AMT - Valuation Issues

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Valuation Issues
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Contents
Valuation Issues1
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Valuation Issues
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Valuation Issues
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1 © AMT Training 2008–2021

Valuation Issues
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© AMT Training 2008–2021 2

Valuation Issues
Valuation
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Complex issues
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Overview
• Enterprise value
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• Stock-based compensation
• Noncontrolling interest
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• Equity method investments

• Leases
• Employee benefits
• Passive minority equity investments
• Preferred stock
• Cash and cash equivalents
• Provisions and contingencies
• Other items

Valuation Issues
Enterprise value
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Enterprise value
Two definitions of EV
Core EV Total EV
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Cash & Cash &

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equivalents equivalents
Debt & Debt &
debt equivalents debt equivalents
Non-core & non-
controlled assets
NCI Total enterprise value NCI

Enterprise value
Equity Equity
• Includes net operating assets of the business • Values net operating assets of the business AND
only non-core and non-controlled assets
• Values all other assets separately • Used in transactions and shows the total amount
• Used for DCF and majority of comparables of funding needed to acquire a business
calculations

Valuation Issues
Enterprise value: The Bridge

Full checklist
• Operating leases
• Money market Cash Debt • Pension deficit
investments • OPEB deficit
• Loans and financial • Derivatives?
receivables • Debt-like provisions
Cash Debt
• Other fixed claims
equivalents equivalents
Equity Preferred
affiliates stock
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Non core
NCI
Total assets
enterprise
value • Pension surplus?
• Derivatives?
• Assets held for sale
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Enterprise Diluted
value • Equity investments equity value
• Investments in debt
securities
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Stock-based compensation
Stock options, restricted stock, performance stock

Valuation Issues
Accounting rules
• The rules apply to stock-based payments made by the company, typically for
executive compensation
• The fair value of the payment is estimated at grant date
• The value is expensed to the income statement over the service period
(grant date to vesting date)
• A non-cash add-back is made when calculating operating cash flow
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• Detailed information is found in the footnotes to the financials and is very
useful for valuation
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Diluted EPS
• Stock-based compensation increases the diluted share count

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– To reflect the potential issuance of stock

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• The increase is computed using the ‘treasury stock method’

• The increased share count reduces the diluted Earnings per Share (EPS)

Valuation Issues
Diluted equity value

Two calculation methods
1. Calculating diluted equity value using Number of outstanding shares 1,000
the diluted number of shares Number of stock options 100
outstanding. Strike price 5
– Using the treasury stock method: Current stock price 12
– Net new shares = Max ((p – s) / p * n,
Cash from options (100 * 5) 500
0)
• Where: p is stock price, s is strike Shares repurchased (500 / 12) 42
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price and n is number of dilutive Net new shares (100 – 42) 58
instruments outstanding
Number of diluted shares outstanding 1,058
Diluted equity value (1,058 * 12) 12,700
Intrinsic value of one option (12 – 5) 7
2. Calculating diluted equity value as
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Intrinsic value of all options (100 * 7) 700
sum of basic equity value plus
intrinsic value of dilutive instruments Basic equity value (1,000 * 12) 12,000
Diluted equity value (12,000 + 700) 12,700
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Dealing with valuation multiples
What to do for the valuation and for the value driver

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Cash
Debt
EBIT / EBITDA
is net of the
stock-based
compensation expense
Past stock
EV awards
Basic equity
(ex. dilution)
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Valuation Issues

Calculation inputs
EV multiples Equity multiples
Numerator Fully diluted market cap Observed share price
Operating metric (EBIT, EBITDA,

Denominator etc.) post stock-based compensation Diluted EPS
expenses
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Dealing with DCF valuation
What to do for FCF, WACC and the valuation roadmap

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Cash
Debt
FCF
is net of the
stock-based
compensation expense
Past stock
EV awards
Basic equity
(ex. dilution)
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Valuation Issues
Dealing with DCF

Free cash flow calculation issues
• Are stock-based awards an economic expense?

• ‘They are not a cash cost’: does this mean they do not impact value?
Company A Company B
Pays staff a $1,000 cash bonus Pays staff a bonus by issuing $1,000
share options to them
Issues $1,000 share options to the market
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Should DCF value these companies differently?
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Dealing with DCF

Calculation inputs
EBIT / NOPAT/ Include projected stock-based compensation expense
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FCF (do not reverse it out of FCF)

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Include value of stock-based compensation:

Method 1 Method 2
Debt Debt
EV-to-equity Past awards
bridge granted Diluted equity
value
Equity value
Divide implied equity Divide implied equity
by basic share count by diluted share count
WACC Use the diluted equity weighting for cost of equity in WACC
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Valuation Issues
Restricted stock vs. restricted stock units
Restricted stock (RS) Restricted stock units (RSU)
Timing of A promise to transfer shares at a

