# Valuation Measurement and Value Creation

MBA1 Finance

Valuation Situations
 We encounter valuation in many situations:  Mergers & Acquisitions  Leveraged Buy-outs (LBOs & MBOs)  Sell-offs, spin-offs, divestitures  Investors buying a minority interest in company  Initial public offerings

 How do we measure value?  Why do we observe these situations? How can managers create value?

MBA1 Finance

 Discounted cash flow (DCF) approaches
 Dividend discount model (DDM)  Free cash flows to equity model (FCFE - direct approach)  Free cash flows to the firm model (FCFF- indirect approach)

 Relative valuation approaches
 P/E (capitalization of earnings)  Enterprise Value/EBITDA  Other: P/CF, P/B, P/S

 Mergers and acquisitions
 Control transaction based models (e.g. value based on acquisition premia of “similar” transactions)

MBA1 Finance

Discounted Cash Flow Valuation
 What cash flow to discount?

 Investors in stock receive dividends, or periodic cash distributions from the firm, and capital gains on re-sale of stock in future  If investor buys and holds stock forever, all they receive are dividends
 In dividend discount model (DDM), analysts forecast future dividends for a company and discount at the required equity return

= g) .g. .. for stability) .  If growth is constant (g2 = g3 = .MBA1 Finance Dividend Discount Models (DDM)  The value of equity (Ve) is the present value of the (expected) future stream of dividends Ve = Div1/(1+r) + Div1(1+g2)/(1+r)2 + Div1(1+g2)(1+g3)/(1+r)3 +... . the valuation formula reduces to: Ve = Div1/(r .g)  Some estimation problems:  firms may not (currently) pay dividends  dividend payments may be “managed” (e.

Firms 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1981 1984 1987 1990 1993 No Change Increase Decrease Source: A. Damodaran. Wiley. Investment Valuation.MBA1 Finance Dividends: The Stability Factor Factors that influence dividends:  Desire for stability  Future investment needs  Tax factors  Signaling prerogatives Dividend changes: Publicly traded U.S. 1997 .

MBA1 Finance Discounted Free Cash Flow Equity (FCFE) Approach (“Direct” Method)  Buying equity of firm is buying future stream of free cash flows (available. .Increase in WC . Exp.Princ. Payments  Problem: Calculating cash flows related to debt (interest/ principal) & other obligations is often difficult! . not just paid to common as dividends) to equity holders (FCFE)  FCFE is residual cash flows left to equity holders after:  meeting interest/principal payments  providing for capital expenditures and working capital to maintain and create new assets for growth FCFE = Net Income + Non-cash Expenses .Cap.

e. firm has significant “growth opportunities”) .MBA1 Finance Valuation: Back to First Principles  Value of the firm = value of fixed claims (debt) + value of equity  How do managers add to equity value?  By taking on projects with positive net present value (NPV)  Equity value = equity capital provided + NPV of future projects  Note: Market to book ratio (or “Tobin’s Q” ratio) >1 if market expects firm to take on positive NPV projects (i.

MBA1 Finance Valuation: First Principles  Total value of the firm = debt capital provided + equity capital provided + NPV of all future projects project for the firm = uninvested capital + present value of cash flows from all future projects for the firm  Note: This recognizes that not all capital may be currently used to invest in projects .

or  Value of “operating assets” or “Total Enterprise Value” (TEV) .MBA1 Finance Discounted Free Cash Flow to the Firm (FCFF) Approach (“Indirect” Approach)  Identify cash flows available to all stakeholders  Compute present value of cash flows  Discount the cash flows at the firm’s weighted average cost of capital (WACC)  The present value of future cash flows is referred to as:  Value of the firm’s invested capital.

MBA1 Finance The DCFF Valuation Process  Value of all the firm’s assets (or value of “the firm”) = Vfirm = TEV + the value of uninvested capital  Uninvested capital includes:  assets not required (“redundant assets”)  “excess” cash (not needed for day-to-day operations)  Value of the firm’s equity = Vequity = Vfirm .Vdebt where Vdebt is value of fixed obligations (primarily debt) .

cash (note: this assumes all cash is “excess”) .MBA1 Finance Total Enterprise Value (TEV)  For most firms.cash TEV = Vequity + Net debt where Net debt is debt . the most significant item of uninvested capital is cash Vfirm = Vequity + Vdebt = TEV + cash TEV = Vequity + Vdebt .

