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- 1. Valuation for Beginners – checkmateAuthors: Eva Hukshorn, Hein Verloop, ABN AMRO / RBS
- 2. AgendaSession 1:• Introduction• Introduction to value• Basic accounting• Discounted Cash Flow valuationSession 2:• Multiples valuation• Leveraged Buy Out valuation• Capita Selecta• Conclusion
- 3. 1 Introduction
- 4. Goal: provide insight in M&A banking• In this course we will provide you some insight in Mergers & Acquisitions, particularly in valuation and valuation techniques: – Discounted Cash Flow (DCF) valuation – Multiples valuation – Comparable Company Analysis (CCA) – Comparable Transaction Analysis (CTA) – Leveraged Buyout (LBO) valuation – Other techniques: share price, premia, etc.• In the next session we will also touch upon items you regularly come across in legal documentation and SPAs, such as: enterprise value, working capital and net debt adjustments, closing accounts• We have built our story around a hypothetic case and will often refer to real life situations and experiences 4
- 5. As a teaser, we begin where we aim to end……understanding multiple valuation techniques Indicative, preliminary valuation range EV EV/EBITDA 2006 CTA 1.8b - 2.2b 9.5x - 11.5x LBO 1.9b - 2.1b 10.0x - 11.0x DCF 1.8b - 2.3n 9.4x - 12.2x CCA 1.5b - 1.7b 7.9x - 9.0x 1,400 1,600 1,800 2,000 2,200 2,400 In EUR millionIndicative and preliminary valuation range of EUR 1.9 billion to EUR 2.1 billion at this earlystage of due diligence 5
- 6. Topics of this session• Introduction to value• Case study that covers the following topics: – Basic accounting / balance sheet mechanics – Basic P&L mechanics – Basic cash flow mechanics – Beyond accounting: towards economics – Introduction to DCF valuation - valuation terminology – Free cash flow – Discounting and discount rate (WACC) – Net present value – Perpetuity / Terminal value – Concepts: Enterprise value / value of operations / equity value etc. 6
- 7. 2 Introduction to value
- 8. Introduction to valueMarket value around EUR Historical cost around 5.5 million EUR 2.0 million Replacement cost Economic value around around EUR 1.5 million EUR 1.8 million Value of an asset (or company) is determined subjectively; to A it might be worth more than to B 8
- 9. Why valuation? Gap• Price ≠ value Subjective (M&A, synergies)Distinction between price and value:• Price is driven by: • Value of a company is driven by: – Demand – Growth & prospects – Supply – Profitability – Capital intensity – Risk – Leverage – Tax 9
- 10. How to determine the value of a firm• Generally the valuation of a company is calculated as follows: Value of the shares (Equity) + Value of interest bearing liabilities (Debt) - Value of cash and cash like items net debt and other adjustments +/- Value of non operating assets and liabilities = Enterprise Value (EV)• In a DCF valuation we reverse these steps – Based on the DCF analysis we know the Enterprise Value (in this context EV is also referred to as the Value of Operations) – Subsequently, we make the same steps as displayed above, but then in reverse order, to calculate the value of the shares: Enterprise Value (Value of Operations) - Value of interest bearing liabilities (Debt) + Value of cash and cash like items net debt and other adjustments +/- Value of non operating assets and liabilities = Value of the shares (Equity) 10
- 11. How to determine the value of a firm (cont d)• Crucial in any valuation analysis in the judgement on what value items (assets and liabilities) are operating and which ones are non-operating – Operating assets are assets a company controls: business activities under direct managerial control – For example: a manufacturing plant, machinery, equipment – Non-operating assets relate to investments in activities not under direct managerial control. The majority of the non-operating items is usually non-core – For example: investments in associates, derivatives, assets held for sale• DCF valuation relates to the valuing the operating activities (the Value of Operations)• In order to make a proper judgement on whether an activity is operating or non-operating, we first of all need to have a better understanding of accounting• Therefore, we will now move towards a case in which we will demonstrate how to tackle this 11