Upfront transfer of shares
award future date
Vesting conditions:
Conditions Typically have service conditions. May also have performance conditions
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(e.g. sales growth, stock price performance, etc.)
Inclusion in Should be included in the reported Excluded from the reported

share count number of basic shares number of basic shares
Dilution Not dilutive

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Noncontrolling interest
Control without full ownership

Valuation Issues
Types of equity investments and the accounting rules

% of equity owned Method of
Type of investment Name
(typically) accounting
Non-strategic (passive)
‘Financial investment’ < 20% Financial asset
investment
Equity affiliate
Strategic investment Equity method
(US GAAP) 20% to 50%
without control consolidation
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Associate (IFRS)
Strategic investment
No ownership Depends on type of
where control is shared Joint arrangement
threshold arrangement
with other investors
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Strategic investment with
Subsidiary > 50% Full consolidation
control
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Noncontrolling interest (NCI)

What is it?
• Noncontrolling interest (NCI, aka ‘minority interest’) is the portion of the

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equity of a subsidiary which is not owned by the parent company

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• Example:
70% 30%
ownership ownership Other
Co A Co B shareholders
(NCI)
• Co A controls Co B by owning 70% of its equity

• The remaining 30% of Co B’s equity is NCI
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Valuation Issues
Noncontrolling interest (NCI)

Accounting rules
• The consolidated financial statements show:

• NCI income (income statement)
• NCI equity (balance sheet)
• NCI dividends (cash flow statement)
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Cash
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Debt
NCI
EBIT / EBITDA is
BEFORE deducting EV
NCI income
NI / EPS is AFTER
deducting NCI income
Equity
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Valuation Issues

Calculation inputs
Include NCI as a separate item in

Numerator the EV-to-Equity bridge when Observed share price
computing EV
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EBIT / EBITDA, without making
Denominator Diluted EPS (post NCI deduction)
any NCI adjustments
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Valuing the NCI
NCI valuation depends on whether the NCI shares are traded, on the
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availability of financial information and on your views / preferences

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Data Alternative methodologies
Share price (if available) Market value
NCI income P/E multiple
Book value of NCI Price to book multiple
Dividends paid to NCI Dividend discount model
Value the subsidiary stand-alone and compute %

Subsidiary financials
of equity value attributable to NCI
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Valuation Issues

Calculation inputs
EBIT / NOPAT/
Do not make any NCI adjustment to EBIT, NOPAT or FCF
FCF
EV-to-equity Include the NCI value in the bridge (thus separating the NCI from the
bridge equity value attributable to the controlling shareholders)
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WACC Include NCI in WACC calculation at appropriate cost of equity
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Equity method investments

Equity affiliates / associates and joint ventures

Valuation Issues
Equity method investments

Accounting rules
• Equity affiliates / associates are equity investments where the investor has
no control but can exercise ‘significant influence’
• Joint ventures are equity investments where control is shared between
two or more investors
• Equity method of accounting
• Equity income is shown on the IS
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• Cost plus % of post-acquisition retained earnings is shown on the BS
• Dividends received are shown on the CFS
• Footnotes provide additional information
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• Decide whether the value of equity method investments should be included

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or excluded from EV
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• Several alternative EV formulations are possible

Cash
Other non-core
assets
Equity invs. /
JVs
Total
EV Consolidated
Core EV
EV
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Valuation Issues
Enterprise value definitions

Core EV Consolidated EV Total EV
EV calculation Excludes the value of Includes the value of equity Includes the value of
equity affiliates as well as affiliates, but excludes any equity investments, and
any other non-core assets other non-core assets also any other non-core
assets (except for cash)
Earnings EBIT / EBITDA excludes EBIT / EBITDA includes EBIT / EBITDA includes
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calculation any equity income and non- equity income but excludes earnings from all assets
core asset earnings non-core asset earnings including equity affiliates
and other non-core assets
(except for cash)
Purpose of Comparables analysis Helpful when the EV is Useful in transactions
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calculation (improves comparability used to estimate the value where all the assets are
across the set) of all strategic assets and being acquired
the equity affiliates are
considered to be strategic
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Core enterprise value
Value Value driver
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Enterprise value (core) 700 EBIT (excl. equity income) 70

+ equity affiliates 280 + equity income 6
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+ cash 100 + interest income 2

- total debt (600) - interest expense (45)
- tax expense (10)
= equity value 480 = profit after tax 23
EV / EBIT 700 / 70 = 10.0x P/E 480 / 23 = 20.9x
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Valuation Issues

