Valuation Measurement and Value Creation

MBA1 Finance

Valuation Situations
We encounter valuation in many situations: Mergers & Acquisitions Leveraged Buy-outs (LBOs & MBOs) Sell-offs, spin-offs, divestitures Investors buying a minority interest in company Initial public offerings

How do we measure value? Why do we observe these situations? How can managers create value?

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Business Valuation Techniques

Discounted cash flow (DCF) approaches
Dividend discount model (DDM) Free cash flows to equity model (FCFE - direct approach) Free cash flows to the firm model (FCFF- indirect approach)

Relative valuation approaches

P/E (capitalization of earnings) Enterprise Value/EBITDA Other: P/CF, P/B, P/S

Mergers and acquisitions

Control transaction based models (e.g. value based on acquisition premia of similar transactions)

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Discounted Cash Flow Valuation

What cash flow to discount?

Investors in stock receive dividends, or periodic cash distributions from the firm, and capital gains on re-sale of stock in future If investor buys and holds stock forever, all they receive are dividends
In dividend discount model (DDM), analysts forecast future dividends for a company and discount at the required equity return

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Dividend Discount Models (DDM)

The value of equity (Ve) is the present value of the (expected) future stream of dividends Ve = Div1/(1+r) + Div1(1+g2)/(1+r)2 + Div1(1+g2)(1+g3)/(1+r)3 +...

If growth is constant (g2 = g3 = . . . = g) , the valuation formula reduces to: Ve = Div1/(r - g) Some estimation problems:
firms may not (currently) pay dividends dividend payments may be managed (e.g., for stability)

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Dividends: The Stability Factor

Factors that influence dividends: Desire for stability Future investment needs Tax factors Signaling prerogatives
Dividend changes: Publicly traded U.S. Firms
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1981 1984 1987 1990 1993 No Change Increase Decrease

Source: A. Damodaran, Investment Valuation, Wiley, 1997

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Discounted Free Cash Flow Equity (FCFE) Approach (Direct Method)

Buying equity of firm is buying future stream of free cash flows (available, not just paid to common as dividends) to equity holders (FCFE) FCFE is residual cash flows left to equity holders after: meeting interest/principal payments providing for capital expenditures and working capital to maintain and create new assets for growth FCFE = Net Income + Non-cash Expenses - Cap. Exp. - Increase in WC - Princ. Payments Problem: Calculating cash flows related to debt (interest/ principal) & other obligations is often difficult!

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Valuation: Back to First Principles

Value of the firm = value of fixed claims (debt) + value of equity How do managers add to equity value? By taking on projects with positive net present value (NPV) Equity value = equity capital provided + NPV of future projects Note: Market to book ratio (or Tobins Q ratio) >1 if market expects firm to take on positive NPV projects (i.e. firm has significant growth opportunities)

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Valuation: First Principles

Total value of the firm = debt capital provided + equity capital provided + NPV of all future projects project for the firm

= uninvested capital + present value of cash flows from all future projects for the firm
Note: This recognizes that not all capital may be currently used to invest in projects

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Discounted Free Cash Flow to the Firm (FCFF) Approach (Indirect Approach)
Identify cash flows available to all stakeholders Compute present value of cash flows Discount the cash flows at the firms weighted average cost of capital (WACC) The present value of future cash flows is referred to as: Value of the firms invested capital, or Value of operating assets or Total Enterprise Value (TEV)

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The DCFF Valuation Process

Value of all the firms assets (or value of the firm) = Vfirm = TEV + the value of uninvested capital Uninvested capital includes: assets not required (redundant assets) excess cash (not needed for day-to-day operations) Value of the firms equity = Vequity = Vfirm - Vdebt where Vdebt is value of fixed obligations (primarily debt)

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Total Enterprise Value (TEV)

For most firms, the most significant item of uninvested capital is cash Vfirm = Vequity + Vdebt = TEV + cash

TEV = Vequity + Vdebt - cash

TEV = Vequity + Net debt where Net debt is debt - cash (note: this assumes all cash is excess)

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Measuring Free Cash Flows to the Firm (FCFF)

Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim FCFF = EBIT (1 - tax rate) + Depreciation and amortization (non cash items) - Capital Expenditures - Increase in Working Capital

What is working capital? Non-cash current assets - non-interest bearing current liabilities (e.g. A/P & accrued liab.)