- 12. DCF valuation approach In order to derive to a DCF, we need to develop an understanding about discounting (WACC) and about Free Cash Flows To understand Free Cash Flows, we need to understand cash flows To understand cash flows, we also need to understand the profit & loss statement and the balance sheet i.e. we need some basic understanding of accounting We will apply a ‘bottom-up’ approach is assessing DCF 12
- 13. Case assignment• Imagine you would have quit the law practice and started your own little enterprise. You would have been the new CEO of the coolest hotdog stand (hotdog kraam) at the Dam square by now… 13
- 14. 3 Basic accounting
- 15. Case assignment I: Balance sheet• First thing to do is: – Incorporate a BV, put EUR 18,000 in as equity and arrange EUR 6,000 with a bank – What does the balance sheet look like on 1 December?• Second thing to do is: – Purchase inventory (worst, broodjes, mosterd) for 1,650 hot dogs during December (cost price EUR 0.50 per hotdog) – Take into account that although you have to pay cash for your purchase, you will only receive your order in one month time – What does the balance sheet on 1 January look like immediately after you made your order and paid? 15
- 16. Case assignment I: Balance sheetOprichtingsbalansAssets EUR Liabilities & Equity EURTotaal Totaal 16
- 17. Case assignment I: Balance sheetOprichtingsbalansAssets EUR Liabilities & Equity EURKraam 0 Eigen vermogen 18,000Voorraad 0 Bankschuld 6,000Nog te ontvangen 0Kas 24,000 Nog te voldoen 0Totaal 24,000 Totaal 24,000 17
- 18. Case assignment I: Balance sheetPer: 01/01Assets EUR Liabilities & Equity EURKraam 20,000 Eigen vermogen 18,000Voorraad 0 Bankschuld 6,000Nog te ontvangen 825Kas 3,175 Nog te voldoen 0Totaal 24,000 Totaal 24,000 18
- 19. Case assignment II: Profit and loss• Assume the following for the first year of operations: Number of hotdogs sold 33,000 Consumer price EUR 1,50 Purchased broodjes, worst & mosterd equivalent of 34,980 hotdogs Cost of ingredients per hotdog EUR 0.50 SG&A (Other costs) EUR 17,100 Depreciation EUR 2,000 Interest rate over EUR 6,000 6% Tax rate 25.5%• Prepare the profit and loss statement of your first year in business 19
- 20. Case assignment II: Profit and loss• Prepare the P&L in the following format: Sales – COGS Gross Profit – SG&A Operating result (EBIT) – Interest Profit Before Tax (PBT) – Tax Net Income Note: COGS = Cost of Goods Sold SG&A = Selling, General & Administrative expenses (i.e. Salaries) Depreciation is to be included in COGS 20
- 21. Case assignment II: Profit and lossProfit and loss EURSales 49,500COGS -18,500Gross profit 31,000SG&A -17,100EBIT 13,900Interest -360PBT 13,540Tax -3,453Net income 10,087 Note: We assume we pay out 70% of our profit as a dividend, which equals to EUR 7,061, i.e. the remainder (EUR 3,026) will be transferred to Retained Earnings 21
- 22. Cash Flow• In addition to preparing an income statement, a company must prepare a cash flow statement – The cash flow statement is like your bank statement. It shows how cash came in and went out – A cash flow statement simply describes the flows of cash into and out to different accounts over the course of one year• To understand cash flow, we will start to assess the cash account on the balance sheet. Almost every account on the balance sheet is linked to cash• In order to prepare the cash account, we need to make some closing statements 22
- 23. Closing statements• We need to calculate our ending inventory:Ending inventory calculation# hotdogs purchased 34,980# hotdogs sold 33,000Results 1,980Inkoopprijs van 1 hotdog 0.50 xInkoopprijs vd voorraad 990• The ending inventory stands at EUR 990 per 31 Dec 2007 23
- 24. Closing statements (2)• As you know, we need to pay our inventory one month in advance, i.e. in December we already need to pay for our stock in January• Given the current favorable market circumstances, we assume a 5% increase in sales growth for 2008• As a consequence, we assume a similar development in our inventory:Sales growth in 2008 5%Inventory 1st month 2007 1,6505% increase 83 +Inventory 1st month 2008 1,733Inkoopprijs van 1 hotdog 0.50 xNog te ontvangen 866• Nog te ontvangen bedragen stands at EUR 866 per 31 Dec 24
- 25. Cash account• Below we have portrayed an overview of all cash expenses since incorporation: Beginning cash 24,000 Sales 49,500 Kraam -20,000 COGS -16,500 SG&A -17,100 Interest -360 Tax -3,453 Dividend -7,061 Maintenance -2,000 Paydown of debt -1,000 Voorraad -990 Nog te ontvangen -866 Ending cash 4,170 25