Increase in Working Capital  What is working capital? Non-cash current assets .non-interest bearing current liabilities (e. A/P & accrued liab.) .MBA1 Finance Measuring Free Cash Flows to the Firm (FCFF)  Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim FCFF = EBIT  (1 .g.tax rate) + Depreciation and amortization (non cash items) .Capital Expenditures .

term liabilities Working capital Permanent Capital Long-term assets Operating assets Uninvested capital Permanent Capital Permanent capital may include “current” items such as bank loans if debt is likely to remain on the books Key: Treat items as either working capital or permanent capital but not both .MBA1 Finance Working Capital vs. Permanent Financing Short-term assets Short.

Hudson’s Bay. Hudson’s Bay (\$millions.719 . FYE Jan 1999) Sales Cost of Goods Sold EBITDA Depreciation EBIT Interest Expense Income Taxes Net Income Dividends \$7. Accounting Cash Flows Income Statement.MBA1 Finance FCFF vs.719 \$ 356 \$ 169 \$ 187 \$ 97 \$ 50 \$ 40 \$ 53 Cash Flow Statement. (\$millions. FYE Jan 1999) Cash flow from operations Net Income Non-cash expenses Changes in WC Cash provided (used) by investments Additions to P.P & E Cash provided (used) by financing Additions (reductions) to debt Additions (reductions) to equity Dividends Overall Net Cash Flows \$ 40 \$ 169 (\$116) (\$719) \$ 259 \$ 356 (\$ 53) (\$ 64) Hudson’s Bay FCFF = 187 * (1.44) + 169 .075 \$6.0.116 = (\$ 561) .

MBA1 Finance FCFF Definition Issues Why is FCFF different from accounting cash flows?  Accounting cash flows include interest paid  We want to identify cash flows before they are allocated to claimholders  FCFF also appears to miss tax savings due to debt  Key: these tax savings are accounted for in WACC .

MBA1 Finance An Example  \$1 million capital required to start firm  Capital structure:  20% debt (10% pre-tax required return): \$200.000  80% equity (15% required return): \$800.000 EBIT in perpetuity (all earnings are paid as dividends)  future capital expenditures just offset depreciation  no future additional working capital investments are required  What should be the value of this firm? .000  tax rate is 40%  firm expects to generate 220.

000 Note: The dividend to equity equals 15% of equity capital .000) \$120.000 \$200.000 (80. continued  Let us look first at how the EBIT is distributed to the various claimants: EBIT Interest EBT tax EAT \$220.000*10% 40% rate Div.000 (20.MBA1 Finance An Example. to common \$120.000) \$200.

2% Pre-tax WACC = 13. continued  The firm here generates a cash flow that is just enough to deliver the returns required by the different claimants.000 . the NPV of the firms projects = 0  Another way to see this: WACC = 0.000.  i.4) + 0.2 * 10% * (1 – 0.e.8 * 15% = 13.4) = 22% EBIT / capital is also 22%. or \$1.MBA1 Finance An Example.2% / (1 – 0. the value of the firm should equal the invested capital. so NPV of future projects for this firm is zero  From “first principles”.

000  Note: we could have accounted for taxes in cash flow and not WACC  WACC without tax adjustment = 14%  Adjusted FCFF = EBIT – actual taxes = \$220.000 – 80.000 = \$140. but only once (no double counting)! .000  Value = \$140.MBA1 Finance An Example.000.14 = \$1.132 = \$1.4) = \$132.000  Key: account for tax benefit.000 * (1 – 0. continued  Now consider FCFF valuation of this firm  FCFF = EBIT * (1-t) = \$220.000.000  Value = 132.000 / 0.000 / 0.

MBA1 Finance Two Stage FCFF Valuation  Impossible to forecast cash flow indefinitely into the future with accuracy  Typical solution: break future into “stages”  Stage 1 : firm experiences high growth Sources of extraordinary growth: product segmentation low cost producer Period of extraordinary growth: based on competitive analysis / industry analysis  Stage 2: firm experiences stable growth .

