Offered to: Securities & Commodities Authority Trainer: Dr. Anis Samet, American University of...

Quantitative Methods in Companies’

ValuationOffered to: Securities & Commodities AuthorityTrainer: Dr. Anis Samet, American University of

Sharjah

2

Day 11. Workshop pre-assessment (5 mn.)2. Session 1: Introduction to values (90 mn)3. Session 2: Discounted cash flow 1(135 mn)4. Session 3: Discounted cash flow 2 (60 mn)5. Day-1-assessment (10 mn)6. Case study, part 1 (45 mn) Day 21. Session 1: Multiples 1 (90 mn)2. Session 2: Multiples 2 (135 mn)3. Alternatives and latest methodologies (60 mn)4. Final-assessment (5 mn)5. Case study, part 2 (45 mn)

Schedule & Outline

Anis Samet, Ph.D., American University of Sharjah


3

Day 1

Quantitative Methods in Companies’ Valuation


4

Please answer the pre-assessment questions!

Workshop Pre-Assessment


5

Financial Statements: A review


6

Financial Statements: Key Words العمومية Balance sheetالميزانية

) ( العمومية/ الميزانية موجودة Asset (balance sheet)أصل / المال رأس استثمار الملكية Equityحقوق

/ التزامات/ / خصوم مطلوباتديون

Liabilities

الدخل/ قائمة Income statement (US)بيانRevenuesاإليراداتExpenseمصروف

النقدي/ التدفق قائمة Cash flow statementبيان / الوارد ) النقد الوارد النقدي التدفق

المقبوض(Cash inflow

/ المدفوع الصادر Cash outflowالنقد / مدمجة/ موحدة مالية قوائم Consolidated financial statementبيانات

المالية Financial statementsالقوائم ) ملحقة ) إيضاحات مالحظات

المالية بالقوائمNote to financial statements

حقوق المساهمين، مال رأسالمساهمين ملكية

Shareholder’s capital, shareholder’s equity

العام Initial Public Offerings (IPO)الكتتاب


7

Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements:

1. Balance Sheet - statement of financial position at a given point in time

2. Income Statement - revenues minus expenses for a given time period

3. Statement of Owner's Equity - also known as Statement of Retained Earnings or Equity Statement

4. Statement of Cash Flows - summarizes sources and uses of cash

Financial Statements


8

The balance sheet is based on the following fundamental accounting model:

Assets = Liabilities + Equity Assets can be classed as either current assets or

fixed assets. Liabilities (current & long term) represent the

portion of a firm's assets that are owed to creditors

Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation

Financial Statements: Balance Sheet


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Balance Sheet: Tabreed


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The income statement presents the results of the entity's operations during a period of timeNet Income = Revenue - Expenses

Revenue refers to inflows from the delivery of a product/service and expenses are outflows incurred to produce revenue

Financial Statements: Income Statement


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Income Statement: Tabreed


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The equity statement explains the changes in retained earnings.

The statement of retained earnings uses information from the Income Statement and provides information to the Balance Sheet

The following equation describes the equity statement for a sole proprietorship:Ending Equity = Beginning Equity +

Investments - (Withdrawals/Paid Dividends) + Income

Financial Statements: Statement of Owner's Equity


13

The statement of cash flows is useful in evaluating a company's ability to pay its bills. For a given period, the cash flow statement provides the following information:

Sources of cash Uses of cash Change in cash balance The cash flow statement breaks the sources

and uses of cash into the following categories:1. Operating activities2. Investing activities3. Financing activities

Financial Statements: Cash Flow Statement


14

Cash Flow Statement: Tabreed

15

Refer to the financial statements of Tabreed in Arabic and English

Arabic English

Financial Statements: Tabreed



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Session 1: Introduction to Values


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Valuation may be done by the seller prior to entertaining prospective buyers, by the buyer who identifies a specific target or by both parties during negotiations to resolve a dispute over price

Company valuation is not an exact science. There are numerous acceptable valuation methods and, in most situations, each will yield a different result

The formal mathematical valuation should only play one part in the overall pricing of the deal and in determining the transaction's true value to the parties