- 26. Case assignment III: Cash Flow• The crux of the cash flow statement is to separate cash flows from operating activities from the other cash flows• Moreover, we need to filter out non-cash items such as depreciation• The cash flow statement distinguishes between three types of cash flows: – Cash flow from operations – Cash flow from investing activities – Cash flow from financing activities 26
- 27. Case assignment III: Cash Flow• The cash flow statement can have the following structure: EBIT+ Depreciation Operating cashflow before changes in WC+ Changes in working capital= Cash flows from operating activities (A)+ Cash flows from investing activities (B)+ Cash flows from financing activities (C)= Net increase in cash (A + B + C)+ Cash at 1 January 2007+ YE cash• Assignment III: Prepare the cash flow statement 27
- 28. Case assignment III: Cash Flow EBIT 13,900+ Depreciation 2,000= Operating cashflow before changes in WC 15,900 Change in inventory -990 Change in receivables -41 Change in payables 0 Income tax expense -3,453 Cash from operating activities 11,416 Acquisition of PPE -2,000 Cash from investing activities -2,000 Paydown of debt -1,000 Interest expense -360 Dividend paid -7,061 Cash from financing activities -8,421= Net increase in cash (A + B + C) 995+ Cash at 1 January 2007 3,175= YE cash 4,170 28
- 29. Case assignment IV: Closing balance sheet• Now that we have prepared the cash statement we can also finalize the closing balance sheet• Prepare the closing balance sheet for 2007 Balans na jr 1: 12/31 Assets EUR Liabilities & Equity EUR Kraam 20,000 Eigen vermogen 21,026 Voorraad 990 Bankschuld 5,000 Nog te ontvangen 866 Kas 4,170 Nog te voldoen 0 Totaal 26,026 Totaal 26,026 29
- 30. 4 Beyond accounting: to economics
- 31. Beyond accounting• For a proper valuation exercise we are in need of economics rather than accounting metrics – Accounting data can be directly retrieved from the annual accounts – In order to retrieve economic values, we need to transform the accounting items to economic items, i.e. we ought to distinguish between operating and non-operating items as essentially we are in search of the value of operations Accounting = backward looking Economics (valuation) = forward looking 31
- 32. Balance sheet: accounting vs. economicBalance sheet Valuation stepsAssets Liabilities & EquityOperating fixed 20,000 Operating 0 Determine economic value of all operatingassets current liabilities assets / liabilitiesOperating 1,856 Debt 5,000 Determine economic value of all non-operatingcurrent assets assets / liabilitiesNon-operating 0 Equity 21,026 Determine value of cashassetsCash 4,170 Determine value of debt 26,026 26,026 Determine value of EQUITY Accounting ≠ Economic 32
- 33. Balance sheet: accounting vs. economicBalance sheet Valuation stepsAssets Liabilities & EquityOperating fixed 20,000 Operating 0 Determine economic value of all operatingassets current liabilities assets / liabilitiesOperating 1,856 Debt 5,000 Determine economic value of all non-operatingcurrent assets assets / liabilitiesNon-operating 0 Equity 21,026 Determine value of cashassetsCash 4,170 Determine value of debt 26,026 26,026 Determine value of EQUITY Accounting ≠ Economic 33
- 34. Income statement: accounting vs. economic AdjustmentsStandard P&L Adjusted P&L • COGS sometimes include Sales depreciation Sales– COGS (= non cash) – COGS (ex depreciation) Gross Profit • SG&A usually includes Gross Profit depreciation and amortisation– SG&A – SG&A (ex depreciation) Operating result (EBIT) EBITDA– Interest – Depreciation Profit Before Tax (PBT) EBITA– Tax Note the introduction – Amortisation Net profit of ‘EBITDA’! EBIT – Interest Profit before tax (PBT) – Tax Net profit Make sure to split cash and non-cash items 34
- 35. Valuation terminology• EV = Value of the total company → value generated by the core operations of a Company → value of operations• Equity value = EV + all cash & non-operating items - all claims by non-residual claimants (net debt)• Net debt = All claims by non-residual claimants - cash• Debt = Interest bearing (bank) debt Debt to equity holders Bonds (convertibles) Debt in pension plans Debt in operating leases ESOP / MSOP programmes• Working capital = All operating current assets minus operating liabilities• Excess cash = Cash that can be used to lower Debt, i.e. cash that is not required for the day-to- day operations of the business• Synergies – Cost synergies – Revenue synergies – Financing synergies 35
- 36. 5 Discounting and discount techniques
