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Valuation methodology
 

Valuation methodology

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Valuation methodology from an academic perspective.

Valuation methodology from an academic perspective.

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    Valuation methodology Valuation methodology Presentation Transcript

    • Valuation methodology
      An overview
      “If I am not worth the wooing, I am surely not worth the winning.” - Henry Wadsworth Longfellow
    • Methodologies
      2
      So what multiple do we use?
      P/E multiple
      Market to Book multiple
      Price to Revenue multiple
      Enterprise value to EBIT multiple
      How about Discounted Cash Flows (DCF)
      NPV, IRR, or EVA based Methods
      WACC method
      APV method
      CF to Equity method
    • Valuation: P/E multiple
      3
      IPO or a takeover target? This is how we get value;
      Value of firm = Average Transaction P/E multiple  EPS of firm
      Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be)
      If valuation is being done to estimate the firm’s value
      Value of firm = Average P/E multiple in industry  EPS of firm
      This method can be used when
      firms in the industry are making a profit (have positive earnings)
      firms in the industry have similar growth rates (more likely for “mature” industries)
      firms in the industry have analogous capital structure
    • Valuation: Price to book multiple
      4
      The application of this method is similar to that of the P/E multiple method.
      Since the book value of equity is essentially the amount of equity capital injected in the firm, this method measures the market value of each dollar of equity injected.
      This method can be used for
      companies in the manufacturing sector which have huge capital requirements.
      companies which are not in technical default (negative book value of equity)
    • Valuation: Value to EBITDA multiple
      5
      This gives us the enterprise value, the value of the business operations (versus the value of the equity).
      In figuring out the enterprise value, just the operational value of the business is included.
      Value from investment activities, such as investment in T-bills or bonds, or investment in stocks of other companies, is not factored in.
      The following economic value balance sheet brings to light the concept of enterprise value.
    • Enterprise Value
      6
      Enterprise Value
    • Value to EBITDA multiple: Example
      7
      Let’s value a Target using the following data points:
      Enterprise Value to EBITDA (business operations only) multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3.
      Recent EBITDA of target company = $20 million
      Cash in hand of target company = $5 million
      Marketable securities held by target company = $45 million
      Interest rate received on marketable securities = 6%.
      Sum of long-term and short-term debt held by target = $75 million
    • Value to EBITDA multiple: Example
      8
      Take the mean (Value/ EBITDA) of recent transactions
      (10.1+9.8+9.2+10.5+10.3)/5 = 9.98
      Interest income from marketable securities
      0.06  45 = $2.7 million
      EBITDA – Interest income from marketable securities
      20 – 2.7 = $17.3 million
      Estimated enterprise value of the target
      9.98  17.3 = $172.65 million
      Add cash plus marketable securities
      172.65 + 5 + 45 = $222.65 million
      Subtract debt to find equity value: 222.65 – 75 = $147.65 million.
    • Valuation: Value to EBITDA multiple
      9
      Since this method measures enterprise value it accounts for different
      capital structures
      cash and security holdings
      By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value.
      Appropriate for valuing companies with heavy debt burdens: while earnings might be negative, EBIT is likely to be positive.
      It provides a measure of cash flows that can be used to support debt payments in levered companies.
    • Heuristic methods: drawbacks
      10
      While heuristic methods are simple, all of them share several common disadvantages:
      they do not accurately reflect the synergies that may be produced in a takeover.
      they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm.
      They assume that the firm being valued is similar to the median or average firm in the industry.
      They require that firms use uniform accounting practices.
    • Valuation: DCF method
      11
      Here we follow the discounted cash flow (DCF) technique we used in capital budgeting:
      Estimate expected cash flows considering the synergy in a takeover
      “PV it,” Discount it at the appropriate cost of capital
    • DCF methods: Starting data
      12
      Free Cash Flow (FCF) of the firm
      Cost of debt of firm
      Cost of equity of firm
      Target debt ratio (debt to total value) of the firm.
    • Template for Free Cash Flow
      13
      “Income Statement”
    • Template for Free Cash Flow
      14
      The goal of the template is to estimate cash flows, not profits.
      Template is made up of three parts.
      An “Income Statement”
      Adjustments for non-cash items included in the “Income statement” to calculate taxes
      Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc.
      The “Income Statement” portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting.
      Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.
    • Template for Free Cash Flow
      15
      There are four categories of items in our “Income Statement”. While the first three items occur most of the time, the last one is likely to be less frequent.
      Revenue items
      Cost items
      Depreciation items
      Profit from asset sales
      Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e.g. depreciation) and subtract all non-cash items added earlier (e.g. gain from salvage).
      There are two type of capital items
      Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E))
      Working capital
    • Template for Free Cash Flow
      16
      It is important to recover both at the end of a finite-lived project.
      Salvage the market value property plant and equipment
      Recover the working capital left in the project (assume full recovery)
    • Template for Free Cash Flow
      17
    • Estimating Horizon
      18
      For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it.
      Since a company is assumed to have infinite life:
      Estimate FCF on a yearly basis for about 5  10 years.
      After that, calculate a “Terminal Value”, which is the ongoing value of the firm.
      Terminal value is calculated one of two ways:
      Estimate a long-term growth and use the constant growth perpetuity model.
      Use a Enterprise value to EBIT multiple, or some such multiple
    • Costs of debt and equity
      19
      Cost of debt can be approximated by the yield to maturity (YTM) of the debt.
      If it is not directly available, check the bond rating of the company and find the YTM of similar rated bonds.
      Cost of equity
      Capital Asset Pricing Model (CAPM)
      Findbeand calculate required re.
      Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.
    • Model of a Firm
      20
      Value from Operations
      Value from investments
      Value generated
      Equal if debt is fairly priced
      Enterprise value
      FIRM
      Value to Equity
      DEBT and other liabilities
      EQUITY
    • Value of equity
      21
      Value of equity
      = Enterprise value
      + Value of cash and investments
      - Value of debt and other liabilities