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Lecture
Business Valuations Techniques

Sep 2012
Inspired by Warren Buffett

Corporate Valuation: A Summary

Class Notes from Market Secret

Concept about Valuation

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Concept about Valuation

Intrinsic Value or true value of Business.

How to reach at that?

Value lies in the eyes of be holders

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Misconceptions about Valuation

Myth 1: A valuation is an objective search for true value
bias in your valuation is directly proportional to who pays you and how much you are paid.

Myth 2.: A good valuation provides a precise estimate of value

there are no precise valuations

Myth 3: . The more quantitative a model, the better the valuation

too much analysis leads to paralysis.

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Approaches to Valuation
Valuation Models

Asset Based Valuation

Discounted Cashf low Models

Relative Valuation

Contingent Claim Models

Liquidation Value
Stable Current

Equity
Firm

Sec tor

Option to delay

Option to expand Young firms

Option to liquidate Equity in troubled firm

Market

Replac ement Cost

Two-stage
Three-stage or n-stage

Normalized

Earnings Book Revenues Value

Sec tor specific

Undeveloped land

Equity Valuation Models

Dividends

Firm Valuation Models

Patent Undeveloped Reserves

Free Cashflow to Firm

Cost of capital approach

APV approach

Excess Return Models

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Basis for all valuation approaches

The use of valuation models in investment decisions (i.e. in decisions on which assets are under valued and which are over valued) are based upon
a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

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Discounted Cash Flow Valuation

What is it: .. present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon cash flows, growth and risk. Information Needed:
to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value

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Discounted Cashflow Valuation: Basis for Approach

t = n CF t Value = t t =1 (1+ r)

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset.

Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: 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.

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Equity Valuation versus Firm Valuation

Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm

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Two Measures of Discount Rates

Cost of Equity: This is the rate of return required by equity investors on an investment. It will incorporate a premium for equity risk -the greater the risk, the greater the premium. This is used to value equity. Cost of capital: This is a composite cost of all of the capital invested in an asset or business. It will be a weighted average of the cost of equity and the after-tax cost of borrowing. This is used to value the entire firm.

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Categorizing Cash Flows

Cash Flow Statement Amt

Cash Flow From Operation

Net Income Add: Dep & Amortization Less: Other Non-Op Income (Inc Int Exp) Add/Less: Changes in Working Capital Cash Flow From Operations Cash Flow From Investing Activity Less: Capex Add: Income from Inevstment (Strategic) Less: Purchase of Investment Cash Flow From Investing Cash Flow From Financing Activity Add: Issue of Equity (Inc SP) Add: Issue of Debt Less: Repayment of Debt Less: Divident Paid Cash Flow From Financing Net Inc/(Dec) in Cash Opening Cash Balance Closing Cash Balance Market Secret 12

Equity Valuation
Figure 5.5: Equity Valuation Assets
Cas h flows considered are cashflow s from assets, after debt payments and after making reinvestments needed for future grow th Ass ets in Place Debt

Liabilities

Grow th Assets

Equity

Discount rate reflects only the cos t of rais ing equity financing

Present value is value of just the equity claims on the firm

Free Cash Flow to Equity = Net Income + Depreciation + Amortization Net Reinvestment (capex + change in working capital) Net Debt Paid (or + Net Debt Issued)

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Firm Valuation
Figure 5.6: Firm Valuation Assets
Cash flows considered are cashflows from assets, prior to any debt payments but after firm has reinvested to create growth assets Assets in Place Debt Discount rate reflects the cost of raising both debt and equity financing, in proportion to their use

Liabilities

Growth Assets

Equity

Present value is value of the entire firm, and reflects the value of all claims on the firm.

Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) + Depreciation + Amortization Net Reinvestment (Capex + Changes in Working Capital).
The tax benefits of debt are not included in FCFF because they are taken into account in the firms cost of capital.

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Difference between FCFF v/s FCFE ?