Introduction to Values


18

While all methods should, in theory, yield the same result, they rarely do, because of factors including, but not limited to, market conditions, the industry in which the target company operates and the type and nature of the business

All valuations are biased. The only questions are how much and in which direction

Simpler valuation models do much better than complex ones

Introduction to Values (cont’d)


19

Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -- in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business

A sound investing is that an investor does not pay more for an asset than it is worth

Importance of Valuation


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The firm’s value is driven by:1. Earnings capacity2. Growth opportunities3. Real corporate performance, as compared

to market benchmarks4. Sales, operating margin, return on

investment

Key Values Drivers


21

Valuation Models

Asset based valuation: Liquidation

value/ Replacement

cost

Discounted Cash Flow models:

Relying on future expected cash flows and determining the

appropriate discount rate to

use

Relative valuation: Using

comparable companies in

the same sector/industry.

Multiples

Alternative and latest

methodologies:Break-even

methodDividend

Discount ModelEconomic-Value

Added (EVA)Adjusted Present

Value (APV)Cash Flow Return on

Investment (CFRI)

Real options

Principal Valuation Methodologies


22

Accounting valuation is important, because the value of assets on a company’s financial statements needs to be reliable

Analysis of this valuation is just as important as the valuation itself

Some assets, such as real estate, which is carried at cost less depreciation, can be carried on the balance sheet at far from their true value

Accounting vs. Market Values


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Session 2: Discounted Cash Flow (DCF) 1

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Discounted Cash Flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money

All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management

Discounted Cash Flow



25

The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions

Discounted Cash Flow (cont’d)


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CFt: Cash flow in period t r: discount rate T: life of the firm


T

T

tt

t

rr

CF

)1(

Value Terminal

)1(Value Firm T

1


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For an asset to have value, the expected cash flows have to be positive some time over the life of the asset

Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate



28

Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement

Process of DCF calculation: Step 1


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Step 2—Estimate the Discount Rate: the next order of business is to estimate the company's weighted average cost of capital (WACC), which is the discount rate that's used in the valuation process



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Step 3—Calculate the Value of the Corporation: the company's WACC is then used to discount the expected cash flows



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Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value



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Operating cash flow (OCF) =Earnings Before Interest and Taxes (EBIT) + depreciation* - taxes

= EBIT(1-T) + depreciation

FCF= OCF – reinvestment= OCF - capital spending - working capital

spending = OCF - capex – ΔNWC

• Depreciation, or more generally any non-cash charges• Capital spending: changing in fixed assets• Working capital=total current assets-total current liabilities

Free Cash Flow: A Reminder


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Firm value = PV of FCF during forecast period +

PV of terminal value

Terminal value = proxy for all cash flows after the forecast period.

Valuing a Firm Using DCF

TT

T

tt

t

WACCWACC

FCF

)1(

Value Terminal

)1(Value Firm

1


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Statement of Income — Example(figures in thousands)

Revenue

Sales Revenue $20,438

Operating Expenses

Cost of goods sold $7,943

Selling, general and administrative expenses $8,172

Depreciation and amortization $960

Other expenses $138

Total operating expenses $17,213

Operating income $3,225

Non-operating income $130

Earnings before Interest and Taxes (EBIT) $3,355

Net interest expense/income $145

Earnings before income taxes $3,210

Income taxes $1,027

Net Income $2,183

EBIT: Example


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FCF1=390 FCF2=600 FCF3=694 Terminal Value=500 WACC: 10% Find the firm’s value using DCF

Valuing a Firm Using DCF: SCA company


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SCA Company’s Value: Using DCF

48.747,1$)1.1(

500

)1.1(

694

)1.1(

600

1.1

390ValueSCA

332


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Session 3: Discounted Cash Flow 2


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As seen before the discount rate that we have used to discount the future cash flow is the WACC

The WACC is the weighted average of the cost of equity and the cost of debt. The weights depend on how much of the firm’s activity is financed by debt and equity

The higher the cost of debt, the higher the WACC The higher the cost of equity, the higher the

WACC The higher the WACC, the lower the firm’s value

Weighted Average Cost of Capital (WACC)


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Where: Ke = cost of equity Kd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt T = corporate tax rate

WACC

DE KTV

DK

E

DWACC *)1(**


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D=2000 E=3000 Ke=12% Kd=8% T=20% Find WACC

WACC: Example


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%76.9%)201(*%8*5000

2000%12*

5000

3000WACC

WACC: Example


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Two companies that are different in term of risk should they have the same WACC?

