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1
Valuation-What do we mean?
 What is valuation?
 How do we come up with a value?
 Art or Science?
 Price versus Value
 http://pages.stern.nyu.edu/~adamodar/
2
Business Valuation
 Using the additive rule, the intrinsic value of
a company is the present value of expected
free cash flows from existing and future
projects.
 Since the value of the whole firm (debt and
equity) and the value of the shareholder’s
equity can both be measured, be sure what
you measuring.
3
The Fair Market Value Balance Sheet
Current Assets
Current Liabilities
(excluding current
long-term debt)
Long-Term
Debt
Property, Plant,
and Equipment
Intangible Assets
Stockholders’
Equity
Goodwill and
Going Concern
Net Working Capital
Market
Value of
Invested
Capital
(L-T Debt
+ Equity)
Net Asset
Value or
Enterprise
Value
(Equity plus
Net Debt)
Just as total assets equals total liabilities plus shareholders’ equity in accounting, in
finance:
4
Business Valuation: Definitions of
Value
Fair Market Value (Price)
The fair market value of an asset is generally defined
as the cash price at which the asset would change
hands between a hypothetical willing buyer and a
hypothetical willing seller, if the asset were offered for
sale on the open market for a reasonable period of time,
and both the buyer and the seller were adequately
informed of the relevant facts with neither being under
any compulsion to act.
5
Investment Value (Intrinsic Value)
The investment value is the value of the asset to a
specific owner or prospective owner. Accordingly, this
type of value considers the owner’s or prospective
owner’s knowledge, abilities, expectations of risks,
earning potential, synergies and other factors.
Business Valuation: Definitions
of Value
6
Valuation Methodologies
 Cost approaches
Accounting book value (Sum of Assets)
Adjusted book value (Replacement Cost)
 Market approaches
Comparable public guideline companies
Comparable transactions
 Income approaches
Dividend and Earnings models
Discounted cash flow models
 Free Cash Flow, Equity Cash Flow, Capital Cash
Flow and APV
7
 The value of individual assets and liabilities are restated
to reflect their market value.
 Typical adjustments include those for:
 Inventory under-valuation (LIFO)
 Bad debt reserves
 Market value of PP&E
 Intangible Assets like patents and brand
 Investments in affiliates
 Tax loss carry-forwards
Cost Approach: Adjusted Book
8
Two general approaches
 Comparable Multiples Analysis
 Comparable Transactions Analysis
Identify publicly-traded companies engaged in similar business
activities with risk/return characteristics similar to those at the
subject company. Infer value from the prices of the securities at
these publicly-traded firms.
Research merger and acquisition data to look at transaction
values of similar companies in the industry.
Caveats: Achieve consistency between numerator and
denominator
 Normalize Financial Statements (non-recurring items,
depreciation)
 Equity value to equity income- PE Multiples
 Invested capital value to invested capital income-EV Multiples
Market Approaches
9
Infers value from the prices of comparable publicly-traded securities or
comparable merger and acquisition transactions
Requires extensive analysis of:
» Products
» Markets
» Sales growth
» Profit margins
Comparable Multiples Analysis
» Geographic scope of operations
» Financial structure
» Financial and Operating Trends
» Quality of Management
» Equity Value Multiples
 Price/Earnings
 Price/Book Value
» Enterprise Value Multiples
 EV/Revenues
 EV/EBITDA
 EV/EBIT
10
Income Approach:
The Enterprise Value of a business
(EV) equals the present value of the
free cash flows that the assets are
expected to provide investors over time
(FCFF) discounted by the asset’s
expected return (discount rate)
PLUS the present value of the tax
shield the assets are capable of
supporting
PLUS the value of any non-
operating assets (excess cash)
(EBIT) x (1 - Average Tax Rate)
Profits From Opns. After Tax (NOPAT)
+ Depreciation and Amortization
- Capital Expenditures
- Additions to Working Capital
Free Cash Flows from the Firm (FCFF)
+ PV of Tax Shield
+ PV of Non-Op. Assets (excess cash)
= DCF Enterprise Value
11
What is a Tax Shield?