FCFF is the cash available to bond holders and stock holders after all expense and investments have taken place. FCFE is the cash available to stock holders after all expense, investments and interest payments to debt-holders. The basic difference is consideration of interest payment in FCFE (v/s FCFF), subtract the interest expense from the cash flow to do valuations. FCFF shows the obligations for both stockholders as well as bondholders whereas FCFE consider only the obligations for stockholders. Factors Cash Flow Expected Growth Discount Rate Beta FCFF Pre Debt Cash Flow (already mentioned) Growth in Opertaing Income = Reinvestment Rate * ROC WACC Bottom-up FCFE Post Debt Cash Flow (already mentioned) Growth in net income = Retention ratio * ROE Cost of Equity Bottom- up

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Valuation with Infinite Life

DISCOUNTED CASHFLOW VALUATION

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Expe cte d Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Firm is in stable growth: Grows at con stant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Fore ver

Le ngth of Pe riod of High Growth

Disc ount Rate Firm:Cost of Capital Equity: Cost of Equity

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Valuing the Home Depots Equity

Assume that we expect the free cash flows to equity at Home Depot to grow for the next 10 years at rates much higher than the growth rate for the economy. To estimate the free cash flows to equity for the next 10 years, we make the following assumptions:
The net income of $1,614 million will grow 15% a year each year for the next 10 years. The firm will reinvest 75% of the net income back into new investments each year, and its net debt issued each year will be 10% of the reinvestment. To estimate the terminal price, we assume that net income will grow 6% a year forever after year 10. Since lower growth will require less reinvestment, we will assume that the reinvestment rate after year 10 will be 40% of net income; net debt issued will remain 10% of reinvestment.

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Estimating cash flows to equity: The Home Depot

Year
1 2 3 4 5 6 7 8 9 10

Net Income
$ $ $ $ $ $ $ $ $ $ 1,856 2,135 2,455 2,823 3,246 3,733 4,293 4,937 5,678 6,530

Reinvestment Needs Net Debt Paid

$ 1,392 $ $ 1,601 $ $ 1,841 $ $ 2,117 $ $ 2,435 $ $ 2,800 $ $ 3,220 $ $ 3,703 $ $ 4,258 $ $ 4,897 $ Sum of PV of FCFE = (139) (160) (184) (212) (243) (280) (322) (370) (426) (490) $ $ $ $ $ $ $ $ $ $

FCFE
603 694 798 917 1,055 1,213 1,395 1,605 1,845 2,122

PV of FCFE
$ $ $ $ $ $ $ $ $ $ 549 576 603 632 662 693 726 761 797 835 $6,833

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Terminal Value and Value of Equity today

FCFE11 = Net Income11 Reinvestment11 Net Debt Paid (Issued)11 = $6,530 (1.06) $6,530 (1.06) (0.40) (-277) = $ 4,430 million Terminal Price10 = FCFE11/(ke g) = $ 4,430 / (.0978 - .06) = $117,186 million The value per share today can be computed as the sum of the present values of the free cash flows to equity during the next 10 years and the present value of the terminal value at the end of the 10th year. Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978)10 = $52,927 million

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Valuing Boeing as a firm

Assume that you are valuing Boeing as a firm, and that Boeing has cash flows before debt payments but after reinvestment needs and taxes of $ 850 million in the current year. Assume that these cash flows will grow at 15% a year for the next 5 years and at 5% thereafter. Boeing has a cost of capital of 9.17%.

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Expected Cash Flows and Firm Value

Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049 million

Year 1 2 3 4

Cash Flow $978 $1,124 $1,293 $1,487

Terminal Value

Present Value $895 $943 $994 $1,047

5 $1,710 $43,049 Value of Boeing as a firm =

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$28,864 $32,743
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What discount rate to use?

Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable.

This hurdle will be higher for riskier projects than for safer projects.
A simple representation of the hurdle rate is as follows: Hurdle rate = Return for postponing consumption + Return for bearing risk Hurdle rate = Riskless Rate + Risk Premium The two basic questions that every risk and return model in finance tries to answer are: How do you measure risk? How do you translate this risk measure into a risk premium?

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The Capital Asset Pricing Model

Uses variance as a measure of risk Specifies that a portion of variance can be diversified away, and that is only the non-diversifiable portion that is rewarded. Measures the non-diversifiable risk with beta, which is standardized around one. Relates beta to hurdle rate or the required rate of return: Reqd. ROR = Riskfree rate + b (Risk Premium) Works as well as the next best alternative in most cases.

