# Chapter 5: Valuation. Albert Banal-Estanol

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1 Corporate Finance Chapter 5: Valuation

2 Company valuation Valuation methods: Based on comparables or multiples Discounting cash flows: Weighted average cost of capital (WACC) Adjusted present value Flow to equity Real Options (we won t see it) The valuation of a firm: Ideko

3 Valuation based on comparables The method of comparables: Does not discount cash flows of the company Comparison with other companies generating "similar flows: E.g. new firm equal to a publicly traded one should have same value Implicitly uses the idea of absence of arbitrage Key: how to adjust for differences in, for example, scale? Answer: use "multiples (ratios on a measure of scale) of similar firms: (as when we use price per sq m of similar flats to find the price of a flat) Enterprise value (equity + net debt) on profits, sales,...(ev/profits, EV/sales, ) Price to Earnings-per-share Ratio (PER) (next slide) Price to book value For firm with unknown values, say bertus. inc, use ratio of similar il firm, apple : EVbertus = Profitsbertus * (EV/profits)Apple Pbertus = EPSbertus * (PER)Apple

4 Price to Earnings Ratio (PER, P/E) Price to earnings ratio: Share price divided by earnings per share (P/EPS), where EPS is defined as EPS = net income / number of shares outstanding Firm s share price should be (EPS of the firm) x (PER of similar companies) Based on the idea that earnings are scalable Calculating the PER: Use earnings historical, in the last 12 months (trailing P/E)... expected, in the next 12 months (forward P/E) (best) Assuming constant growth of dividends: P Div / EPS Dividend Payout Rate EPS r g r g Forward P/E 1 E E Industries with high growth and high payout ratios have high PER

5 Multiples of the enterprise value Multiples l of the enterprise value: Value divided by earnings-before-interest-payments measure For example EBIT or EBITDA Takes into account the value of debt (good for comparisons) Firm value: (EBIT of the firm) x (V/EBIT of similar companies) Assuming constant growth of free cash flows: V FCF / EBITDA EBITDA r g wacc FCF High multiple for companies with high growth

6

7 Limitations How similar il the similar il companies are? Many differences between the minimum and maximum E.g. how to adjust for differences in expected growth? And for accounting differences in different countries? Valuing using comparables... We only know the relative value to a group of companies We don t know whether industry is over/undervalued High tech bubble couldn t have been detected with this method

8 Valuation using cash flows

9 Methods discounting cash flows Methods covered: Weighted average cost of capital (WACC) Adjusted present value Flow to equity In the appendix: Capital cash flows (for equity and debt holders)

10 Remember the new project of Avco: RFX? Technology expected obsolete after four years Expected sales of \$60 million per year over the next four years Manufacturing costs and operating expenses expected to be \$25 million and \$9 million, respectively, per year Upfront R&D and marketing expenses of \$6.67 million \$24 million in equipment (straight line depreciation over four years) Avco pays a corporate tax rate of 40% Here, review the investment decision: Make precise definition of free cash flows Value and net present value Financing i decision: i sources and uses of funds

11 Free cash flows, a precise definition Free cash flows: (after-tax) tax) flows generated from operations, without taking into account the debt structure, or in other words, the hypothetical cash flows to equity holders if there was no debt Unlevered net income can also be computed by adding back the after-tax interest to the Net income

12 Assumptions Project has average risk Project s cost of capital based on the risk of the firm D/E and D/V (where D is net debt) constant: Risk of equity and debt (and WACC) do not change Firm will need to adjust continuously its leverage The corporate tax is the only imperfection E.g. financial distress or agency costs not significant

13 Valuation using the weighted average cost of capital Remember, the (after-tax) tax) cost of capital is: r wacc E D r E r D (1 T C ) E D E D As we saw earlier,... Taking into account taxes, cost of capital is lower Interest tax deductible and cost of capital with D It can be shown that the (levered) value of the project is V L o C1 C2 C3 CT r (1 r ) (1 r ) (1 r ) = 3 wacc wacc wacc where Ct is the free cash flow r U r A wacc T

14 Avco s balance sheet (at market values) Net debt: D=320m - 20m=300m Enterprise value: Equity + Net Debt = Equity + Gross Debt - Cash, or market value of non-cash assets (here, 600 m)

15 Valuation using the weighted average cost of capital Avco s WACC: r wacc (10%) (6%)(1 0.40) 6.8% The present value (incorporating the tax advantage): V L o ( ) 18 ( ) 18 ( ) = m NPV= 61.25m 28m = 33.25m > 0

16 Summary: WACC method for investment decisions Steps: Determine free cash flows of the investment Compute (after-tax) tax) WACC Compute value of the investment, including the tax benefit of the leverage, by discounting the free cash flow of the investment using the WACC Compute the NPV (=added shareholder value) by subtracting the initial investment to the investment value If positive, go ahead! If negative, don t!

