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Valuation Training

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This Slideshare presentation is a partial preview of the full business document. To view and download the full document, please go …

This Slideshare presentation is a partial preview of the full business document. To view and download the full document, please go here:
http://flevy.com/browse/business-document/valuation-training-777


This is a training document on business valuation. It gives an overview of major valuation concepts and issues, discusses alternative valuation methods and provides practical examples for business valuation.
It is particularly useful to financial analysts, MBA students, and consultants.

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  • 1. Valuation 1 Valuation Valuation
  • 2. Valuation 4 Valuation Overview Valuation is a huge topic. Some Key issues in valuation analysis. Cost of Capital in DCF or Discounted Earnings Selection of Market Multiple and Adjustment Growth Rates in Earnings and Cash Flow Projections Terminal Value Method and Calculation Use several vantage points Do not assume false precision This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 3. Valuation 7 Analytical framework for Valuation – Combine Forecasts of Economic Performance with Cost of Capital In financial terms, value comes from ROIC and growth versus cost of capital Competitive position such as pricing power and cost structure affects ROIC P/E ratio and other valuation come from ROIC and Growth This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 4. Valuation 10 Valuation Diagram • Valuation using discounted cash flows requires forecasted cash flows, application of a discount rate and measurement of continuing value (also referred to as horizon value or terminal value) Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value Discount Rate is WACC Enterprise Value Net Debt Equity Value Reference: Private Valuation; Valuation Mistakes This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 5. Valuation 13 ROIC Issues • Issues with ROIC include Will the ROIC move to WACC because of competitive pressures Evidence suggests that ROIC can be sustained for long periods Consider the underlying economic characteristics of the firm and the industry What is the expected change in ROIC When ROIC moves to sustainable level, then can move to terminal value calculation Examine the ROIC in models to determine if detailed assumptions are leading to implausible results Migration tableThis document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 6. Valuation 16 Sustaining Growth and ROIC > WACC • Mean Reversion of Long-term Growth Competition tends to compress margins and growth opportunities, and sub-par performance spurs corrective actions. With the passage of time, a firm’s performance tends to converge to the industry norm. Consideration should be given to whether the industry is in a growth stage that will taper down with the passage of time or whether its growth is likely to persist into the future. Competition exerts downward pressure on product prices and product innovations and changes in tastes tend to erode competitive advantage. The typical firm will see the return spread (ROIC-WACC) shrink over time. A study by Chan, Karceski, and Lakonishok titled, “The Level and Persistence of Growth Rates,” published in 2003. According to this study, analyst “growth forecasts are overly optimistic and add little predictive power.” This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 7. Valuation 19 Example of Comparing Valuation under Alternative Methods This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 8. Valuation 22 Venture Capital Method • Two Cash Flows Investment (Negative) IPO Terminal Value (Positive) Terminal Value = Value at IPO x Share of Company Owned • Valuation of Terminal Value Discount Rates of 50% to 75% Risky cash flows Other services See the article on private valuation This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 9. Valuation 25 Venture Capital Method Continued • In the venture capital method, there are only two cash flows The investment The value when the company is sold • The value received when the company is sold depends on the percentage of the company that is owned. If there is dilution in ownership, the value is less. • Therefore, an adjustment must be made for dilution and the percent of the company retained. e.g. Share value without dilution = 17.5/700,000 = 25 per share If an additional 30% of shares is floated, the value per share must be increased by 30% to maintain the value. Value per share = 17.5/((500,000+VC shares) x 1.3) VC Shares: (25 x 1.3)/17.5-500,000 = 343,373 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 10. Valuation 28 Replacement Value and Tobin’s Q • Recall Tobin’s Q as: Q = Enterprise Value / Replacement Cost • Buy assets