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Valuation Situations

We encounter valuation in many situations:

Mergers & Acquisitions Initial Public Offerings / Follow on Offering Qualified Institutional Placements Private Equity and Buyout Investors buying a minority interest in Companies Sell-offs, Spin-offs and Divestment

How do we measure value? How can I-Bankers create value?

**Business Valuation Techniques
**

Discounted Cash Flow (DCF) approaches

Dividend Discount Model (DDM) Free Cash Flows to Equity Model (FCFE) - Direct Approach Free Cash Flows to the Firm Model (FCFF) - Indirect Approach

**Relative Valuation approaches
**

P/E Multiples (capitalization of earnings) Enterprise Value / EBITDA Others: P/CF, P/B, P/S

**Mergers and Acquisitions
**

Control transaction based models

(eg., value based on acquisition premia or control premium)

**Discounted Cash Flow Valuation
**

What cash flow to discount?

Investors in stock receive dividends, or periodic cash distributions from the company, and capital gains on re-sale of stock in future If investor buys and holds stock forever, all they receive are dividends In Dividend Discount Model (DDM), analysts forecast future dividends for a company and discount at the required equity return

the valuation formula reduces to (Geometric Progression): Ve = Div1/(r ..Dividend Discount Model (DDM) The value of equity (Ve) is the present value of the (expected) future stream of dividends Ve = Div1/(1+r) + Div1(1+g2)/(1+r)2 + Div1(1+g2)(1+g3)/(1+r)3 +. . . If growth is constant (g2 = g3 = .. = g) .g) Some estimation problems: firms may not (currently) pay dividends dividend payments may be not be stable .

S. 1997 No Change Increase Decrease . Damodaran. Investment Valuation. Wiley. Firms 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1981 1984 1987 1990 1993 Source: A.Dividends: The Stability Factor Factors that influence dividends: Desire for stability Future investment needs Tax factors Signaling prerogatives Dividend changes: Publicly traded U.

Principal Repayments Problem: Calculating cash flows related to debt (interest and principal) and other obligations is often difficult! .Increase in WC .Cap. Exp. .Discounted Free Cash Flow to Equity (FCFE) Approach (³Direct´ Method) Buying equity of firm is buying future stream of free cash flows (available. not just paid to common as dividends) to equity holders (FCFE) FCFE is residual cash flows left to equity holders after: meeting interest and principal payments providing for capital expenditures and working capital to maintain and create new assets for growth FCFE = Net Income + Non-Cash Expenses .

firm has significant ³growth opportunities´) .e.Valuation: Back to First Principles Value of the firm = value of fixed claims (debt) + value of equity How do finance managers add to equity value? By taking on projects with positive net present value (NPV) Equity Value = Equity capital projects provided + NPV of future Note: Market to book ratio > 1 if market expects firm to take on positive NPV projects (i.

Discounted Free Cash Flow to the Firm (FCFF) Approach (³Indirect´ Approach) Identify cash flows available to all stakeholders Compute present value of cash flows Discount the cash flows at the firm¶s weighted average cost of capital (WACC) The present value of future cash flows is referred to as: Value of the firm¶s invested capital. or Value of ³Operating Assets´ or ³Total Enterprise Value´ (TEV) .

Vdebt where Vdebt is value of fixed obligations (primarily debt) .DCFF Valuation Process Value of all the firm¶s assets (or value of ³the firm´) = Vfirm = TEV + the value of uninvested capital Uninvested capital includes: assets not required (³redundant assets´) ³excess´ cash (not needed for day-to-day operations) Value of the firm¶s equity = Vequity = Vfirm .

cash TEV = Vequity + Net debt where Net debt is debt .cash (note: this assumes all cash is ³excess´) . the most significant item of uninvested capital is cash Vfirm = Vequity + Vdebt = TEV + cash TEV = Vequity + Vdebt .Total Enterprise Value (TEV) For most firms.

