Business Valuation Modeling

Objectives:

 Understand the difference between Equity Value and Enterprise Value and when to use
them
 Understand why comparable company analysis is performed
 Understand why precedent transaction analysis is performed
 Understand what discounted cash flow analysis is; calculate FCF, WACC, NPV
 Understand various factors impacting valuation that connat be discretely modeled
 Understand how to effectively present the result of valuation analysis

This course focuses in valution related to:

 Sell a business
 Raise money
 IPO
 Acquire a business
 Make investment recommendations
 Internal business decisions making

Introduction

Valuation is based on expected future performance that involves:

 Analyze past performance (historical data)

 Create financial forecast of future
 Analysis of the industry; the nature of competition
 Analyze the economic environment
 Applying acceptable valuation methods; there are many valuation metods which may arrive
at different values

Science VS Art on Valuation

Financial Valuation Techniques:

a) Cost apparoach : Sort of like an opportunity cost; when looking to acquire company, there is
a consideration whether to pay for the business that is already operating or just build it.
a. Cost to build
b. Replacement cost
 b) Market approach (relative value): Look at what other business or asset are worth and use
them as a proxy on what we are trying to value. This method give a review on how much a
company worth relative to other.
a. Public company comparables
b. Precedent transactions: Look ata past M&A, where we can see how much an
acquiring company paid for the business
c) Discounted cash flow: Intrinsic value; look at the company in isolation by forecasting the
future performance typically about 5 years.

These various method may come up to different values, so we need to triangulate on some type of
value that makes the most sense; so it’s about arriving at a range of values then the art of deciding
where within those value the actual business value lies.

Equity Value VS Enterprise Value

The value of company is the sum of all of its assets. Those assets are used to generate cash flow and
they are what the business is actually worth; this is know as enterprise value, value of the entire
enterprise.

To finance its asset, company has a capital structure that consist of debt and equity. This capital
structure impacts what the shareholders own; this is know as equity value; value that is left after
deducting net debt.

 Enterprise value / Firm value / Total Enterprise Value (TEV) => what and entire company is
worth
 Equity value / Market cap => what the amount that is worth for the shareholders

Net Debt

Gross Debt (Short-term + Long-term)

Less: Cahs and cash equivalents

Net Debt

Two assumptions:
 It is assumed that cash can be netted against debt that needs to be repaid. So the cash is
ofsetting the debt in a situation where it is required that cash could be used to pay off
 Cash is not an operating asset that generates cash flow for the business. So it wouldn’t be
included in the asset value of a company or firm value.
Valuation Multiples

Relative valuation - the value of an asset is derived from the pricing of comparabales assets

The assets of a business generate 100% of the cash flows and available to all types of investors; with
debtholders as the priority to be paid first before the shareholders. By understanding this, we can
understand the valuation multiples using enterprise value and equity value.

 Enterprise value ratio : the denominator is before the interest expense is paid; this metric
includes cash flow that is available to debt and equity investors

Enterprise Value = Equity Value (Market Cap) + Net Debt

 EV to Sales Multiple

Enterprise Value
Sales

Or

Enterprise Value X EBIT∨EBITDA

EBIT∨EBITDA Sales
EBIT/EBITDA Margin

 EV to EBITDA and EBIT Multiples : most commonly metrics in valuation.

Enterprise Value
EBIT∨EBITDA

 EV to Capital Employed Multiple : The higher this multiple is, the better job the
company is doing of taking capital raised and turn it into enterprise value or asset
value.
Enterprise Value
BV of Debt + Equity

Or

Enterprise Value EBIT ∨EBITDA

EBIT∨EBITDA X Capital Employed
Return on Capital Employed (ROCE)

 EV to Free Cash Flows to the Firm (FCFF)

FCFF = EBIT (1-t) + D&A – Change in NCW - Capex
FCFF is also known as unlevered cash flows. This is not commonly used, since FCFF is
quiete volatile as NCW and Capex move around. It is much more common use FCFF
as the form of DCF valuation.

Enterprise Value
FCFF
 Equity value ratio : the denominator is after the interest expense is paid.

Equity Value = Share price x Number of Shares Outstanding

 P/E Multiple

Market Cap . or Share Price

Net Earnings EPS

P/E ratio is driven by several things:

a) Growth prospects : Investors are willing to pay a lot more for a company that has a
higher growth of earnings; so a rapidly growing company will has a higher P/E ratio
b) Shareholder risk : A high risk company will be traded at discount, vice versa
c) Cash flow generation : A company that is able to generate high cash flow may has a
high P/E ratio because of the value that is captured in the cash flow.