+ FCFFt (1+kc)t . capital expenditures.MBA1 Finance Stage 1 Valuation  Forecast annual FCFF as far as firm expects to experience extraordinary growth  generally sales driven forecasts based on historical growth rates or analyst forecasts  EBIT. working capital given as a percentage of sales  Discount FCFF at the firm’s WACC (kc) VALUE1 = FCFF1 1+kc + FCFF2 (1+kc)2 + . . .

g .MBA1 Finance Stage 2 Valuation  Start with last FCFF in Stage 1  Assume that cash flow will grow at constant rate in perpetuity  Initial FCFF of Stage 2 may need adjustment if last cash flow of Stage 1 is “unusual” spike in sales or other items capital expenditures should be close to depreciation  Value 1 year before Stage 2 begins = FCFFt * (1+g) Kc .

MBA1 Finance Stage 2 Valuation Present value of Stage 2 cash flows (Terminal Value or TV): TV = FCFFt * (1+g) Kc .g x 1 (1+kc)t Key issue in implementation: Terminal growth (g)  rate of “stable” growth in the economy (real rate of return ~1-2% plus inflation)  TEV = VALUEt + TV .

MBA1 Finance Discounted FCFF Example Assumptions Year 1 2 3 EBIT 40 50 60 Dep 4 5 6 Cap Ex 6 7 8 W/C Change 2 3 4 Tax rate = 40% kc = 10% Vdebt = value of debt = \$100 Growth (g) of FCFFs beyond year 3 = 3% .

0.0.7 .4 = 30 .8 .2 = 20 Year 2 FCFF = 50*(1 .4) + 6 .0.4) + 5 .3 = 25 Year 3 FCFF = 60*(1 .Increase in WC Year 1 FCFF = 40*(1 .CapEx .MBA1 Finance Discounted FCFF Example (cont’d) FCFF = EBIT*(1-t) + Dep .6 .4) + 4 .

MBA1 Finance Discounted FCFF Example (cont’d) 20 | | t=0 1 P = Vfirm 25 | 2 30 | 3 30*(1+g) 30*(1+g)2 | 4 | 5 30*(1+g)/(kc-g) TEV = 20/(1+kc) + 25/(1+kc)2 + 30/(1+kc)3 + [30*(1+g)/(kc-g)]/(1+kc)3 .

0 .10 .7 = 393.100.MBA1 Finance Discounted FCFF Example (cont’d) TEV = 20/(1.10)3 = 18.0 TEV + Cash (unused assets) = Vfirm ==> Vfirm = TEV =393.0 Vfirm = Vdebt + Vequity ==> Vequity = Vfirm .5 + 331.0.2 + 20.Vdebt Vequity = 393.10)3 + [30*(1.10)2 + 30/(1.0 .03)]/(1.03)/(0.10) + 25/(1.0 = 293.7 + 22.

MBA1 Finance Relative Valuation: Capitalization of Earnings  Compute the ratio of stock price to forecasted earnings for “comparable” firms determine an appropriate “P/E multiple”  If EPS1 is the expected earnings for firm we are valuing. P = “P/E multiple” x EPS1 . then the price of the firm (P) should be such that: P / EPS1 = “P/E multiple”  Rearranging.

they should trade at same PE  Implied price of ABC = 25 * 1.5  Note: Analyst prefer “forward looking” ratios but “backward looking” ratios are more readily available  Key: Make comparisons “apples with apples” .80 = 25  If ABC and XYZ are comparable.50  Comparable company: XYZ corporation  Next year’s forecasted EPS = \$0.Example  ABC Company:  Next year’s forecasted EPS = \$1.80  Current share price = \$20  PE ratio = 20 / 0.MBA1 Finance Relative Valuation .50 = \$37.

assume payout ratio is PO%  D1 = PO * EPS1 P = D1 ke .g P EPS1 = PO ke .g P = PO *EPS1 ke .g  P/E ratios capture the inherent growth prospects of the firm and the risks embedded in discount rate .MBA1 Finance P/E Ratios and the DDM  Recall the constant growth DDM model.

the “P/E multiple” relates to growth and risk of underlying cash flows for firm  Key: identification of “comparable” firms similar industry. risk. leverage industry average .MBA1 Finance P/E Ratio Based Valuation  Fundamentally. growth prospects.

interest.cash  EBITDA: earnings before taxes. then the TEV for the firm should be such that: TEV / EBITDA1 = “EV/EBITDA multiple” .MBA1 Finance TEV / EBITDA Approach  TEV = MVequity + MVdebt . depreciation & amortization  Compute the ratio of TEV to forecasted EBITDA for “comparable” firms determine an appropriate “TEV/EBITDA multiple”  If EBITDA1 is the expected earnings for the firm we are valuing.