g. A/c Payable & accrued liab.Increase in Working Capital What is working capital? Non-cash current assets .Capital Expenditures .Measuring Free Cash Flows to the Firm Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim FCFF = EBIT ± Actual tax + Depreciation and amortization (non cash items) .non-interest bearing current liabilities (e.) .

you would be safe to assume the market-risk premium as 8-9%. This is essentially the return someone investing in the market (Nifty or Sensex) can expect to make above and beyond the risk-free rate. .CAPM (Cost of Equity) Capital Asset Pricing Model (CAPM) is a way of finding an acceptable rate of return for an asset (think Modern Portfolio Theory). CAPM or RE = Rf + x [E(RM) ± Rf] Rf = Risk-Free Rate (10-year G-Sec) E(RM) = Expected Return of the Market [E(RM) ± Rf] is usually referred to as the market-risk premium. Currently. It is often used in valuation as the cost of equity for a company.

50 + 169 . millions. / Capex Cash provided (used) by financing Additions (reductions) to debt Additions (reductions) to equity Dividends Overall Net Cash Flows 40 169 (116) (79) 25 35 (53) 21 Hazira¶s Bay FCFF = 187 .719 356 169 187 97 50 40 53 Cash Flow Statement.FCFF v/s Accounting Cash Flows Income Statement.79 . FYE March 2010) Sales Cost of Goods Sold EBITDA Depreciation EBIT Interest Expense Income Taxes Net Income Dividends 7. (Rs.116 = 111 . millions. Hazira Bay (Rs. Hazira Bay. FYE March 2010) Cash flow from operations Net Income Non-cash expenses Changes in WC Cash provided (used) by Inv.075 6.

FCFF: Definition Issues Why is FCFF different from accounting cash flows? Accounting cash flows include interest paid We want to identify cash flows before they are allocated to claimholders FCFF also does not consider any equity or debt issue as the same has been captured in the capex .

000 80% equity (15% required return): Rs.000 EBIT in perpetuity (all earnings are paid as dividends) future capital expenditures just offset depreciation no future additional working capital investments are required What should be the value of this firm? .000 Tax rate is 40% Firm expects to generate Rs.200.800. 1 million capital required to start firm Capital Structure: 20% debt (10% pre-tax required return): Rs. 220.An Illustration Rs.

000 Note: The dividend to equity equals 15% of equity capital .220.000*10%) EBT Rs.000) (Rs.120.000) 40% rate EAT Rs.) Let us look first at how the EBIT is distributed to the various claimants: EBIT Rs.000 Interest (20. to common Rs.000 Div.120.200.000 Tax (80.200.An Illustration (continued«.

8 * 15% = 13. NPV of future projects for this firm = 0 Hence.An Illustration (continued«. the value of the firm should equal the invested capital.2% Pre-tax WACC = 13.4) = 22% EBIT / Capital is also 22%.000 . or Rs. i.1.e.) The firm here generates a cash flow that is just enough to deliver the returns required by the different claimants.000.2% / (1 ± 0.2 * 10% * (1 ± 0.. the NPV of the firms projects = 0 Another way to see this: WACC = 0.4) + 0.

but only once (no double counting)! .An Illustration (continued«.140.000 / 0.140.220.000 * (1 ± 0.132.132 = Rs.14 = Rs.000 / 0.000 Key: Account for tax benefit.220.1.000 ± 80.1.000 Value = 132.000 = Rs.000.000.000 Value = Rs.000 We could have accounted for taxes in cash flow and not WACC WACC without tax adjustment = 14% Adjusted FCFF = EBIT ± actual taxes = Rs.) Now consider FCFF valuation of this firm FCFF = EBIT * (1-t) = Rs.4) = Rs.

Two Stage FCFF Valuation Impossible to forecast cash flow indefinitely into the future with accuracy Typical solution: break future into ³stages´ Stage 1 : firm experiences high growth Sources of extraordinary growth: product segmentation low cost producer Period of extraordinary growth: based on competitive analysis / industry analysis Stage 2: firm experiences stable growth .

