Business Valuation

Limitations of Valuation Models

1
Outline

 Limitations of Valuation Models:

1-Appropriate Valuation
2-Private Companies
3-Weighted Average Cost of Capital
4-Capital Asset Pricing Model
5-APT or Multifactor Models
6-Stand-Alone and Synergies

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1-Appropriate Valuation: DCF and Relative Valuation

 Discounted cash flow: The cash flows of a firm is identifiable. Moreover there
is a long time horizon for the forecasting cash flows and a confidence in it.
Although the current cash flows are negative, they will turn positive in the
future. The firm's competitive advantage is supposed to be sustainable.
 Relative Valuation:
– Comparable: Information to forecast cash flows is unavailable. And there
is a confidence the markets are on average right.
• Comparable companies: Growths, returns and risks are similar between firms.
Besides, the time horizon is short. The current cash flows are positive. If the
growth rate differs largely between firms, using PEG ratio is recommended.
• Comparable transactions: Numerous transactions of similar firms exist.
Besides, the time horizon is short.
• Same or comparable industry: Profitability, growth, and risk of firms within an
industry or comparable industry is substantially similar.
– Book value: The earnings power or tangible value are in the assets. The
cash flows are negative. That is why the firm should be a firm in rate-of-
return regulated industries or a financial institution.
– Tangible book value: The assets of the firm are highly liquid. The cash
flows are negative. That is why the firm should be a financial services or
product distribution business.

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1-Appropriate Valuation: Relative Valuation

 Comparable firms should exhibit the same ratio.

 The ratio is estimated from a competitor, a sample of competitors or the
industry can be applied to the firm’s data.
 Competitors should have at least the same business model (if no listed
competitors or no competitor in this industry).
Ratio Underlying assumption
V/Sales Most often used (very easy). Level of sales is the relevant indicator. Or the only one in
common…
V/EBITDA Same operating structure but some differences between investment and depreciation
policy, debt policy (capital structure), tax.
V/EBIT Same operating structure, same investment and depreciation policy but some
differences between debt policy (capital structure) and tax.
V/EBT Same operating structure, same investment and depreciation policy, same debt policy
(capital structure) but some differences between tax.
PER Same operating structure, same investment and depreciation policy, same debt policy
(capital structure) same tax.
V/CE It’s equivalent to a Market/Book ratio and depends on firms’ lifecycle and growth.

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1-Appropriate Valuation: Asset Based Valuation

 Asset Based Valuation:

– Liquidation Method: Assets should be separable, tangible and
marketable. Each asset is valued like if it is liquidated today.
– Break-up Method: The sum of the businesses or product lines is higher
than the company's value of equity.
– Replacement Cost Method: Assets should be easily identifiable,
separable and tangible. Each asset is valued like if it will be replicated. The
cash flows are negative.

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2-Private Companies: Business valuation

 Comparable Company Analysis:

– The assumption is that similar firms in the same industry have similar
multiples.
– This is the most common private company valuation method.
– We have to establish a "peer group" of companies that share similar
characteristics in terms of size, industry, operation,...

 Discounted Cash Flow method:

– We estimate the target's discounted cash flow based on acquired financial
information from its publicly-traded peers.
– We start by determining the applicable revenue growth rate based on the
average growth rates of comparable companies.
– We then make projections of the firm's revenue, operating expenses,
taxes,... to generate the free cash flows.
– We determine the WACC from its cost of equity, cost of debt, tax rate and
capital structure.
– We estimate the firm's beta by taking the industry average beta.
– We refer to the target's public peers to find the industry norm of tax rate
and capital structure.
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2-Private Companies: First Chicago Method

 First Chicago Method or Venture Capital Method is a business valuation

approach that combines elements of both a multiples-based valuation and a
discounted cash flow (DCF) valuation approach.

 This method involves also the construction of different scenarios: a best-case, a

base-case and a worst-case scenario. A probability can be assigned to each
case.

 This method provides a valuation that incorporates both the firm's upside
potential and downside risk.

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2-Private Companies: Problem 4.1

 Watch this video and answer to the following questions.

 Private Company Valuation:
– https://www.youtube.com/watch?v=UesQ3Lum-KQ

 1) What are the three main categories of private companies?

 2) What does the discount rate in the valuation of a private company take into
account?
 3) Which category of private companies is more impacted by its private
characteristic?

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3-Weighted Average Cost of Capital: Leverage effect

 Whatever the origin (debt or equity) of the capital invested in the firm’s assets,
the cash flow generated from asset is the same (it depends on the firm’s
activity).