Consolidated enterprise value
Value Value driver
Enterprise value 980 EBIT (incl. equity income) 76
(incl. equity affiliates)
+ cash 100 + interest income 2
- total debt (600) - interest expense (45)
- tax expense (10)
= equity value 480 = profit after tax 23
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EV / EBIT 980 / 76 = 12.9x P/E 480 / 23 = 20.9x
Consolidated EV / EBIT is P / E remains the same
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Valuing equity method investments
Affiliate / associate valuation depends on whether the affiliate / associate shares are
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traded, on the availability of financial information and on your views / preferences

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Data Alternative methodologies
Share price (if available) Market value
Affiliate / associate income P/E multiple
Book value of affiliate / associate Price to book multiple
Dividends received from affiliate /

Dividend discount model
associate
Value the affiliate / associate stand-alone and compute
Published financials
% of equity value attributable to parent
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Valuation Issues
What to do for FCF, WACC and the valuation roadmap
Cash
Equity method
Debt
investments
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FCF
Should not
include equity EV
income
Equity
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Calculation inputs
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EBIT / NOPAT/ FCF Exclude equity income. Resulting EV is ‘core’.

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EV-to-equity bridge Include equity affiliate / associate as a separate item in the bridge
If the equity method investments are material and are considered to

be long-term investments, consider making an adjustment to
WACC
WACC, using the market value of equity affiliates / associates and
the expected return on those investments
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Valuation Issues
Leases
IFRS and US GAAP
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Leases
Key valuation issues
• Valuation multiples
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– Do multiples need lease adjustments?

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– Are there comparability problems?

• DCF models
– How do leases impact free cash flow?
– Does WACC need lease adjustments?
– Does the EV-Equity bridge need lease adjustments?
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Valuation Issues
Lessee accounting
Overview
New rules effective from the start of 2019

– IFRS 16 and ASC topic 842
US GAAP
IFRS
Finance lease Operating lease
Right-of-use asset,
Balance sheet
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Lease liability
Depreciation / amortization,
Income statement Rent expense
Interest expense
Interest payment,
Cash flow statement Rent payment
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Repayment of lease liability
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Leases in valuation multiples – Profits

Comparability adjustments
IFRS and
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US GAAP Comparability
US GAAP
(operating leases) adjustment
(finance leases)
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Higher Lower EBITDAR

EBITDA
(no charge) (rent expense) (add back rent)
Higher Lower Adjusted EBIT

EBIT
(no interest expense) (rent expense) (add back interest)
Reduced by depreciation
Reduced by rent
Net Income and interest expenses No adjustment
expense post-tax
post-tax
EBITDAR is the simplest adjustment to compare operating profit in IFRS vs US GAAP
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Valuation Issues
Leases in valuation multiples – Profits

Example – Operating lease-adjusted EBIT and EBITDAR
Income Statement Reported Adjustments Adjusted

Sales 3,623 3,623
Operating lease rent expense 572 (572) 0
Other operating expenses (exc. D&A) 2,741 2,741
EBITDA 310 882 EBITDAR
D&A (PP&E) 174 174
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D&A (RoU asset) 495 2 495
Adjusted
EBIT 136 213
EBIT
Interest expense on lease liability 77 1 77
Other net interest expense 8 8
Profit before tax 128 128
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Interest on lease liability = Lease liability * interest rate = 1,517 * 5.4% = 77
Depreciation on RoU asset = Rent expense – interest = 572 – 77 = 495
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Leases in valuation multiples

EV calculation
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Cash
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Debt The lease liability is reported

on balance sheet and
must always be included in the
bridge when calculating EV
starting from market cap
Lease liability
EV
Equity
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Valuation Issues
Leases in DCF valuation – IFRS and US GAAP finance leases

Calculation inputs
Leases treated as financing items

Do not adjust EBIT and NOPAT
FCF:
EBIT / NOPAT/ FCF
• Add back the RoU asset depreciation expense (just like PP&E depreciation)
• Deduct the additions to RoU assets (just like capex additions to PP&E)
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EV-to-Equity
Include the lease liability in debt
bridge
WACC Include the lease liability in debt
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The resulting EV is inclusive of the lease debt
Note: this method can also be applied to US GAAP operating leases after replacing the rent expense with
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implied depreciation and interest expense
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Leases in DCF valuation – US GAAP operating leases

Calculation inputs
Operating leases treated as operating items

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EBIT / NOPAT/ FCF Keep the rent expense in your forecast (do not reverse it out)
EV-to-Equity Do not add the operating lease liability to debt

bridge (rent payments already deducted in FCF)
WACC Do not include the operating lease liability in debt
The resulting EV is net of the operating lease debt
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Valuation Issues
Appendix
Estimating the lease liability
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Capitalization methods
Two methods
• Two methods are commonly used to estimate a lease liability:

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– Present value (PV) method

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– Multiple method
• IFRS and US GAAP use the PV method
• Warning: the two methods do not give the same results
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Valuation Issues
Method 1: PV method
• Discount the future rent payments to the present
• Data on future rent payments is found in the notes to the financial statements
(check ‘commitments’ or ‘lease’)
– Commitments after year 5 are usually disclosed as a single figure (total)
• Must be split into a series of yearly payments
– IFRS: commitments for years 2 to 5 are disclosed as a single figure
• Must be spread (e.g. as an average) over years 2 to 5
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• Discount rate
– Ideally, should be the discount rate associated with the leases, however this is usually not
disclosed
– Alternative estimation approaches:
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• Company’s cost of debt / Incremental cost of borrowing
• Average interest rate: Interest expense / average debt outstanding
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Method 1: PV method - example
Year 1 43
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Year 2 40
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Year 3 36
Year 4 31
Year 5 29
Thereafter 162
No. of years (162 / 29) (rounded) 6
Year 6 - 11 'annual' payment (162 / 6) 27
NPV at 6% - Debt equivalent 251.8
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Valuation Issues
Method 2: Multiple method
• Method traditionally used in valuation practise

Operating lease expense 53
Multiple x 8
Debt equivalent = 424
• Multiple is industry-based and depends on:
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– Average life of the leased assets, and
– Discount factor
• Moody’s industry multiples were often used as source. However,
Moody’s no longer estimates the lease liability (unless the company does not
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capitalize leases on balance sheet)
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Method 2: Sector multiples - illustrative only
Multiple Selected Industries
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Aerospace & Defense, Alcoholic Beverage, Automobile Manufacturer and Supplier, Building Materials, Chemical,
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Construction, Consumer Durables and Electronics, Homebuilding & Property Development, Integrated Oil & Gas,
Manufacturing, Medical Product & Device, Mining, Oilfield Services, Packaged Goods, Packaging Manufacturers,
3 Paper & Forest Products, Passenger Railway, Pay TV-Cable & Direct-to-Home Satellite Operators,
Pharmaceutical, Postal & Express Delivery, Regulated Water Utilities, Semiconductor, Shipping, Soft Beverage,
Software, Steel, Surface Transportation & Logistics, Technology Hardware and Services, Telecommunications,
Tobacco, Trading Companies
Apparel, Broadcast & Advertising Related, Consumer Services, Gaming, Healthcare Service Providers, Insurance
4 Brokers, Insurers, Large Global Diversified Media, Publishing, Regulated Electric & Gas Networks, Regulated
Electric & Gas Utilities, REITs
5 Communications Infrastructure, Lodging & Cruise, Passenger Airlines, Retail, Securities Firms
Asset Managers, Generic Project Finance, Natural Gas Pipelines, Privately Managed Airports & Related Issuers,
6
Privately Managed Port Companies, Restaurant, Unregulated Power Companies, Unregulated Utilities
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Valuation Issues
Comparing capitalization methods
• The multiple method gives a valuation of 424 but the present value method
gives only 252. Why?
– The multiple may imply a longer useful life than the contractual payments
• We used a relatively high multiple of 8x
– The PV method uses the minimum contractual payments, which typically result in a
declining schedule (because lease contracts expire over time)
– Minimum contractual payments may be lower than the actual payments
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• The multiple method may be preferable for a going concern
– Equity valuation view
– But it all depends on the choice of multiple
• The PV method may be preferable on a break-up basis
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– Credit view
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Employee benefits
Pensions and other post-employment benefits

Valuation Issues
Employee benefits
• Post-employment benefits
• Two key categories:
– Pension benefits
– Non-pension benefits (aka OPEBs)
• E.g. life insurance, medical insurance, etc.
• Types of benefit plans:
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– Defined contribution: contributions into the plan are guaranteed
– Defined benefit: benefit payments are guaranteed
• Only defined benefit plans give rise to potential valuation issues
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Funded vs unfunded pension plans
Funded Unfunded
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• Separate pension plan • No separate pension plan

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Company
Company
Cash contributions Assets Obligations
Pension plan
• Company pays pensions
Assets Obligations
• Balance sheet reports the total
• Plan pays pensions pension liabilities
• Balance sheet reports the
net position (surplus or deficit)
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Valuation Issues
Valuation
Deficit or surplus?
Key measurements:
– Market value of plan assets
– Present value of expected benefit payments
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Present value
Value Surplus
─ of benefit =
of plan assets (Deficit)
obligations
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Adjusting the EV
• Large deficits (or surpluses) can distort valuation multiples

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• To remove the distortion:

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– Treat a deficit like debt

– Treat a surplus like a non-core asset
Adjusted EV
• Example, for a deficit:
Standard EV calculation Cash Deficit
Cash
Debt Debt
EV
EV
Equity Equity
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Valuation Issues
Valuing the surplus / deficit
• The net position (surplus or deficit) is provided in the notes to the financial
statements
– Always use the information in the notes
– Do not rely on the balance sheet presentation
• Valuing the deficit
– Use the value from the notes
– Consider making a tax adjustment
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• Reflects tax deduction on future cash payments to fund the deficit
• Use deferred tax disclosure or estimate it using MTR
• Valuing the surplus
– Do not treat as a cash equivalent
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– Valuation depends on manner of recovery, tax implications and other considerations
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Income statement items
Component Classification Location

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+ Service cost X Operating Above EBIT

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expense
+ Interest cost X Financial expense Below EBIT
- Expected return on assets (X) Financial income Below EBIT
+/- Losses / gains * X/(X) Non-recurring Below EBIT (US GAAP)

items In OCI (IFRS)
= Defined benefit expense X
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Valuation Issues
EBIT calculation
Year 2 Year 1
Keep in EBIT
Service cost $186 $177
Interest cost 318 311
These are Expected return on plan assets (281) (291)
financial items
and should be
Amortization of prior service cost 28 5
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removed from EBIT Recognized net actuarial (gain) loss 31 3
Total $282 $205
These are non-recurring items
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Income statement presentation
• As of 2018 US GAAP requires companies to present:

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– Service cost within operating expenses

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– The other components of the defined benefit expense below operating income
• Similarly, IFRS companies report:
– Service cost in operating income
– Interest cost and the return on plan assets within financial income / expense on the
income statement
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Valuation Issues
Value drivers
Only service cost is relevant for EV calculation
Return on
Plan Interest cost
plan assets assets Plan
obligations
Cash
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Service cost Debt
EV
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Equity
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Calculation inputs
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Include deficit or surplus in the

Numerator No adjustment necessary
EV-to-Equity bridge
Remove any non-recurring

Denominator Only service cost in EBIT component of employee benefits
cost
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Valuation Issues

Example
Pre adjustment Post adjustment
EBIT 100 EBIT 100

(check that only service cost is included)
Employee benefits deficit 98

Net debt 500 Net debt 500
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Equity 400 Equity 400
Enterprise value 900 Adjusted enterprise value 998
EBIT multiple 9.0x Adjusted EBIT multiple 10.0x
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Calculation inputs
Treated as operating Treated as debt / non-core

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Include total employee

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EBIT / NOPAT/ FCF Include service cost only

benefits cost
Include changes in deficit or Exclude (ignore) changes in deficit

FCF
surplus or surplus
EV-to-equity No adjustment for deficit or Include deficit or surplus as a

bridge surplus separate item in the bridge
If deficit / surplus is long-term:

No adjustment for deficit or - Include deficit in debt
WACC
surplus - Make separate adjustment
for a surplus
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Valuation Issues
Passive minority equity investments

Equity investments under 20% ownership
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0-20% ownership
• Assumption is that the investor is ‘passive’ i.e. interested in dividend income
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and capital gains, not in running the company

• Presented on BS in non-current assets (‘Investments’) or in current assets as
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part of a portfolio of assets held for trading

• Valued at cost at acquisition date. Subsequently marked-to-market.
– If no fair value is available, it stays at ‘cost’
• If held for trading, changes in FV are recognized in the IS as gains / losses
– ‘Fair value through profit & loss’
• If not held for trading, changes in FV are recognized outside of IS
– But the accumulated gain / loss goes through the IS if and when asset is sold
– ‘Fair value through OCI’ aka ‘Available for sale’
• Dividends received are included in the IS (usually under EBIT)
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Valuation Issues

Example
1. If no fair value available (e.g. private company shares): keep the investment at cost;
no effect on the income statement
2. If fair value is available (e.g. listed company) and stock is held for trading:
use fair value through P&L accounting
Investment  20 Retained earnings  20
(gain)
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3. If fair value is available (e.g. listed company) and stock is not held for trading:
use fair value through OCI accounting (aka ‘available for sale’ accounting)
– Changes in the investment value are recognized in an equity account and the accumulated gain or
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loss is reflected in the income statement only when the investment is sold
Investment  20 Equity (OCI)  20
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• These investments are financial in nature and therefore any P&L impact
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should be below EBIT / EBITDA

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• Value the investments at market value

• Keep these investments out of EV: include their value as a separate item in
the EV-to-equity bridge
– E.g. ‘non-core assets’
64

Valuation Issues
• Since these investments are financial in nature, they should be excluded

from the FCF
• Therefore, they will not be included in the EV
• Include their value as a separate item in the EV-to-equity bridge
– E.g. ‘non-core assets’
• WACC may need an adjustment, but only if the investments are material and
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are considered to be long-term
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Preferred stock