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From Cost of Equity to Cost of Capital

The cost of capital is a composite cost to the firm of raising financing to fund its projects. In addition to equity, firms can raise capital from debt

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Estimating the Cost of Debt

If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate. If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated, and it has recently borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

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Estimating Cost of Capital: Boeing

Equity
Cost of Equity = 5% + 1.01 (5.5%) = Market Value of Equity = Equity/(Debt+Equity ) = 82% 10.58% $32.60 Billion

Debt
After-tax Cost of debt = Market Value of Debt = Debt/(Debt +Equity) = 5.50% (1-.35) = 3.58% $ 8.2 Billion 18%

Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%

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Estimating the Expected Growth Rate

Expected Growth

Net Income

Operating Income

Rete ntion Ra tio= 1 - Dividends/Net Income

Retu rn on Equity Net Income/Book Value of Equity

Reinvestment Rate = (Net Ca p Ex + Chg in WC/EBIT(1-t)

Retu rn on Capital = EBIT(1-t)/Book Value of Capital

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Expected Growth in EPS

gEPS = (Retained Earningst-1/ NIt-1) * ROE = Retention Ratio * ROE = b * ROE ROE = (Net Income)/ (BV: Common Equity) This is the right growth rate for FCFE Proposition: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

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Expected Growth in EBIT And Fundamentals

Reinvestment Rate and Return on Capital gEBIT = (Net Capex + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Return on Capital = (EBIT(1-tax rate)) / (BV: Debt + BV: Equity)

This is the right growth rate for FCFF Proposition: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital.

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Getting Closure in Valuation

A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. Since we cannot estimate cash flows forever, we estimate cash flows for a growth period and then estimate a terminal value, to capture the value at the end of the period:
t = CFt Value = t t = 1 (1+ r)

Value =

t = N CFt Terminal Value t (1 + r)N t = 1 (1 + r)

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Stable Growth and Terminal Value

When a firms cash flows grow at a constant rate forever, the present value of those cash flows can be written as: Value = (Expected Cash Flow Next Period) / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. While companies can maintain high growth rates for extended periods, they will all approach stable growth at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the terminal value of all cash flows beyond.

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Relative Valuation
In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include - Price/Earnings (P/E) ratios
and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)

Price/Book (P/BV) ratios

and variants (Tobin's Q)

Price/Sales ratios . EV/EBITDA

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Valuing Unlisted, start-up, Young & Growth Companies

Valuation Issues Limited /No history Negative operating cash flow ( in some cases) No market value for debt/equity More holes is given details

Cash flow from existing assets

Est growth from new and improved efficiency on existing assets Discount rates emerged from assessment of risk business/equity Assesstment when the firm will become a stable growth firm

Importance
Value transactions (1) Public v/s Pvt, (2) IPO, and (3) VC

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Life Cycle of Early Stages Co.

Characteristics No history Small/No-revenues, Operating losses Dependent on Private Equity Many dont survive Multiple Claims on Equity Illiquid Investment Vs Public

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Example:Valuing Unlisted,start-up,Young Co.

Illustration 1: Valuing Secure Mail Venture Capital Approach (Relative valuation approach)
Secure Mail is a small software company that has developed a new computer virus screening program that it believes will be more effective than existing anti-virus programs. The company is fully owned by its founder and has no debt outstanding. The firm has been in existence only a year, has offered a beta version of the software for free to online users but has never sold the product (revenues are zero). During its year of existence, the firm incurred $ 15 million in expenses, thus recording an operating loss for the year of the same amount. As a venture capitalist, you have been approached about providing $ 30 million in additional capital to the firm, primarily to cover the commercial introduction of the software and expanding the market for the next two years. To value the firm, you decide to employ the venture capital approach. 1.The founder believes that the virus program will quickly find a market and that revenues will be $ 300 million by the third year. 2. Looking at publicly traded companies that produce anti-virus software, you come up with two companies that you feel are relevant comparables.
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Example:Valuing Unlisted,start-up,Young Co.

Illustration 1: Valuing Secure Mail Venture Capital Approach (Relative valuation approach)
PEERS AVERAGE Company ($ MN) Symantec Mcap 9388 Debt 2300 Cash 1890 EV 9798 Rev 5874 EV/sales 1.67x

McAfee
Average

4167
6778

0
1150

394
1142

3773
6786

1308
3591

2.88x
2.28x

VENTURE CAPITAL TARGET RATE OF RETURN - STAGE IN LIFE CYCLE TARGET RATE OF STAGE RETURN START UP FIRST STAGE 50% 40% 70% 60%

SECOND STAGE
BRIDGE /IPO

35%
25%

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Example:Valuing Unlisted,start-up,Young Co.

