Valuation

Valuationistheprocessofestimatingthepotentialmarketvalueofafinancialasset.
Prevaluationconsiderations
Typeofbuyer:Strategicvs.Financialbuyer

Strategicbuyerisinterestedinearningfromtheoperationsofthecompany
whereasfinancialbuyerswanttoearnreturnoninvestmentbyresellingthe
company.

Ingeneral,strategicbuyerswillbereadytopayhigherpremiumsthanfinancial
buyers.

Transactionalcontext:Friendlyvs.Hostiletakeover

Inhostiletakeoversmanagementdoesnotendorsetheproposedtransaction
andtheoffertoshareholdersisoftenunsolicited.Incaseoffriendlymergers,
partiesinvolvedreachamutualagreementonsellingpriceandstructureofthe
transaction.

Generally,premiumpaidisonhighersideincaseofhostiletakeovers.

Marketconditions
Inbullishmarketconditionsmergeractivitiesareinfullswing,whichcausepremiums
inbuiltinthevaluationtoreachanalltimehighascomparedtoindown(bearish)
marketconditions.
Valuationapproaches:
Assetbasedapproach:Thisapproachisbasedontheprinciplethatthevalueofthe
companyisequaltothesumofitsparts.
However,thisapproachissuitableonlyundercertaincircumstances,forexample,when
companyisgoingintoliquidationbecausemostoftheassetsarerecordedattheir
acquisitionvalueswhichmaynotreflecttheirearningpotential.

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Incomebasedapproaches:
Theseapproachescalculatevalueofthecompanybasedonitsfutureearningcapacity.
Thefollowingmethodsofvaluationfallunderthiscategory:

Discountedcashflowmethod(DCF)

Capitalizationofearningsmethod

Adjustedpresentvaluemethod(APV)

Marketbasedapproaches:
Undertheseapproachesacompanyisvaluedbymakingcomparisonbetweenthe
companyunderstudytoitspeergroup.Themethodsthatfallunderthisapproach
are:

Publiccomparableanalysis

Acquisitionmultipleanalysis

Parametersusedinvaluation:
Equityvalueisthevalueoftheequityi.eshareholdersofthecompany.
Differentmeasuresofequityvalueare:
BookValue:isthevalueoftheequityshareholdersclaimasrecordedinthefinancial
statements.
Marketvalue:isthevalueoftheequityshareholderscalculatedattheprevailing
marketprice.
Intrinsicvalue:istheforwardlookingmeasureoftheequityshareholdersclaim
calculatedbyconsideringthefutureincomegeneratingcapacityofthecompany.
Enterprisevaluerepresentsthevalueofequityalongwithdebtandothersourcesof
capital.

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Enterprisevalue=Equityvalue+Netdebt+Preferredstock+Minorityinterest

NetDebt=DebtCashandcashequivalents

Debtincludesallinterestbearingliabilitiesonthebalancesheet.

EnterprisevalueisalsoreferredtoasFirmvalueofTotalcapitalization.
Cashflows:therearetwomaintypesofcashflows:
Unleveredfreecashflows(UFCF)orFreeCashFlowsfortheFirm(FCFF):thesearethe
cashflowsgeneratedbyoperationofthecompany.
UFCF=EBIT(1t)+DepreciationCapitalexpenditureWorkingcapital
EBITDA(earningsbeforeinterest,taxes,depreciationandamortization)isaclose
approximateforoperatingcashflows(FCFF/UFCF)ofthecompany.
Freecashflowforequity(FCFE)isthecashflowavailabletotheequityshareholders.
FCFE=UFCFI(1t)Principalrepaid+NewdebtPreferreddividend
Weightedaveragecostofcapitalisthediscountrateappropriatetotheriskinessof
theoperatingresultsofthecompany.

Discountedcashflowmethod:
Valueofequitycanbecalculatedintwoways:

Valuethecompanyandthensubtractnonequityfinancialclaimsfromthat
value.

Calculatecashflowsforequity,discountthematcostofequity.

StepsintheEnterpriseDCFmodel

ValuethecompanysoperationsbydiscountingFCFFatWACC

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Valuenonoperatingassetsandadditthevalueofoperatingassetstoarriveat
valueofthefirm(EnterpriseValue)

Subtractnonequityclaims(debt,preferredsharecapital,minorityclaim)from
thisvaluetocalculateEquityvalue.

