1Valuation-What do we mean? What is valuation? How do we come up with a value? Art or Science? Price versus Value http://pages.stern.nyu.edu/~adamodar/
2Business Valuation Using the additive rule, the intrinsic value ofa company is the present value of expectedfree cash flows from existing and futureprojects. Since the value of the whole firm (debt andequity) and the value of the shareholder’sequity can both be measured, be sure whatyou measuring.
3The Fair Market Value Balance SheetCurrent AssetsCurrent Liabilities(excluding currentlong-term debt)Long-TermDebtProperty, Plant,and EquipmentIntangible AssetsStockholders’EquityGoodwill andGoing ConcernNet Working CapitalMarketValue ofInvestedCapital(L-T Debt+ Equity)Net AssetValue orEnterpriseValue(Equity plusNet Debt)Just as total assets equals total liabilities plus shareholders’ equity in accounting, infinance:
4Business Valuation: Definitions ofValueFair Market Value (Price)The fair market value of an asset is generally definedas the cash price at which the asset would changehands between a hypothetical willing buyer and ahypothetical willing seller, if the asset were offered forsale on the open market for a reasonable period of time,and both the buyer and the seller were adequatelyinformed of the relevant facts with neither being underany compulsion to act.
5Investment Value (Intrinsic Value)The investment value is the value of the asset to aspecific owner or prospective owner. Accordingly, thistype of value considers the owner’s or prospectiveowner’s knowledge, abilities, expectations of risks,earning potential, synergies and other factors.Business Valuation: Definitionsof Value
6Valuation Methodologies Cost approachesAccounting book value (Sum of Assets)Adjusted book value (Replacement Cost) Market approachesComparable public guideline companiesComparable transactions Income approachesDividend and Earnings modelsDiscounted cash flow models Free Cash Flow, Equity Cash Flow, Capital CashFlow and APV
7 The value of individual assets and liabilities are restatedto reflect their market value. Typical adjustments include those for: Inventory under-valuation (LIFO) Bad debt reserves Market value of PP&E Intangible Assets like patents and brand Investments in affiliates Tax loss carry-forwardsCost Approach: Adjusted Book
8Two general approaches Comparable Multiples Analysis Comparable Transactions AnalysisIdentify publicly-traded companies engaged in similar businessactivities with risk/return characteristics similar to those at thesubject company. Infer value from the prices of the securities atthese publicly-traded firms.Research merger and acquisition data to look at transactionvalues of similar companies in the industry.Caveats: Achieve consistency between numerator anddenominator Normalize Financial Statements (non-recurring items,depreciation) Equity value to equity income- PE Multiples Invested capital value to invested capital income-EV MultiplesMarket Approaches
9Infers value from the prices of comparable publicly-traded securities orcomparable merger and acquisition transactionsRequires extensive analysis of:» Products» Markets» Sales growth» Profit marginsComparable Multiples Analysis» Geographic scope of operations» Financial structure» Financial and Operating Trends» Quality of Management» Equity Value Multiples Price/Earnings Price/Book Value» Enterprise Value Multiples EV/Revenues EV/EBITDA EV/EBIT
10Income Approach:The Enterprise Value of a business(EV) equals the present value of thefree cash flows that the assets areexpected to provide investors over time(FCFF) discounted by the asset’sexpected return (discount rate)PLUS the present value of the taxshield the assets are capable ofsupportingPLUS the value of any non-operating assets (excess cash)(EBIT) x (1 - Average Tax Rate)Profits From Opns. After Tax (NOPAT)+ Depreciation and Amortization- Capital Expenditures- Additions to Working CapitalFree Cash Flows from the Firm (FCFF)+ PV of Tax Shield+ PV of Non-Op. Assets (excess cash)= DCF Enterprise Value
11What is a Tax Shield? It is the value of the capability of theassets of the business to take on debt. Since interest payments are deductible fortax purposes, having debt reduces taxliability which increases cash flow andtherefore increases the value of theassets. If two businesses have the same FCF butonly one has assets that can beleveraged then it should be worth more to
12What is a Non-Operating Asset ? Excess Cash- Substantially more cashthan required to operate the business. Marketable Securities – Publicly tradedsecurities that can be quickly turned intocash. Patents not currently in use. Strategic Investments not generating cashflow.
13Surgeon and ButcherThe “surgeon” can use a tool of the “butcher”in order to simplify the calculation.FCFFT,t = NOPATt + (DEPt - CAPEXt +/- ∆WCt )Is Equivalent to:FCFF = NOPAT +/– (Net Asset Intensity)*(Change in Sales)Where Net Asset Intensity is defined as the net amount ofinvestment in working capital and PPE as a percentage of salesrequired to operate the business.