Valuation Issues
Debt vs. equity
Debt Equity
Type of claim Fixed (contractual) Residual
Upside opportunity Fixed Unlimited
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Ranking is important.
Downside risk At the bottom of the ranking
May have collateral
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Capital appreciation and
Reward Interest
dividends
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Valuing preferred stock
• If listed, use market value

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• If not listed, use book value or estimate a fair value

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– E.g. using a NPV approach

• Always examine the terms of the preferred stock
– Is the dividend fixed?
– Is the dividend cumulative?
– Is there a redemption date?
– Is there a redemption option?
– Etc.
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Valuation Issues
Cash
Debt
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EBIT / EBITDA
is BEFORE deducting
preferred stock Preferred
dividends stock
EV
EPS is AFTER
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deducting preferred
Equity stock dividends
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Calculation inputs
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AM
Include preferred stock in

Numerator EV-to-Equity bridge when Observed share price
computing EV
EBIT / EBITDA, without making

Diluted EPS (post preferred stock
Denominator any adjustments for preferred
dividends deduction)
stock dividends
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Valuation Issues

Calculation inputs
Use EBIT, NOPAT or FCF without making any adjustment for preferred
EBIT / NOPAT/
stock. The DCF will value 100% of the shareholders’ interests, both
FCF
common / ordinary and preferred
Include the preferred stock value in the bridge (thus separating the
EV-to-equity
preferred stock from the equity value attributable to the holders of
bridge
common / ordinary shares)
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WACC Include preferred stock in the WACC calculation *
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* Check whether preference dividends are tax deductible for the issuer
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Cash and cash equivalents

Operating cash, restricted cash, excess cash

Valuation Issues
Cash
Accounting rules
• On the balance sheet but check the footnotes to see if there are any
restrictions
• Cash equivalents may be shown on a separate line since the accounting
definition is very narrow
• Interest income is in the ‘financial’ section of the income statement
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Dealing with comparables
• Operating cash balances should be considered part of EV

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– This is the cash required to run the day-to-day business operations

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– The level is judgmental (e.g. a casino will need more than a manufacturing business)
• Excess cash should be treated as part of the capital structure and shown
either separately in the valuation or netted against debt
• Interest income is below EBIT / EBITDA
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Valuation Issues
Cash
DCF adjustments
Operating cash Excess cash
Leave out changes in excess cash from

Include changes in operating cash
FCF calculation, as excess cash is
balances in FCF (similar to inventory)
FCF treated as a financial asset
Operating cash interest should be
Exclude interest income from FCF
added to FCF (should be minimal)
calculation
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EV to equity calc No adjustment for operating cash Adjust for excess cash
WACC No adjustment of WACC Include as a negative component
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*Note: In practice, the differentiation between excess and operating cash can be difficult. The
most common approach is to treat all cash as if it were excess cash
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Restricted cash
What to do?
• The nature of the restriction needs to be understood clearly

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• Cash may be restricted for debt repayment (sinking fund) and therefore it
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should be netted off against debt just like excess cash

• Operating restricted cash – generally arises in businesses where customers
pay in advance – should be treated like operating cash
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Valuation Issues
Provisions and contingencies

Valuing the underlying fixed claim
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Provisions
What are they?
Quasi debt provisions Quasi operational provisions
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Restructuring Customer loyalty program

Pension Product warranty
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Litigation / legal Ongoing deferred tax liabilities

Environmental rectification Decommissioning provisions
Deferred taxes (M&A)
Specific and debt-like Operational rather than financial
Consider treatment as a debt equivalent Created continuously by day-to-day business operations
Normalize I/S metrics and value separately from core EV if

Treat as an operational liability and hence part of core EV
treated like debt
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Valuation Issues
Provisions
Accounting example
• Company A expenses 2,000 in year 1, and 1,000 in year 2 in respect of a
legal claim
• Settlement of the litigation was expected in Year 3 but happens in Year 4
Year Assets L&E Provision balance
Year 1 NA RE  (2,000) Balance: 2,000

Provisions  2,000
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Year 2 NA RE  (1,000) Balance: 3,000
Provisions  1,000
Year 3 NA NA Balance: 3,000
Year 4 Cash  (3,000) Provisions  (3,000) Balance: 0
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• If provision is expensed as an operating item, should EBIT / EBITDA be
adjusted and how ?
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Provisions
EBIT (post provision): 200 Debt: 600
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Assumptions Provision expense: 45 Cash: 110

Valuation multiple 7.0X
AM
Method 1: Method 2:
Embed provision in EV calc Provision is valued separately at 315 (45 * 7)
Cash = 110 Cash = 110