DCFEquations:
n

FCFFt
T.V
+

t
(1+ WACC) n
t=1 (1+ WACC)

EnterpriseValue =

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Forecastperiodistheperiodoverwhichcashflowscanbeforecastedwithreasonable
certainty.
Beyondforecastperiod,terminalvaluecalculatesthepresentvalueofthecashflows
ofthecompany.
Terminalvalueattheendofnthyearcanbecalculatedusingthefollowingformula:

T.Vn =

FCFF(n +1)

(WACC g)

Where,gisthegrowthrateatwhichfirmscashflowsareassumedtogrowindefinitely.

Note:Thereshouldbeconsistencybetweenthenumeratoranddenominatorwhile
applyingDCFmodel.Whenenterprisevalueiscalculated,FCFFshouldbediscountedby
WACC;forcalculatingEquityvalue,FCFEshouldbediscountedatcostofequity.
Weightedaveragecostofcapital(WACC):
WACCiscalculatedusingthefollowingformula:

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Theweightsshouldbemarketvalueweightsinsteadofbookvalueweights.
Iftargetcapitalstructureofthecompanyisknown,theweightsthatcompanytargets
shouldbeusedforcalculatingWACC.
Costofequity:themostpopularmethodforapplyingcostofequityisCAPM,theequation
forwhichisasfollows:

Notethatbetavaluetobeusedforcalculatingcostofequityshouldbeleveredbetai.e.
firmbetaadjustedforcapitalstructureofthecompany.Theformulausedforthelevering
upthebetais

Capitalizationofearnings:ThemodelissimplifiedversionofDCFmethodofvaluingthe
company.Iffollowingassumptionsaremade,DCFequationwilltransformincapitalization
ofearnings

Earningsofthecompanyareacloseapproximateforcashflows.

Thereisnoexpectedgrowthintheearningsofthecompany.
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Valueoffirmundertheseassumptionswillbeearnings[EBIT*(1t)]dividedbycostof
capital(WACC).
Adjustedpresentvaluemethod:calculatesthevalueofthecompanyinfollowing
components:
Enterprisevalueasifthecompanywasallequityfinanced
+PVofdebttaxshieldsandotherimpactsofdebt
Expectedbankruptcycosts
Unleveredvalueofcompany

Unleveredterminalvalueofthecompany.Notethattheformulacalculatesterminalvalue
attheendofnthyearanditneedstobefurtherdiscountedtobringthevalueatzero
period.

TheunleveredcostofequitycanbefoundoutusingCAPMequationandputtingvalueof
unleveredbeta.

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Theformulaforconvertingleveredbetaintounleveredbetais:

Calculatingdebtimpact:
Debthastwoimpacts:
Firstoneisthepositiveimpactandthatistheavailabilityofthedebttaxshield,the
presentvalueofwhichiscalculatedasfollows:

Theaboveformulacanbetransformedandwrittenas

Thesecondimpactofdebthasnegativevalueandrelatestobankruptcycost.
PVofexpectedbankruptcycosts=Probabilityofbankruptcy*PVoftotal
bankruptcycosts.

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Finallythevalueofthefirmiscalculatedbycombiningthesecomponents.Thusvalueof
thefirmis:
Valuefirm=Valueallequityfinancedfirm+P.V.ofInteresttaxshieldPVofbankruptcy
costs
Multiplesmethod
Publiccomparableanalysis:
Thismethodofvaluationisusedforcalculatingtherelativevalueofthecompanyby
comparingittoothersimilarcompanies.
Thevalueofthetargetcompanyiscalculatedbycreatingasetofkeyfinancialratios
andapplyingthemtothecharacteristicsofthecompanyunderstudy.
Themultiplesusedareasfollows:
Equityvaluemultiples:

Price/EPS

PE/Earningsgrowth(PEGRatio)

Price/FCFEpershare

EquityValue/NetIncome

EquityValue/AfterTaxcashflows

EquityValue/BookValue

Enterprisevaluemultiples:

Enterprisevalue/Revenues

Enterprisevalue/EBITDA

Enterprisevalue/EBIT

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Acquisitioncomparableanalysis:Underthisapproachpeergroupiscreatedonthe
basisofcomparabletransaction.
TheadvantageofthismethodoverComparableCompanyAnalysisisthatthemultiples
createdincludethebuiltinpremiumspaidtothecompaniesincludedinthe
comparabletransactions.

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