No! Why? Shareholders investing in the riskier company

require a higher return and therefore a higher Ke

Banks lending money to the riskier company require a higher interest rate and therefore a higher Kd

So the riskier company has a higher WACC A higher WACC lead to a lower value

How Risk is perceived in DCF?


43

The cost of debt depend on the interest paid by the company on the outstanding loans

The cost of debt is the weighted average of the costs of different debt instruments used by the company (e.g., bonds, sukuk, bank loans, ..)

WACC Components: Cost of Debt


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The cost of equity represents the rate of return required by shareholders to invest in a company

The required rate of return depends on the riskiness of the company

If the company is a public company, we can estimate the cost of equity using the Capital Asset Pricing Model (CAPM)

If the company is a private company, we try to find a comparable public company to estimate the cost of equity using the CAPM

WACC Components: Cost of Equity


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CAPM is used to determine a theoretically appropriate required rate of return of an asset

E(R):is the expected return on the asset Rf: is the risk-free rate of interest such as

interest arising from government bonds Β: is the sensitivity of the expected excess

asset returns to the expected excess market returns

E(Rm): is the expected return of the market

Capital Asset Pricing Model (CAPM)

))((*)( fmf rRErRE


46

Rf: 5% Β: 1.4 E(Rm): 12% Find E(R) E(R)=5%+1.4*(12%-5%)=14.8%

CAPM


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Strengths1. CAPM is based on the idea that investors demand

additional expected return if they are asked to accept additional risk

2. the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium.

Weaknesses:1. The model assumes that asset returns are normally

distributed2. The model assumes that all investors have access to

the same information3. The model assumes that the variance of returns is

an adequate measurement of risk

Strengths and Weakness of CAPM


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Terminal value is quite large compared to expected annual cash flows

DCF valuation is sensitive to the terminal value

It is difficult to estimate the terminal/residual value of a company

Residual and Terminal Value


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Strengths of DCF Weaknesses of DCF

DCF offers the closet thing to the company’s intrinsic value

Length of projection period?

DCF allows to find out which companies are overpriced and which ones are underpriced

Confidence about future cash flows

DCF analysis is a great tool to analyze what assumptions and conditions have to be fulfilled in order to reach a certain company value

Other sources of value (cash, holdings in other firms, non-operating assets)

DCF is a valid method to assess the company’s value if special precaution is put on the validity of the underlying assumptions

DCF valuation depends on the quality of inputs: forecasted CFs and WACC. Garbage-in garbage-out principle holds

Strengths & Weaknesses of DCF


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It is very easy to manipulate the DCF analysis to result in the value that you want it to result in by adjusting the inputs

This is even possible without making changes that would be significant from an economist’s point of perspective, e.g. a change in the perpetual growth rate or in the WACC by just a few base points

Analysts or business professionals have no tools to estimate the input factors with that kind of exactness

Manipulation of Values


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Session 4: Case study


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Case Study: SCA Company Year 1 Year 2 Year 3

Revenues 1000 1500 2000Cost of goods sold 500 700 1000

Depreciation 100 100 150

EBIT 400 700 850

Interests 100 100 120

Taxable income 300 600 730

Taxes 60 120 146

Net Income 240 480 584

∆ in capital spending

0 100 100

∆ in working capital

50 -20 60


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Terminal value=500 Tax rate=20% Ke= 14% Kd=7.5% D/V=50%, E/V=50% Find the firm’s value using DCF What would be the firm value if the WACC is

12% or 15%?

Case Study: SCA Company


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Day 2

Quantitative Methods in Companies’ Valuation


55

Valuation Models

Asset based valuation: Liquidation

value/ Replacement

cost

Discounted Cash Flow models:

Relying on future expected cash flows and determining the

appropriate discount rate to

use

Relative valuation: Using

comparable companies in

the same sector/industry.

