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VALUATION
METHODOLOGY
An overview
“If I am not worth the wooing, I am
surely not worth the winning.” - Henry
Wadsworth Longfellow
Methodologies2
So what multiple do we use?
P/E multiple
Market to Book multiple
Price to Revenue multiple
Enterprise value to EBIT multiple
How about Discounted Cash Flows (DCF)
NPV, IRR, or EVA based MethodsWACC method
APV method
CF to Equity method
Valuation: P/E multiple3
IPO or a takeover target? This is how we get value;
Value of firm = Average Transaction P/E multiple EPS of firm
Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be)
If valuation is being done to estimate the firm’s value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when
firms in the industry are making a profit (have positive earnings)
firms in the industry have similar growth rates (more likely for “mature” industries)
firms in the industry have analogous capital structure
Valuation: Price to book multiple4
The application of this method is similar to that of the P/E multiple method.
Since the book value of equity is essentially the amount of equity capital injected in the firm, this method measures the market value of each dollar of equity injected.
This method can be used for
companies in the manufacturing sector which have huge capital requirements.
companies which are not in technical default (negative book value of equity)
Valuation: Value to EBITDA
multiple5
This gives us the enterprise value, the
value of the business operations (versus the
value of the equity).
In figuring out the enterprise value, just the
operational value of the business is included.
Value from investment activities, such as
investment in T-bills or bonds, or investment in
stocks of other companies, is not factored in.
The following economic value balance sheet
brings to light the concept of enterprise value.
Enterprise Value6
Economic Value Balance Sheet
PV of future cash from business
operations$1500
Cash $200 Debt $650
Marketable securities $150 Equity $1200
$1850 $1850
Enterprise Value
Value to EBITDA multiple:
Example7
Let’s value a Target using the following data
points:
Enterprise Value to EBITDA (business operations
only) multiple of 5 recent transactions in this industry:
10.1, 9.8, 9.2, 10.5, 10.3.
Recent EBITDA of target company = $20 million
Cash in hand of target company = $5 million
Marketable securities held by target company = $45
million
Interest rate received on marketable securities = 6%.
Sum of long-term and short-term debt held by target =
$75 million
Value to EBITDA multiple:
Example8
Take the mean (Value/ EBITDA) of recent transactions
(10.1+9.8+9.2+10.5+10.3)/5 = 9.98
Interest income from marketable securities
0.06 45 = $2.7 million
EBITDA – Interest income from marketable securities
20 – 2.7 = $17.3 million
Estimated enterprise value of the target
9.98 17.3 = $172.65 million
Add cash plus marketable securities
172.65 + 5 + 45 = $222.65 million
Subtract debt to find equity value: 222.65 – 75 = $147.65 million.
Valuation: Value to EBITDA
multiple9
Since this method measures enterprise value it accounts for different capital structures
cash and security holdings
By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value.
Appropriate for valuing companies with heavy debt burdens: while earnings might be negative, EBIT is likely to be positive.
It provides a measure of cash flows that can be used to support debt payments in levered companies.
Heuristic methods: drawbacks10
While heuristic methods are simple, all of them
share several common disadvantages:
they do not accurately reflect the synergies that
may be produced in a takeover.
they assume that the market valuations are
accurate. For example, in an overvalued
market, we might overvalue the firm.
They assume that the firm being valued is similar
to the median or average firm in the industry.
They require that firms use uniform accounting
practices.
Valuation: DCF method11
Here we follow the discounted cash flow
(DCF) technique we used in capital budgeting:
Estimate expected cash flows considering the
synergy in a takeover
“PV it,” Discount it at the appropriate cost of
capital
DCF methods: Starting data12
Free Cash Flow (FCF) of the firm
Cost of debt of firm
Cost of equity of firm
Target debt ratio (debt to total value) of the
firm.
Template for Free Cash Flow13
“Inco
me
Sta
tem
en
t”
Working capital
Year 0 1 2
Revenue
Costs
Depreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flow
Change in working capital
Capital Expenditure Capital items
Salvage of assets
Free cash flow
Template for Free Cash Flow14
The goal of the template is to estimate cash flows, not profits.
Template is made up of three parts.
An “Income Statement”
Adjustments for non-cash items included in the “Income statement” to calculate taxes
Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc.
The “Income Statement” portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting.
Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.
Template for Free Cash Flow15
There are four categories of items in our “Income Statement”. While
the first three items occur most of the time, the last one is likely to
be less frequent.
Revenue items
Cost items
Depreciation items
Profit from asset sales
Adjustments for non-cash items is to simply add all non-cash items
subtracted earlier (e.g. depreciation) and subtract all non-cash
items added earlier (e.g. gain from salvage).
There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or Property,
Plant, and Equipment (PP&E))
Working capital
Template for Free Cash Flow16
It is important to recover both at the end of a finite-lived project.
Salvage the market value property plant and equipment
Recover the working capital left in the project (assume full recovery)
Template for Free Cash Flow17
Taxable income = Revenue - Costs - Depreciation + Profit from asset sales
NOPAT = Taxable income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
Add the noncash items you subtracted earlier and subtract the noncash items you added earlier.
Estimating Horizon18
For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it.
Since a company is assumed to have infinite life:
Estimate FCF on a yearly basis for about 5 10 years.
After that, calculate a “Terminal Value”, which is the ongoing value of the firm.
Terminal value is calculated one of two ways:
Estimate a long-term growth and use the constant growth perpetuity model.
Use a Enterprise value to EBIT multiple, or some such multiple
Costs of debt and equity19
Cost of debt can be approximated by the yield to
maturity (YTM) of the debt.
If it is not directly available, check the bond rating
of the company and find the YTM of similar rated
bonds.
Cost of equity
Capital Asset Pricing Model (CAPM)
Find e and calculate required re.
Use Gordon-growth model and find expected re.
Under the assumption that market is efficient, this is
the required re.
Model of a Firm20
Value from
Operations
FIRM
DEBT and
other
liabilities
EQUITY
Value generated
Value to Equity
Equal if debt
is fairly priced
Value from
investments
Enterprise value