity

T = Corporate tax rate.

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TV

V(1ββ

TV

V(1ββ

E

DUR

E

DLU

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Small Company Adjustment Since Beta is measured against the S&P 500, which are

companies with market caps > $1 billion, and your Beta proxies are also large companies you need to add a 2-5% adjustment to the calculated discount rate for size risk.

Over time small companies demand a higher return by investors because of the inherent risk of size.

This is demonstrated by the historical returns of small cap versus large cap publicly traded stocks.

You can avoid this if the proxy companies are similar in market size to yours.

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Putting the Pieces Together-CCF Method Calculate FCF to Owners (Debt and Equity) Estimate a Terminal Value Calculate the Tax Shield (if appropriate) Estimate a Discount Rate on Assets (Ka) Discount all of these FCF’s at this rate (Ka) Run sensitivities Make adjustments for control, liquidity, key

man etc. Subtract beginning debt if you want to know

Equity Value

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Levels of Value-Control and Liquidity

Control Premium

Marketability Discount

100%Control

MarketableMinority Interest

Closely-HeldMinority Interest

M&A data generally assumes that the Buyer is acquiring control of the company and, if the acquired company was privately held, assumes a lack of marketability in the firm’s securities.

The price of publicly traded comparables assume that the security is marketable, but the price reflects a minority interest in the firm and a premium would have to be paid to gain control

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