17 Constant D/V ratios Balance sheet without t the project: What s the effect of the project in the asset value? What do we have to do to keep a D/V constant? What are the sources and uses of funds?

18 Implementing a constant D/V ratio Target D / E =1 or D / V = ½ Finance new investments with (net) debt = 50% of their market value Increased market value: 61.25, hence need to increase net debt by (e.g. eliminate cash holdings (20m) and borrow more (10.625)) Uses of funds: pay investment (28m) and pay the rest to shareholders ( = \$2.625m) together with the increased equity value (30.625m), in total (= NPV)

19 Debt capacity Definition: Amount of net debt D t to maintain constant ratio L L V t D t d V d = t or D t where d is "target" ratio and V L t is leveraged value at time t (remember that V L 0 is continuation value, not NPV!) Notice that levered value will change over time, therefore the amount of debt should also change!!! Alternative: maintain non-constant target debt level

20 Implementing a constant D/V ratio over time We need to reduce debt outstanding every year: negative net borrowing! Leveraged g value at any t can also be computed backwards, recursively: V L t FCFt 1 1 r V wacc L t1

21 Adjusted present value method Find unlevered value (Vu) by discount free cash flows at ru: E D r U re rd Pretax WACC E D E D It can be shown that it is valid to use this equation even if there are taxes as long as company adjusts to a target debt level Adjust for imperfections (in this example, only taxes) L U V APV V PV(Interest Tax Shield) PV (Financial i Distress, Agency, and dissuance Costs)

22 Computing the tax shields Interest Tax shield paid Db Debt interest paid t t t-1 * r D * corporate tax If we keep a constant leverage, the tax shield has a similar risk as the project discount with the unlevered WACC t

23 Adjusted present value method, RFX Unlevered weighted average cost of capital: r % % 8.0% U Unlevered value and tax shields: U V \$59.62 million PV (interest tax shield) \$1.63 million And therefore L U V V PV ( Int tax shield) m and NPV m

24 Summary: APV method for investment decisions Steps: Determine free cash flows of the investment Compute (pre-tax) WACC Compute value of investment, adding the unlevered value and value of imperfections (e.g. tax shield), both of them computed using the pre-tax WACC Compute the net present value by subtracting the initial iti investment t to the present value If positive, go ahead! If negative, don t!

25 Advantages of this method Easier to apply than the WACC if the leverage ratio is not constant Explicitly measures the value of the imperfections and therefore can identify their contributions

26 Flow to equity method Compute cash flow available for equity holders (FCFE), taking into account... The interest paid on debt Changes in net debt amounts: D t -D t-1 (FCFEs must match the sum of dividends and repurchases) See next slide! Discount using the cost of equity capital to find the added value to shareholders (=NPV) NPV ( FCFE) 2.62 \$33.25 million Dividend at time 0 Equity value at time 0

27

28 Alternative way to find FCFE From FCF to FCFE: FCFE FCF (1 c ) (Interest Payments) (Net Borrowing)

29 Appendix: method based on the capital cash flows

30 Capital cash flow method Find the capital cash flows, defined as cash flows available for all the security holders (debt and equity), which are equal to the sum of the cash flows to equity holders and the cash flows to debt holders See next slide Discount them at the pre-tax WACC (8%): V L o (1 0.08) 08) (1 0.08) 08) (1 0.08) 08) = m Find the NPV, subtracting the initial investment

31 Capital cash flows (CCF) Cash flows to debt holders (FCFD) Net borrowing Interest expense Cash flow from debt Cash flows to equity holders (FCFE) Capital cash flows (CCF) = FCFD + FCFE

32 Incremental Equity and Debt values From FCFD, we can compute the debt value: D (1 0.06) (1 0.06) 8.93 (1 0.06) = m From FCFE, we can compute the equity value: E o (1 0.1) 9.52 (1 0.1) 9.27 (1 0.1) = And therefore, the enterprise value V o D o E o = m m

33 Valuing Ideko: A financial modeling example

34 Why do we need to value companies? For buy/sell transactions To be able to compare value with market share price For IPOs For estates and wills For compensation systems based in value creation To identify and rank value drivers Strategic decisions on continuation of business Strategic planning

35 Valuing Ideko Ideko... Designs and produces sports eyewear Its founder and owner wants to sell the company Is unlisted What value do we assign to Ideko? Possible to buy at the end of fiscal year (2005) We would implement operational and financial improvements It would sold five years later The company has a book value of \$ 87m PKK could buy it for \$ 150m. Is it a good idea?