+ FCFFt (1+kc)t (1+kc)2 . . capital expenditures. . working capital given as a percentage of sales Discount FCFF at the firm¶s WACC (kc) VALUE1 = FCFF1 1+kc + FCFF2 + .Stage 1 ± Valuation Forecast annual FCFF as far as firm expects to experience extraordinary growth generally sales driven forecasts based on historical growth rates or analyst forecasts EBIT.

g .Stage 2 ± Valuation Start with last FCFF in Stage 1 Assume that cash flow will grow at constant rate in perpetuity Initial FCFF of Stage 2 may need adjustment if last cash flow of Stage 1 is ³unusual´ spike in sales or other items capital expenditures should be close to depreciation Value 1 year before Stage 2 begins = FCFFt * (1+g) Kc .

Stage 2 ± Valuation Present value of Stage 2 cash flows (Terminal Value or TV): TV = FCFFt * (1+g) Kc g x 1 (1+kc)t Key issue in implementation: Terminal growth (g) rate of ³stable´ growth in the economy (real rate of return ~1-2% plus inflation) Stage 1 and Stage 2 ± TEV = VALUEt + TV .

100 Growth (g) of FCFFs beyond year 3 = 3% .Discounted FCCF: Illustration Assumptions Year 1 2 3 EBIT 40 50 60 Dep 4 5 6 Capex 6 7 8 W/C Change 2 3 4 Tax rate = 40% kc = 10% Vdebt = value of debt = Rs.

4) + 5 .4) + 4 .2 = 20 FCFF = 50*(1 .4) + 6 .Capex .Increase in WC Year 1 Year 2 Year 3 FCFF = 40*(1 .7 .6 .3 = 25 FCFF = 60*(1 .0.4 = 30 .8 .0.0.Discounted FCCF: Illustration (continued) FCFF = EBIT*(1-t) + Dep .

Discounted FCCF: Illustration (continued) 20 | 1 25 | 2 30 | 3 30*(1+g) | 4 30*(1+g)2 | 5 | t=0 P = Vfirm 30*(1+g)/(kc-g) TEV = 20 / (1+kc) + 25 / (1+kc)2 + 30 / (1+kc)3 + [30 * (1+g) / (kc-g)] / (1+kc)3 .

2 + 20.0 = 293.Vdebt Vequity = 393.10 .0.7 = 393.03)] / (1.10) + 25 / (1.10)3 = 18.5 + 331.7 + 22.10)3 + [30 * (1.0 .10)2 + 30 / (1.0 .0 Vfirm = Vdebt + Vequity ==> Vequity = Vfirm .03) / (0.Discounted FCCF: Illustration (continued) TEV = 20 / (1.100.0 TEV + Cash (unused assets) = Vfirm ==> Vfirm = TEV =393.

Relative Valuation: Capitalisation of Earnings Compute the ratio of stock price to forecasted earnings for ³comparable´ firms determine an appropriate ³P/E multiple´ If EPS1 is the expected earnings for firm we are valuing. P = ³P/E multiple´ x EPS1 . then the price of the firm (P) should be such that: P / EPS1 = ³P/E multiple´ Rearranging.

50 = Rs.0.37.20 PE ratio = 20 / 0.80 = 25 If ABC and XYZ are comparable.P/E Multiple Valuation: Illustration ABC Company: Next year¶s forecasted EPS = Rs.5 Note: Analyst prefer ³forward looking´ ratios ³backward looking´ ratios are more readily available Key: Make comparisons ³apples with apples´ but .1. they should trade at same PE Implied price of ABC = 25 * 1.80 Current share price = Rs.50 Comparable Company: XYZ corporation Next year¶s forecasted EPS = Rs.

leverage industry average . risk.P/E Ratio Based Valuation Fundamentally. the ³P/E multiple´ relates to growth and risk of underlying cash flows for firm Key: identification of ³comparable´ firms similar industry. growth prospects.

EV / EBIDTA Approach (EBIDTA Multiple) TEV = MVequity + MVdebt . Compute the ratio of TEV to forecasted EBITDA for ³comparable´ firms determine an appropriate ³TEV / EBITDA multiple´ If EBITDA1 is the expected earnings for the firm we are valuing. then the TEV for the firm should be such that: TEV / EBITDA1 = ³EV / EBITDA multiple´ .Cash EBITDA: Earnings before Depreciation and Amortization Interest. Taxes.