- 37. Discounted Cash Flow (DCF)• D = Discounting – Time value – Risk• CF = Cash Flow – Focus on cash generation from operating the company minus investments to sustain and grow the company – In addition: do not take into account non-cash costs Operating fixed assets Equity Free Cash Flows (operating flows) Operating Working capital Financing flows Debt Non-operating Non-operating flows assets & liabilities 37
- 38. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 38
- 39. DCF overview 7 Excess cash P&L & marketable Equity value securities 1 7 Free Cash MV preferred Cash Flow 2 Flow equity 3+4 7 MV of Value of Corporate B/S WACC 5 minority Operations value interests 6 7 MV of Terminal interest- value bearing debtAccounting 7 7 MV of MV of other financial financial = input = output fixed assets1 liabilities2 Notes: 1) including non-operating investments 2) including underfunded pension plans Enterprise value is the equivalent of Value of Operations 39
- 40. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 40
- 41. Operating Free Cash Flow• FCF is the difference between all revenues and sources of cash resulting from the strategy and all cash expenses and investments necessary to implement the strategy• Free cash flow (FCF) is cash that is not required to fund the firm and can be used at managements discretion beyond continuing the existing operating strategy• For example: FCF can be used to service debt or make payouts to shareholders (FCF is available to all claimants and providers of capital) 41
- 42. How to derive Free Cash Flows?• Preparing the Free Cash Flow (FCF) is somewhat similar to preparing the cash flow statement• Main difference: financing flows should be left out EBIT Costs, no expenses: prevent+ Depreciation ‘double counting’+ Amortisation+ Sustaining capital expenditure Cash flow before interest and taxes (CBIT)– Cash taxes Cash flow before new investments (CBNI)– Expansion capital expenditure± Change in working capital Free Cash Flow from operations 42
- 43. Background on ‘new’ items in the FCF• Capital expenditure (CAPEX) – Sustaining CAPEX, i.e. maintenance of existing (fixed) assets: maintenance of the kraam – Expansion CAPEX, i.e. investment in new assets that will serve to grow and expand the business, e.g. enlargement of the kraam – Both type of investment will result in higher depreciation levels 43
- 44. Background on ‘new’ items in the FCF (cont’d)• Cash taxes Cash taxes – Cash taxes represent an adjustment to taxes payable (from the P&L): taxes that 2008 relate to non-operating activities (e.g. PBT 13,540 financing) are added to (resp. subtracted from) taxes payable Rate 25.5% 1 Taxes 3,453• Case Assignment V: Prepare the Free Cash Flow statement for 2007 Net interest 360 Rate 25.5% 2 Taxes 92 CBIT 13,900 Implied cash tax rate 25.5% 3 Cash taxes 3,545 44
- 45. Case assignment V: Free Cash FlowFree Cash Flow statement 2008 Revenues EBIT+ Depreciation– Sustaining investments in tangible assets CBIT Cash taxes CBNI Expansion capex Working capital investments FCF 45
- 46. Case assignment V: Free Cash FlowFree Cash Flow statement 2008 Revenues 49,500 EBIT 13,900+ Depreciation 2,000– Sustaining investments in tangible assets -2,000 CBIT 13,900 Cash taxes -3,545 CBNI 10,356 Expansion capex 0 Working capital investments -1,031 FCF 9,324 46
- 47. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 47
- 48. Case assignment V: Forecasting• Forecasts are crucial for a proper valuation exercise – Essentially, we need to forecast the Free Cash Flows and discount them back to today to calculate the present value of operations – In order to come up with a forecasted Free Cash Flow, we first need to prepare a forecasted P&L, balance sheet and cash flow statement 48
- 49. Forecasting financial statementsProfit & loss account Standard model ConsiderRevenue growth % growth GDP, market growth, inflation, volume vs. price, price pressure, product mix, acquisitions/disposalsGross margin % of revenues price pressure, efficiency, product mix, raw material costsOperating costs growth % growth sales growth, variable vs. fixed costs, inflation, wage costs, efficiencyDepreciation % of opening tangible fixed accounting policy change, large assets investments (current & historic)Amortisation % of opening intangible fixed goodwill: linear write-off and no assets additions 49
