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Valuation methods
An overview

2001 M. P. Narayanan

University of Michigan

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Methodologies

Comparable multiples P/E multiple Market to Book multiple Price to Revenue multiple Enterprise value to EBIT multiple Discounted Cash Flow (DCF) NPV, IRR, or EVA based Methods

WACC method APV method CF to Equity method

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University of Michigan

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Valuation: P/E multiple

If valuation is being done for an IPO or a takeover, 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 firm value Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when firms in the industry are profitable (have positive earnings) firms in the industry have similar growth (more likely for mature industries) firms in the industry have similar capital structure
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Valuation: Price to book multiple

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 invested in the firm, this method measures the market value of each dollar of equity invested. This method can be used for

companies in the manufacturing sector which have significant capital requirements. companies which are not in technical default (negative book value of equity)

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University of Michigan

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Valuation: Value to EBITDA multiple

This multiple measures the enterprise value, that is

the value of the business operations (as opposed to the value of the equity). In calculating enterprise value, only the operational value of the business is included. Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded. The following economic value balance sheet clarifies the notion of enterprise value.

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University of Michigan

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Enterprise Value
Economic Value Balance Sheet
PV of future cash from business operations Cash Marketable securities $1500 $200 $150 $1850 Debt Equity $650 $1200 $1850

Enterprise Value

2001 M. P. Narayanan

University of Michigan

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Value to EBITDA multiple: Example

following data:

Suppose you wish to value a target company using the

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

2001 M. P. Narayanan

University of Michigan

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Value to EBITDA multiple: Example

Average (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.
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Valuation: Value to EBITDA multiple

accounts for different

Since this method measures enterprise value it

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 large debt burden: while earnings might be negative, EBIT is likely to be positive. Gives a measure of cash flows that can be used to support debt payments in leveraged companies.
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Heuristic methods: drawbacks

several common disadvantages:

While heuristic methods are simple, all of them share

they do not accurately reflect the synergies that may be generated in a takeover. they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm under consideration. 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.

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University of Michigan

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Valuation: DCF method

technique we used in capital budgeting:

Here we follow the discounted cash flow (DCF)

Estimate expected cash flows considering the synergy in a takeover Discount it at the appropriate cost of capital

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University of Michigan

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DCF methods: Starting data

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.

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University of Michigan

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Template for Free Cash Flow

Working capital Year Revenue Costs Depreciation of equipment Profit/Loss from asset sales Taxable income Tax Net oper proft after tax (NOPAT) Depreciation Profit/Loss from asset sales Operating cash flow Change in working capital Capital Expenditure Salvage of assets Free cash flow 0 1 2

Income Statement

Noncash item Noncash item

Adjustment for for non-cash

Capital items

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University of Michigan

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Template for Free Cash Flow

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.

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University of Michigan

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Template for Free Cash Flow

While the first three items occur most of the time, the last one is likely to be less frequent.

There are four categories of items in our Income Statement.

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 noncash 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
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Template for Free Cash Flow

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)

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University of Michigan

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Template for Free Cash Flow

Taxab le income = Revenue - Costs - Depreciation + Profit from asset sales NOPAT = Taxab le 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 sub tracted earlier and sub tract the noncash items you added earlier.

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University of Michigan

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Estimating Horizon

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
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Costs of debt and equity

Cost of debt can be approximated by the yield to

maturity 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

CAPM

Find be and calculate required re.

Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.

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University of Michigan

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Model of a Firm

Value from Operations

Enterprise value

Value from investments

Value generated
Equal if debt is fairly priced

FIRM
Value to Equity

DEBT and other liabilities

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Value of equity

Value of equity

= Enterprise value + Value of cash and investments - Value of debt and other liabilities

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University of Michigan

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