and talent etc and should receive the ROIC. Earn industry average ROIC. If the ROIC > industry average, then Q > 1. If the ROIC < industry average, then Q < 1 This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 11. Valuation 31 Fundamental Valuation • What was behind the bull market of 1980-1999 EPS rose from 15 to 56 Nominal growth of 6.9% -- about the growth in the real economy (the real GDP) Keeping P/E constant would have large share price increase Long-term interest rates fell – lower cost of capital increases the P/E ratio • Real Market Value by ROIC versus growth Select strategies that lead to economic profit Market value from expected performance This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 12. Valuation 34 Bt = It +1 + It +2 + It +3 + ... + It +n + F (1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)n Debt (Bond) Valuation • Bt is the value of the bond at time t • Discounting in the NPV formula assumes END of period • It +n is the interest payment in period t+n • F is the principal payment (usually the debt’s face value) • r is the interest rate (yield to maturity) Case exercise to illustrate the effect of discounting (credit spread) on the value of a bond This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 13. Valuation 37 Example of Capitalization Rates • Proof of capitalization rates using excel and growing cash flows This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 14. Valuation 40 Valuation and Sustainable Growth • Value depends on the growth in cash flow. Growth can be estimated using alternative formulas: Growth in EPS = ROE x (1 – Dividend Payout Ratio) Growth in Investment = ROIC x (1-Reinvestment Rate) Growth = (1+growth in units) x (1+inflation) – 1 • When evaluating NOPLAT rather than earnings, a similar concept can be used for sustainable growth. Growth = (Capital Expenditures/Depreciation – 1) x Depreciation Rate • Unrealistic to assume growth in units above the growth in the economy on an ongoing basis. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 15. Valuation 43 Multiples - Summary • Useful sanity check for valuation from other methods • Use multiples to avoid subjective forecasts • Among other things, well done multiple that accounts for Accounting differences Inflation effects Cyclicality • Use appropriate comparable samples • Use forward P/E rather than trailing • Comprehensive analysis of multiples is similar to forecast • Use forecasts to explain why multiples are different for a specific company This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 16. Valuation 46 Which Multiple to Use • Valuation from multiples uses information from other companies • It is relevant when the company is already in a steady state situation and there is no reason to expect that you can improve estimates of EBITDA or Earnings • One of the challenges is to understand which multiple works in which situation: Consumer products EV/EBITDA may be best Intangible assets make book value inappropriate Different leverage makes P/E difficult Banks/Insurance Market/Book may be best Not many intangible assets, so book value is meaningful Book value is the value of loans which is adjusted with loan loss provisions Cost of capital and financing is very important because of the cost of deposits This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 17. Valuation 49 Multiples in Pennzoil Merger – Comparison of Merger Consideration to Trading Multiples This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 18. Valuation 52 Comparison with all Acquisitions Since 2001 All US Banking Acquisitions with a total deal value over $200m SOV-Waypoint Deals in 2004 Deals since 2003 Deals since 2002 Deals since 2001 # of Deals 1 7 16 20 28 Median 238.5 256.1 238.7 238.7 Mean 241.0 249.6 240.8 244.6 Median 304.7 299.2 290.4 299.2 Mean 319.3 309.6 301.4 307.3 Median 20.7 20.4 20.3 20.3 Mean 20.9 20.3 19.9 20.2 Median 29.9 30.4 30.1 30.2 Mean 31.4 32.8 32.1 31.4 238.5 251.8 22.0 32.1 Price/Book Price/Tangible Book Price/LTM Earnings Price/Deposits This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 19. Valuation 55 Studies of Liquidity Discount • Private and public transactions Attempt to compute EV/EBITDA in public and private transactions Adjust so that the transactions are comparable Compute the ratio in pubic and private transactions Discount of 20 to 28 percent for US firms Discount of 44 to 54 percent for non-US firms • Other studies Value in IPO versus value of private trades before IPO High liquidity in 40-50% range, but selection bias Theory involves control by public board This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 20. Valuation 58 Where to Find Data Yahoo Finance.com This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 21. Valuation 61 P/E Ratio versus EV/EBITDA • Use the EV/EBITDA when the funding does not make much difference in valuation Many companies in an industry with different levels of gearing and companies do not attempt to maximize leverage Very high levels of gearing and wildly fluctuating earnings When the earnings are affected by accounting policy and account adjustments • Use the P/E ratio when cost of funding clearly affects valuation and/or when the level of gearing is stable and similar for different companies Debt capacity can provide essential information on valuation EBITDA does not account for taxes, capital expenditures to replace existing assets, depreciation and other accounting factors that can affect value. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 22. Valuation 64 Microsoft P/E , ROE Etc • Microsoft’s P/E has fallen even though EPS has Grown. The PE is explained by ROE falling and growth falling as implied in the PE formula. Microsoft EPS and ROE 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1 9 9 11 9 9 21 9 9 31 9 9 41 9 9 51 9 9 61 9 9 71 9 9 81 9 9 92 0 00 2 0 0 12 0 02 2 0 0 32 0 0 42 0 0 5 EPS 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% ROE Microsoft P/E and Growth 0 10 20 30 40 50 60 1991 1992 19931994 1995 1996 1997 1998 1999 20002001 2002 2003 P/ERatio 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% GrowthRate PE Ratio Past 3 Year GrowthThis document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 23. Valuation 67 Use of P/E Ratio Formula to Compute the Required Return on Equity Capital • It will become apparent later that one cannot get away from estimating the cost of equity capital and the CAPM technique is inadequate from a theoretical and a practical standpoint. • The following example illustrates how the formula can be used in practice: k = (1-g/r)/(P/E) + g • This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 24. Valuation 70 Relationship Between Multiples • Enterprise Value = NOPLAT x (1-g/ROIC)/(WACC – g) • NOPLAT = Investment x ROIC • NOPLAT = EBIT x (1-t) • EBITDA = EBIT + Depreciation EV/EBITDA • EBT = EBIT – Interest • NI = EBT x (1-t) NI/Market Cap • Market Cap = EV – Debt MB = Market Cap/Equity This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 25. Valuation 73 Comparative Multiples • Once taxes, leverage and depreciation are added, the multiples diverge as shown on the table below: This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 26. Valuation 76 Valuation Valuation From Discounted Free Cash Flow This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 27. Valuation 79 Discounted Cash Flow • Why would you make a cash flow forecast of more than one year If the company is stable and you know the stable level of earnings and cash flow, then a cash flow forecast does not add anything to the valuation analysis If you do not know what the future earnings will be, then a cash flow forecast is helpful as long as you have information to make the forecast If you know earnings and cash flow will fluctuate and then reach a stable amount, then discounted cash flow will be better than multiple analysis This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 28. Valuation 82 Unfunded Pension Liabilities • Defined benefit versus defined contribution No issue with defined contribution since contribution covers future obligations and there is no future obligation that is not covered Defined benefit can lead to requirements to fund that are not included in investment reserves Difference is unfunded liability or asset Unfunded liability is like debt – it will be a future fixed obligation like future debt service Note that this assumes the current level of free cash flow does not already consider the fixed obligation • If a company runs a defined-benefit pension plan for its employees, it must fund the plan each year. If the company funds its plan faster then expenses dictate, the company can recognise a portion of the excess assets on the balance sheet. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 29. Valuation 85 $ Explicit forecasts 8,924.43 Terminal valuation 17,811.59 Appraised Enterprise Value (AEV) 26,736.02 Plus: Listed investments 3,416.00 Plus: Other investments 4,356.00 Plus: Cash 20,316.00 Total Appraised Value 54,824.02 Less: Bank & other debt 24,282.00 Less: Minorities 78.00 Equity value 30,464.02 DCF Example to Compute Equity Value from Free Cash Flow – Net Debt is Bank and Minority Interest minus Cash and Listed Investments Note how investments are added and debt is deducted in arriving at equity value Treatment of other investments depend on definition of free cash flow. Here, income from other investments must not be in free cash flow This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 30. Valuation 88 • Terminal or continuing value is analogous to dividends and capital gains. Free cash flow is dividends, residual value is capital gain. • A few methods of computing residual value include: Perpetuity EBITDA Multiple P/E Ratio Market to Book Ratio Replacement Cost NOPLAT • Present value of residual amount to add to present value of cash flow to establish enterprise value Continuing Value to Add to Free Cash Flow First, high growth firms with high net capital expenditures are assumed to keep reinvesting at current rates, even as growth drops off. Not surprisingly, these firms are not valued very highly in these models. Second, the net capital expenditures are reduced to zero in stable growth, even as the firm is assumed to grow at some rate forever. Here, the valuations tend to be too high. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 31. Valuation 91 Example of Discounted Cash Flow Analysis • For the Exelon discounted cash flow analysis, Lehman Brothers calculated terminal values by applying a range of terminal multiples to assumed 2009 EBITDA of 7.72x to 8.72x. This range was based on the firm value to 2004 estimated EBITDA multiple range derived in the comparable companies analysis. The cash flow streams and terminal values were discounted to present values using a range of discount rates of 5.43% to 6.43%. From this analysis, Lehman Brothers calculated a range of implied equity values per share of Exelon common stock. • PSE&G: For PSEG's regulated utility subsidiary, Morgan Stanley calculated a range of terminal values at the end of the projection period by applying a multiple to PSE&G's projected 2009 earnings and then adding back the projected debt and preferred stock amounts in 2009. The price to earnings multiple range used was 14.0x to 15.0x and the weighted average cost of capital was 5.5% to 6.0%. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 32. Valuation 94 Continuing Cash Flow from NOPLAT and ROIC • Using a multiple of NOPLAT has a couple of advantages It is not distorted by large of small capital expenditures Continuing value directly relates to assumptions about ROIC For companies with low leverage, the NOPLAT multiplier is similar to the P/E ratio • Formulas for Computing Continuing Value with NOPLAT Free Cash = NOPLAT – Capital Expenditure + Depreciation Free Cash = ROIC x Investment – Capital Expenditure + Depreciation The equation becomes: Free Cash = (1-Real Growth/Real ROIC) x NOPLAT In this formulation G = ROIC x Plowback Rate Similar to ROE x Retention Rate This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 33. Valuation 97 Practical Issues and Continuing Value • Book Value – when book value means something from an economic standpoint Banks Utility Companies • EV/EBITDA, P/E – companies without lumpy investments Telcom Manufacturing • Replacement Cost – when replacement cost can be established Oil, Gas and Mining Airlines •It seems foolish to assume that current multiples will remain constant as the industry matures and changes and that investors will continue to pay high multiples, even if the fundamentals do not justify them. If there is stable growth, the P/E multiple in the terminal value should be lower. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 34. Valuation 100 Valuation Valuation from Projected EPS and Dividend per Share This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 35. Valuation 103 Illustration of EPS and DPS Valuation • Demonstrate that incorporation of growth reduces to the formula EPS/(k-g) • Compute present value of the EPS over the forecast horizon This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 36. Valuation 106 Example of Business Segment Analysis in Corporate Models This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 37. Valuation 109 Firm Valuation versus Equity Valuation Multiples – Depreciation Rate Return and Cost of Capital Enterprise Value - NOPLAT 100,000.00 Required Equity Return 10% Enterprise Value - FCF 100,000.00 Growth Rate 0% Return on Invested Capital 10% WACC 10.0% Leverage Return on Invested Capital 10.0% Leverage (Book Value) 0% Return on Equity 10.0% Interest Rate 8% Other P/E Ratio 10.00 Deprecitation Rate 5% EV/EBITDA 6.7 Cap Exp/Depreciation 100% Market to Book 1.00 Investment 100,000 ROIC Multiple - [(1-(g/ROIC))/(WACC-g)] 10.00 Tax Rate 0% FCF Multiple - 1/(WACC-g) 10.00 ResultsAssumptions This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 38. Valuation 112 • From the perspective of convenience, it is often easier to estimate equity than the DCF, especially when leverage is changing significantly over time (for example, in project finance and in leveraged buyouts where equity IRR is used). • Equity value measures a real cash flow to owners, rather than an abstraction (free cash flows to the firm exist only on paper). Free cash flow is affected to a large extent by capital expenditures which can cause problems. Firm versus Equity Valuation This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 39. Valuation 115 At 50% Payout – Growth is ½ of the ROE Price to Earnings Computation Long-Term Growth Rate 0.00% Total Value (Sum of Annual Value) 6.85 Stable Growth Rate 7.5% Initial