- 50. Forecasting financial statementsProfit & loss account Standard model ConsiderDividend pay-out ratio % of net earnings before percentage of earnings or stable DPS extraordinaries growthPreferred interim dividends % of preferred share capital outstandingPreferred interim dividend % of preferred dividendsInterest on debt interest rate maturity of debt, default spreadInterest on cash interest rate current market rate 50
- 51. Forecasting financial statementsBalance sheet Standard model ConsiderStock days days of incr. revenues efficiency of working capital, seasonalityTrade debtors days days of incr. revenues efficiency of working capital, country mix, seasonality, annual averageOther debtors % of incr. revenues timing, annual average, constituentsOperating cash % of incr. revenues idem stock days, industry averageTrade creditors days days of total incr. costs idem trade debtorsOther creditors % of incr. revenues idem other debtorsCash flow statementCapital expenditure % of incr. resp total revenues large investments, maintenance vs.(expansion and sustaining) expenditure 51
- 52. Case assignment V: Forecasting• As you have just noticed, forecasting is an exercise that requires us to make certain assumptions on the development of our company: – We assume revenue growth with 5% in the first two years and thereafter with 3% – Moreover, we assume that COGS and SG&A as a percentage of revenues remain constant (i.e. 2008 levels)• Prepare the P&L for 2009 - 2012 52
- 53. Forecasting the P&L• Revenues growth by more than EUR 8,000 P&L 2007 2008 2008F 2009F 2009F 2010F 2010F 2011F 2011F 2012F to almost EUR 58,000 in 2011 Revenues 49,500 51,975 54,574 56,211 57,897 Growth 5.0% 5.0% 3.0% 3.0%• What can you say about the profitability of COGS -16,500 -17,325 -18,191 -18,737 -19,299 the company going forward? As a % of revenues 33.3% 33.3% 33.3% 33.3% 33.3% Gross Profit 33,000 34,650 36,383 37,474 38,598 Gross margin 66.7% 66.7% 66.7% 66.7% 66.7% SG&A -17,100 -17,955 -18,853 -19,418 -20,001 As a % of revenues 34.5% 34.5% 34.5% 34.5% 34.5% EBITDA 15,900 16,695 17,530 18,056 18,597 EBITDA margin 32.1% 32.1% 32.1% 32.1% 32.1% Depreciation -2,000 -2,000 -2,000 -2,000 -2,000 As a % of revenues 4.0% 3.8% 3.7% 3.6% 3.5% EBIT 13,900 14,695 15,530 16,056 16,597 EBIT margin 28.1% 28.3% 28.5% 28.6% 28.7% Interest (@ 6%) -360 -300 -240 -180 -120 PBT 13,540 14,395 15,290 15,876 16,477 27.4% 27.7% 28.0% 28.2% 28.5% Tax -3,453 -3,671 -3,899 -4,048 -4,202 Tax rate 25.5% 25.5% 25.5% 25.5% 25.5% Net Profit 10,087 10,724 11,391 11,827 12,276 Profit margin 20.4% 20.6% 20.9% 21.0% 21.2% Dividend (i.e. bonus for employee) -7,061 -7,507 -7,974 -8,279 -8,593 Dividend ratio 70.0% 70.0% 70.0% 70.0% 70.0% Retained earnings 3,026 3,217 3,417 3,548 3,683 53
- 54. Forecasting the balance sheet• In our case, forecasting of the balance sheet requires little assumptions – We assume that Inventory and Receivables both remain at a constant percentage of revenues• All other BS items are a consequence of other decisions we have made at an earlier stage in our case: – Depreciation equals the maintenance investment in our kraam, i.e. fixed assets remain constant – Equity is adapted automatically: the retained earnings from the P&L flow into Equity – Debt is paid down yearly in six years and subsequently decreases with EUR 1,000 per year Cash = last year’s cash + the net increase in cash (from CF) 54
- 55. Forecasting the balance sheetBalance sheetBalance sheet 2007 2008 2008F 2009F 2009F 2010F 2010F 2011F 2011F 2012FAssetsKraam 20,000 20,000 20,000 20,000 20,000As a % of revenues 40.4% 38.5% 36.6% 35.6% 34.5%Inventory 990 1,040 1,091 1,124 1,158As a % of revenues 2.0% 2.0% 2.0% 2.0% 2.0%Receivables 866 910 955 984 1,013As a % of revenues 1.8% 1.8% 1.8% 1.8% 1.8%Cash 4,170 6,294 8,614 11,101 13,720As a % of revenues 8.4% 12.1% 15.8% 19.7% 23.7%Total assets 26,026 28,243 30,661 33,209 35,892Liabilities & EquityEquity 21,026 24,243 27,661 31,209 34,892Debt 5,000 4,000 3,000 2,000 1,000Payables 0 0 0 0 0As a % of revenues 0.0% 0.0% 0.0% 0.0% 0.0%Total liabilities & Equity 26,026 28,243 30,661 33,209 35,892 55
- 56. Case assignment VI: Forecasting cash flows• With the information presented (P&L and balance sheet) at hand now prepare the cash flow statement for 2009 - 2012• Subsequently, prepare the Free Cash Flow statement for the period 2009 - 2012 56