 Then, as a consequence of the cash flow identity:

– When the part of the cash flow from assets generated with debt financing
is higher than the cash flow paid to creditors, the surplus is given to
stockholders who earn a higher cash flow than supposed by the amount
they have invested in equity.
=> Positive leverage effect due to debt financing

– But, when this part of the cash flow from asset generated with debt
financing is not sufficient to pay cash flow to creditors, the missing part
comes from stockholders’ cash flow. Thus, stockholders earn a lower cash
flow than supposed by the amount they have invested in equity.
=> Negative leverage effect due to debt financing

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3-Weighted Average Cost of Capital: A relevant discount rate

 The Present Value of future cash flows is negatively related to level of the
discount rate.
– If the discount rate chosen is too high, the value found for the firm will be
underestimated.
– If the discount rate chosen is too low, the value found for the firm will be
overestimated.
 An objective discount rate is needed to find the true value.

 What are the components of an appropriate discount rate ?

 The answer begins with some questions :
– What is the nature of the cash flows taken into account ?
– Why do you expect a discount when present value of a future cash flow is
considered?
 Indeed, you bear some risks and expect to receive a compensation for that.

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3-Weighted Average Cost of Capital: Marginal cost

 The marginal cost is the cost of the last dollar of capital raised.

 The discount rate of cash flows to stockholder (defined by stockholders)

represents a minimum rate of return required by stockholders for the risks they
bear when they invest in the firm’s equity.
– Not only cash flows are expected to be positive (most often), but also they
have to be sufficiently important, compared with the amount invested by
stockholders, to insure a sufficiently high rate of return.
return
– This expected rate of return, or required return, is the cost of equity
financing.
– When the return offered to stockholder is higher or equal than required,
they are incited to invest in the firm’s equity.

 Cash flows to creditors are discounted at the cost of debt financing :

– the interest rate (as a risk free rate plus a default premium), which should
be the current YTM,
– but as the interest paid is deduced from taxable income and leads to pay
less taxes, the real cost is lower from the firm’s point of view. We calculate
“a cost after tax”.
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3-Weighted Average Cost of Capital: The components

 Cash flows from assets should satisfied a required rate of return on assets. This
required return on assets depends on the risks bear when you invest in those
assets but it has also a lower bound : assets must offer a return sufficiently high
to pay the cost of equity financing and the cost of debt financing, taken into
account the relative amount of those sources of financing. (Weighted Average
Cost of Capital or WACC)
E D
WACC = k = × kE + × k D (1 − Tax rate)
E+D E+D

– kD , the cost of debt before tax corresponds to the current interest rate or
YTM.
– E D reflect the capital structure of the firms in terms of market
and
E+D E+D
values. As the current firm’s capital structure can differ from the “target”
one [expected for subsequent years as an “optimal capital structure”
maximizing the firm’s value], the use of target ratios would be prefer.
– kE , the cost of equity (or return expected by stockholders) can be
estimated with: CAPM, APT (Arbitrage Pricing Theory) or Multifactor
models, BARRA model, 3-factor model (Fama-French), 4-Factor model
(Cahart), Zero growth model, Constant growth model, ROE…

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4-Capital Asset Pricing Model: The cost of equity

 CAPM (Capital Asset Pricing Model): the most applied (at this time…)
k Ei = R f + β i × (Market Risk Premium )

– Where Rf is the risk free rate

– And Market Risk Premium = expected market return – Rf

 The beta is the covariance between the returns of the firm’s stock and the
market’s returns, divided by the variance of the market’s returns (Calculations
based on time series). σ
βi = firm i , market

σ 2
market

 In the CAPM, only one source of risk: the difference between return with and
without risk.

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4-Capital Asset Pricing Model: Problem 4.2 (1)

Date Mkt Return RF KHC Price

2020-07-01 31.93
 1) What is the Beta of Kraft Heinz Company (NYSE:KHC) 2020-06-01 2.46% 0.0246% 30.50
2020-05-01 5.59% 0.0559% 29.99
using the covariance and variance with the market?
σ
2020-04-01 13.65% 0.1365% 24.02
2020-03-01 -13.27% -0.1327% 24.75
βi = firm i , market 2020-02-01 -8.01% -0.0801% 29.20

σ 2
market
2020-01-01
2019-12-01
0.02%
2.91%
0.0002%
0.0291%
32.29
30.50
2019-11-01 3.99% 0.0399% 32.12
– Find the monthly return of KHC (RKHC). 2019-10-01 2.21% 0.0221% 27.93
2019-09-01 1.61% 0.0161% 25.42
– Determine the Covariance between KHC and the 2019-08-01 -2.42% -0.0242% 32.10
2019-07-01 1.38% 0.0138% 31.26
market. 2019-06-01 7.11% 0.0711% 27.68
2019-05-01 -6.73% -0.0673% 33.20
– Determine the Variance of the market. 2019-04-01 4.17% 0.0417% 32.80
2019-03-01 1.29% 0.0129% 33.41
2019-02-01 3.58% 0.0358% 48.14
2019-01-01 8.62% 0.0862% 42.75
2018-12-01 -9.36% -0.0936% 51.40
2018-11-01 1.87% 0.0187% 55.13
2018-10-01 -7.49% -0.0749% 55.49
2018-09-01 0.21% 0.0021% 58.45
2018-08-01 3.60% 0.0360% 60.00
2018-07-01 3.35% 0.0335% 62.50
2018-06-01 0.62% 0.0062% 57.64
2018-05-01 2.79% 0.0279% 56.32
2018-04-01 0.43% 0.0043% 61.94
2018-03-01 -2.23% -0.0223% 67.14
2018-02-01 -3.54% -0.0354% 78.12
2018-01-01 5.69% 0.0569% 78.22
2017-12-01 1.15% 0.0115% 80.95
2017-11-01 3.20% 0.0320% 77.71
2017-10-01 2.34% 0.0234% 77.55
2017-09-01 2.60% 0.0260% 80.75
2017-08-01 0.25% 0.0025% 87.38
2017-07-01 1.94% 0.0194% 85.96

