Valuation Measurement andValue Creation

Valuation Situations

We encounter valuation in many situations: Mergers & Acquisitions Initial Public Offerings / Follow on Offering Qualified Institutional Placements Private Equity and Buyout Investors buying a minority interest in Companies Sell-offs, Spin-offs and Divestment

How do we measure value? How can I-Bankers create value?

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 Multiples (capitalization of earnings) Enterprise Value / EBITDA Others: P/CF, P/B, P/S

Mergers and Acquisitions Control transaction based models (eg., value based on acquisition premia or control premium)

Business Valuation Techniques

Discounted Cash Flow Valuation

What cash flow to discount? Investors in stock receive dividends, or periodic cash

distributions from the company, 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

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 (Geometric Progression):

Ve = Div1/(r - g)

Some estimation problems: firms may not (currently) pay dividends dividend payments may be not be stable

Dividend Discount Model (DDM)

Factors that influence dividends:

Desire for stabilityFuture investment needsTax factorsSignaling prerogatives

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1981 1984 1987 1990 1993

No Change

Increase

Decrease

Dividend changes: Publicly traded U.S. Firms

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

Dividends: The Stability Factor

Discounted Free Cash Flow to 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 and 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 - Principal Repayments

Problem: Calculating cash flows related to debt (interest and principal) and other obligations is often difficult!

Value of the firm = value of fixed claims (debt) + value of equity

How do finance 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 > 1 if market expects firm to take on positive NPV projects (i.e. firm has significant “growth opportunities”)

Valuation: Back to First Principles

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 firm’s weighted

average cost of capital (WACC)

The present value of future cash flows is referred to as: Value of the firm’s invested capital, or

Value of “Operating Assets” or “Total Enterprise Value” (TEV)

Value of all the firm’s 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 firm’s equity = Vequity = Vfirm - Vdebt

where Vdebt is value of fixed obligations (primarily debt)

DCFF Valuation Process

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”)

Total Enterprise Value (TEV)

Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim

FCFF = EBIT – Actual tax

+ 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/c Payable & accrued liab.)

Measuring Free Cash Flows to the Firm

Capital Asset Pricing Model (CAPM) is a way of finding an acceptable rate of return for an asset (think Modern Portfolio Theory). It is often used in valuation as the cost of equity for a company.

CAPM or RE = Rf + β x [E(RM) – Rf]

Rf = Risk-Free Rate (10-year G-Sec)

E(RM) = Expected Return of the Market

[E(RM) – Rf] is usually referred to as the market-risk premium. This is essentially the return someone investing in the market (Nifty or Sensex) can expect to make above and beyond the risk-free rate. Currently, you would be safe to assume the market-risk premium as 8-9%.

CAPM (Cost of Equity)

Income Statement, Hazira Bay(Rs. millions, FYE March 2010)

Sales 7,075Cost of Goods Sold 6,719EBITDA 356Depreciation 169EBIT 187Interest Expense 97Income Taxes 50Net Income 40Dividends 53

Cash Flow Statement, Hazira Bay,(Rs. millions, FYE March 2010)

Cash flow from operations Net Income 40 Non-cash expenses 169 Changes in WC (116)Cash provided (used) by Inv. / Capex (79)Cash provided (used) by financing Additions (reductions) to debt 25 Additions (reductions) to equity 35 Dividends (53)Overall Net Cash Flows 21

Hazira’s Bay FCFF = 187 - 50 + 169 - 79 - 116 = 111

FCFF v/s Accounting Cash Flows

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 does not consider any equity or debt issue as the same has been captured in the capex

FCFF: Definition Issues

Rs. 1 million capital required to start firm

Capital Structure: 20% debt (10% pre-tax required return): Rs.200,000 80% equity (15% required return): Rs.800,000

Tax rate is 40% Firm expects to generate Rs. 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?