Earnings 1.03 Equity Cost of Capital 15.0% PE Ratio - Value/Net Income 6.67 P/E Formula: (1-g/r)/(k-g) 6.67 PEG: PE/Growth 0.89 Year 1 2 3 4 5 6 7 8 9 10 Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% Holding Period 10 Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE TRUE Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE Investment Beginning Investment 6.85 Beginning Equity (Last Period Ending) 6.85 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 Add: Earnings (ROE x Beginning Equity) 1.03 1.10 1.19 1.28 1.37 1.48 1.59 1.70 1.83 1.97 Less: Dividends (NI x Payout Ratio) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98 Ending Equity (Beg + Income - Payout) 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 14.12 Cash Flow to Equity and Valuation Cash flow from Dividends from Above 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98 Terminal Multiple of Earnings from Above 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 6.67 Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 14.12 Total Cash Flow (Terminal + Dividends) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 15.10 Required Return on Equity 15.00% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Discount Factor [1/(required return + 1)^yr] 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25 Value of Cash Flow [CF x Discount Fac] x Switch 0.45 0.42 0.39 0.36 0.34 0.32 0.30 0.28 0.26 3.73 Period Future Earn Current Growth 10 1.97 1.03 7.50% Growth over Forecast Horizon This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 40. Valuation 118 Effect of Growth – Microsoft Example – Long-term Equals the Current Growth – P/E is 20 Price to Earnings Computation Long-Term Growth Rate 7.50% Total Value (Sum of Annual Value) 20.55 Long-term Return 15.0% Initial Earnings 1.03 Equity Cost of Capital 10.0% PE Ratio - Value/Net Income 20.00 P/E Formula: (1-g/r)/(k-g) 20.00 PEG: PE/Growth 2.67 Year 1 2 3 4 5 6 7 8 9 10 Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Dividend Payout 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% 50.00% Holding Period 10 Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE TRUE Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE Investment Beginning Investment 6.85 Beginning Equity (Last Period Ending) 6.85 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 Add: Earnings (ROE x Beginning Equity) 1.03 1.10 1.19 1.28 1.37 1.48 1.59 1.70 1.83 1.97 Less: Dividends (NI x Payout Ratio) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98 Ending Equity (Beg + Income - Payout) 7.36 7.92 8.51 9.15 9.83 10.57 11.36 12.22 13.13 14.12 Cash Flow to Equity and Valuation Cash flow from Dividends from Above 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 0.98 Terminal Multiple of Earnings from Above 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 42.35 Total Cash Flow (Terminal + Dividends) 0.51 0.55 0.59 0.64 0.69 0.74 0.79 0.85 0.92 43.34 Required Return on Equity 10.00% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% Discount Factor [1/(required return + 1)^yr] 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39 Value of Cash Flow [CF x Discount Fac] x Switch 0.47 0.46 0.45 0.44 0.43 0.42 0.41 0.40 0.39 16.71 Period Future Earn Current Growth 10 1.97 1.03 7.50% Growth over Forecast Horizon This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 41. Valuation 121 • A stable growth rate is a growth rate that can be sustained forever. Since no firm, in the long term, can grow faster than the economy which it operates it - a stable growth rate cannot be greater than the growth rate of the economy. • It is important that the growth rate be defined in the same currency as the cash flows and that be in the same term (real or nominal) as the cash flows. • In theory, this stable growth rate cannot be greater than the discount rate because the risk-free rate that is embedded in the discount rate will also build on these same factors - real growth in the economy and the expected inflation rate. Growth Rate and Discount Rate This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 42. Valuation 124 Length of Time Until Stable Growth – 10 Years – P/E is 15 Price to Earnings Computation Long-Term Stable Growth Rate 3.00% Total Value (Sum of Annual Value) 15.92 Long-term Return 20.0% Initial Earnings 1.03 Equity Cost of Capital 10.0% PE Ratio - Value/Net Income 15.49 P/E Formula: (1-g/r)/(k-g) 12.14 PEG: PE/Growth 1.48 Year 1 2 3 4 5 6 7 8 9 10 Return on Equity 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Dividend Payout 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% 30.00% Holding Period 10 Switch for Terminal Period FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE FALSE TRUE Switch for Cash Flow Period TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE TRUE Investment Beginning Investment 6.85 Beginning Equity (Last Period Ending) 6.85 7.57 8.36 9.24 10.21 11.29 