Financial Modelling and Company ValuationA Sharing Session by Tan Heng Leng29th August 2014

Agenda

Valuation Approaches

Free-Cash Flow Models

Weighted average cost of capital

Application: Derive Enterprise Value of Pura

Limited

What is valuation

How much money something is worth?

Why valuation?

Valuation Approaches

Determined by a stream of

forecasted cash flows

Benchmark against other comparable companies

Based on book values in

balance sheet

Income based approach

▪ Value both business acquisitions and disposals

▪ Understanding the value of a business and then pricing in synergies

Applicability

▪ Most complex technique

▪ Large range of assumptions

▪ Prone to forecasting error

Weakness

▪ Based on discounted future cash flows

▪ Most technically robust approach

▪ Focus on true economic drivers of value

Strength

Market based approach

▪ To compare and contrast the relative values of investments within a portfolio

▪ Provide a ‘sense check’ for business acquisition / disposal decisions

Applicability▪ Relies wholly on

available data of comparable companies

▪ Broad assumptions made

▪ No detailed analysis of intrinsic drivers of value

▪ Difficult to apply to privately owned entity

Weakness▪ Straightforward

technique

▪ Readily available data

▪ Benchmarking the relative value of organisations against each other

▪ Uses market based factors instead of analyst own estimate

Strength

Market based approach

Three (3) Steps Approach

2 Convert these to a standardised statistic (Price / Earnings) which becomes the valuation multiplier

Apply the valuation multiplier to the assets being valued3

1 Identify comparable assets and their market value

Example:

Value of Turquoise Ltd : RM 1,500 mil (market capitalisation)

Current year earnings : RM 100 mil

Earnings multiple : 1500 ÷ 100 = 15 times

Cost based approach

▪ Obtain preliminary view of the base value of a business especially in a divestment exercise

▪ Liquidation value used where all assets are sold and liabilities are repaid

▪ Used to value excess assets within a business

Applicability▪ Book value does not

reflect current fair values

▪ May significantly undervalue a business (intangibles value are often ignored)

Weakness▪ Simple and quick

▪ Data readily available in balance sheet

▪ Has an element of certainty - based on assets that are owned

Strength

Enterprise Value vs Equity Value

Question:

Should this WACC be the

Acquirer WACC or Target’s

WACC?

What is Free Cash Flow?

Definition:Cash flow available to suppliers of capital (i.e. debt holders and equity holders) after:

All operating expenses have been paid in cash Necessary investments in working capital; and Fixed capital have been made

EBIT / Operating Income 100+ Depreciation and Amortisation 5EBITDA 105- Income Tax (25)- Change in Net Working Capital (10)Operating Cash Flow 70- Capital Expenditure (20)FCF in forecast period 50

What is Free Cash Flow to Equity (“FCFE”)?

FCF in forecast period 50.0- Interest expense (10.0)- Debt repayment (20.0)+ Tax benefit on interest 2.5FCF to Equity Holders 22.5

Example:

Free Cash Flow Valuation Framework

Step-by-Step Guide

•Step 1: Value the business/ operating assets

•Step 2: Value the company

•Step 3: Value the company’s equity

•Step 4: Find the fair value per share

Main idea !Fair value of a stock = the present value of all the cash that can be

potentially be distributed

Corporate Valuation vs Project Valuation

What is the difference between:

valuing TNB as a company

VS

valuing an IPP project?

Terminal Value

Y0 Y1 Y2 Y3 Y4 Y5

Explicit forecast period

Firm in steady state

Step 1: Calculate terminal value

Step 2: Derive present value of terminal value to Year 0

Step 3: Add Present Value of Terminal Value to Present value of FCFs to arrive at final enterprise value

Weighted Average Cost of Capital

Definition:Discount rate used to find the Present Value of the FCFs.

The return an investor would require for owning all the capital issued / raised

WACC = wdkd(1-t) + wprp + weke

Where:

wd,wp,we = proportion of debt, preference shares and ordinary

shares

t = corporate tax rate

kd, kp, ke= cost of debt, cost of preference shares, cost of equity

Cost of Equity

Definition: cost of equity (ke)

= rate of return that shareholders require on their investment in an organisation

Application: Financial Modelling Basics Steps

Big Step Baby Steps

1. Project income statement

i. Understand income statement mechanics by keying in historical data

ii. Document assumptionsiii. Project income statements

2. Project balance sheet

i. Understand balance sheet mechanics by keying in historical data

ii. Document assumptionsiii. Project balance sheet items

3. Project cash flow statement

i. Link income statement and balance sheet items to cash flow statement

ii. Dividends and share repurchasesiii. Wrap up the cash flow statement

4. Balancing i. Deal with the PLUG that make the financial statements balance!

Case Study: Pura Limited

IMD is investigating the acquisition of Pura Limited, a biscuit-manufacturing company based in Sungai Petani, Kedah.

FCF drivers

1.Current level of sales = RM 22.1 mil per annum

2.Sales growth rate during the forecast period = 4.5% per annum

3.Operating expenses (net of interest and depreciation): remain constant at 88.8% of sales per annum

4.Income tax rate = 30% of EBITDA

5.Fixed capital and working capital

Incremental fixed capital rate = 15.0%

Working capital investment rate = 10.0%

6.WACC = 10.0%

7.Terminal value growth rate = 1.5%

8.Market value of debt = RM10 mil

Case Study: Pura Limited

Step 1: Calculate FCF in the forecast period by applying FCF drivers

Step 2: Calculate the terminal value using a growth rate of 1.5%

Step 3: Calculate the enterprise and equity values

Thank you