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Working Capital vs. Permanent Financing

Short-term assets
Short- term liabilities Working capital Permanent Capital

Long-term assets

Operating assets Uninvested capital

Permanent Capital

Permanent capital may include current items such as bank loans if debt is likely to remain on the books
Key: Treat items as either working capital or permanent capital but not both

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FCFF vs. Accounting Cash Flows

Income Statement, Hudsons Bay ($millions, FYE Jan 1999) Sales Cost of Goods Sold EBITDA Depreciation EBIT Interest Expense Income Taxes Net Income Dividends $7,075 $6,719 $ 356 $ 169 $ 187 $ 97 $ 50 $ 40 $ 53 Cash Flow Statement, Hudsons Bay, ($millions, FYE Jan 1999) Cash flow from operations Net Income Non-cash expenses Changes in WC Cash provided (used) by investments Additions to P,P & E Cash provided (used) by financing Additions (reductions) to debt Additions (reductions) to equity Dividends Overall Net Cash Flows

$ 40 $ 169 ($116) ($719) $ 259 $ 356 ($ 53) ($ 64)

Hudsons Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561)

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FCFF Definition Issues

Why is FCFF different from accounting cash flows? Accounting cash flows include interest paid We want to identify cash flows before they are allocated to claimholders FCFF also appears to miss tax savings due to debt Key: these tax savings are accounted for in WACC

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An Example
$1 million capital required to start firm Capital structure: 20% debt (10% pre-tax required return): $200,000 80% equity (15% required return): $800,000 tax rate is 40% firm expects to generate 220,000 EBIT in perpetuity (all earnings are paid as dividends) future capital expenditures just offset depreciation no future additional working capital investments are required What should be the value of this firm?

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An Example, continued
Let us look first at how the EBIT is distributed to the various claimants:
EBIT Interest EBT tax EAT $220,000 (20,000) $200,000 (80,000) $120,000 $200,000*10%

40% rate

Div. to common

$120,000

Note: The dividend to equity equals 15% of equity capital

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An Example, continued
The firm here generates a cash flow that is just enough to deliver the returns required by the different claimants.
i.e. the NPV of the firms projects = 0 Another way to see this: WACC = 0.2 * 10% * (1 0.4) + 0.8 * 15% = 13.2% Pre-tax WACC = 13.2% / (1 0.4) = 22% EBIT / capital is also 22%, so NPV of future projects for this firm is zero

From first principles, the value of the firm should equal the invested capital, or $1,000,000

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An Example, continued
Now consider FCFF valuation of this firm
FCFF = EBIT * (1-t) = $220,000 * (1 0.4) = $132,000 Value = 132,000 / 0.132 = $1,000,000

Note: we could have accounted for taxes in cash flow and not WACC
WACC without tax adjustment = 14% Adjusted FCFF = EBIT actual taxes = $220,000 80,000 = $140,000 Value = $140,000 / 0.14 = $1,000,000

Key: account for tax benefit, but only once (no double counting)!

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Two Stage FCFF Valuation

Impossible to forecast cash flow indefinitely into the future with accuracy Typical solution: break future into stages Stage 1 : firm experiences high growth Sources of extraordinary growth: product segmentation low cost producer Period of extraordinary growth: based on competitive analysis / industry analysis Stage 2: firm experiences stable growth

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Stage 1 Valuation
Forecast annual FCFF as far as firm expects to experience extraordinary growth
generally sales driven forecasts based on historical growth rates or analyst forecasts EBIT, capital expenditures, working capital given as a percentage of sales

Discount FCFF at the firms WACC (kc)

VALUE1 =

FCFF1
1+kc

FCFF2
(1+kc)2

+ . . . +

FCFFt
(1+kc)t

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Stage 2 Valuation
Start with last FCFF in Stage 1 Assume that cash flow will grow at constant rate in perpetuity
Initial FCFF of Stage 2 may need adjustment if last cash flow of Stage 1 is unusual spike in sales or other items capital expenditures should be close to depreciation