Problems with P/E ratio:

a) Cannot cope with negative earnings; there is no negative P/E ratio
b) Earning can be manipulated; all sorts of accounting items impact the number
c) Earnings can be volatile
d) For cyclical industries, such as mining; as the cycle moves aroung the P/E ratio may
be misleading, at the peak of cycel the P/E may be low that may misguide to a lower
price and buy signaling, whereas at the trough of cycle the P/E ratio may be high
that indicates an overvaluation.

P/E ratio is very effective for mature, stable business that have steady earnings. It is
important to use normalized approached on earnings when valuing a company by
adjusting:
 Non recurring / exceptional items
 Over or under depreciation
 Profit/loss on sale of property
 Significant profisions or asset write downs

 P/BV : Not commonly used accross industry but frequently used in banking and
insurance
BV of Equity = Total value of Common Shares (Exclude Preferred Shares & Minority Interest)

Market Cap .
Book Value of Equity

P/BV is driven by ROE and all the P/E drivers. The relationship of P/BV and P/E can be
seen by dividing P/BV to P/E ratio, which result on Earnings / BV of Equity; that is ROE.

 P/ Free Cash Flows to the Equity (FCFE)

FCFE = OCF – Capex + Net Debt (Issued – Repayment)

FCFE is cash flows that are left for equity shareholders. Major driver of P/FCF is cash
conversion, which is earning / free cash flows, that indicates how much of the firm’s
earnings are translataed into free cash flow.

Market Cap .
FCFE
Life cycle stages for ech multiples :

Comparable Company Analaysis

The metrics that are used for comparable company alaysis is factored by the industry spesific and
the lifecycle of the company

Pros:

 The logic used is if investors are willing to pay X for competitors, they must be willing to pay
Y for us; and this is how multiples valuation is used to value the company in question.
 There are observable value for a company (what investors are actually paying for the
business right noe)
 The information is readily available and current
 There are a large number of potential companies to compare to

Cons:

 No perfect comparable; each business is unique, all the small changes between company can
add up to a lot
 Hard to adjust for growth, management team, jurisdiction, or other factors
 Easy to vall into “value trap” (a company that looks cheap is assumed to be good value) or
“overvalued fallacy” (trade at high price so people assumes that it is overvalued)

Steps of Comparable Company Analysis:

1) Build a list of comparable company

2) Go to company website to download the financial information
3) Get the historical data; around 3 to 5 years of historical data
4) Get forward looking information; finding forecasts metrics
5) Build a table and calculate
6) Compare and adjust the numbers including normalization, the arrive to the proper value
An in-depth understand of the company being valued and its peers is requires to perform
comparable company analysis. Several factors that are need to be considered to determine the
comparable companies are:

 Business activities
 Geographical location
 Size and growth profiles
 Profitability profiles
 Accounting policies
 Similar capital structures

Precedent M&A Transactions

This technique looks at the M&A that happened in the past to see what other companies paid for
similar business to the one we are trying to value.

Pros:

 Shows the value investors paid for the entire company, not just one share
 Inclludes takeover premium / control premium; this is relevant for M&A transaction
 Includes synergy value

Cons:

 Hard to find relevant transactions; since there is only few M&A ina any given year in an
industry
 Need access to a database like Bloomberg
 These metrics can quickly become stale dated; valuations that were paid several years in the
past are not necessarily relevant to market condition today

Steps of Precedent M&A Transaction:

1) Use bloomberg or other database to find past transactions

2) Fin press release for each transactions
3) Obtain relevent data, though may be very limited; such as price paid, form of cosideration
(cash / shares), takeover premium, synergies announced, another terms/conditions
4) Build a table and calculate the ratios
5) Apply those multiples to company in question

Overall, this technique is similar to comparable company analysis, except the information is harder
to find.
  The ratios have emedded in them a takover premium
 The transaction value which is enterprise value, includes what the buyer paid for the whole
business and may have values that was paid for synergies.

To determine the relevant transactions, there several thing to be considered:

 Business activities
 Geographical location
 Type of transaction / buyer (strategic buyer or financial buyer)
 Size and growth profiles
 Recent time period

Discounted Cash Flow (DCF) Model

Intrinsic value approach; forecast the future cash flows into the future, then discount them at the
company’s WACC, and arrive at the NPV. This is the most detailed approach of business valuation.