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4-Capital Asset Pricing Model: Problem 4.2 (2)

Date Mkt Return RF KHC Price HSY Price CAG Price

2020-07-01 31.93 129.77 35.40
2020-06-01 2.46% 0.0246% 30.50 135.87 34.79
2020-05-01 5.59% 0.0559% 29.99 131.44 33.29
2020-04-01 13.65% 0.1365% 24.02 128.39 28.34
2020-03-01 -13.27% -0.1327% 24.75 144.32 26.86
2020-02-01 -8.01% -0.0801% 29.20 155.77 33.02
2020-01-01 0.02% 0.0002% 32.29 147.23 34.25
2019-12-01 2.91% 0.0291% 30.50 147.67 28.85
2019-11-01 3.99% 0.0399% 32.12 147.26 27.11
2019-10-01 2.21% 0.0221% 27.93 154.79 30.72
2019-09-01 1.61% 0.0161% 25.42 158.48 28.12
2019-08-01 -2.42% -0.0242% 32.10 152.40 29.01
2019-07-01 1.38% 0.0138% 31.26 134.69 26.65
2019-06-01 7.11% 0.0711% 27.68 131.93 26.73
2019-05-01 -6.73% -0.0673% 33.20 125.00 30.88
2019-04-01 4.17% 0.0417% 32.80 114.77 27.69
2019-03-01 1.29% 0.0129% 33.41 111.12 23.42
2019-02-01 3.58% 0.0358% 48.14 106.05 21.72
2019-01-01 8.62% 0.0862% 42.75 106.18 21.14
2018-12-01 -9.36% -0.0936% 51.40 108.52 32.27
2018-11-01 1.87% 0.0187% 55.13 107.24 35.75
2018-10-01 -7.49% -0.0749% 55.49 102.25 34.02
2018-09-01 0.21% 0.0021% 58.45 100.71 36.86
2018-08-01 3.60% 0.0360% 60.00 98.32 36.68
2018-07-01 3.35% 0.0335% 62.50 92.90 35.41
2018-06-01 0.62% 0.0062% 57.64 90.12 37.16
2018-05-01 2.79% 0.0279% 56.32 92.00 37.00
2018-04-01 0.43% 0.0043% 61.94 98.54 36.80
2018-03-01 -2.23% -0.0223% 67.14 98.20 36.06
2018-02-01 -3.54% -0.0354% 78.12 105.45 37.90
2018-01-01 5.69% 0.0569% 78.22 113.48 37.68
2017-12-01 1.15% 0.0115% 80.95 111.04 37.45
2017-11-01 3.20% 0.0320% 77.71 106.57 34.26
2017-10-01 2.34% 0.0234% 77.55 109.20 33.75
2017-09-01 2.60% 0.0260% 80.75 105.38 32.59
2017-08-01 0.25% 0.0025% 87.38 105.51 34.28
2017-07-01 1.94% 0.0194% 85.96 107.05 35.67

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4-Capital Asset Pricing Model: Problem 4.2 (3)

 2) What is the Beta of Kraft Heinz Company (NYSE:KHC) using the regression
with the market?
Rit –RFt = ai + bi × (RMt – RFt ) + eit
Rit is the return on security or portfolio i for period t, RFt is the risk free return,
RMt is the return of the market, and eit is a zero-mean residual.

– Determine the difference between the monthly return of KHC and the risk
free rate (RKHC - RF).
– Determine the difference between the market and the risk free rate (RMkt -
RF).
– In Excel, select 2 columns and 3 lines and write the following formula
"=LINEST('column of ((RKHC - RF)';'column of (RMkt - RF)';;TRUE)"
(DROITEREG in French). Then to validate, you have to type
"Ctrl+Shift+Enter“ to get the following data.
Beta Coefficient Const Coefficient
Beta Standard Deviation Const Standard Deviation
R² Standard error estimate
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4-Capital Asset Pricing Model: Problem 4.2 (3)