Debt = 600 Debt = 600
EV and equity
value derivation Prov. = 315
EV = 1,400
Equity = 910 EV = 1,715
Equity = 910
EBIT * multiple Adj. EBIT * multiple

(200 * 7.0x) (( 200 + 45) * 7.0x)
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Valuation Issues
Provisions
• Method 1 works well for quasi operational provisions

• Method 2 should be used for quasi debt provisions. Treatment as a separate
component of the valuation allows flexibility in the valuation
Method 1 Method 2a Method 2b
Provision is de facto valued at 315, Provision is de facto valued at 315, Provision is valued at 45 in the notes,
multiple of 7.0x multiple of 7.0x multiple of 1.0x
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Cash = 110 Cash = 110 Cash = 110
Debt = 600 Debt = 600 Debt = 600
Prov. = 315 Prov. = 45

EV = 1,400
Equity = 910 EV = 1,715 EV = 1,715
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Equity = 910 Equity = 1,180
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Provisions
Dealing with DCF
Method 1 Method 2 Method 3
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Provision expenses in Add back provision expenses to Add back all provision expenses to
AM
EBIT EBIT as non cash items EBIT as non cash items

Include changes in DO NOT include changes in DO NOT include changes in
FCF
provision balances provision balances provision balances
Combination produces Include forecast provision cash DO NOT include forecast cash
FCF impact flows flows
EV to
Include provisions using an
equity No provision No provision
‘appropriate’ valuation
value
Include provision as a separate

WACC No adjustments No adjustments
component
82

Valuation Issues
Contingent liabilities
• A possible obligation whose existence can only be confirmed by uncertain

future events
• Or an obligation that is not recognized because:
– Outflow is not probable
– Amount cannot be measured with reasonable certainty
– Such obligations as performance guarantees, letters of credit, legal claims or debt
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guarantees
• Contingent liabilities are off balance sheet. They are disclosed in the notes to
the accounts, unless remote
• No expense is reflected in the income statement
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• When deciding whether to adjust for contingent liabilities, consider whether

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there has been a price adjustment

AM
• To establish whether liabilities are a debt equivalent determine:

– Is there a fixed claim?
– What is the likelihood of future cash outflow?
– Read the footnotes to see if a valuation is given
– Use this or consider applying a probability weighting
84

Valuation Issues
Dealing with DCF
• This is not included in the FCF and therefore no valuation is embedded in EV

• It needs to be adjusted in the EV to equity value calculation
• This item should be included in the WACC calculation as part of debt
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Other items
Assets held for sale
Derivatives
Dividend payable

Valuation Issues
Assets held for sale
• Assets held for sale (net of liabilities held for sale) is the ring fenced book
value of discontinued operations
• These should be treated separately for the for comparables and DCF as non-
core non-continuing items
• In general, consolidated company income statement is already cleaned out
from earnings from discontinued operations (assets held for sale). Therefore
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no adjustment is necessary for EBIT/ EBITDA and FCF calculations
• Use earnings after discontinued operations for EPS calculations for P/E
multiples
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Derivative assets and liabilities

Operating derivatives Financial derivatives
T
Types of Commodity derivatives Financial derivatives

derivatives
AM
Some foreign exchange derivatives Some foreign exchange derivatives
Could be non core asset or a financial liability,

EV treatment Part of core EV, no adjustments are necessary
adjustment might be necessary
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Part of ongoing cost of doing business.

Part of ongoing operating expenses, hence no Assuming that companies hedge reasonably the
Income statement
need to clean out gains /(losses) in the hedge will net out the gains /
(losses) in the underlying security
88

Valuation Issues
Derivatives
Hedge accounting basics
Fair value hedge Cash flow hedge
The underlying item is marked –to- market in the The underlying item is marked –to- market in the
Balance sheet balance sheet balance sheet
The hedging instrument is also marked-to-market The hedging instrument is also marked-to-market
Gains and losses on underlying are put in the IS

(potentially COGS, SG&A or other operating
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lines) Gains and losses on derivative are taken to equity
and then recycled to the IS, when the hedged cash
flow happens.
Income statement Gains and losses on the derivative are also taken
on the IS, but potentially only the ineffective
portion of hedge goes to “other” section. Over hedge on the derivative is taken to IS
immediately
This approach assumes the match between
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gains / losses in the same line item otherwise
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Derivatives
Adjustments
• Option 1:
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– Do not clean out gains and losses on the underlying and the derivative from the IS
AM
– Take the balance sheet debt numbers post fair value adjustments (you might have to look
in the footnotes)
• Option 2:
– Clean out the hedging items on the IS (both for the underlying and the derivative); this
could be very challenging
– Use debt figures before fair value adjustments for EV calculation
90