MVdebt + cash  Multiples again determined from “comparable” firms  similar issues as in the application of P/E multiples  leverage less important concern .MBA1 Finance TEV / EBITDA Approach  Rearranging: TEV = “EV/EBITDA multiple” x EBITDA1  Next solve for equity value using: MVequity = TEV .

5 * 50 = 375 million  Value of equity = 375 + 0 – 50 = \$325 million  Price per share = 325/20 = \$16.MBA1 Finance EV/EBITDA Valuation . value of debt = \$50 million. cash = \$0  Comparable company: XYZ corporation  Next year’s forecasted EBITDA = \$40 million  Current share price = \$20. cash = \$0  EV = 20* 10 + 100 – 0 = \$300 million  EV/EBITDA ratio = 300 / 40 = 7. value of debt = \$100 million. they should trade at same EV/EBITDA  Implied EV for ABC = 7.5  If ABC and XYZ are comparable.25 .Example  ABC Company:  Next year’s forecasted EBITDA = \$50 million  Shares outstanding = 20 million. shares outstanding = 10 million.

for example. price to earnings? .MBA1 Finance Other Multiple Based Approaches  Other multiples:  Price to Cash Flow: P = “P/CF multiple” X CF1  Price to Revenue: P = “P/Rev multiple” X REV1  Multiple again determined from “comparable” firms  Why would you consider price to revenue over.

etc. EBITDA.MBA1 Finance Merger Methods  Comparable transactions:  Identify recent transactions that are “similar”  Ratio-based valuation Look at ratios to price paid in transaction to various target financials (earnings. sales.) Ratio should be similar in this transaction  Premium paid analysis Look at premiums in recent merger transactions (price paid to recent stock price) Premium should be similar in this transaction .

“synergistic gains”   Information .“undervalued assets”   Agency problems .“entrenched management”   Market power .MBA1 Finance Aside: Why Merge or Acquire Another Firm?  Efficiency .“corporate hubris” X .

MBA1 Finance Aside: Most Mergers “Fail”!  Post-merger “success” defined as earnings on invested funds > cost of capital  McKinsey & Co. or projected synergies not realized . estimates 61% fail and only 23% succeed because:  Inadequate due diligence by acquirer  No compelling strategic rationale  Overpay.

Damodaran. The more quantitative a model. inputs are subjective values will change as new information is revealed a valuation by necessity involves many assumptions the quality of a valuation will be directly proportional to the time spent in collecting the data and in understanding the firm being valued the presumption should be that the market is correct and that it is up to the analyst to prove their valuation offers a better estimate 2. Since valuation models are quantitative. A good valuation provides a precise estimate of value 4.MBA1 Finance Some Valuation “Myths” 1. A well-researched. “Investment Valuation: Tools and Techniques for Determining The Value of Any Asset” . The market is generally wrong • Source: A. valuation is objective • • • • models are quantitative. well-done model is timeless 3. the better the valuation 5.

.MBA1 Finance Value Creation Summary  Firms create value by earning a return on invested capital above the cost of capital  The more firms invest at returns above the cost of capital the more value is created  Firms should select strategies that maximize the present value of expected cash flows  The market value of shares is the intrinsic value based on market expectations of future performance (but expectations may not be “unbiased”)  Shareholder returns depend primarily on changes in expectations more than actual firm performance Source: “Valuation: Measuring and Managing the Value of Companies”. McKinsey & Co.

any synergies. etc. for capital raising: timing.)?  what are the key risks?  Valuation analysis  several approaches + sensitivities (tied to risks)  Address case specific issues  e.MBA1 Finance Valuation Cases  Size-up the firm being valued  do projections seem realistic (look at past growth rates. for M&A: identification of fit (size-up bidder).  e. deal structure.g. structuring the transaction. bidding strategy. etc. .g. past ratios to sales. etc.