EV / EBIDTA Approach (EBIDTA Multiple) Rearranging: TEV = ³EV / EBITDA multiple´ x EBITDA1 Next solve for equity value using: MVequity = TEV .MVdebt + cash Multiples again determined from ³comparable´ firms similar issues as in the application of P/E multiples leverage less important concern .

300 million EV / EBITDA ratio = 300 / 40 = 7.40 million Current share price = Rs.325 million Price per share = 325 / 20 = Rs.50 million Shares outstanding = Rs.25 . 20 million. Value of Debt = Rs. Cash = Rs.5 If ABC and XYZ are comparable. Cash = Rs.20.0 EV = 20 * 10 + 100 ± 0 = Rs.16.50 million.100 million.5 * 50 = 375 million Value of equity = 375 + 0 ± 50 = Rs.0 Comparable Company: XYZ Corporation Next year¶s forecasted EBITDA = Rs. they should trade at same EV/EBITDA Implied EV for ABC = 7. Value of Debt = Rs.EV / EBIDTA Multiple Valuation: Illustration ABC Company: Next year¶s forecasted EBITDA = Rs. Shares outstanding = 10 million.

for example.Other Multiple based Approaches Other multiples: Price to Cash Flow: P = ³P/CF multiple´ X CF1 Price to Revenue: P = ³P / Rev multiple´ X REV1 Multiple again determined from ³comparable´ firms Why would you consider price to revenue over. price to earnings? .

etc. sales.) Ratio should be similar in this transaction Premium paid analysis Look at premiums in recent merger transactions (price paid to recent stock price) Premium should be similar in this transaction .Merger Methods Comparable transactions: Identify recent transactions that are ³similar´ Ratio-based valuation Look at ratios to price paid in transaction to various target financials (earnings. EBITDA.

³Investment Valuation: Tools and Techniques for Determining The Value of Any Asset´ . inputs are subjective A well-researched. valuation is objective models are quantitative. well-done model is timeless values will change as new information is revealed A good valuation provides a precise estimate of value a valuation by necessity involves many assumptions The more quantitative a model. Damodaran. the better the valuation the quality of a valuation will be directly proportional to the time spent in collecting the data and in understanding the firm being valued The market is generally wrong the presumption should be that the market is correct and that it is up to the analyst to prove their valuation offers a better estimate Source: A.Some Valuation Myths Since valuation models are quantitative.

Valuation Creation Summary Firms create value by earning a return on invested capital above the cost of capital The more firms invest at returns above the cost of capital the more value is created Firms should select strategies that maximize the present value of expected cash flows The market value of shares is the intrinsic value based on market expectations of future performance (but expectations may not be ³unbiased´) Shareholder returns depend primarily on changes in expectations more than actual firm performance Source: ³Valuation: Measuring and Managing the Value of Companies´. McKinsey & Co. .

for M&A: identification of fit (size-up bidder). structuring the transaction. etc. . etc. past ratios to sales. etc. bidding strategy. for capital raising: timing.Valuation Cases Size-up the firm being valued Do projections seem realistic (look at past growth rates. deal structure.g.)? What are the key risks? Valuation Analysis several approaches + sensitivities (tied to risks) Address case specific issues e. e. any synergies.g.

1991.Valuation References Copeland. Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Irwin) Benninga and Sarig. Pratt. Investment Valuation (Wiley). The Quest for Value (Harper Collins) Harvard Business School Notes: An Introduction to Cash Flow Valuation Methods (9-295-155) A Note on Valuation in Private Settings (9-297-050) Note on Adjusted Present Value (9-293-092) . Reilly and Schweihs. 1997. Valuation: Measuring and Managing the Value of Companies (Wiley) A Damodaran. Corporate Finance: A Valuation Approach (McGraw Hill) Stewart.1996.1994. 1996. Koller and Murrin.

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