 It is the value of the capability of the
assets of the business to take on debt.
 Since interest payments are deductible for
tax purposes, having debt reduces tax
liability which increases cash flow and
therefore increases the value of the
assets.
 If two businesses have the same FCF but
only one has assets that can be
leveraged then it should be worth more to
12
What is a Non-Operating Asset ?
 Excess Cash- Substantially more cash
than required to operate the business.
 Marketable Securities – Publicly traded
securities that can be quickly turned into
cash.
 Patents not currently in use.
 Strategic Investments not generating cash
flow.
13
Surgeon and Butcher
The “surgeon” can use a tool of the “butcher”
in order to simplify the calculation.
FCFFT,t = NOPATt + (DEPt - CAPEXt +/- ∆WCt )
Is Equivalent to:
FCFF = NOPAT +/– (Net Asset Intensity)*(Change in Sales)
Where Net Asset Intensity is defined as the net amount of
investment in working capital and PPE as a percentage of sales
required to operate the business.
14
Asset Intensity
Sales 1000 % 1100 +100
AR 150 15% 165
Inv 100 10% 110
Net PPE 100 10% 110
AP (50) (5%) (55)
Other ST
Liab.
(50) (5%) (55)
Net Asset
Intensity
250 25% 275
Net Assets
Adj. to
NOPAT
25
15
∆Net Fixed Assets vs
Depreciation plus CAPEX
Period 1 Period 2 Period 3 Period 4 Period 5
Depreciation - income statement 500 1,000 1,500 2,000 2,500
Gross Fixed Assets 5,000 10,000 15,000 20,000 25,000
Accumulated depreciation - balance sheet 500 1,500 3,000 5,000 7,500
Net Fixed Assets 4,500 8,500 12,000 15,000 17,500
Method One:
Add Depreciation 500 1,000 1,500 2,000 2,500
Subtract CAPEX 5,000 5,000 5,000 5,000
Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)
Method Two:
Change in Net Fixed Assets 4,000 3,500 3,000 2,500
Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)
16
Calculating the Terminal Value - PV(TVT)
The present value of the terminal value, PV(TVt), is frequently estimated by
“capping” the cash flows at the end of a period for which detailed
projections are produced. The constant growth model is typically used to
estimate the terminal value.
TVT = FCFT(1+g)/(KT - g)
where:
FCFT – operating cash flow in year T
KT - appropriate cost of capital in year T
g - expected growth rate of the free cash flows (growth of economy)
Note that TVT is in year T dollars. It must be discounted back to year 0
before it is used in equation.
Most DCF valuation models are extremely sensitive to terminal value
assumptions
17
 Since the constant growth model assumes that the cash
flows will grow at rate “g” forever, you should try to prepare
detailed cash flow projections for a period at least as long
as it takes the business to stabilize.
Note that “g” cannot exceed K or the sum of expected inflation and the expected
real growth rate of the economy.
Selecting the Terminal Year
Cash
Flows
Year0 T
18
Alternative Terminal Value
 Can use a multiple of free cash flow
of from 6-10 times.
Cash Flow Multiples
Equivalency
Terminal Growth rate
Discount Rate 0% 3% 6%
10% 10.0 14.7 26.5
15% 6.7 8.6 11.8
20% 5.0 6.1 7.6
19
EBITDA vs FCF…What Gives??
Equivalent EBITDA
FCF Multiple 5 X 7 X 9 X
Net Asset 0% 8.3 11.7 15.0
Intensity 30% 9.0 12.6 16.2
60% 9.8 13.7 17.6
 Assumes EBITDA Margin of 20%
 EBIT Margin of 10%
 40% Tax Rate
20
Equivalency:
So:
 5 X EBITDA
Is the same as;
 9.0 X FCF at 30% Net Asset Intensity;
And
 3% Perpetuity Growth at 15% Discount Rate and
0% Net Asset Intensity
21
Cont’d:
 Can use comparable ratios as well such
as….
P/E, EV/Sales, P/Book, EV/EBITDA etc.
Can use salvage value if exiting business
Sometimes zero for depleting assets like
natural resources.