MBA1 Finance Applications  We will apply valuation principles in variety of settings:  Private sales Graphite Mining. Huaneng Power . Oxford Learning Centres  Mergers & Acquisitions Oxford Learning Centres. Empire Company  Capital Raising Tremblay. Eaton’s.

Reilly and Schweihs.MBA1 Finance Valuation References Copeland. Valuation: Measuring and Managing the Value of Companies(Wiley) Damodaran.wharton. 1997. Investment Valuation (Wiley).upenn. The Quest for Value (Harper Collins) Harvard Business School Notes: An Introduction to Cash Flow Valuation Methods (9-295-155) A Note on Valuation in Private Settings (9-297-050) Note on Adjusted Present Value (9-293-092) . http://www. Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Irwin) Benninga and Sarig. Koller and Murrin.html Stewart.stern.edu/~adamodar/ Pratt.1996. 1991. 1996.edu/~benninga/home.1994.nyu. Corporate Finance: A Valuation Approach (McGraw Hill) http://finance.

473 065.0 :065.3.3.1          9  !'172    .1.

.   %' .

 .  .

 .   .

 .    .

.  (.

  .  .

1.3.1 %' .3.473 065.0 :065.

   .

    .

     .

   (.

88098 '172 '172 %' '172 '/0-9 '06:9 '06:9 '172 '/0-9 '06:9      .            %' .8 :3:80/.

90 !.3.9441894.425..7338 147 ..3..65.-0 1728 /0907230.955:  425:90907..656.557457.0 %3.7.57.890/0.0941470.3.3..3..7.

04190172 ! 84:/-08:.:3  9039057.9.73381471720.90/0.70.2:950  1!\$ 890050..9 !.

!\$  !.

33  ! !.77.2:950  #0.

2:950 !\$ .

65.0 %3..3..3.3..

3  090.943  090.473  425..3.47547.890/!\$   :770398..7 81470.-0.7057.890/!\$   425.94 .0  !7.425. .7 81470.7.

/0.78438 .0.948.7/443 7.-0 9084:/97.3/.9 8.    1..948-:9 -..70..70247070.89570107 147.425.-0  0.20!  250/57.425.55089.7/443 7..041      4903.7./.5508 ..

.948!    !  !\$ !  0  ! !  !\$ 0  ! !\$ ! 0   !..3974924/0.4:9 7.3.  #0.90.3.4389.51.0 #%.88:205.6:.

984190 172.3/9078802-0//0/3/8..90 .4:397.948.7.59:7090307039749574850.

 90 !.65  :3/.3..3..2039.3.0 #%.:1.6.

2:950 70..0 3/:897.3/78 41:3/073..94341 .73/:897 749574850.07.-0 1728 82.07.90894749 .98 78 0.0 .425.8148147172  0/0391..7.

3.425.7338-014709.0  %''06:9 '/0-9 .3.-0 1728 /0907230..90 %'.3.0 ''7796.943  425:90907.8  %0.890/%147 .943  ..557457.9441%'941470.7.2479..08 3907089 /0570.

.%2:950  1% 890050.:3 90390%'1479017284:/-08:.9.7338147901720.90/0.70 .9 %'.

%  '.

%2:950 .

77.33 %' '.0 ''7796.3.0  #0.3.

:0:83 '06:9 %' '/0-9 ...7.3/0907230/1742 ..-0 1728  82.%2:950 %  0984.55.94341!.8390.788:08.014706:9.8  :9508..425.

073 .008825479.39.2:9508  0.07.43.

0 '.3.3..65.3.

7057.3  090.3/3 243.943  090.:0 41/0-9 243..0 8.890/% 243  \$.3/3 243.:041/0-9 243 .7.47547...7 81470.8  '      243  '.8  425.425..890/% 243  :770398. .7084:989..3..-0.7084:989.7 81470.473  425.

94 .%7.

/0.3/.7.    1.20'.-0 9084:/97.9 8.425.70.

70.%  250/'147   243  '.05078.:04106:9    243  !7.

   .

73.3.:17796.9 3.84 ! !.3.094.0:  9072:9508  !7.0 ".

2:950   !7.03:0 ! !.094#0.