Date Mkt Return RF KHC Price HSY Price CAG Price RKHC
2020-07-01 31.93 129.77 35.40
2020-06-01 2.46% 0.0246% 30.50 135.87 34.79 4.69%
2020-05-01 5.59% 0.0559% 29.99 131.44 33.29 1.70%
2020-04-01 13.65% 0.1365% 24.02 128.39 28.34 24.85%
2020-03-01 -13.27% -0.1327% 24.75 144.32 26.86 -2.95%
2020-02-01 -8.01% -0.0801% 29.20 155.77 33.02 -15.24%
2020-01-01 0.02% 0.0002% 32.29 147.23 34.25 -9.57%
2019-12-01 2.91% 0.0291% 30.50 147.67 28.85 5.87%
2019-11-01 3.99% 0.0399% 32.12 147.26 27.11 -5.04%
2019-10-01 2.21% 0.0221% 27.93 154.79 30.72 15.00%
2019-09-01 1.61% 0.0161% 25.42 158.48 28.12 9.87%
2019-08-01 -2.42% -0.0242% 32.10 152.40 29.01 -20.81%
2019-07-01 1.38% 0.0138% 31.26 134.69 26.65 2.69%
2019-06-01 7.11% 0.0711% 27.68 131.93 26.73 12.93%
2019-05-01 -6.73% -0.0673% 33.20 125.00 30.88 -16.63%
2019-04-01 4.17% 0.0417% 32.80 114.77 27.69 1.22%
2019-03-01 1.29% 0.0129% 33.41 111.12 23.42 -1.83%
2019-02-01 3.58% 0.0358% 48.14 106.05 21.72 -30.60%
2019-01-01 8.62% 0.0862% 42.75 106.18 21.14 12.61%
2018-12-01 -9.36% -0.0936% 51.40 108.52 32.27 -16.83%
2018-11-01 1.87% 0.0187% 55.13 107.24 35.75 -6.77%
2018-10-01 -7.49% -0.0749% 55.49 102.25 34.02 -0.65%
2018-09-01 0.21% 0.0021% 58.45 100.71 36.86 -5.06%
2018-08-01 3.60% 0.0360% 60.00 98.32 36.68 -2.58%
2018-07-01 3.35% 0.0335% 62.50 92.90 35.41 -4.00%
2018-06-01 0.62% 0.0062% 57.64 90.12 37.16 8.43%
2018-05-01 2.79% 0.0279% 56.32 92.00 37.00 2.34%
2018-04-01 0.43% 0.0043% 61.94 98.54 36.80 -9.07%
2018-03-01 -2.23% -0.0223% 67.14 98.20 36.06 -7.75%
2018-02-01 -3.54% -0.0354% 78.12 105.45 37.90 -14.06%
2018-01-01 5.69% 0.0569% 78.22 113.48 37.68 -0.13%
2017-12-01 1.15% 0.0115% 80.95 111.04 37.45 -3.37%
2017-11-01 3.20% 0.0320% 77.71 106.57 34.26 4.17%
2017-10-01 2.34% 0.0234% 77.55 109.20 33.75 0.21%
2017-09-01 2.60% 0.0260% 80.75 105.38 32.59 -3.96%
2017-08-01 0.25% 0.0025% 87.38 105.51 34.28 -7.59%
2017-07-01 1.94% 0.0194% 85.96 107.05 35.67 1.65%
Variance 0.00265 Covariance 0.00307
Beta 1.16

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4-Capital Asset Pricing Model: The risk free rate

 At the beginning: the risk free rate was a short term interest rate (Tobin’s
analysis of Keynes’ comments on long term and illiquid saving vs short term but
liquid saving).
 As shown by Fisher Black, the return on the less risky asset could be consistent
with the theory.
 As a stocks’ market refer to long term, the risk free asset could be a long term
risk free asset. The choice of a short term or a long term risk free asset impacts
the market risk premium.
premium

 Commonly used risk free asset or estimate of risk free rate:

– 3-month Treasury Bills
– 5-year Government Bonds
– 10-Year Government Bonds
– 30-Year Government Bonds

 10-year YTM for a large firm rated AAA (because of scarcity of AAA-rated
Government Bonds nowadays …).
 An estimate based on interest rate-drivers: long term real interest rate (real
economic growth expected) + long term expected inflation rate.
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4-Capital Asset Pricing Model: Market risk premium

 Historical Market Risk Premium vs Implied Market Risk Premium

 Historical risk premium (estimated and preferred by academics and some
experts) are usually lower than Implied risk premium (preferred by some
independent experts ).
– Historical risk premium is an historical average (arithmetic or geometric
mean) computed with time series.
– Implied risk premium can be inferred from a dividend discount model:
 Example 1: By knowing the next dividend paid (Div1), the expected growth rate
of dividends (g) and the current stock price (P0),
d1 d1
P0 = ⇔ kE = + g = dividend yield + growth rate
kE − g P0
 implied risk premium = k E − R f = (dividend yield + growth rate) − R f
 Example 2: Based on the knowledge of a stream of future dividends and current
and final prices,
d1 d2 d3 d t + Pt
P0 = + + + ... +
(1 + k E )1 (1 + k E )2 (1 + k E )3 (1 + k E )t
 implied risk premium = k E − R f
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4-Capital Asset Pricing Model: « Short » list of problems