22
Discount Rate
Required Rate of Return (Opportunity Cost)
 Risk Free Rate
Treasury Bond (10 year)
 + “Market” Risk Premium
 + Unique Risk of the Company (Beta)
 Variability of Sales and Income
 Concentration of Sales
 Cyclicality
 Market Position
 + Small company risk
23
Estimating the Discount Rate
 CAPM measures the stocks volatility
relative to a stock index (S&P 500) to
determine a Beta (covariance) for the
company. This beta can be adjusted for
capital structure and measures the
systematic (market) risk of the company.
 This risk premium is estimated by
multiplying the firm’s beta times the
historical market premium of equities minus
the historical risk free rate.
24
The Security Market Line
Expected
Return
(r)
Expected
Market
Return
(rm)
Risk
Free
Rate (rf)
0 .5 1.0 Beta (β)
r = rf + β(rm - rf)
Market Portfolio
Security Market Line
25
Historical Market Risk prem.
S&P 500 vs 10 Yr Treasury Bonds
Source : Damodaran Online (NYU Prof)
Then: Base Rate = 5% + Beta(4%) + Adjustments
Period Stocks 10 yr Bonds Risk Premium
1928-2012 9.31% 5.11% 4.2%
1962-2012 9.73% 6.8% 2.93%
2002-2012 7.02% 5.31% 1.71%
26
Estimating Beta
Return On Share
Return On
Market
+
β = .4
+
+
+
+ +
+++
+
+
+
+
+
++
+
+
+
+
+
+ +
+
+
++
+
Return On Share
Return On
Market
+
β = 1.6
+
+
+
+ +
+++
+
+
+
+
+
++
+
+
+
+
+
+ +
+
+
+
+
+
Beta is the slope of the regression line
27
Using Comparables - Beta
 Small businesses do not have “observed”
betas and therefore we must use “market
comparables” to “estimate” the beta of the
firm we are evaluating.
 In order to do this we must make some
adjustments to the observed Beta’s for the
varying degrees of debt.
28
Re-Levered Beta
 Most public companies we use for comparables have
some amount of debt, thus their “beta” is considered to
be a “levered beta”.
 In order to adjust for the varying levels of debt in our
“proxy companies" we “un-lever” the betas in order to put
everyone on the same playing field.
 We then use the “un-levered” beta to calculate our
Expected Return on Assets, which is the discount rate to
be used for the Capital Cash Flow Method.
29
Adjusting Beta for Leverage
 Un-levering and Re-levering betas:
βU = βL/ (1+ VD/VE)(1-T)
βL = βU * (1+ (VD/VE)(1-T))
Where:
βL is the levered beta of a comparable company
βU is the asset (unlevered) beta (assumes βd is 0)
βL is the relevered beta
VD/VE is the market value of debt divided by the market value of
equity
T = Corporate tax rate.
))1)((
))1)((
T
V
V
(1ββ
T
V
V
(1ββ
E
D
UR
E
D
LU
−+=
−+=
30
Small Company Adjustment
 Since Beta is measured against the S&P 500, which are
companies with market caps > $1 billion, and your Beta
proxies are also large companies you need to add a 2-5%
adjustment to the calculated discount rate for size risk.
 Over time small companies demand a higher return by
investors because of the inherent risk of size.
 This is demonstrated by the historical returns of small cap
versus large cap publicly traded stocks.
 You can avoid this if the proxy companies are similar in
market size to yours.
31
Putting the Pieces Together-CCF
Method
 Calculate FCF to Owners (Debt and Equity)
 Estimate a Terminal Value
 Calculate the Tax Shield (if appropriate)
 Estimate a Discount Rate on Assets (Ka)
 Discount all of these FCF’s at this rate (Ka)
 Run sensitivities
 Make adjustments for control, liquidity, key
man etc.
 Subtract beginning debt if you want to know
Equity Value
32
Levels of Value-Control and Liquidity
Control
Premium
Marketability
Discount
100%
Control
Marketable
Minority Interest
Closely-Held
Minority Interest
M&A data generally
assumes that the
Buyer is acquiring
control of the
company and, if the
acquired company
was privately held,
assumes a lack of
marketability in the
firm’s securities.