Illustration 1: Solution Venture Capital Approach (Relative valuation approach)
A TARGET REVENUE (mn) B C D TARGET EV/Sales (AVG PEERS) CAPITAL INFUSION TARGET RETURN $300 2.28x $30 50%

A*B ESTIMATED VALUE IN 3YRS VALUE TODAY ESTIMATED VALUE IN 3YRS TARGET RETURN

$682.89

$682.89 50%

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Example:Valuing Unlisted,start-up,Young Co.

Illustration 1: Valuing Secure Mail Venture Capital Approach (Relative valuation approach)
VALUE TODAY = ESTIMATED VALUE IN 3YRS (1+ TARGET RETURN) = POST MONEY VALUE = = PROPORTIONAL SHARE OF EQUITY = CAPITAL INFUSION POST MONEY VALUE = 14.8% $202.34 VALUE TODAY + CAPITAL INFUSION $232.34

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Example:Valuing Unlisted,start-up,Young Co.

Illustration 2: Valuing Secure Mail TOP Down Approach (Valuing using DCF) 1. Potential market size for the product/service 2. Market Share 3. Operating expenses/margins 4. Investments for growth 5. Compute tax effect 6. Check for internal consistency 7. FCFF 8. Beta 9. Cost of Capital 10. Terminal Value 11. Corpoarate Value

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Economic Value Added (EVA)

EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on economic capital employed is greater than the cost of that capital.

NOPAT = Operating Income (1-Tax Rate) Adj NOPAT = NOPAT + Other Income Adj Capital = S Debt + L Debt + Minority Int + Equity EVA = Adj NOPAT/Adj Capital

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How to value cash and cross holdings

Many students believe that valuing surplus cash on a companys balance sheet is an easy task. Just add the nominal value of the surplus cash to the value of the operating business derived from method like DCF or Enterprise Value (EV).

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How to value cash and cross holdings

1 know what is surplus and whats not

Cash provided by customers (e.g advance or deposits on the liabilities) are not surplus. Surplus means that if you take it out, you dont have to replace it. For example, ENGINEERS INDIA LTD (EIL) BHARAT ELECTRONICS LTD (BEL) (has large advances from customers as source of cash)

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How to value cash and cross holdings

2 Cash in seasonal businesses

Cash in some seasonal businesses may be surplus in lean seasons but required for conducting business for busy seasons. For Example, Cox & Kings Limited MAHINDRA HOLIDAYS & RESORTS INDIA LTD (Cash must not be treated as surplus even if BS show surplus cash in a lean season)

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How to value cash and cross holdings

3 Cash in hand of the value creator

A $100 bill in the hands of a value creator is worth more than $100 to his investors.

Conversely, the same $100 is worth less than $100 in the hands of a

value

destroyer.
Be wary of cash on BS of companies which have a track record of value destruction (e.g. dividend policy, acquisitions, expansion, and diversifications).

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How to value cash and cross holdings

4 Capital allocation skills matter

A $100 bill in the hands of scoundrel is worth less than $100 to his investors.

Conversely, the same $ 100 is worth more than $100 in the hands of the

honest

manager.
For Example,

Cash on Infosys v/s Afteks balance sheet

(Be wary of cash on the balance sheets of companies run by crooks)

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How to value cash and cross holdings

5 Corporate governance matters

In other words, the closer the cash resides near the pockets of the investors, the closer to its nominal value, should be its fair value to investors, other things remaining the same This happens, for example, in the cash of holding companies which have subsidiaries which have subsidiaries which have the cash. For Example, STERLITE Group

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Options/Warrants/Convertibles
Simple capital structure Complex capital structure

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Options/Warrants/Convertibles
Simple capital structure

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Options/Warrants/Convertibles
Simple capital structure

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Options/Warrants/Convertibles
Dilutive Antidilutive

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Options/Warrants/Convertibles
For Example: Dilutive/Antidilutive

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Options/Warrants/Convertibles
For Example: Dilutive/Antidilutive

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Options/Warrants/Convertibles
For Example: Warrants/Options/Convertibles

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Options/Warrants/Convertibles
For Example: Warrants/Options/Convertibles

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Options/Warrants/Convertibles
For Example: Warrants/Options/Convertibles

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Options/Warrants/Convertibles
Complex Capital Stucture

Options/Warrants/Convertibles
For Example: Options/Convertibles

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Options/Warrants/Convertibles
Solutions Basic EPS = Net Income Preferred Divident Weighted average number of common shares outstanding

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Options/Warrants/Convertibles

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M&A
Swap Ratio

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Examples

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