15∆Net Fixed Assets vsDepreciation plus CAPEXPeriod 1 Period 2 Period 3 Period 4 Period 5Depreciation - income statement 500 1,000 1,500 2,000 2,500Gross Fixed Assets 5,000 10,000 15,000 20,000 25,000Accumulated depreciation - balance sheet 500 1,500 3,000 5,000 7,500Net Fixed Assets 4,500 8,500 12,000 15,000 17,500Method One:Add Depreciation 500 1,000 1,500 2,000 2,500Subtract CAPEX 5,000 5,000 5,000 5,000Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)Method Two:Change in Net Fixed Assets 4,000 3,500 3,000 2,500Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)
16Calculating the Terminal Value - PV(TVT)The present value of the terminal value, PV(TVt), is frequently estimated by“capping” the cash flows at the end of a period for which detailedprojections are produced. The constant growth model is typically used toestimate the terminal value.TVT = FCFT(1+g)/(KT - g)where:FCFT – operating cash flow in year TKT - appropriate cost of capital in year Tg - expected growth rate of the free cash flows (growth of economy)Note that TVT is in year T dollars. It must be discounted back to year 0before it is used in equation.Most DCF valuation models are extremely sensitive to terminal valueassumptions
17 Since the constant growth model assumes that the cashflows will grow at rate “g” forever, you should try to preparedetailed cash flow projections for a period at least as longas it takes the business to stabilize.Note that “g” cannot exceed K or the sum of expected inflation and the expectedreal growth rate of the economy.Selecting the Terminal YearCashFlowsYear0 T
18Alternative Terminal Value Can use a multiple of free cash flowof from 6-10 times.Cash Flow MultiplesEquivalencyTerminal Growth rateDiscount Rate 0% 3% 6%10% 10.0 14.7 26.515% 6.7 8.6 11.820% 5.0 6.1 7.6
19EBITDA vs FCF…What Gives??Equivalent EBITDAFCF Multiple 5 X 7 X 9 XNet Asset 0% 8.3 11.7 15.0Intensity 30% 9.0 12.6 16.260% 9.8 13.7 17.6 Assumes EBITDA Margin of 20% EBIT Margin of 10% 40% Tax Rate
20Equivalency:So: 5 X EBITDAIs the same as; 9.0 X FCF at 30% Net Asset Intensity;And 3% Perpetuity Growth at 15% Discount Rate and0% Net Asset Intensity
21Cont’d: Can use comparable ratios as well suchas….P/E, EV/Sales, P/Book, EV/EBITDA etc.Can use salvage value if exiting businessSometimes zero for depleting assets likenatural resources.
22Discount RateRequired Rate of Return (Opportunity Cost) Risk Free RateTreasury Bond (10 year) + “Market” Risk Premium + Unique Risk of the Company (Beta) Variability of Sales and Income Concentration of Sales Cyclicality Market Position + Small company risk
23Estimating the Discount Rate CAPM measures the stocks volatilityrelative to a stock index (S&P 500) todetermine a Beta (covariance) for thecompany. This beta can be adjusted forcapital structure and measures thesystematic (market) risk of the company. This risk premium is estimated bymultiplying the firm’s beta times thehistorical market premium of equities minusthe historical risk free rate.
25Historical Market Risk prem.S&P 500 vs 10 Yr Treasury BondsSource : Damodaran Online (NYU Prof)Then: Base Rate = 5% + Beta(4%) + AdjustmentsPeriod Stocks 10 yr Bonds Risk Premium1928-2012 9.31% 5.11% 4.2%1962-2012 9.73% 6.8% 2.93%2002-2012 7.02% 5.31% 1.71%
26Estimating BetaReturn On ShareReturn OnMarket+β = .4++++ +++++++++++++++++ ++++++Return On ShareReturn OnMarket+β = 1.6++++ +++++++++++++++++ ++++++Beta is the slope of the regression line
27Using Comparables - Beta Small businesses do not have “observed”betas and therefore we must use “marketcomparables” to “estimate” the beta of thefirm we are evaluating. In order to do this we must make someadjustments to the observed Beta’s for thevarying degrees of debt.
28Re-Levered Beta Most public companies we use for comparables havesome amount of debt, thus their “beta” is considered tobe a “levered beta”. In order to adjust for the varying levels of debt in our“proxy companies" we “un-lever” the betas in order to puteveryone on the same playing field. We then use the “un-levered” beta to calculate ourExpected Return on Assets, which is the discount rate tobe used for the Capital Cash Flow Method.
29Adjusting Beta for Leverage Un-levering and Re-levering betas:βU = βL/ (1+ VD/VE)(1-T)βL = βU * (1+ (VD/VE)(1-T))Where:βL is the levered beta of a comparable companyβU is the asset (unlevered) beta (assumes βd is 0)βL is the relevered betaVD/VE is the market value of debt divided by the market value ofequityT = Corporate tax rate.))1)(())1)((TVV(1ββTVV(1ββEDUREDLU−+=−+=
30Small Company Adjustment Since Beta is measured against the S&P 500, which arecompanies with market caps > $1 billion, and your Betaproxies are also large companies you need to add a 2-5%adjustment to the calculated discount rate for size risk. Over time small companies demand a higher return byinvestors because of the inherent risk of size. This is demonstrated by the historical returns of small capversus large cap publicly traded stocks. You can avoid this if the proxy companies are similar inmarket size to yours.
31Putting the Pieces Together-CCFMethod Calculate FCF to Owners (Debt and Equity) Estimate a Terminal Value Calculate the Tax Shield (if appropriate) Estimate a Discount Rate on Assets (Ka) Discount all of these FCF’s at this rate (Ka) Run sensitivities Make adjustments for control, liquidity, keyman etc. Subtract beginning debt if you want to knowEquity Value
32Levels of Value-Control and LiquidityControlPremiumMarketabilityDiscount100%ControlMarketableMinority InterestClosely-HeldMinority InterestM&A data generallyassumes that theBuyer is acquiringcontrol of thecompany and, if theacquired companywas privately held,assumes a lack ofmarketability in thefirm’s securities.The price ofpublicly tradedcomparables assumethat the security ismarketable, but theprice reflects aminority interest inthe firm and apremium wouldhave to be paid togain control