The price of
publicly traded
comparables assume
that the security is
marketable, but the
price reflects a
minority interest in
the firm and a
premium would
have to be paid to
gain control
33
34

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Valuation class

  • 1. 1 Valuation-What do we mean?  What is valuation?  How do we come up with a value?  Art or Science?  Price versus Value  http://pages.stern.nyu.edu/~adamodar/
  • 2. 2 Business Valuation  Using the additive rule, the intrinsic value of a company is the present value of expected free cash flows from existing and future projects.  Since the value of the whole firm (debt and equity) and the value of the shareholder’s equity can both be measured, be sure what you measuring.
  • 3. 3 The Fair Market Value Balance Sheet Current Assets Current Liabilities (excluding current long-term debt) Long-Term Debt Property, Plant, and Equipment Intangible Assets Stockholders’ Equity Goodwill and Going Concern Net Working Capital Market Value of Invested Capital (L-T Debt + Equity) Net Asset Value or Enterprise Value (Equity plus Net Debt) Just as total assets equals total liabilities plus shareholders’ equity in accounting, in finance:
  • 4. 4 Business Valuation: Definitions of Value Fair Market Value (Price) The fair market value of an asset is generally defined as the cash price at which the asset would change hands between a hypothetical willing buyer and a hypothetical willing seller, if the asset were offered for sale on the open market for a reasonable period of time, and both the buyer and the seller were adequately informed of the relevant facts with neither being under any compulsion to act.
  • 5. 5 Investment Value (Intrinsic Value) The investment value is the value of the asset to a specific owner or prospective owner. Accordingly, this type of value considers the owner’s or prospective owner’s knowledge, abilities, expectations of risks, earning potential, synergies and other factors. Business Valuation: Definitions of Value
  • 6. 6 Valuation Methodologies  Cost approaches Accounting book value (Sum of Assets) Adjusted book value (Replacement Cost)  Market approaches Comparable public guideline companies Comparable transactions  Income approaches Dividend and Earnings models Discounted cash flow models  Free Cash Flow, Equity Cash Flow, Capital Cash Flow and APV
  • 7. 7  The value of individual assets and liabilities are restated to reflect their market value.  Typical adjustments include those for:  Inventory under-valuation (LIFO)  Bad debt reserves  Market value of PP&E  Intangible Assets like patents and brand  Investments in affiliates  Tax loss carry-forwards Cost Approach: Adjusted Book
  • 8. 8 Two general approaches  Comparable Multiples Analysis  Comparable Transactions Analysis Identify publicly-traded companies engaged in similar business activities with risk/return characteristics similar to those at the subject company. Infer value from the prices of the securities at these publicly-traded firms. Research merger and acquisition data to look at transaction values of similar companies in the industry. Caveats: Achieve consistency between numerator and denominator  Normalize Financial Statements (non-recurring items, depreciation)  Equity value to equity income- PE Multiples  Invested capital value to invested capital income-EV Multiples Market Approaches
  • 9. 9 Infers value from the prices of comparable publicly-traded securities or comparable merger and acquisition transactions Requires extensive analysis of: » Products » Markets » Sales growth » Profit margins Comparable Multiples Analysis » Geographic scope of operations » Financial structure » Financial and Operating Trends » Quality of Management » Equity Value Multiples  Price/Earnings  Price/Book Value » Enterprise Value Multiples  EV/Revenues  EV/EBITDA  EV/EBIT
  • 10. 10 Income Approach: The Enterprise Value of a business (EV) equals the present value of the free cash flows that the assets are expected to provide investors over time (FCFF) discounted by the asset’s expected return (discount rate) PLUS the present value of the tax shield the assets are capable of supporting PLUS the value of any non- operating assets (excess cash) (EBIT) x (1 - Average Tax Rate) Profits From Opns. After Tax (NOPAT) + Depreciation and Amortization - Capital Expenditures - Additions to Working Capital Free Cash Flows from the Firm (FCFF) + PV of Tax Shield + PV of Non-Op. Assets (excess cash) = DCF Enterprise Value
  • 11. 11 What is a Tax Shield?  It is the value of the capability of the assets of the business to take on debt.  Since interest payments are deductible for tax purposes, having debt reduces tax liability which increases cash flow and therefore increases the value of the assets.  If two businesses have the same FCF but only one has assets that can be leveraged then it should be worth more to
  • 12. 12 What is a Non-Operating Asset ?  Excess Cash- Substantially more cash than required to operate the business.  Marketable Securities – Publicly traded securities that can be quickly turned into cash.  Patents not currently in use.  Strategic Investments not generating cash flow.