- 57. Forecasting cash flowsCash flow statementCash Flow 2007 2008 2008F 2009F 2009F 2010F 2010F 2011F 2011F 2012FEBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Operating cashflow before changes in WC 15,900 16,695 17,530 18,056 18,597Change in inventory -990 -50 -52 -33 -34Change in receivables -41 -43 -45 -29 -30Change in payables 0 0 0 0 0Income tax expense -3,453 -3,671 -3,899 -4,048 -4,202Cash from operating activities 11,416 12,931 13,533 13,946 14,332Acquisition of PPE -2,000 -2,000 -2,000 -2,000 -2,000Cash from investing activities -2,000 -2,000 -2,000 -2,000 -2,000Paydown of debt -1,000 -1,000 -1,000 -1,000 -1,000Interest expense -360 -300 -240 -180 -120Dividend paid -7,061 -7,507 -7,974 -8,279 -8,593Cash from financing activities -8,421 -8,807 -9,214 -9,459 -9,713Net increase in cash 995 2,124 2,320 2,487 2,619Cash at 1 January 3,175 4,170 6,294 8,614 11,101YE cash 4,170 6,294 8,614 11,101 13,720 57
- 58. Forecasting cash flowsFree cash flow statementFree Cash Flow 2007 2008 2008F 2009F 2009F 2109F 2010F 2011F 2011F 2012FRevenues 49,500 51,975 54,574 56,211 57,897EBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Sustaining investments in tangible assets -2,000 -2,000 -2,000 -2,000 -2,000CBIT 13,900 14,695 15,530 16,056 16,597Cash taxes -3,545 -3,747 -3,960 -4,094 -4,232CBNI 10,356 10,948 11,570 11,961 12,365Expansion capex 0 0 0 0 0Working capital investments -1,031 -93 -97 -61 -63FCF 9,324 10,855 11,472 11,900 12,302 58
- 59. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 59
- 60. Discounting• Discounting cash flows is what someone is willing to pay today in order to receive an anticipated cash flow in future years• Hence, the future cash flows must be discounted in order to express their present values in order to properly determine the value of a company• Future cash flows are discounted at a certain rate over time at a rate (also called: “rate of return”), that reflects the perceived riskiness of the cash flows• The applied discount rate reflects two things: – The time value of money – A risk premium• We will now take a closer look at both items Essentially, discounting is all about two things: time and risk 60
- 61. Discounting - time value of money• Congratulations!!! You have just won EUR 1,000 in the Staatsloterij!• You have the unconventional luxury of two payment options: – Receive EUR 1,000 now – Receive EUR 1,000 in a year from now• Does EUR 1,000 today have the same value as EUR 1,000 one year from now? 61
- 62. Discounting - time value of money• If you choose option A, receiving EUR 1,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. Your future value will be EUR 1,000 plus any interest acquired over the year• For option B, you dont have time on your side, and the payment received in one year would be your future value e.g EUR 1,000 Present Future value value t=0 t=1 years Option A EUR 1,000 EUR 1,000 + interest Option B EUR 1,000 - interest EUR 1,000 The time value of money demonstrates that, all things being equal, it is better to have the money now rather than later 62
- 63. Discounting – risk premium• In addition to the time value, the discount rate reflects a risk premium that represents the extra return investors demand, because they want to be compensated for the risk that the cash flow might not materialize after all• An example: Time value t=0 t=1 100 100 106Cash in handAnnual saving 6%return Time value + riskIncorporating riskCash in hand 100 100 110Profit XY 10% 63
- 64. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 64
- 65. Discount rates• Let s go back to the previous example: Time value t=0 t=1Cash in hand 100 100 106Annual saving 6%return Time value + riskIncorporating riskCash in hand 100 100 110Profit XY 10%• The discount rates respectively are: 106 – - 1 x 100% i.e. 6% 100 – 110 i.e. 10% - 1 x 100% 100 65
- 66. Discount rates: Case assignment• What would be the present value of EUR 1,000 you will receive in one year from now, given a discount rate of 6%?• What would be the present value of EUR 1,000 you will receive in two years from now, given a discount rate of 6%?• What would be the present value of EUR 1,000 you will receive in three years from now, given a discount rate of 6%? 66
- 67. Discount rates: Case assignment• Discount rate: 6% Now 1 2 3 Years 943.39 1,000.00 889.99 1,000.00 839.62 1,000.00 1000 ,• Calculation: ( + 0.06)1,2,3 1• whereby 1 is the discount factor 1,2,3 ( + 0.06) 1 Discount factor: 1 / (1 + discount rate)t where t = {1,2,…,T} 67
