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An overview

©2001 M. P. Narayanan University of Michigan

FIN Methodologies

✦ Comparable multiples

■ P/E multiple

■ Market to Book multiple

■ Price to Revenue multiple

■ Enterprise value to EBIT multiple

**✦ Discounted Cash Flow (DCF)
**

■ NPV, IRR, or EVA based Methods

◆ WACC method

◆ APV method

◆ CF to Equity method

©2001 M. P.

University of Michigan 2

Narayanan

University of Michigan 3 Narayanan . ■ Value of firm = Average Transaction P/E multiple × EPS of firm ■ Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be) ✦ If valuation is being done to estimate firm value ■ Value of firm = Average P/E multiple in industry × EPS of firm ✦ This method can be used when ■ firms in the industry are profitable (have positive earnings) ■ firms in the industry have similar growth (more likely for “mature” industries) ■ firms in the industry have similar capital structure ©2001 M. P.FIN Valuation: P/E multiple ✦ If valuation is being done for an IPO or a takeover.

University of Michigan 4 Narayanan . ✦ This method can be used for ■ companies in the manufacturing sector which have significant capital requirements. ✦ Since the book value of equity is essentially the amount of equity capital invested in the firm. ■ companies which are not in technical default (negative book value of equity) ©2001 M.FIN Valuation: Price to book multiple ✦ The application of this method is similar to that of the P/E multiple method. P. this method measures the market value of each dollar of equity invested.

or investment in stocks of other companies. such as investment in treasury bills or bonds. ©2001 M. only the operational value of the business is included. P. ✦ Value from investment activities. ✦ The following economic value balance sheet clarifies the notion of enterprise value. that is the value of the business operations (as opposed to the value of the equity). ✦ In calculating enterprise value. is excluded. University of Michigan 5 Narayanan .FIN Valuation: Value to EBITDA multiple ✦ This multiple measures the enterprise value.

University of Michigan 6 Narayanan . P.FIN Enterprise Value Economic Value Balance Sheet PV of future cash from business $1500 operations Cash $200 Debt $650 Marketable securities $150 Equity $1200 $1850 $1850 Enterprise Value ©2001 M.

P. University of Michigan 7 Narayanan . 10.3.FIN Value to EBITDA multiple: Example ✦ Suppose you wish to value a target company using the following data: ■ Enterprise Value to EBITDA (business operations only) multiple of 5 recent transactions in this industry: 10. ■ Recent EBITDA of target company = $20 million ■ Cash in hand of target company = $5 million ■ Marketable securities held by target company = $45 million ■ Interest rate received on marketable securities = 6%.2. 10.5. 9. 9.8. ■ Sum of long-term and short-term debt held by target = $75 million ©2001 M.1.

8+9.3 = $172. University of Michigan 8 Narayanan .65 million ✦ Add cash plus marketable securities ■ 172.FIN Value to EBITDA multiple: Example ✦ Average (Value/ EBITDA) of recent transactions ■ (10. ©2001 M.5+10.65 million ✦ Subtract debt to find equity value: 222.1+9.7 = $17. P.2+10.7 million ✦ EBITDA – Interest income from marketable securities ■ 20 – 2.98 ✦ Interest income from marketable securities ■ 0.06 × 45 = $2.65 + 5 + 45 = $222.3)/5 = 9.98 × 17.65 – 75 = $147.65 million.3 million ✦ Estimated enterprise value of the target ■ 9.

✦ Appropriate for valuing companies with large debt burden: while earnings might be negative. ✦ Gives a measure of cash flows that can be used to support debt payments in leveraged companies.FIN Valuation: Value to EBITDA multiple ✦ Since this method measures enterprise value it accounts for different ■ capital structures ■ cash and security holdings ✦ By evaluating cash flows prior to discretionary capital investments. P. ©2001 M. this method provides a better estimate of value. University of Michigan 9 Narayanan . EBIT is likely to be positive.

For example. all of them share several common disadvantages: ■ they do not accurately reflect the synergies that may be generated in a takeover. in an overvalued market. ©2001 M. P. ■ they assume that the market valuations are accurate.FIN Heuristic methods: drawbacks ✦ While heuristic methods are simple. ■ They require that firms use uniform accounting practices. ■ They assume that the firm being valued is similar to the median or average firm in the industry. we might overvalue the firm under consideration. University of Michigan 10 Narayanan .