 Market problems:
– A financial index is not representative of a market;
– Some assets are not traded on a market;
– Current markets are not representative of all the risks impacting the firm
and its stockholders;
 Empirical “anomalies” (January effect, size effect, P/B, …; survival bias);
 Asynchronous data and asynchronous arrival of information;
 The firm can be non-listed on a market; no direct competitor or no listed
competitors;
 Non stationary beta and non stationary market risk premium;
 Lower R²: the idiosyncratic risk has increased over time and the systematic or
systemic risk (beta) is less and less powerful to explain returns;
 Beta and capital structure;
 Choice of risk free rate and or a market risk premium; a risk free rate doesn’t
exist…

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4-Capital Asset Pricing Model: Levered and unlevered beta

 Since a portfolio’s beta seems to be much more stationary and the difference of
risk between a firm with or without leverage can be captured by the relationship
between a beta with leverage (reflecting economic and financial risks) and an
unlevered beta (economic risk only):
 Methodology
– Select a sample of competitors (same industry; comparable firms) listed
on a market
– Find the largest financial index that could be a proxy of the market (MSCI
world,…)
– Based on historical time series (4 or 5 years at least, monthly data),
estimate their beta (reflecting their leverage)
– Neglect non significant estimate of beta (R² less than 15%)
β with leverage
– use their D/E ratio to infer their unlevered beta: β unlevered = D [1 + E × (1 − tax rate)]
– Take the average unlevered beta of this sample as a measure of economic
risks commonly impacting this industry
– Use the average unlevered beta and the D/E ratio of the studied firm to
 D 
find an estimate of its beta with leverage:β =β × 1 + × (1 − tax rate )
with leverage unlevered  
 E 
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4-Capital Asset Pricing Model: Problem 4.3

 Mars Incorporated is a company known for the confectionery items that it

creates, such as Mars bars, Milky Way bars, M&M's, Skittles, Snickers, and Twix.
They also produce non-confectionery snacks, such as Combos, and other foods,
including Ben's Orginal Rice, and pasta sauce brand Dolmio, as well as pet
foods, such as Pedigree, Whiskas, Nutro and Royal Canin brands (Wikipedia).
 However, Mars Inc. is a private company. So, we have identified similar
companies that are public companies such as Kraft Heinz Company
(NYSE:KHC), Hershey Company (NYSE:HSY), and ConAgra Foods (NYSE:CAG).
Assume the tax rate is 21%.
 What is the value of the Beta that we can apply to Mars Incorporated?