Value 1 year before Stage 2 begins =

FCFFt * (1+g)
Kc - g

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Stage 2 Valuation
Present value of Stage 2 cash flows (Terminal Value or TV):
TV = FCFFt * (1+g) Kc - g
x

1 (1+kc)t

Key issue in implementation: Terminal growth (g) rate of stable growth in the economy (real rate of return ~1-2% plus inflation) TEV = VALUEt + TV

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Discounted FCFF Example

Assumptions Year
1 2 3

EBIT
40 50 60

Dep
4 5 6

Cap Ex
6 7 8

W/C Change
2 3 4

Tax rate = 40% kc = 10% Vdebt = value of debt = $100 Growth (g) of FCFFs beyond year 3 = 3%

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Discounted FCFF Example (contd)

FCFF = EBIT*(1-t) + Dep - CapEx - Increase in WC Year 1 FCFF = 40*(1 - 0.4) + 4 - 6 - 2 = 20 Year 2 FCFF = 50*(1 - 0.4) + 5 - 7 - 3 = 25 Year 3 FCFF = 60*(1 - 0.4) + 6 - 8 - 4 = 30

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Discounted FCFF Example (contd)

20 | | t=0 1 P = Vfirm 25 | 2 30 | 3 30*(1+g) 30*(1+g)2 | 4 | 5

30*(1+g)/(kc-g)

TEV = 20/(1+kc) + 25/(1+kc)2 + 30/(1+kc)3 + [30*(1+g)/(kc-g)]/(1+kc)3

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Discounted FCFF Example (contd)

TEV = 20/(1.10) + 25/(1.10)2 + 30/(1.10)3 + [30*(1.03)/(0.10 - 0.03)]/(1.10)3
= 18.2 + 20.7 + 22.5 + 331.7 = 393.0 TEV + Cash (unused assets) = Vfirm ==> Vfirm = TEV =393.0 Vfirm = Vdebt + Vequity ==> Vequity = Vfirm - Vdebt Vequity = 393.0 - 100.0 = 293.0

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Relative Valuation: Capitalization of Earnings

Compute the ratio of stock price to forecasted earnings for comparable firms determine an appropriate P/E multiple If EPS1 is the expected earnings for firm we are valuing, then the price of the firm (P) should be such that: P / EPS1 = P/E multiple Rearranging, P = P/E multiple x EPS1

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Relative Valuation - Example

ABC Company: Next years forecasted EPS = $1.50 Comparable company: XYZ corporation Next years forecasted EPS = $0.80 Current share price = $20 PE ratio = 20 / 0.80 = 25 If ABC and XYZ are comparable, they should trade at same PE Implied price of ABC = 25 * 1.50 = $37.5 Note: Analyst prefer forward looking ratios but backward looking ratios are more readily available Key: Make comparisons apples with apples

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P/E Ratios and the DDM

Recall the constant growth DDM model; assume payout ratio is PO% D1 = PO * EPS1 P = D1 ke - g P = PO *EPS1 ke - g P EPS1 = PO ke - g

P/E ratios capture the inherent growth prospects of the firm and the risks embedded in discount rate

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P/E Ratio Based Valuation

Fundamentally, the P/E multiple relates to growth and risk of underlying cash flows for firm Key: identification of comparable firms similar industry, growth prospects, risk, leverage industry average

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TEV / EBITDA Approach

TEV = MVequity + MVdebt - cash EBITDA: earnings before taxes, interest, depreciation & amortization Compute the ratio of TEV to forecasted EBITDA for comparable firms determine an appropriate TEV/EBITDA multiple If EBITDA1 is the expected earnings for the firm we are valuing, then the TEV for the firm should be such that: TEV / EBITDA1 = EV/EBITDA multiple

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TEV / EBITDA Approach

Rearranging: TEV = EV/EBITDA multiple x EBITDA1 Next solve for equity value using: MVequity = TEV - MVdebt + cash Multiples again determined from comparable firms similar issues as in the application of P/E multiples leverage less important concern