  • 13. 13 Surgeon and Butcher The “surgeon” can use a tool of the “butcher” in order to simplify the calculation. FCFFT,t = NOPATt + (DEPt - CAPEXt +/- ∆WCt ) Is Equivalent to: FCFF = NOPAT +/– (Net Asset Intensity)*(Change in Sales) Where Net Asset Intensity is defined as the net amount of investment in working capital and PPE as a percentage of sales required to operate the business.
  • 14. 14 Asset Intensity Sales 1000 % 1100 +100 AR 150 15% 165 Inv 100 10% 110 Net PPE 100 10% 110 AP (50) (5%) (55) Other ST Liab. (50) (5%) (55) Net Asset Intensity 250 25% 275 Net Assets Adj. to NOPAT 25
  • 15. 15 ∆Net Fixed Assets vs Depreciation plus CAPEX Period 1 Period 2 Period 3 Period 4 Period 5 Depreciation - income statement 500 1,000 1,500 2,000 2,500 Gross Fixed Assets 5,000 10,000 15,000 20,000 25,000 Accumulated depreciation - balance sheet 500 1,500 3,000 5,000 7,500 Net Fixed Assets 4,500 8,500 12,000 15,000 17,500 Method One: Add Depreciation 500 1,000 1,500 2,000 2,500 Subtract CAPEX 5,000 5,000 5,000 5,000 Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500) Method Two: Change in Net Fixed Assets 4,000 3,500 3,000 2,500 Net Adjustment to GAAP EBIAT (4,000) (3,500) (3,000) (2,500)
  • 16. 16 Calculating the Terminal Value - PV(TVT) The present value of the terminal value, PV(TVt), is frequently estimated by “capping” the cash flows at the end of a period for which detailed projections are produced. The constant growth model is typically used to estimate the terminal value. TVT = FCFT(1+g)/(KT - g) where: FCFT – operating cash flow in year T KT - appropriate cost of capital in year T g - expected growth rate of the free cash flows (growth of economy) Note that TVT is in year T dollars. It must be discounted back to year 0 before it is used in equation. Most DCF valuation models are extremely sensitive to terminal value assumptions
  • 17. 17  Since the constant growth model assumes that the cash flows will grow at rate “g” forever, you should try to prepare detailed cash flow projections for a period at least as long as it takes the business to stabilize. Note that “g” cannot exceed K or the sum of expected inflation and the expected real growth rate of the economy. Selecting the Terminal Year Cash Flows Year0 T
  • 18. 18 Alternative Terminal Value  Can use a multiple of free cash flow of from 6-10 times. Cash Flow Multiples Equivalency Terminal Growth rate Discount Rate 0% 3% 6% 10% 10.0 14.7 26.5 15% 6.7 8.6 11.8 20% 5.0 6.1 7.6
  • 19. 19 EBITDA vs FCF…What Gives?? Equivalent EBITDA FCF Multiple 5 X 7 X 9 X Net Asset 0% 8.3 11.7 15.0 Intensity 30% 9.0 12.6 16.2 60% 9.8 13.7 17.6  Assumes EBITDA Margin of 20%  EBIT Margin of 10%  40% Tax Rate
  • 20. 20 Equivalency: So:  5 X EBITDA Is the same as;  9.0 X FCF at 30% Net Asset Intensity; And  3% Perpetuity Growth at 15% Discount Rate and 0% Net Asset Intensity
  • 21. 21 Cont’d:  Can use comparable ratios as well such as…. P/E, EV/Sales, P/Book, EV/EBITDA etc. Can use salvage value if exiting business Sometimes zero for depleting assets like natural resources.