Multiples

Alternative and latest

methodologies:Break-even

methodDividend

Discount ModelEconomic-Value

Added (EVA)Adjusted Present

Value (APV)Cash Flow Return on

Investment (CFRI)

Real options

Principal Valuation Methodologies


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Session 1: Multiples 1


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Relative valuation models: Comparable companies valuation

(trading market valuation) Comparable transactions valuation

1. Define a set of publicly traded comparable companies

2. Observe how those companies are valued by the market

3. Apply that valuation to the firm

Multiples


58

Mostly used multiples:1. Price-to-earnings ratio2. Price-to-book ratio3. Enterprise value to Earnings before

Interest, Taxes, Depreciation, and Amortization (EBITDA)

4. Enterprise value to revenues

Mostly Used Multiples


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Definition of 'Price-Earnings Ratio - P/E Ratio'

A valuation ratio of a company's current share price compared to its per-share earnings

Calculated as: Market Value per Share Earnings per Share (EPS)

Price-to-Earnings Ratio


60

For example, if a company is currently trading at $43 per share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95)

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings

Price-to-Earnings Ratio


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A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the book value per share

Also known as the "price-equity ratio” and calculated as:

A lower P/B ratio could mean that the stock is undervalued

Price-to Book Ratio

Shares of s)/#Liabilitie and Assets Intangible -Assets (Total

PriceStock Ratio P/B


62

For example, if a company is currently trading at $43

Total assets $1,000,000 Total liabilities $400,000 Intangible assets $100,000 Number of outstanding shares: 10,000 Find price-to-book ratio Price-to-book ratio

=43/($500,000/10000)=0.86

Price-to-Book Ratio


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It represents the enterprise value per dollar of EBITDA. It is calculated as:

Enterprise Value to EBITDA

Shareper EBITDA

PriceStock MultipleEBITDA


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EBIT=$400,000 Amortization & Depreciation=$50,000 Number of outstanding shares: 10,000 Find enterprise value to EBIT (1.075) Find enterprise value to EBITDA (0.96)

Enterprise Value to EBITDA


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It represents the enterprise value per dollar of revenues. It is calculated as:

Enterprise Value to Revenues

Shareper Revenues

PriceStock Multiple Revenues


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Revenues=$600,000 Number of outstanding shares: 10,000 Find the enterprise value to revenues

(0.716)

Enterprise Value to Revenues


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A well-designed, accurate multiples analysis can provide valuable insights about a company and its competitors. Conversely, a poor analysis can result in confusion

Building Effective Multiples


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To apply multiples properly, use the following four best practices:

Building Effective Multiples

Choose comparables with similar prospects

Use enterprise

value multiples

Use multiples based on forward

looking data

Eliminate non-operating items

Step 1

To analyze a

company using

comparables, you

must first create an

appropriate peer

group.

Step 2

Use an enterprise

value multiple to

eliminate effects from

changes in capital

structure and one

time gains and losses

Step 3

When building a

multiple, the

denominator should

use a forecast of

profits, rather than

historical profits

Step 4

Enterprise-value

multiples must be

adjusted for non

operating items

hidden within

enterprise value and

reported EBITA


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Session 2: Multiples 2


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When you gather the information for comparables, you should make sure that the multiples are determined in the same manner and then applied consistently to the subject company

Many analysts remove non-recurring items from earnings before calculating these ratios so to get a better picture of the underlying earnings of a company

Consistency and Comparability


71

According to best practices it is necessary to identify peers with the same business concept, accounting principles, growth, ROIC and financial and operational risk

It is important not to base a multiple valuation on a single year’s estimates. Sales, EBITDA etc. are different between years. DCF catch this volatility but a one-year multiple doesn’t

A multiple valuation should always be based on estimates from multiple years

Peers and Historic Analysis


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Strengths Weaknesses

Easy to produce Measures relative, not intrinsic value

Different estimates of value, depending on which multiple you use

Availability of comparables?