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EV/EBITDA Valuation - Example

ABC Company:
Next years forecasted EBITDA = $50 million Shares outstanding = 20 million; value of debt = $50 million; cash = $0

Comparable company: XYZ corporation

Next years forecasted EBITDA = $40 million Current share price = $20; shares outstanding = 10 million; value of debt = $100 million; cash = $0 EV = 20* 10 + 100 0 = $300 million EV/EBITDA ratio = 300 / 40 = 7.5

If ABC and XYZ are comparable, they should trade at same EV/EBITDA
Implied EV for ABC = 7.5 * 50 = 375 million Value of equity = 375 + 0 50 = $325 million Price per share = 325/20 = $16.25

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Other Multiple Based Approaches

Other multiples: Price to Cash Flow: P = P/CF multiple X CF1 Price to Revenue: P = P/Rev multiple X REV1 Multiple again determined from comparable firms Why would you consider price to revenue over, for example, price to earnings?

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Merger Methods
Comparable transactions: Identify recent transactions that are similar Ratio-based valuation
Look at ratios to price paid in transaction to various target financials (earnings, EBITDA, sales, etc.) Ratio should be similar in this transaction

Premium paid analysis

Look at premiums in recent merger transactions (price paid to recent stock price) Premium should be similar in this transaction

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Aside: Why Merge or Acquire Another Firm?

Efficiency - synergistic gains Information - undervalued assets Agency problems - entrenched management

Market power - corporate hubris X

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Aside: Most Mergers Fail!

Post-merger success defined as earnings on invested funds > cost of capital McKinsey & Co. estimates 61% fail and only 23% succeed because: Inadequate due diligence by acquirer No compelling strategic rationale Overpay, or projected synergies not realized

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Some Valuation Myths

1. Since valuation models are quantitative, valuation is objective
models are quantitative, inputs are subjective values will change as new information is revealed a valuation by necessity involves many assumptions the quality of a valuation will be directly proportional to the time spent in collecting the data and in understanding the firm being valued the presumption should be that the market is correct and that it is up to the analyst to prove their valuation offers a better estimate

2. A well-researched, well-done model is timeless

3. A good valuation provides a precise estimate of value

4. The more quantitative a model, the better the valuation

5. The market is generally wrong

Source: A. Damodaran, Investment Valuation: Tools and Techniques for Determining The Value of Any Asset

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Value Creation Summary

Firms create value by earning a return on invested capital above the cost of capital The more firms invest at returns above the cost of capital the more value is created Firms should select strategies that maximize the present value of expected cash flows The market value of shares is the intrinsic value based on market expectations of future performance (but expectations may not be unbiased) Shareholder returns depend primarily on changes in expectations more than actual firm performance
Source: Valuation: Measuring and Managing the Value of Companies, McKinsey & Co.

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Valuation Cases
Size-up the firm being valued do projections seem realistic (look at past growth rates, past ratios to sales, etc.)? what are the key risks? Valuation analysis several approaches + sensitivities (tied to risks) Address case specific issues e.g. for M&A: identification of fit (size-up bidder), any synergies, bidding strategy, structuring the transaction, etc. e.g. for capital raising: timing, deal structure, etc.

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Applications
We will apply valuation principles in variety of settings: Private sales Graphite Mining, Oxford Learning Centres Mergers & Acquisitions Oxford Learning Centres, Empire Company Capital Raising

Tremblay, Eatons, Huaneng Power

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Valuation References
Copeland, Koller and Murrin,1994, Valuation: Measuring and Managing the Value of Companies(Wiley) Damodaran,1996, Investment Valuation (Wiley); http://www.stern.nyu.edu/~adamodar/ Pratt, Reilly and Schweihs, 1996, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Irwin) Benninga and Sarig, 1997, Corporate Finance: A Valuation Approach (McGraw Hill) http://finance.wharton.upenn.edu/~benninga/home.html Stewart, 1991, The Quest for Value (Harper Collins) Harvard Business School Notes: An Introduction to Cash Flow Valuation Methods (9-295-155) A Note on Valuation in Private Settings (9-297-050) Note on Adjusted Present Value (9-293-092)