- 68. Discount rate = Cost of capital• The discount rate is also referred to as the cost of capital• In other words, the cost of capital represents the cost for time and risk. Or, to put it differently: the required return all capital providers demand• For example: – As a shareholder of Philips you require an annual return of 10% on your shares (equity) – As a lending bank to Philips, RBS requires a 6% annual interest rate• Altogether, the Cost of Capital (Kc) represents the blend of all required return to capital providers – Equity: Ke (Cost of Equity) – Debt: Kd (Cost of Debt) Weighted Average Cost of Capital (WACC) 68
- 69. Weighted Average Cost of Capital (cont d)• Obviously, you wouldn t be able to tell the WACC as we have not yet provided the total market value of equity and debt of the company• So, let s suppose Philips is financed with: – EUR 2,000 in equity – EUR 1,500 in debt• We already provided: – All equity holders demand an annual return of 10% (i.e. Ke = 10%) – All debt providers demand an annual interest of 6% (i.e. Kd = 6%)• Hence, what would be the WACC for Philips? – A. 7.1% – B. 7.5% – C. 8.3% 69
- 70. Weighted Average Cost of Capital (cont d)• Answer C would be the correct one!• Calculation occurs as follows: 2,000 1,500WACC = ! 10% + ! 6% = 7.9% 5% 8.3% (2,000 + 1,500 ) (2,000 + 1,500 )• In formula terms: Equity DebtWACC = ! Ke + ! Kd Equity + Debt Equity + Debt 70
- 71. Weighted Average Cost of Capital (cont d)• In the calculation, there is one crucial item we still would need to incorporate:Indeed: TAXES!• Bear in mind that there is a tax shield (tax advantage) on the cost of debt• This changes our WACC formula to: Equity DebtWACC = " Ke + " Kd " (1 ! T ) Equity + Debt Equity + Debt Whereby T equals to the corporate tax rate (25.5% in The Netherlands) 71
- 72. A closer look at the cost of equity (Ke)• As we have explained, the cost of equity equals the required return of equity investors (10% at Philips)• The required return by equity investors can in fact be decomposed in two parts: – The so called risk free return – The return that is specifically related to the Philips stock and the market (i.e. the AEX index) Ke = risk free return + risk bearing return 72
- 73. A closer look at the cost of equity (Ke)• The risk free rate (Rf) represents a floor , i.e. a return that is virtually without risk and that anyone can make. Usually, the risk free rate equals the yield to a 10yr Government Bond (currently around 4.3%) 4.5 4.4 4.3 4.2 4.1 4.0 3.9 0.04 0.02 0 3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 30y Current Previous 73
- 74. A closer look at the cost of equity (Ke)• The market always has a Beta of 1, it is the ‘benchmark’• The return that is specifically related to the Philips stock and the market (i.e. the AEX index) is in fact bearing risk• We need to measure the risk/return of the Philips share relative to the market (the AEX index)• In order to calculate this rate, we need three items: – The deviation of the risk of the Philips stock vis-à-vis the risk of the market (called Beta) – The expected return of the Market (Rm) # " (Rm ! Rf ) – The risk free rate (Rf) of 4.3%• We now get to the following formula: = also referred to as Market Risk Premium (MRP) 74
- 75. A closer look at the cost of equity (Ke)• The Beta of a stock is usually higher or lower than the market – The Beta is higher when a share is more risky (volatile) than the market for a certain period of time (e.g. 5 yrs). To compensate for the additional risk, such shares will demand higher returns (e.g. cyclical or volatile industries, such as semiconductors) – Conversely, the Beta is lower when a share incorporates less risk (less volatility) than the market. Consequently, required returns are lower (e.g. stable sectors like utilities) 75
- 76. A closer look at the cost of equity (Ke)• In the end, the Cost of Equity (Ke) still equals the sum of the risk free returns and risk-bearing returns that can be summarised in the following formula: Ke = Rf + # " (Rm ! Rf )• Graphical version: E9R) Ke = Rf + # " (Rm ! Rf ) rf Market risk(beta) 76
- 77. Case assignment: Calculate the Ke• With the aforementioned information in mind, calculate the Ke for our hot dog kraam at the Dam square:• Please assume the following: – Risk Free Rate of Return 4.50% – Market Rate of Return 10.50% – Company s Beta 1.02• The Cost of Equity (Ke) will be: 4.50% + 1.02*(10.50% - 4.50%) = 10.62% 77