Vulnerable to manipulation (definition of comparables)

Multiples: Strengths and Weaknesses


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Session 3: Alternative and Latest Methodologies


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It represents the number of years required to get back the initial investment

For instance, an investment costs you $100,000 and you will be receiving $25,000 each year so it takes you 4 years to break-even

The shorter the time to break-even, the better the project

Some investors care about the number of years it takes to get back their initial investment

Break-Even Method


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Dividend Discount Model (DDM) uses predicted dividends divided by (the discount rate –the dividends’ growth rate)

This procedure has many variations, and it doesn't work for companies that don't pay out dividends

As some companies do not change their dividends from year-to year, then an average growth over a certain number of years will be used

E.g., dividend per share=1$, discount rate=10$, dividend growth rate=3%, so the value is $14.28

Dividend Discount Model

RateGrowth Dividend - RateDiscount

SharePer DividendStock of Value


76

Adjusted Present Value (APV) is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing

This method is often used for a highly leveraged project

The APV method is not used as frequently in practice as is the DCF analysis

Adjusted Present Value Method


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CFRI is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings

Example: Cash flow=$5,000 and the capital employed has a market value of $6,000 so the CFROI=20%

Cash Flow Return on Investment

Employed Capital of ValueMarket

FlowCash CFROI


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For the corporation, it is essentially the internal rate of return (IRR)

CFROI is compared to a hurdle rate to determine if Investment is performing adequately

The hurdle rate is the total cost of capital for the corporation (WACC)

The CFROI must exceed the hurdle rate to satisfy both the debt financing and the investors expected return

Example: CFROI=12% and WACC=8% so do we accept the investment?

Cash Flow Return on Investment


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The Economic Value Added (EVA) is a measure of surplus value created on an investment

Define the return on capital (ROC) to be the cash flow return on capital earned on an investment

Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment

EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)

Economic Value Added


80

EVA is a measure of dollar surplus value, not the percentage difference in returns

It is closest in both theory and construct to the net present value of a project in capital budgeting

The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projectsValue= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects

Economic Value Added


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Example: Return on Capital (2010)= 12.77% Cost of Capital (WACC) (2010)= 8.85% Capital in Assets in Place (2010): $29,500 EVA? EVA (2011)=(12.77%-8.85%)*$29,500=

$1,154.5

Economic Added Value


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Real options analysis (ROA) is widely recognized as a superior method for valuing projects with managerial flexibilities

There are cases in which a firm may enter a new product market or region by making a relatively small investment in order to establish a foothold and acquire the option to either expand it or exit this market when more information is obtained

Real Options


83

For example the opening of a new oil field involves a series of decisions about whether to lease an area, how to explore it, what wells and pipelines to build, and so on

This perspective contrasts with the traditional view of a project as set of decisions made once at the beginning and unchanged during the life of the project

In general, projects do not correspond to the situation assumed by traditional analyses, and the options view is much more realistic

Real Options: Example


84

Real options approach recognizes that risks can be managed, to avoid bad outcomes or take advantage of good ones are they become apparent

The use of real options practically always leads to higher values for the same project than the traditional methods, precisely because the options perspective recognizes that managers make future decisions about a project as uncertainties become resolved

Real Options

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Valuation Method Usefulness Comments

DCF Widely used Easy to implement

Multiples Widely used Depends on the accounting information

Break-Even Not frequently used Does not take into account future cash flows that occur after the break-even point

DDM Not frequently used Used for firms paying dividends

APV Not frequently used Used for a highly leveraged project

EAV Increasingly used Depends on accounting and economic data

CFROI Not frequently used Similar to DCF

Real Options Not frequently used Suitable for specific projects

Summary of Valuation Methods



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Final assessment


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Session 4: Case study


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Royal Ahold is a global retail supermarket group based in Europe and the United States with company headquarters in Amsterdam, The Netherlands

There are six comparables to Royal Ahold Find the value of Royal Ahold using Sales,

EBITDA, EBIT, and PER 2008 Multiples

Case Study: Royal Ahold


89



90

Royal Ahold data for 2008


Sales/Share EBITDA/Share EBIT/Share Net Income/Share $ 100.00 $ 6.00 $ 3.00 $ 2.50


91

Thank you!

Offered to: Securities & Commodities Authority Trainer: Dr. Anis Samet, American University of...

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