KHC HSY CAG

Debt 28.86 5.29 10.00
Equity 39.00 26.96 16.95

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Date Mkt Return RF KHC Price HSY Price CAG Price RKHC RKHC-RF RMkt-RF
2020-07-01 31.93 129.77 35.40
2020-06-01 2.46% 0.0246% 30.50 135.87 34.79 4.69% 4.66% 2.44%
2020-05-01 5.59% 0.0559% 29.99 131.44 33.29 1.70% 1.64% 5.53%
2020-04-01 13.65% 0.1365% 24.02 128.39 28.34 24.85% 24.72% 13.51%
2020-03-01 -13.27% -0.1327% 24.75 144.32 26.86 -2.95% -2.82% -13.14%
2020-02-01 -8.01% -0.0801% 29.20 155.77 33.02 -15.24% -15.16% -7.93%
2020-01-01 0.02% 0.0002% 32.29 147.23 34.25 -9.57% -9.57% 0.02%
2019-12-01 2.91% 0.0291% 30.50 147.67 28.85 5.87% 5.84% 2.88%
2019-11-01 3.99% 0.0399% 32.12 147.26 27.11 -5.04% -5.08% 3.95%
2019-10-01 2.21% 0.0221% 27.93 154.79 30.72 15.00% 14.98% 2.19%
2019-09-01 1.61% 0.0161% 25.42 158.48 28.12 9.87% 9.86% 1.59%
2019-08-01 -2.42% -0.0242% 32.10 152.40 29.01 -20.81% -20.79% -2.40%
2019-07-01 1.38% 0.0138% 31.26 134.69 26.65 2.69% 2.67% 1.37%
2019-06-01 7.11% 0.0711% 27.68 131.93 26.73 12.93% 12.86% 7.04%
2019-05-01 -6.73% -0.0673% 33.20 125.00 30.88 -16.63% -16.56% -6.66%
2019-04-01 4.17% 0.0417% 32.80 114.77 27.69 1.22% 1.18% 4.13%
2019-03-01 1.29% 0.0129% 33.41 111.12 23.42 -1.83% -1.84% 1.28%
2019-02-01 3.58% 0.0358% 48.14 106.05 21.72 -30.60% -30.63% 3.54%
2019-01-01 8.62% 0.0862% 42.75 106.18 21.14 12.61% 12.52% 8.53%
2018-12-01 -9.36% -0.0936% 51.40 108.52 32.27 -16.83% -16.74% -9.27%
2018-11-01 1.87% 0.0187% 55.13 107.24 35.75 -6.77% -6.78% 1.85%
2018-10-01 -7.49% -0.0749% 55.49 102.25 34.02 -0.65% -0.57% -7.42%
2018-09-01 0.21% 0.0021% 58.45 100.71 36.86 -5.06% -5.07% 0.21%
2018-08-01 3.60% 0.0360% 60.00 98.32 36.68 -2.58% -2.62% 3.56%
2018-07-01 3.35% 0.0335% 62.50 92.90 35.41 -4.00% -4.03% 3.32%
2018-06-01 0.62% 0.0062% 57.64 90.12 37.16 8.43% 8.43% 0.61%
2018-05-01 2.79% 0.0279% 56.32 92.00 37.00 2.34% 2.32% 2.76%
2018-04-01 0.43% 0.0043% 61.94 98.54 36.80 -9.07% -9.08% 0.43%
2018-03-01 -2.23% -0.0223% 67.14 98.20 36.06 -7.75% -7.72% -2.21%
2018-02-01 -3.54% -0.0354% 78.12 105.45 37.90 -14.06% -14.02% -3.50%
2018-01-01 5.69% 0.0569% 78.22 113.48 37.68 -0.13% -0.18% 5.63%
2017-12-01 1.15% 0.0115% 80.95 111.04 37.45 -3.37% -3.38% 1.14%
2017-11-01 3.20% 0.0320% 77.71 106.57 34.26 4.17% 4.14% 3.17%
2017-10-01 2.34% 0.0234% 77.55 109.20 33.75 0.21% 0.18% 2.32%
2017-09-01 2.60% 0.0260% 80.75 105.38 32.59 -3.96% -3.99% 2.57%
2017-08-01 0.25% 0.0025% 87.38 105.51 34.28 -7.59% -7.59% 0.25%
2017-07-01 1.94% 0.0194% 85.96 107.05 35.67 1.65% 1.63% 1.92%
Variance 0.00265 Covariance 0.00307
Beta 1.16
Beta Constant
Coeff 1.19 -0.03
Stand. Dev. 0.30 0.02
R² 0.32 0.09

Business Valuation - 23
4-Capital Asset Pricing Model: Historical risk premia in US

From Damodaran (US data) Risk Premium Standard Error

Arithmetic 3-month 10-Year
S&P500 Stocks - T.Bills Stocks - T.Bonds Stocks - T.Bills Stocks - T.Bond
Average T.Bills T. Bond
1928-2019 11.57% 3.40% 5.15% 8.18% 6.43% 2.08% 2.20%

1965-2019 11.89% 4.64% 7.39% 7.26% 4.50% 2.38% 2.73%

2005-2019 14.02% 0.52% 4.35% 13.51% 9.67% 3.85% 4.87%

Risk Premium

Geometric 3-month 10-Year

S&P500 Stocks - T.Bills Stocks - T.Bonds
Average T.Bills T. Bond
1928-2019 9.71% 3.35% 6.96% 6.35% 4.83%

1970-2019 10.51% 4.58% 9.18% 5.93% 3.52%

2010-2019 13.44% 0.51% 7.06% 12.93% 9.31%

Business Valuation - 24
4-Capital Asset Pricing Model: Historical and Implied

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html

Business Valuation - 25
5-APT or Multifactor Models: The cost of equity

 APT (Arbitrage Pricing Theory) has been developed by Ross (1976) and
Huberman (1982).
 Based on simplest and less costly assumptions (than the CAPM), returns are
explained by several factors of risk.

 Principles (No-Arbitrage condition [Law of one price])

– If some shares or portfolios of shares react with the same sensibility to
common factors, they should offer the same expected return;
– If a strategy exists to increase return without increasing risk and without
cost, investors would capture this arbitrage opportunity.

 expected   sensibility  risk premium   sensibility  risk premium 

  = Rf +   ×   +  to factor 2  ×  factor 2  + K
 return   to factor 1   factor 1     
 Relevant factors are “extracted” from time series data by applying Factor
analysis and Principal Components Analysis…
 But the theory doesn’t explain how much factors should be relevant and what
are they (no economic interpretation) ….

Business Valuation - 26
5-APT or Multifactor Models: Multi-factor models

 Multi-factor models are based on the logic underlying APT but are not derived
from theory and mathematical assumptions.
 Multi-factor models just try to include intuitive factors or macro and micro
factors identified by empirical (so, some factors can be omitted).

