The Absolute Basics

What is Being Valued?

Enterprise value is the value of the firm to

all providers of capital.. Equity, debt and other.

Equity value is the value of the firm to the

providers of equity capital only, i.e. Shares.

Valuation Approach the Choices

Cashflow Valuation
DCF EVA

Multiples
Enterprise Equity Operational

Asset based break up scenarios Optimal Deprival Value market power Capitalisation Rate real estate assets

Presentation Logic
Deals with:
Cost of capital Capital structure Cashflow model

common to all methods common to all methods

Multiple model

Capital Structure I
Generally the capital structure consists of:
1.Equity

representing business and asset representing financial risk

risk 2.Debt

Capital Structure II
Debt is lower cost than equity, but Using more debt adds financial risk, and Thus increases the cost of equity Debt may have tax

Cost of Capital I
Value is destroyed unless projects and companies meet or beat their cost of capital:
Cost of capital is an opportunity cost the sacrifice to investing in the company 2. Cost of capital represents the risks in investing in the company
1.

Cost of Capital II
Value is destroyed unless projects and companies meet or beat their cost of capital:
All providers face their own cost of capital debt, equity, or a mixture 2. The company faces a mix or blend called weighted average cost of capital.
1.

All Roads Lead to Cost of Capital

Despite apparent differences, all valuation methods:
1.Can and are related to a cost of capital DCF,

EVA, Cap rate, ODV, asset value 2.Including multiples, can be directly linked to cost of capital through the reciprocal relationship 3.Express cost of capital components in one way or another

The Cost of Debt Capital

The market cost of raising the marginal tranche of debt capital (the next increment)...
1.The riskfree rate (as proxied by [say]

well traded government debt in country of cashflow origin)

Plus

2.A debt premium reflecting industry and

company business risk As determined by rating or market data.

Riskfree rate of interest such as the interest paid on government bonds PLUS
A premium for taking risk....

The Cost of Equity Capital

The market cost of raising the marginal

tranche of equity capital (the next increment)...

1.The riskfree rate (as proxied by [say] well traded

government debt in country of cashflow origin) Plus

2.The premium for investing in equities (ERP equity

risk premium) of 4.0% 7.0% Times Equity Beta (the index of company risk)

The Riskfree rate PLUS a premium for equity market risk adjusted by BETA... The company risk index

Two Betas Equity and Asset

Equity beta = asset beta / (1 debt % )
Only equity beta can be measured in the

market

Asset beta = equity beta * (1 debt % )

Asset beta must be derived from equity

beta

Example
The equity beta for the tele communications industry often sits at around 0.80. The Debt to total capital ratio for the tele communication industry often sits at around 50%

So: Equity beta = 0.80 Asset beta = 0.80 * ( 1 - . 50) = 0.40

Estimating Beta
Building an equity beta:
Establish the equity beta for an industry Find asset beta given industry capital

structure Use company capital structure to find company equity beta

Draw data from Bloomberg, Reuters, Valueline or similar

Example
Industry equity beta is 0.80 Industry Debt to capital is 50% My company Debt to total capital is 65%

Asset beta is: 0.80 * (1 - .50) = 0.40)

My equity beta is: 0.40 / (1-.65) = 1.14

Summarising....
Cost of debt = risk free + debt risk premium Cost of equity = risk free + (equity beta *

ERP)
In the capital structure of debt and equity:
Equity is valued at the cost of equity Debt is valued at the cost of debt

Last twist: Debt is adjusted for tax deductibility...

Multiply it by (1 Tc).... The corporate tax rate.

Last twist: tax and cost of debt

Debt cost is adjusted for tax deductibility... Multiply it by (1 Tc).... The corporate tax rate.