An Illustration

Let us look first at how the EBIT is distributed to the various claimants:

EBIT Rs.220,000Interest (20,000)

(Rs.200,000*10%)EBT Rs.200,000Tax (80,000) 40% rateEAT Rs.120,000

Div. to common Rs.120,000

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

An Illustration (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%, NPV of future projects for this firm = 0

Hence, the value of the firm should equal the invested capital, or Rs.1,000,000

An Illustration (continued….)

Now consider FCFF valuation of this firm FCFF = EBIT * (1-t) = Rs.220,000 * (1 – 0.4) =

Rs.132,000 Value = 132,000 / 0.132 = Rs.1,000,000

We could have accounted for taxes in cash flow and not WACC WACC without tax adjustment = 14% Adjusted FCFF = EBIT – actual taxes

= Rs.220,000 – 80,000 = Rs.140,000

Value = Rs.140,000 / 0.14 = Rs.1,000,000

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

An Illustration (continued….)

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

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 firm’s WACC (kc)

FCFF1 + FCFF2 + . . . + FCFFt

1+kc (1+kc)2 (1+kc)t

VALUE1 =

Stage 1 – 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

Stage 2 – Valuation

Stage 2 – Valuation

Present value of Stage 2 cash flows (Terminal Value or TV):

Key issue in implementation: Terminal growth (g) rate of “stable” growth in the economy (real rate of

return ~1-2% plus inflation)

Stage 1 and Stage 2 – TEV = VALUEt + TV

1

(1+kc)txTV =

FCFFt * (1+g)

Kc - g

Assumptions

Year EBIT Dep Capex W/C Change1 40 4 6 22 50 5 7 33 60 6 8 4

Tax rate = 40% kc = 10%

Vdebt = value of debt = Rs.100

Growth (g) of FCFFs beyond year 3 = 3%

Discounted FCCF: Illustration

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

Discounted FCCF: Illustration (continued)

20 25 30 30*(1+g) 30*(1+g)2

| | | | | | t=0 1 2 3 4 5P = Vfirm

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

Discounted FCCF: Illustration (continued)

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

Discounted FCCF: Illustration (continued)

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

Relative Valuation: Capitalisation of Earnings

ABC Company: Next year’s forecasted EPS = Rs.1.50

Comparable Company: XYZ corporation Next year’s forecasted EPS = Rs.0.80 Current share price = Rs.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 = Rs.37.5

Note: Analyst prefer “forward looking” ratios but “backward looking” ratios are more readily available

Key: Make comparisons “apples with apples”

P/E Multiple Valuation: Illustration

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

P/E Ratio Based Valuation

TEV = MVequity + MVdebt - Cash EBITDA: Earnings before Interest, Taxes,

Depreciation and 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”

EV / EBIDTA Approach (EBIDTA Multiple)

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

EV / EBIDTA Approach (EBIDTA Multiple)

ABC Company: Next year’s forecasted EBITDA = Rs.50 million Shares outstanding = Rs. 20 million; Value of Debt = Rs.50

million; Cash = Rs.0 Comparable Company: XYZ Corporation

Next year’s forecasted EBITDA = Rs.40 million Current share price = Rs.20; Shares outstanding = 10 million;

Value of Debt = Rs.100 million; Cash = Rs.0 EV = 20 * 10 + 100 – 0 = Rs.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 = Rs.325 million Price per share = 325 / 20 = Rs.16.25

EV / EBIDTA Multiple Valuation: Illustration

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?

Other Multiple based Approaches

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

Since valuation models are quantitative, valuation is objective models are quantitative, inputs are subjective

A well-researched, well-done model is timeless values will change as new information is revealed

A good valuation provides a precise estimate of value a valuation by necessity involves many assumptions

The more quantitative a model, the better the valuation 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 market is generally wrong 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

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

Some Valuation Myths

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.

Valuation Creation Summary

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.

Valuation Cases

Copeland, Koller and Murrin,1994, Valuation: Measuring and Managing the Value of Companies (Wiley)

A Damodaran,1996, Investment Valuation (Wiley);

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)

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)

Valuation References

Questions