- 78. Case assignment: Calculate the WACC• With the aforementioned information in mind, calculate the WACC for our hot dog kraam at the Dam square:• Please assume the following: – Debt to Equity ratio = 0.33* – Cost of Equity = 10.62% – Pre-tax cost of debt = 6% – Tax rate = 25.5%• The WACC will be: – WACC = 0.75*10.62% + 0.25*6%*(1-25.5%) = 9.1%• What does this imply for any future investments you are planning to make? Note: If D/E = 1/3, then D/(D+E) = 1/(1+3) = 0.25 78
- 79. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 79
- 80. Case assignment: Discount the Free Cash Flows• Now we have calculated the Free Cash Flows and derived a discount rate (a WACC of 9.1%), we can actually start to discount our cash flows• Assignment: discount the FCFs (2008 - 2011) of our Kraam and calculate the Present Values of the annual cash flows• In doing so bear in mind what we have mentioned previously: Discount factor: 1 / (1 + discount rate)t where t = {1,2,…,T} 80
- 81. Case assignment: Discount the Free Cash Flows• The result would be as follows:Free Cash Flow 2007 2008F 2009F 2010F 2011FRevenues 49,500 51,975 54,574 56,211 57,897EBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Sustaining investments in tangible assets -2,000 -2,000 -2,000 -2,000 -2,000CBIT 13,900 14,695 15,530 16,056 16,597Cash taxes -3,545 -3,747 -3,960 -4,094 -4,232CBNI 10,356 10,948 11,570 11,961 12,365Expansion capex 0 0 0 0 0Working capital investments -1,031 -93 -97 -61 -63FCF 9,324 10,855 11,472 11,900 12,302Cost of capital (WACC) 9.1% 9.1% 9.1% 9.1%Discount factor 0.917 0.841 0.771 0.707PV of FCF 9,953 9,644 9,172 8,694• Key question: What is the value of our operations? 81
- 82. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 82
- 83. Terminal value: let s first get back toour last question• Q: What is the value of our operations? Free cash flow 2007 2008F 2009F 2010F 2011F FCF 9,324 10,855 11,472 11,900 12,302 Cost of capital (WACC) 0.0 9.1% 9.1% 9.1% 9.1% Discount factor 0.917 0.841 0.771 0.707 PV of FCF 9,953 9,644 9,172 8,694• A: The value of our operations equals the sum of: – The sum of the PV of the Free Cash Flows generated from 2008 - 2011 (portrayed above) – The sum of the PV of the Free Cash Flows generated from 2012 - ∞ (also known as: Terminal Value) 83
- 84. The concept of Terminal Value• Forecasting until infinity is a harsh exercise, therefore we use a shortcut: – We split the forecasted periods in two sections: – The explicit forecast period (generally 5 to 10 years from now) – The terminal value period (year 11 → ∞)• Terminal Value equals the value of all Free Cash Flows after the period explicit forecast period• Crucial assumption for the Terminal Value is that Free Cash Flows are constant 84
- 85. The concept of Terminal Value (cont d)Terminal value Explicit forecast period Terminal Value 30% 70% 2007 2011 ∞ 60% 40% 2007 2015 ∞ 50% 50% 2007 2013 ∞ 85
- 86. The concept of Terminal Value (cont d)• What in your opinion would be a valid assessment of Terminal Value? – A. Model in an endless number of Free Cash Flows and discount them back – B. Model 100 years of Free Cash Flows and discount them back – C. Something else 86
- 87. The concept of Terminal Value (cont d)• Option A would be calculated as follows: FCF T WACC ! g i.e. mathematically a perpetuity Whereby ‘g’ represents the growth of Free Cash Flows• g > 0 implies constant growth• g = 0 a constant state• Make sure not to mix up the concepts of growth and value creation – Growth does not automatically lead to value creation! 87
- 88. Overview DCF approach1. Determine operating Free Cash Flows2. Forecasting3. Discounting4. Discount rates5. Discount the Free Cash Flows6. Shortcut to determine Terminal Value7. All other valuable items 88
- 89. A recap of all topics covered today Excess cash P&L & marketable Equity value securities Free Cash MV preferred Cash Flow Flow equity MV of Value of Corporate B/S WACC minority Operations value interests MV of Terminal interest- value bearing debtAccounting MV of MV of other financial financial = input = output fixed assets1 liabilities2 Notes: 1) including non-operating investments 2) including underfunded pension plans Enterprise value is the equivalent of Value of Operations 89
- 90. 7 Wrap up
- 91. Let s see whether we gained some more insight Indicative, preliminary valuation range EV EV/EBITDA 2006 CTA 1.8b - 2.2b 9.5x - 11.5x LBO 1.9b - 2.1b 10.0x - 11.0x DCF 1.8b - 2.3n 9.4x - 12.2x CCA 1.5b - 1.7b 7.9x - 9.0x 1,400 1,600 1,800 2,000 2,200 2,400 In EUR millionIndicative and preliminary valuation range of EUR 1.9 billion to EUR 2.1 billion at this earlystage of due diligence 91

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