12.47 13.78 15.23 16.82 Add: Earnings (ROE x Beginning Equity) 1.03 1.14 1.25 1.39 1.53 1.69 1.87 2.07 2.28 2.52 Less: Dividends (NI x Payout Ratio) 0.31 0.34 0.38 0.42 0.46 0.51 0.56 0.62 0.69 0.76 Ending Equity (Beg + Income - Payout) 7.57 8.36 9.24 10.21 11.29 12.47 13.78 15.23 16.82 18.59 Cash Flow to Equity and Valuation Cash flow from Dividends from Above 0.31 0.34 0.38 0.42 0.46 0.51 0.56 0.62 0.69 0.76 Terminal Multiple of Earnings from Above 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14 12.14 Terminal Cash Flow (Earnings x Mult x (1+g)) - - - - - - - - - 33.86 Total Cash Flow (Terminal + Dividends) 0.31 0.34 0.38 0.42 0.46 0.51 0.56 0.62 0.69 34.62 Required Return on Equity 10.00% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% Discount Factor [1/(required return + 1)^yr] 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39 Value of Cash Flow [CF x Discount Fac] x Switch 0.28 0.28 0.28 0.28 0.29 0.29 0.29 0.29 0.29 13.35 Period Future Earn Current Growth 10 2.52 1.03 10.50% Growth over Forecast Horizon This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 43. Valuation 127 • There are a number of reasons why a firm might have negative earnings, and the response will vary depending upon the reason: - If the earnings of a cyclical firm are depressed due to a recession, the best response is to normalize earnings by taking the average earnings over a entire business cycle. - Normalized Net Income = Average ROE * Current Book Value of Equity - Normalized after-tax Operating Income = Average ROC * Current Book Value of Assets - Once earnings are normalized, the growth rate used should be consistent with the normalized earnings, and should reflect the real growth potential of the firm rather than the cyclical effects. Valuation of Firms that are Losing Money This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 44. Valuation 130 • The valuation of a private firm is more difficult than stock in a publicly traded firm. In particular, A. The information available on private firms will be sketchier than the information available on publicly traded firms. B. Past financial statements, even when available, might not reflect the true earnings potential of the firm. Many private businesses understate earnings to reduce their tax liabilities, and the expenses at many private businesses often reflect the blurring of lines between private and business expenses. Valuation of a private firms This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 45. Valuation 133 EPS adjustments Item For recurring net profit Profits and losses on operations discontinued during the period IN Profits or losses on disposals of investm ents acquired for resale but not held in the ordinary course of business IN Extraordinary item s O UT G ains or losses on the disposal of fixed assets IN G ains or losses on the disposal of subsidiaries/associates or business units O UT G oodw ill am ortisation O UT Provisions for reorganisation or restructuring IN N o te : a d ju stm e n ts o n ly m a d e to th e e xte n t dis clo su re a llow s a nd m a teria lity e qu ires This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 46. Valuation 136 Dilution – Factors and treatment • Contingently issuable shares - Include shares in the calculation of basic EPS if the contingency has been met. • Options or warrants in existence over as yet un-issued shares – Assume exercise of outstanding dilutive options and warrants • Loan stock or preference shares convertible into equity shares in the future – Assume that instruments are converted therefore saving interest but increasing the number of shares in issue This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 47. Valuation 139 Equivalence factor approach Net Profit $300,000 Par value No. Total par value Price Class A Primary $5.00 800,000 $4,000,000 $10 Class B Secondary $0.50 4,000,000 $2,000,000 $1.2 $6,000,000 Secondary to primary equivalence factor 0.1 Equivalent number of primary shares 1,200,000 Class A EPS 25.00c (300,000 / 1,2000,000) Class A PE 40.00x (10.00 / 0.25) Class B EPS 2.5 Class A EPS x equivalence factor Class B PE 48.00x (10.00 / 0.25) Multiple share classes This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 48. Valuation 142 Issues in the application of PEs • Accounting Policy differences – Particularly significant for cross border comparisons where companies may follow local, international or US GAAP • Loss making companies – No earnings therefore no PE • Cyclical companies – PEs volatile through the cycle and therefore difficult to benchmark • Finding a suitable benchmark – Difficult to find companies that are perfect matches in all determinants of a PE • Growth – As discussed value and growth are not always the same • Capital market conditions – The cost of equity will vary depending on underlying interest rate environment that is likely to be different in different countries • Financing – The greater the gearing of a company the greater the cost of equity and therefore, all other things being equal, the lower the value and the lower the PE This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 49. Valuation 145 Valuation of Subsidiary Companies in Different Countries • How would things differ if we are valuing companies from different countries, different sectors etc. • Cash flows should be stated in the currency where the subsidiary is located (Malaysian Ringgit) Compute prices and costs in Baht and Ringgit and then translate the revenues and costs in Baht to Ringgit To convert the Baht to Ringgit, use the expected future spot Ringet/Baht exchange rates Since, as a practical matter, forward exchange rates are not available beyond 18 months, compute future spot rates from interest rate parity Interest rate parity means that if you invest in risk free securities of different currencies, the spot exchange rate must reflect the future values. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 50. Valuation 148 Free Cash Flow We often talk about free cash flow, sometimes, it is challenging to assess what is "free“ cash flow or not, may wish to elaborate on that rather than just defining free cash flow in a text book term. The basic point is to keep things consistent. If you define FCF as EBITDA without other income, then the valuation does not include other investments. On the other hand if FCF is defined using Cash B/4 Financing that includes other income, the other investments are included in the valuation This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 51. Valuation 151 Terminal Value Terminal value, and the use of a stable growth rate. How do you determine that, what is the rule of thumb and how do you determine which year onwards should be terminal year (i.e. how long should your forecasted period be). On how to calculate a WACC, rather than just providing the formula of WACC, it would be useful to give instructions on where to find the market premium data, betas and what is the best method vs the most practical method. Should we include country risk, exchange rate risks etc and how to get them. Also there is no mentioning of cash revolver and how to calculate it. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 52. Valuation 154 First, Find the File This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 53. Valuation 157 P/E Ratio, Growth and Required Return • P/E = (1/r) + PVGO/EPS PVGO -- present value per share of future growth opportunities r -- required rate of return on equity • This formula does not include the component of whether earnings are greater than cost of capital This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 54. Valuation 160 Industry by Industry P/E Ratio – Sorted from Highest to Lowest This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
  • 55. Valuation 163 Finance Professor • A finance professor received a call from a large financial institution in New York, asking him to interview for a position on their scientific advisory committee. He agreed to go up and interview, knowing that such a position would be prestigious and with the extra income we would be able to purchase more consumer durables. As all of you know, interviews are a long and painful process. The interviews lasted two days and at the end of the last day the professor was interviewing with the chief executive who would ultimately be making the hiring decision. At the very end of the interview, the executive asked him, “what is 7 times 3?” The finance professor confidently responded, “22.” • When he got home from New York his family, for once, was eagerly awaiting his return… with lists of consumer durables in their hands. “How did it go?” they asked. “Good,” he said, “except in the last interview they asked me 7x3 and I said 22.” “Ohh! Dad!!!” they cried, “it’s 21!” They threw out their lists of consumer durables, knowing he would never get the job. • Much to his surprise he got a call 2 weeks later saying he’d gotten the position and the firm was having a reception in his honor. At the reception he found the executive and went up to him. “Do you remember our interview?” the professor asked. “Yes,” said the executive. “And do you remember when you asked me 7x3 and I said 22.” “Yes,” replied the executive, “I wrote down your answer.” “Well the correct answer is 21,” said the professor, “why did I get the job?” “Well,” said the executive, “of all the finance professors we interviewed… you were the closest.” • The moral of the story is, if I can do this, you can do this: pricing bonds and non-American options using monte carlo simulation to replicate the results achieved explicitly using decision trees. This document is a partial preview. Full document download can be found on Flevy: http://flevy.com/browse/document/valuation-training-777
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