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Azure Group CFO Network – valuation overview

Wayne Lonergan

18 May 2011

22

Overview

• Enterprise value – what is it?• Calculating value• Discount rates• GFC• Impairment testing• Where its all gone / going

33

Enterprise value

• Equity value (i.e. market value of shares plus premium for control)

Plus

• Net interest bearing debt

Equals

• Enterprise value

44

How valuations are done

• Capitalise maintainable earningsOr• Discount future cash flows

55

Different multiples

• Equity value = price earnings ratio x profit after tax

• Enterprise value = EBIT multiple x EBIT

66

Discount rate – deriving cost of debt

• Current entity borrowing interest rate less tax at 30%– i.e. market based rate

• Easy

77

Discount rate – deriving cost of equity

• Ke = Rf + β (MRP)• i.e. cost of equity = Risk free rate + beta x

Market risk premium

88

Discount rates – deriving cost of equity

AboutGovernment bond rate plus (Rf) 6%Beta (relative volatility) β Generally 0.6 to 2.0 timesTimes market risk premium (MRP) 6%

99

Example – BHP

• Government bonds 6%• Beta of BHP 1.2 x• MRP 6%

• Calculation for equity discount rate:= Rf + β (MRP)

= 6% + 1.2 x 6%= 6% + 7.2%= 13.2% (note, after tax)

Discount rate

1010

Funding – part debt / part equity

• BHP’s weighted average cost of capital:– 70% equity x 13.2% (from slide 9)Plus– 30% debt 7% less 30% tax = 4.9%

• Equals WACC 10.71% (after tax)

• (70% x 13.2% + 30% x 4.9%)

1111

Calculating value

Discount Rate x CFY1+

x CFY2+

x CFY3etc

Discounting is like compound interest in reverse

1212

Discounting 10%

Value$

$100 Today = 100$100 End Y1 = 91$100 End Y2 = 83$100 End Y3 = 75

etc

1313

Impairment testing

• Can’t reverse goodwill write-downs (even if impairment is due to interest rate rise)

• Unrecognised intangible values “hide” goodwill losses• Upgrades and hence future benefits have to be

“committed”, or else ignored• Many DCF’s are only 5 years

– Too short a forecast period– Most value is in terminal value– Terminal value easy to get wrong

Lots of silly rules

1414

Impairment testing

• If its (barely) profitable, its not impaired• If profit exceeds interest cost of debt, its not impaired• You only impair fixed assets. Stock, debtors etc are subject

to their own different accounting standards and are excluded from the asset base for impairment testing

In reality• This isn’t correct

What many directors (wrongly) believe

1515

Impairment testing – the reality

• AIFRS impairment test higher of:– Market value– Value in use (VIU)

• VIU uses company view of cash flows not market views• VIU = L.O.O.C.• But most companies use it (guess why?)• VIU reduces write-downs

1616

ASX All Ordinaries Index

1717

Impairment testing – overview

• Things generally aren’t too bad in Australia• Things are very bad overseas in Western World ( large govt

debt and deficits in USA, UK, Spain, Portugal, Ireland etc)• China has saved us, so far• Australian consumers are worried (house values, interest

rates, electricity costs, etc)

On balance• Tread carefully• Watch China• If China falters significantly – watch out!

1818

GFC – what many forget

• Mean reversion applies in a crisis

Note:1 Forced down by Government.2 Much lower in USA etc.3 At least.4 Or lower, if debt available at all.

Pre-GFC%

In GFC%

After GFC%

Bonds 6 4(1) (2) 6Interest on debt 6 9 ++ 7MRP 6 7(3) 6Debt to equity ratio 60 / 40 30(4) / 70 40 / 60

+ liquidity crisis (no buyers)

1919

The GFC hangover

• Interest costs still higher than pre-GFC (credit spread up 1% or more)

• Credit availability reflected in debt / equity ratio significantly lower

• End result – values have generally fallen• Index 2007 6,000 (+)

2011 5,000 (-)

2020

Valuation trends 2007 – 2011

• Lower earnings multiples in 2011• Much less debt• Increased cost of debt• Significant sectoral differences (e.g. Mining vs Retail)

2121

Will it get better?

• Major government debts due espec to bail outs / stimulus packages

• USA (e.g.):– Large government annual deficit– Debt exceeds 100% of GDP– Very low interest rates aren’t stimulating demand much

• Similar, some worse, problems in most of Western world• T.G.F.C.

2222

Getting better – “best guess”

• Australia depends on China• Rest of world (except e.g. Asia) in poor state• Will take a very long time to fix (e.g. USA, UK, Spain,

Portugal, Ireland, Greece, etc)

2323

Recommended reading

Available from leading book stores orAllen & Unwin

www.allenandunwin.com

Available from leading book stores or Sydney University Press www.sup.usyd.edu.au

(Alternatively contact Lonergan Edwards on 02 8235 7500)