#0.7338 .07 147 0.425.250 57.09470.7.0940.-0 1728  4:/4:..2:950 #'  :950.03:04.3/0907230/1742 .438/0757.

7338 % 8.7./9470.0392070797.08 09.3.739897.8 0...70913.74:8 9..94 -.-097..943 44.03997.57.9484:/-082.9438  /039170./..0 !702:284:/-082.88 44.943  !702:25..3.039894.70 82.0 5.3.38.:..80/.38.9.38.05./397. #.9438 57.739897.38.9489457.95702:28370.94389.61:  425.38.94394.97.943 ..38.7  #.0 99 .3..

0 :1 96908956..:0/.03.02039 !  .943 :3/07.. 830789.574-028 039703.38 !  31472.994  11.3.47547.3.90:-78  .7095407 .0/2.88098 !  03.3.

.  .80.7.9081.0890/1:3/8.943..90/:0/03.6:707  4.0  .0/ .42503897..0 :1 6:.48941.3. 475740.075.3/43 8:.0-..00/-0.59.90/83070834970./06:.733843 3.90.3.088 /0130/.3  !489 20707 8:..380 4 0892.. 99:.:80  3.

4.9..9.0907.65 ..7.0.743 W \$4:7.:..941.0.0/ .943574.9.:.9041.:  \$3.0 W W W W 24/08.9.:.943%448.570.0 .3/ 9.082.7098.0 .:..36:081470907233 %0'.0 35:98.08893.:08.3/3:3/0789.8994574.943-0/70.399.:..0892039'..9.9390/.:0/ 905708:2594384:/-09.9438 4-0.7.3.943411078.3  3.943-30.3.:0  %024706:.0 ..998:59490.0/ 0 /43024/08920088  44/..90  0 7080.30.9902.3.3/%0.70980307.9490 920850393....:04138809 . -099070892..943  %02.708:-0.399.83031472...706:.24/0 90-0990790.3.0 &64.88:259438 906:.399.:.:.0.94324/08..24/.9574547943.:.706:.9.3.4770.40.3/390 172-03.800892.943870./08.9.

.902470..92.709050.70..90089.3/.8148  %02.1725071472.0 \$4:7.9438411:9:705071472..9  728.-4...0 '.089..3.:041425.39.90/.743.9430.:.:08.709:73433...:0-.59.9:.3..3.349-0 :3-.380 4 .9.65&44.8:73.94382..090.3.80/  \$.59.80/ 432..090.70.59.733.90/  72884:/800.0890/ .:041050.308 .3.0 -:9 050.943824709.9.704/07709:738/0503/572..  %0247017283.9.:0418.3083 050.390'.9709:738.48941.48941 .9897..709.0 .70889039738.:0-0.3.-4.90.2090 5708039.

943.95.::  \$0 :590172-03.88:08  0  147 /0391.:.   .:0/  /45740.70900788  '.88  80.0 .08 09.80850..83923 /0.9:70 09.07. 44.897.90 897:.943 09.3.59.38.3..948948.3..9.9434119 80 :5-//07  ..897:.908 5.65.9:7390 97.1..08 80389.3.3830708 -//3897.89749 7...908 90/94788  //7088.7. .5574.9438800270.  0  147.89..

#.:..943 8 :.55.6:89438  147/0.65:  0.733039708 2570425.70941809938  !7.3.303!407 .908.08 7.59.943573.3.83 %702-.0 7730..59033  147/0.733039708  07078 .5083. ..3  ..

0892039'.3/:773  '.:.943 0 995.308 0 .0 .:041 425.3.9430.3/ 407.:.390'.8:73.3  3.24/.3.65%950: 450.3/.3.7.3..

.

 89073 3: 0/:.

/.7.=.24/.

:3..3/557.903.. .3/\$.3.0'.08  '.88.9435574.7.308 73 0333. !7.:.3/\$.8.41 4800/425.7  47547.99 #0.:83088%03.  995.

.

0 .7943 :5033 0/:.13.3.

=-0333.

94394.79  %0":089147'..:0    .90\$09938    49043/:890/!708039'.:0 .:.7/:83088\$.420 92 \$90.943094/8    49043'.444908 33974/:.7507438 .9433!7.7.84'..:.