FIN Valuation: DCF method ✦ Here we follow the discounted cash flow (DCF) technique we used in capital budgeting: ■ Estimate expected cash flows considering the synergy in a takeover ■ Discount it at the appropriate cost of capital ©2001 M. P. University of Michigan 11 Narayanan .

FIN DCF methods: Starting data ✦ Free Cash Flow (FCF) of the firm ✦ Cost of debt of firm ✦ Cost of equity of firm ✦ Target debt ratio (debt to total value) of the firm. ©2001 M. P. University of Michigan 12 Narayanan .

P. University of Michigan 13 Narayanan .FIN Template for Free Cash Flow Working capital Year 0 1 2 Revenue “Income Statement” Costs Depreciation of equipment Noncash item Profit/Loss from asset sales Noncash item Taxable income Tax Net oper proft after tax (NOPAT) Depreciation Adjustment for Profit/Loss from asset sales for non-cash Operating cash flow Change in working capital Capital Expenditure Capital items Salvage of assets Free cash flow ©2001 M.

■An “Income Statement” ■ Adjustments for non-cash items included in the “Income statement” to calculate taxes ■ Adjustments for Capital items. not profits. such as capital expenditures. outflows are negative.FIN Template for Free Cash Flow ✦ The goal of the template is to estimate cash flows. ✦ Template is made up of three parts. interest. Items are entered with the appropriate sign to avoid confusion. etc. the cost of debt. working capital. This is because. salvage. University of Michigan 14 Narayanan . ©2001 M. ✦ Sign convention: Inflows are positive. ✦ The “Income Statement” portion differs from the usual income statement because it ignores interest. P. is included in the cost of capital and including it in the cash flow would be double counting.

While the first three items occur most of the time. ■ Revenue items ■ Cost items ■ Depreciation items ■ Profit from asset sales ✦ Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e. the last one is likely to be less frequent.g. University of Michigan 15 Narayanan . and Equipment (PP&E)) ■ Working capital ©2001 M. gain from salvage).FIN Template for Free Cash Flow ✦ There are four categories of items in our “Income Statement”. P. ✦ There are two type of capital items ■ Fixed capital (also called Capital Expenditure (Cap-Ex). Plant. depreciation) and subtract all non- cash items added earlier (e. or Property.g.

P. ■ Salvage the market value property plant and equipment ■ Recover the working capital left in the project (assume full recovery) ©2001 M.FIN Template for Free Cash Flow ✦ It is important to recover both at the end of a finite-lived project. University of Michigan 16 Narayanan .

University of Michigan 17 Narayanan .Depreciation + Profit from asset sales NOPAT = Taxab le income .Capital Expenditure + Salvage of equipment .FIN Template for Free Cash Flow Taxab le income = Revenue . ©2001 M.Tax Operating cash flow = NOPAT + Depreciation .Opportunity cost of land + Salvage of land Adjustment of noncash items: Add the noncash items you sub tracted earlier and sub tract the noncash items you added earlier.Profit from asset sales Free cash flow = Operating cash flow . P.Change in working capital .Costs .

calculate a “Terminal Value”. University of Michigan 18 Narayanan . P.FIN Estimating Horizon ✦ For a finite stream. it is usually either the life of the product or the life of the equipment used to manufacture it. ✦ Since a company is assumed to have infinite life: ■ Estimate FCF on a yearly basis for about 5 − 10 years. or some such multiple ©2001 M. ■ After that. which is the ongoing value of the firm. ■ Use a Enterprise value to EBIT multiple. ✦ Terminal value is calculated one of two ways: ■ Estimate a long-term growth and use the constant growth perpetuity model.

✦ Cost of equity ■ CAPM ◆ Find β e and calculate required re. ©2001 M. University of Michigan 19 Narayanan . Under the assumption that market is efficient. this is the required re. ■ Use Gordon-growth model and find expected re. ✦ If it is not directly available. P.FIN Costs of debt and equity ✦ Cost of debt can be approximated by the yield to maturity of the debt. check the bond rating of the company and find the YTM of similar rated bonds.

P. University of Michigan 20 Narayanan .FIN Model of a Firm Value from Value from Operations investments Value generated Equal if debt Enterprise value is fairly priced FIRM Value to Equity DEBT and other EQUITY liabilities ©2001 M.

University of Michigan 21 Narayanan . P.FIN Value of equity ✦ Value of equity = Enterprise value + Value of cash and investments .Value of debt and other liabilities ©2001 M.

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