36 Steps Quick look at the resulting comparables Business plan: Improvement in operations Improvement in working capital management Leveraging up: repay existing debt and issue new debt Sources and uses of funds: With new debt issued, how much do we need to pay? (*) Find the value of the equity: Use comparables to find the resale value in 2010 Use adjusted present value method to find value in 2005 Find the equity value, subtracting the debt value, and compare it with price that we need to pay for that equity (*)

37 Income statement and balance sheet

38 Comparables, rough first approximation Assuming a price of \$150m for all the equity: EV= Equity + Net Debt = Equity + Debt Cash = 150m + 4.5m 6.5m =148m (estimating \$6.5m as cash holding in excess of working capital needs)

39 Business plan: improvement in operations Sales: We expect that... The market, as a whole, will grow at 5% annually (current size: 10m units) Reducing administrative costs and redirecting resources to sales and marketing, market share grows from 10 to 15% in five years Sales can be met with existing production line If the volume exceeds 50% we ll require expansion of production capacity Price: We expect that... The average selling price to grow by 2% per year The cost of raw materials to increase 1% per year Labour costs to grow by 4% per year

40 The business plan in numbers

41 Working capital management Reduction of the credit to customers (and inventory): Accounts receivables days required* annual sales 365 days

42

43 Increasing leverage We plan to increase leverage This debt will have an interest rate of 6.8% In addition the company will need more funds in 2008 and 2009 because of the expansion Interest in Year t Interest Rate Ending Balance in Year ( t 1)

44 Buying Ideko Uses of funds to purchase: Price (\$150m) and payment of existing debt (\$ 4.5m) In addition there will be \$ 5m in transaction costs Sources of Funds: New debt (\$100m) and excess cash of Ideko (\$6.5m) The contribution required is \$ 53m

45 Forecasting earnings (pro forma) Sales: Sales Market Size Market Share Average Sales Price Raw materials (same for labour costs): Raw Materials Market Size Market Share Raw Materials per Unit Sales & marketing costs (same for administrative): Sales and Marketing Sales (Sales and Marketing % of Sales) Income tax: Income Tax Pretax Income Tax Rate

46

47 Forecasting free cash flows After-Tax Interest Expense (1 Tax Rate) (Interest on Debt Interest on Excess Cash) (here, excess cash = 0 (all paid out to the buyer)) Net Borrowing in Year t Net Debt in Year t Net Debt in Year ( t 1)

48 Estimating the cost of capital Based on the CAPM of comparable firms: (Ideko is unlisted) RS rf s s( Rmkt rf) s Excess return of stock s Excess return of market portfolio

49 Unlevering the betas We should compute the unlevered beta: (based on the capital structure) Equity Value Net Debt Value U Enterprise Value E Enterprise Value D

50 Ideko s unlevered cost of capital Since Ideko products... Are not as luxurious as those of Oakley, its sales should vary less with the economic cycle They are not prescription products as Luxottica s They are fashion rather than sporty... the beta should be around 1.20 (cost of capital closer to Oakley s than Nike s or Luxottica s) Hence r r ( E[ R ] r ) 4% 1.20(5%) U f U mkt f 10%

51 Multiple method to estimate continuation value For example using the EBITDA.. Continuation Enterprise Value at Forecast Horizon EBITDA at Horizon EBITDA Multiple at Horizon

52 The alternative: discounting cash flows! Continuation value in year T: Enterprise Value in Year T L FCFT 1 VT r g wacc If sales grow at a nominal rate g and if the proportion of operating expenditures is constant, t income will also grow at a rate g

53 Adjusted present value method Final value in 2010 and free cash flows Method: compute recursively: Calculate the unlevered value U U FCF t V t Vt 1 1 ru Calculate the value of the tax shields Interest Tax Shield T Tt 1 1 r s s t t 1 D Discount with r D because debt is predetermined

54 Estimating the equity value Given that the initial equity cost of the purchase is \$53m, the purchase is attractive: ti \$113m \$53m = \$60m

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