 For example, Chen-Roll-Ross (1986) show that if we look at the DCF model:
– The discount rate could be influenced by:
• Interest rate
• Expected inflation
• Risk aversion (measured by the market risk premium)
– The cash Flows are influenced by:
• Expected inflation
• Economic growth

Business Valuation - 27
5-APT or Multifactor Models: Barra’s model

 Another example is the Barra’s model (Bar Rosenberg and Associates, now MSCI
Barra)

 See:
http://www.msci.com/products/portfolio_management_analytics/equity_models

 Assumptions: returns depend on the industry, the firm’s size and earnings.

 Identified factors reflect differences in stock returns’ patterns explained by their

industry and other sources of risk.

 Illustration for the US market: Volatility, momentum, size, non-linear size,

trading activity, growth (earnings), earning-to-price, book-to-price, fluctuations
in earnings, leverage, sensitivity to the currency, the dividend-price relationship,
…

Business Valuation - 28
5-APT or Multifactor Models: 3-factor model

 Emprical tests of the CAPM or APT have shown the weakness of these models to
explain recurring evidence of abnormal returns.

 Fama et French (1992, 1993) : 3-factor model

 Some empirical « anomalies » seem to be captured by:

– SMB premium: small (large) firms offer a larger (smaller) risk premium
than predicted by models;
models this called the « size effect ».
– HMB premium: returns on firms with a high Book/Market seem to be
higher than for firms with a low Book/Market. We expect a value stock
(returns mainly come from dividend yield; no or small growth) to exhibit a
high B/M ratio and a growth stock (returns mainly come from capital gain
– growth - ; low dividend yield) to exhibit a low B/M ratio.

 Such a model is applied, in France, by Associés en Finance (www.associes-

finance.com/) for the valuation of firms and their WACC with TRIVIAL®.
 Recently, Fama and French have tried to enhance their model by including 2
other factors (5-factor model).

Business Valuation - 29
5-APT or Multifactor Models: 5-factor model

 3-factor model (FAMA-FRENCH 1993)

Rit –RFt = ai + bi × (RMt – RFt ) + si × SMBt + hi × HMLt + eit

 Rit is the return on security or portfolio i for period t, RFt is the risk free return,
RMt is the return on the value-weight (VW) market portfolio, and eit is a zero-
mean residual,
 SMBt is the return on a diversified portfolio of small stocks minus the return on a
diversified portfolio of big stocks,
 HMLt is the difference between the returns on diversified portfolios of high and
low B/M stocks (value stocks vs growth stocks),

 5-factor model (FAMA-FRENCH 2014)

Rit –RFt = ai + bi × (RMt – RFt ) + si × SMBt + hi × HMLt + ri × RMWt + ci × CMAt + eit

 RMWt is the difference between the returns on diversified portfolios of stocks

with robust and weak profitability,
 CMAt is the difference between the returns on diversified portfolios of the stocks
of low and high investment firms, which we call conservative and aggressive.

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5-APT or Multifactor Models: Fama-French coefficients

June Last 3 Last 12

2020 Months Months
Fama-French 3 Research Factors

Rm-Rf 2.45 22.94 6.56

SMB 2.56 9.09 -4.92
HML -2.03 -9.93 -35.59

Fama-French 5 Research Factors (2x3)

Rm-Rf 2.45 22.94 6.56

SMB 1.89 7.71 -12.30
HML -2.03 -9.93 -35.59
RMW 0.13 3.98 0.08
CMA 0.37 -4.70 -5.58

Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.htm

Business Valuation - 31
5-APT or Multifactor Models: Fama-French portfolios

SMB HML RMW CMA

Size and Book-to-Market Portfolios
Small Value Small Value
Small Neutral Small Neutral
Small Growth Small Growth

Big Value Big Value

Big Neutral Big Neutral
Big Growth Big Growth

Size and Operating Profitability Portfolios

Small Robust Small Robust
Small Neutral Small Neutral
Small Weak Small Weak

Big Robust Big Robust

Big Neutral Big Neutral
Big Weak Big Weak

Size and Investment Portfolios

Small Conservative Small Conservative
Small Neutral Small Neutral
Small Aggressive Small Aggressive

Big Conservative Big Conservative

Big Neutral Big Neutral
Big Aggressive Big Aggressive
Business Valuation - 32
5-APT or Multifactor Models: Portfolios returns

June 2020 Last 3 Months Last 12 Months

Size and Book-to-Market Portfolios
Small Value 3.52 25.46 -22.97
Small Neutral 2.25 20.66 -10.61
Small Growth 5.42 39.54 10.54
Big Value 1.38 19.69 -17.68
Big Neutral
-1.41 13.23 -10.60
Big Growth
3.54 25.47 19.99
Size and Operating Profitability Portfolios
Small Robust 3.42 39.53 -14.80
Small Neutral 2.71 20.30 -13.07
Small Weak 4.55 31.27 0.31

Big Robust 4.17 25.23 18.42

Big Neutral -0.62 16.97 -1.77
Big Weak 2.77 25.54 3.15

Size and Investment Portfolios 5.18 31.15 -6.70

Small Conservative 2.44 20.48 -13.72
Small Neutral
4.39 34.45 -0.73
Small Aggressive