  • 22. 22 Discount Rate Required Rate of Return (Opportunity Cost)  Risk Free Rate Treasury Bond (10 year)  + “Market” Risk Premium  + Unique Risk of the Company (Beta)  Variability of Sales and Income  Concentration of Sales  Cyclicality  Market Position  + Small company risk
  • 23. 23 Estimating the Discount Rate  CAPM measures the stocks volatility relative to a stock index (S&P 500) to determine a Beta (covariance) for the company. This beta can be adjusted for capital structure and measures the systematic (market) risk of the company.  This risk premium is estimated by multiplying the firm’s beta times the historical market premium of equities minus the historical risk free rate.
  • 24. 24 The Security Market Line Expected Return (r) Expected Market Return (rm) Risk Free Rate (rf) 0 .5 1.0 Beta (β) r = rf + β(rm - rf) Market Portfolio Security Market Line
  • 25. 25 Historical Market Risk prem. S&P 500 vs 10 Yr Treasury Bonds Source : Damodaran Online (NYU Prof) Then: Base Rate = 5% + Beta(4%) + Adjustments Period Stocks 10 yr Bonds Risk Premium 1928-2012 9.31% 5.11% 4.2% 1962-2012 9.73% 6.8% 2.93% 2002-2012 7.02% 5.31% 1.71%
  • 26. 26 Estimating Beta Return On Share Return On Market + β = .4 + + + + + +++ + + + + + ++ + + + + + + + + + ++ + Return On Share Return On Market + β = 1.6 + + + + + +++ + + + + + ++ + + + + + + + + + + + + Beta is the slope of the regression line
  • 27. 27 Using Comparables - Beta  Small businesses do not have “observed” betas and therefore we must use “market comparables” to “estimate” the beta of the firm we are evaluating.  In order to do this we must make some adjustments to the observed Beta’s for the varying degrees of debt.
  • 28. 28 Re-Levered Beta  Most public companies we use for comparables have some amount of debt, thus their “beta” is considered to be a “levered beta”.  In order to adjust for the varying levels of debt in our “proxy companies" we “un-lever” the betas in order to put everyone on the same playing field.  We then use the “un-levered” beta to calculate our Expected Return on Assets, which is the discount rate to be used for the Capital Cash Flow Method.
  • 29. 29 Adjusting Beta for Leverage  Un-levering and Re-levering betas: βU = βL/ (1+ VD/VE)(1-T) βL = βU * (1+ (VD/VE)(1-T)) Where: βL is the levered beta of a comparable company βU is the asset (unlevered) beta (assumes βd is 0) βL is the relevered beta VD/VE is the market value of debt divided by the market value of equity T = Corporate tax rate. ))1)(( ))1)(( T V V (1ββ T V V (1ββ E D UR E D LU −+= −+=
  • 30. 30 Small Company Adjustment  Since Beta is measured against the S&P 500, which are companies with market caps > $1 billion, and your Beta proxies are also large companies you need to add a 2-5% adjustment to the calculated discount rate for size risk.  Over time small companies demand a higher return by investors because of the inherent risk of size.  This is demonstrated by the historical returns of small cap versus large cap publicly traded stocks.  You can avoid this if the proxy companies are similar in market size to yours.
  • 31. 31 Putting the Pieces Together-CCF Method  Calculate FCF to Owners (Debt and Equity)  Estimate a Terminal Value  Calculate the Tax Shield (if appropriate)  Estimate a Discount Rate on Assets (Ka)  Discount all of these FCF’s at this rate (Ka)  Run sensitivities  Make adjustments for control, liquidity, key man etc.  Subtract beginning debt if you want to know Equity Value
  • 32. 32 Levels of Value-Control and Liquidity Control Premium Marketability Discount 100% Control Marketable Minority Interest Closely-Held Minority Interest M&A data generally assumes that the Buyer is acquiring control of the company and, if the acquired company was privately held, assumes a lack of marketability in the firm’s securities. The price of publicly traded comparables assume that the security is marketable, but the price reflects a minority interest in the firm and a premium would have to be paid to gain control
  • 33. 33
  • 34. 34