Columbia Valuation outline
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    Columbia Valuation outline Columbia Valuation outline Document Transcript

    • Fall 2006 Outline For ValuationThe steps to value a firm consist of four major components:1. FCF – free cash flow to the firm2. Optimal Capital Structure3. WACC – weighted average cost of capital4. Residual ValueNotes on timing: Year 0: date at which you want to calculate the firm’s value Year T+1: beginning of steady state growth in FCFI. Free Cash Flow to the Firm (FCF) First Steps: Identify any redundant assets (excess cash, marketable securities). Adjust working capital in year 0 so that it includes only necessary cash. Use this adjusted figure when you calculate the change in working capital into year 1. Redundant assets should also be deducted from your guess at capital when determining optimal capital structure. Redundant assets should be added to final firm valuation, along with NPV of FCF and residual values. Determining free cash flows: FCF = NOP – ΔWC - ΔNFA Identify explicit assumptions about future values: sales growth rate, operating profit margins, tax rates, fixed asset requirements (CAPEX), and working capital requirements. Use these in your projections. Project missing numbers based on ratio analysis: - Use historical balance sheet/ income statement data - Assume that average of past ratios (ARDOH, INVDOH, COGS/Sales, etc.) will hold in the future Multiply projected EBIT by (1-effective tax rate) to get net operating profits (NOP) - Note: we use effective tax rate here, but marginal tax rate for levering betas and calculating cost of debt - Historical effective tax rate = Tax/EBT - Use a tax schedule if you have it, otherwise use a historical average of Tax/EBT Change in net fixed assets - Project NFA for each year based on net fixed asset turnover (NFATO), determine year-to-year change - Alternatively: calculate the change in net PP&E = CAPEX – depreciation Change in working capital - May be given as WC, or as separate current assets (CA) and automatic sources (AS) - Subtract AS from CA to get WC, determine year-to-year change Ken Ayotte 1
    • 1 SalesII. Optimal Capital Structure OPM D h Cap = Cap rD We need 5 inputs in the above equation to get the optimal D/Cap ratio: 1. h = coverage ratio (EBIT/I) in the realistic worst case (RWC) scenario Choose a number based on vulnerability analysis (How costly is distress?) Factors: Specialized work force, specialized suppliers of custom inputs, dependence on a dealer network, customers expecting continuing support, threat of competitive attack, continuing need to access capital markets Appropriate range for the purpose of this class: 1 to 3. Pick a ratio based on an analysis of the factors above and justify your number 2. OPM = operating profit margin (EBIT/Sales) in the RWC Choose a number based on variability analysis (How likely is distress to occur?) Look at historical OPM figures and evaluate information given in case about future prospects to arrive at an estimate Pick a percentage and justify your number (if not given) 3. Sales = Sales figure from year 0 income statement 4. Cap = capital guess = market val of equity + market val of debt – redundant assets For market value of equity, use the value of an offer if you have it. Otherwise, use current (year 0) market cap = number of shares outstanding times current share price For market value of debt, use book value of debt as a proxy Subtract off redundant assetsNow, plug these first four inputs into your optimal D/Cap equation. This will give you a relationshipbetween D/Cap and rd (call this the firm’s demand for debt) Use this and data from comparable firms, asshown below, to determine D/Cap and rd simultaneously: 5. rd = firm’s future cost of debt, based on it’s optimal capital structure 1 Sales OPM D h Cap For a set of appropriate comparable firms, find their D/Cap ratio and their rd = Cap rD Take the rd of a comparable firm and plug it in to the D/Cap equation. It will give you a D/Cap. Does this value match up closely with the D/Cap of the comp? YES? Stop. The rd you tried and the D/Cap you got are the right values. NO? If the D/Cap you got is higher than the D/Cap of the comp, your rd must be higher. If the D/Cap you got is lower than the D/Cap of the comp, your rd must be lower. Repeat this procedure with other comps to find a required range for rd. (Example: rd must be between 8% and 12%) Choose an appropriate rd within the required range. Plug it into the D/Cap equation to get your optimal D/Cap. Ken Ayotte 2
    • III. Weighted average cost of capital (WACC)Weighted average cost of capital: WACC = [KD * optimal D/Cap] + [rE * optimal E/Cap]Required return on debt: Calculate after-tax cost of debt (KD), using the interest rate from the optimal capital structure section: KD = rD (1-marginal tax rate)Required return on equity: 1. Find asset beta (un-levering equity betas): Decide on comparable firms—firms with similar assets as the assets you are trying to value. Un-lever their equity betas using current D/E ratio. Take an average to find an estimate of the asset beta. Note: For un-levering equity betas, use net debt for both your own firm and the comps if you know the redundant assets. If you can’t estimate it, use the D/E you are given.. ⎡ D⎤ 2. Re-lever to get beta equity: β E = ⎢1 + (1 − t ) ⎥ β A ⎣ E⎦ Re-lever the average beta asset using the optimal D/E ratio. Make sure to use debt to equity ratio, not D/Cap, to calculate betas. D D D Cap D = = E E 1− D Cap 1 + D Cap E 3. CAPM: estimate required return on equity: Calculate cost of equity (rE) rE = rf + β E (rm − rf ) - For rf, use longest bond available minus 1% - Use 8% for risk premium (rm-rf)IV. Residual values:Alternative estimation techniques: Growth in perpetuity: FCFt +1 If the company has growth opportunities: RVt = WACC − g Ken Ayotte 3
    • Be sure you have projected enough years to be in a steady state, in which g is the growth of both sales and FCF. Year T+1 is the year such that after this year, FCF grows at g (T+2, etc). Use FCF in year T+1 as the numerator in the perpetuity. Note that the value you get is in year T dollars. No profitable growth (PVGO=0): If the company does not expect value-added growth use: NOP +1 RVT = T r Always calculate both of the above values. The difference between the two is the NPV of future growth opportunities in year T dollars. Is this difference reasonable based on the economics of the business? If not, the choice of g may be unreasonable. Liquidation: If the company is to be liquidated: - Project assets and current non-debt liabilities in liquidation year - Apply appropriate liquidation percentages (e.g, cash 100%, AR X%, inventory Y%, etc) - Subtract cash proceeds from full book value for taxable gain/loss - Multiply gain/loss by marginal tax rate - Add tax benefit (in case of loss)/Subtract tax liability (in case of gain) to/from cash proceeds. The sum is the total liquidation value. Multiples: You expect that after the estimation period the company is going to be “similar” to a firm for which you have a “multiple” (Equity + Net Debt)/EBIT or (Equity + Net Debt)/EBITDA. Apply that multiple at year T. You can find the multiple by using an average of the multiples of good comps. You could also use your own current multiple along with the comps.Putting the pieces together: Valuation Firm value: Discount FCF and residual value to year 0 using WACC Firm value = PV(FCF) + PV(RV) + Redundant assets Equity value: Equity Value = Firm Value - Current debt (not optimal debt, and not net debt) Evaluation: Divide equity value by shares outstanding, and compare to current stock price Divide equity value by earnings (equivalently, implied share price divided by earnings-per- share) and compare to P/E ratios of comparable firms. Do the multiples implied by the valuation compare sensibly to the multiples of publicly traded firms? Interpret discrepancies and justify your answer Ken Ayotte 4