So: Corporate tax rate = 30% Cost of debt = 8.5% Tax adjusted cost of debt = 0.08 * (1 0.3) = 5.6%

Blend Equity and Debt Costs to calculate WACC

Weighted Average Cost of Capital

Example........
Riskfree Debt Tax rate ERP Equity rate Premium Beta Cost of Debt 55 . % 55 . % 5. % N/ A 55 N/ A Cost of Equity 55 N/ A . % N/ A 5 % 55 . 5 Percent debt 5% Weighted cost debt 5 Percent equity 5% Weighted cost equity 5 TOTAL 55 5% WACC 11% . 1 11% . 1 55% . 5

55 . % 5. % 55

The Cashflow Valuation Equation

Value of near term cashflows Plus Terminal value

Discounted to Present value at:

1.The WACC for the value of the enterprise 2.The cost of equity for the value of equity

Cashflow to the enterprise is....

Earnings before interest and taxes (EBIT) Minus Cash taxes on EBIT Minus Investments Plus Depreciation Plus (minus) Change in Working capital equals Free Cash Flow. Available to ALL INVESTORS

Estimating Terminal Value I

1. Estimate a constant growth rate ( g ) from

last year of the near term flows out to infinity

2. Multiply the estimated cashflow of the last

year of the near forecast period by 1 + g

Estimating Terminal Value II

3. Divide this value by cost of capital minus g

to get terminal value

4. Discount TV back to the present using cost

of capital.

Enterprise and Equity Value

Enterprise value Equity value debt Test:
Cashflow sensitivities Cost of capital sensitivities Terminal value sensitivities (growth rate)

= near term plus terminal = enterprise value less

Why test?
Growth Cost of c apital Near term $ Terminal $ PV near term PV terminal Value 11 1 11 1 , 1 $ 5 % 5% 5 11 1 $ 11 1 Growth Cost of c apital Near term $ Terminal $ PV near term PV terminal Value 55 5 55 5 , 5 $ 5 % 5% 5 55 5 $ 55 5

$ $ $

55 5 55 5 , 5 55 5 , 5

$ $ $

55 5 55 5 , 5 55 5 , 5

The Valuation Multiple Equation

Based on comparative analysis. Popular in media: Comparisons drawn from:
Market observations Transaction observations Fundamental data

All adjusted to normalise data and allow as analysis of like with like to greatest extent possible or feasible.

The idea is that, on average, a company should, over time have roughly the same value as its peers.
Example: If the ratio of Telco share prices to Telco earnings is 8.0 then a typical Telco earning $0.50 should trade at about: $0.50 x 8 = $4:00

Multiple Valuation Process

Process to calculate:
Identify an appropriate variable Find the necessary inputs for the calculation Normalise - adjust the numbers to remove

extraordinary or one off effects Compute ratio numerous formulae available Apply multiple to company being valued

Check against another method

Enterprise Multiples
Estimate value of the enterprise to all capital providers: EBITDA most cash like, skirts accounting issues, captures operating costs, only deals with tax indirectly.

Revenue useful with negative or zero earnings, skirts accounting treatment, difficult to launder.

Equity Multiples
Estimate value of the enterprise to equity capital providers:
P|EBIT avoids tax and capital structure

differences, pre tax relationship to other methods.

P|E very popular, oft quoted, simple to

understand, difficult to compare because of tax and capital structure differences.

A helpful relationship:
1 / P|EBIT = (pre tax) ROIC

Operating Multiples
Many industries have unique operating multiples which can be used comparatively:

Media P | number of subscribers Energy P | KWh production capacity Accommodation P | number of room Tourism P | visitor nights / spend Agriculture P | output per stock unit Telecom P | fixed / mobile subscribers

Identical process to other cases. Identical weaknesses.

Multiples - Characteristics
Advantages
Simple and resource light Easy to communicate Commonly used

Disadvantages
Single variable focus simplistic Assume straight line trend Subjective in normalising and comparing

Conclusions
Valuation is...

A blend of art and science but a disciplined and systematic blend. Thoroughly dependent on all of the explicit and implicit assumptions made. An estimation process whose outer limits ought to be tested for revision purposes. Likely to perform best when it reflects fit for purpose decisions in design.