Four step approach to build proper DCF:

1) Gather critical information about the company, at a minimum:

a. Review the latest annual and quarter report in detail
b. Listen to the most quarterly earnings webcast / conference call; found on investor’s
relation page
c. Review available sell side research
d. Review research on the industry; to understand the competitor and dynamics on the
industry

All of those information can be combined together in Public Information Book (PIB), consist
of:
 New releases for last 6 to 12 months
 SEC Filing for last 3 to 5 years
 Research Industry, competitor and company itself
 Corporate / investor presentations
 Credit ratings – 2 to 3 rating agency
 Conference cell transcript – Q&A by the analysts

2) Perform a comprehensive company and industry analysis ; understanding the business, the
dynamics and competition in the industry. At a minimum:
a. A thorough assessment and crititique of a company’s stated strategy; how effective
it is, etc, supported by evidence
 b. An assessment of the management team and its ability to deliver against its stated
strategy
c. A robust review of a company’s financial statements
d. A detailed and quantified assessment of a company’s competitive advantages and
disadvantages
e. An assessmenet of industry dynamics within the industry as well as general
economic and demographic trends

A careful
consideration should
be given to these
three layers as the
forecast of DCF model
is being buily

 PEST analyasis is a useful framework for analyzing the external environment to identify
opportunities and threats. PEST stands for:
 Political forecasting
 Social forecasting
 Economic forecasting
 Tecnological forecasting
 Porter’s 5 Forces is a powerful tool for assessing industry attractiveness, consist of:
 Rivalry amongst firm in industry
 Potential new entrants and barriers to entry
 Buyers and their bargaining power
 Threat of substitutes
 Suppliers and their bargainning power

Before build DCF model, it isi important to understand how these frameworks impact the ability
of company to generate cash flows and the growth rate of the company. The key is to ask
yourself, do the assumptions that are being made in the forecast match with these frameworks
that we analyze.

 Tools for assessing competitive advantage:

o Cost leadership
o Differantiation
o Cost focus
o Differantiation focus
 Tools for assessing business lifecycle; this is helpful to identify the company’s profile of
revenue, profitability and cashflow, it gives a sense to the forecast that want to be built.

 Guide to assess the management team of a company; things that are need to be
considered:
 Past performance – the track record
 Reputation – any comment by press, customers and the competitors
 Planning – clear and consistent business strategy; groth approach
 Experience / stability – Qualification, business and financial cumen, etc
 Attitude towards risk – Any identified risks, the mitigation and strategy toward them

Gain a holistic view of management team by considering those factors, then use it when building
the forecast, so it the assumptions are make sense to the management condition.

Putting all of those qualitative analysis together as SWOT Analysis; summarize both internal and
external factors of the company

3) Determine the key asuumptions that will drive the valuation; determine what will drive the
following:
 Revenue; number of customers, number of subscriber, volume of traffic on a
website, conversion rate from leads to order
 Gross margin; percent of sales, direct input costs
 EBITDA; SGA assumption (fixed or variable)
 Working capital; turnover ratio
 Capex; sustaining capital (the amount of capital required to continue operations at
the current level), growth capital (what is gonna spent on growing the business), if
there is an aggresive growth on its revenue, it make sense that there has to be a
capex profile to support it
 Capital structure; capital injection requirement, excess capital to be redistributed

4) Build the DCF valuation model from scratch

Company Value = NPV of all future cash flows

 The two-stage approach to DCF valuations is a common solution to the problem of how we
forecast the cash flow of a company because of issues of uncertainty, it includes calculation of
cash flows for forecastable period plus terminal value

Value of the firm=CF ¿ forecastable period +Terminal Value

There are two ways of terminal value calcuulation:

 Perpetual growth rate => assume that company is growing in a stable growth rate
 Exit multiple value => assume the company is sold at the end of the period

DCF analysis => Forecasting free cash flow to the firms; cash flows available to all funding
providers

Weighted Average Cost of Capital

The combination of equity and debt cost based on their portion on capital structure
WACC = [Cost of Equity X %Eq] + [Cost of Debt X %Debt]

 Cost of Equity = Risk free rate + Beta x Risk Premium (CAPM)

Affecting factors:
o Beta : Market Risk => volatility of weekly returns of the stock relative to the index
 Interest rates
 Business/economic cycle
 Inflation
 Political/legislation
 Socio economic
o Alpha : Firm-specific Risk
 Management
 Profits
 Operations
 Projects
 Products

 Cost of Debt = Average yield x (1 – Tax rate)

Presentation of Result

Use a football field charts to show the range of values of business based on varioud techniques, then
use line to point the number that want to be highlighted, whether it is an average number, target
price, or etc