Valuation Issues
Number of shares
Free float
Free float
–Not held by long term investors
–Available for trading
–Establish liquidity of share price
Outstanding
–Issued less treasury stock
Issued
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Authorized
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Cum-div and ex-div price
=Shares prices can be either cum-div or ex-div

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– Cum-div
AM
• Buyer receives next dividend (and all thereafter)

– Ex-div (after ex-div date, but before dividend paid)
• Seller receives the next dividend
• Buyer receives all dividends thereafter
Price
Dividend amount
Cum-div trading Ex-div trading

Time
Ex-dividend date
92

Valuation Issues

Impact on enterprise value
• When undertaking a comparables analysis, enterprise value is based on a

calculation starting with equity value, and therefore price
• Cum-div price
– Equity value includes value of dividend to be paid
– No additional dividend liability should be recognized in the calculation of EV as the
dividend is not yet due
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• Ex-div price
– Equity value does not include value of dividend to be paid
– Additional dividend liability should be recognized in calculation of EV as the dividend is
due, but has not yet been paid
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– Adjustment should be made until the dividend payment date
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Example: dividends undeclared
• Stock price: 1.00

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• Stock price: Cum-div

Cash
AM
• Dividends: Undeclared 500

• Diluted NoSO: 1,000 Debt
2,000
• Debt: 2,000
• Cash 500
EV
2,500
Equity
1,000
Enterprise value calculation does not need a
dividend liability as no dividend is declared
94

Valuation Issues

Example: dividends undeclared, cum div

• Stock price: Cum-div
Cash
• Dividends: 0.10 per share 500
2,000
• Debt: 2,000
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• Cash 500
EV
2,500
Equity
1,000
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Enterprise value calculation should not include a
separate dividend liability as dividend is included in
the cum-div price
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Example: dividends undeclared, ex div

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• Stock price: Ex-div

Cash
AM
• Dividends: 0.10 per share 500

2,000
• Debt: 2,000
• Cash 500
EV Liability
2,500 100
Equity
Enterprise value calculation needs a separate 900
dividend liability as the dividend is not included in
the ex-div price and has not been paid
96

Valuation Issues

Example: dividends paid, ex div

• Stock price: Ex-div
Cash
• Dividends: Paid 400
2,000
• Debt: 2,000
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• Cash 400
EV
2,500
Equity
900
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Enterprise value calculation should not include a
separate dividend liability as the dividend is not
included in the ex-div price and has been paid
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Data providers
• Check the pricing settings of the data provider that being used for pricing
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information
AM
• For example within the user settings of Bloomberg, it is possible to either

download raw pricing information, or dividend adjusted pricing information
• The setting is universal for all downloaded prices, so always check before
making the dividend liability adjustment described above
• Care should be taken to ensure the potential dividend liability is treated
correctly
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Valuation Issues
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Please note:
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Valuation Issues
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Valuation Issues
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© AMT Training 2008–2021 B

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1 © AMT Training 2008–2021

© AMT Training 2008–2021 2

• Equity method investments

3 © AMT Training 2008–2021

Cash & Cash &

NCI Total enterprise value NCI

© AMT Training 2008–2021 4

Enterprise value: The Bridge

5 © AMT Training 2008–2021

• Stock-based compensation increases the diluted share count

– To reflect the potential issuance of stock

• The increase is computed using the ‘treasury stock method’

© AMT Training 2008–2021 6

Diluted equity value

Dealing with valuation multiples

What to do for the valuation and for the value driver

7 © AMT Training 2008–2021

Dealing with valuation multiples

Numerator Fully diluted market cap Observed share price

Operating metric (EBIT, EBITDA,

Dealing with DCF valuation

What to do for FCF, WACC and the valuation roadmap

© AMT Training 2008–2021 8

Dealing with DCF

• Are stock-based awards an economic expense?

Dealing with DCF

FCF (do not reverse it out of FCF)

Include value of stock-based compensation:

9 © AMT Training 2008–2021

Restricted stock vs. restricted stock units

Restricted stock (RS) Restricted stock units (RSU)

Timing of A promise to transfer shares at a

Inclusion in Should be included in the reported Excluded from the reported

Dilution Not dilutive

© AMT Training 2008–2021 10

Types of equity investments and the accounting rules

Noncontrolling interest (NCI)

• Noncontrolling interest (NCI, aka ‘minority interest’) is the portion of the

equity of a subsidiary which is not owned by the parent company

• Co A controls Co B by owning 70% of its equity

11 © AMT Training 2008–2021

Noncontrolling interest (NCI)

• The consolidated financial statements show:

Dealing with valuation multiples

What to do for the valuation and for the value driver

© AMT Training 2008–2021 12

Dealing with valuation multiples

Include NCI as a separate item in

Valuing the NCI