Big Conservative 2.89 21.00 9.95

Big Neutral 1.26 19.23 2.35
Big Aggressive 2.93 27.11 15.14

Business Valuation - 33
6-Stand-Alone and Synergies: Strategic and Financial issues

 Strategic issues:
– The competitive dynamics of their industry like the industry profitability
and the industry cash flow
– The performance of the company within the industry like its market share
– The reliability of the data used by determining cyclical movement and
relationship between fixed and variable expenses

 Financial issues:
– Adjusting the data such as no anomalies, nonrecurring charges or
accounting practices affect abnormally the valuation
– Finding historical data for a long period of time (five to seven years)
– Determining financial ratio to analyze more accurately the firms’ capacity
compared to the industry to justify the choices

Business Valuation - 34
6-Stand-Alone and Synergies: Acquirer and Target Firms’ Value

 Firm Valuation:
– Future cash flows are determined for the next years until the growth rate
becomes constant
– These future cash flows are based on the data of the strategic and
financial issues
– The future cash flows’ components could be a percentage of the projected
revenue.
– The strategic and financial issues are historical data but should also take
into account new product introductions or additional expenses that will be
made in the future
– Multiple scenarios can be identified and analyzed

Business Valuation - 35
6-Stand-Alone and Synergies: Value Created and Destroyed

 Value Created:
– Cost savings resulting from eliminating duplicate facilities and employees,
and by rationalizing purchasing and cutting overhead
– These cost-savings are more easily identified and will be surely realized
– Underutilized capacity like equipments, patents or licenses are sources of
value
– The possibility to increase the borrowing capacity of the combined firms
– The access to new sources such as new clients, technologies, patents…
– The acquirer firm can reduce its tax liability because of the income tax loss

 Value Destroyed:
– The poor product quality, the poor productivity, the high employee
turnover, and the wages above comparable industry levels
– The terms and conditions of the contracts with customers are not
sufficiently detailed
– Unresolved lawsuits can cause also problems and losses
– Taking liabilities of the target firm without knowing exactly all its
commitments

Business Valuation - 36
6-Stand-Alone and Synergies: Net synergy

 Net Value:
– The net synergy value is the difference between the estimated created
value and estimated destroyed value
– The costs associated with recruiting and training, realizing cost savings,
achieving productivity improvements, and exploiting revenue opportunities
should be added
– The replacing cost of skilled workers of the target firm leaving the
acquiring company can be important
– The expenses link to the layoffs to avoid redundant positions
– The way the layoffs are conducted can decrease remaining employees’
motivation

 There are two categories of synergy:

– Revenue-related synergy: the opportunities on sales and marketing due to
the combination of the target and acquiring companies.
– Cost-saving related synergy: the opportunities obtained by improving
productivity due to the combination of the target and acquiring companies
such as eliminating duplicate operations, processes, and personnel.

Business Valuation - 37
6-Stand-Alone and Synergies: The Range

 The acquiring company determines the offer price range for the target firm. The
offer price range is defined with a minimum offer price and a maximum offer
price.
 The minimum bid price corresponds to the value of the target as a stand-alone
business ($450 million).
 The maximum bid price represents the sum of the minimum bid price, the
stand-alone business of the target, and the value of the net synergy minus the
transaction cost (450 + 400 – 25 = $825 million).

Business Valuation - 38
6-Stand-Alone and Synergies: The Distribution of Synergy

 The solution is to base this distribution on the portion of the synergy value from
the target firm compared to the net synergy value from combining firms.
 If the synergy value from the target firm is $150 million and the net synergy
value from combining firms is $400 million, then the target firm contributes to
37.5 percent of the synergy resulting from the combining firms.
 Since the value of the target as a stand-alone business is $450 million, the offer
price could be $600 million.
 In practice, many factors surrounding the transaction affect the amount of the
purchase price. Some are quantified and others are subjective.

Business Valuation - 39
6-Stand-Alone and Synergies: The Distribution of Synergy

 The maximum bid price is $825 million and the minimum bid price is $450
million.
 Since the target company has 25 million shares outstanding. The maximum
offer price per share is $33.00 and the minimum offer price per share is $18.00.
 The acquiring firm's shareholders take all the benefits of the merger if the offer
price per share is at its minimum, $18.00.
 The target firm's shareholders take all the benefits of the merger if the offer
price per share is at its maximum, $33.00.

Business Valuation - 40
6-Stand-Alone and Synergies: The Premium

 The target’s stockholders receive oftenly the vast majority of the benefits
because the acquiring company must offer a premium to the current stock price
to gain control.

 The offer price by the acquiring firm includes a premium over the target’s
current price. The excess of the offer price over the target’s premerger price is
the premium.

 If the target’s current value is $450 million and the offer price is $650 million,
the merger premium is $200 million.

 The target firm receives an excess of $200 million due to merger synergies and
for letting the acquiring company the control of the target firm.

Business Valuation - 41