ENTERPRISE VALUATION. Degree in Business Administration CORPORATE FINANCE. Szabolcs Sebestyén

Transcription

1 ENTERPRISE VALUATION Szabolcs Sebestyén Degree in Business Administration CORPORATE FINANCE Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 1 / 36

2 Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 2 / 36

3 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 3 / 36

4 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 4 / 36

5 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF The Discounted Cash-Flow Method The value of a firm lies in its potential to create wealth That is, its value does not depend on its current situation nor on its past, but on its capacity to generate future cash flows The discounted cash-flow method (DCF) determines the value of the firm from a dynamic perspective rather than from a static one Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 5 / 36

6 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Free Cash Flow to the Firm (1) How to find cash flows for firm value calculation? The objective is to determine the free cash flow to the firm (FCFF): the amount of cash that a firm can pay out to investors after paying for all investments necessary for growth The cash inflow is The cash outflow is Hence, FCFF is given by EBIT (1 t c ) + Depreciation Capex + Change in Non-Cash NWC FCFF = EBIT (1 t c ) + Depreciation Capex Change in Non-Cash NWC Free cash flows can be negative for rapidly growing businesses Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 6 / 36

7 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Free Cash Flow to the Firm (2) An alternative way to calculate FCFF adds up the cash flows to all claim holders, FCFF = FCF to Equity + Interest Expense (1 t c ) + + Prinicipal Repayments New Debt Issues+ + Preferred Dividends Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 7 / 36

8 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 8 / 36

9 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Enterprise Value Given the free cash flows, we can compute the enterprise value (EV) as FCFF t EV = (1 + R WACC ) t n t=1 where n is the valuation horizon The firm value (FV) is FV = EV + Market Value of Non-Operating Assets Non-operating assets are assets that are not essential to the ongoing operations of a business, but may still generate income or provide a return on investment Cash and marketable securities Holdings in other firms Other non-operating assets (e.g., unused land) Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 9 / 36

10 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Terminal Value (1) The valuation horizon, n, is often arbitrarily chosen Up to n the cash flows are explicitly estimated, and this period is typically characterised by extraordinary growth It is reasonable to assume further operation of the firm after the valuation horizon but at a stable growth rate The terminal value is generally calculated as the PV of a perpetuity, TV n = FCFF n+1 R WACC g n where g n is the constant growth rate after the valuation horizon, n Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 10 / 36

11 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Terminal Value (2) The FCFF used in the perpetuity formula should correspond to a steady state where the value of both fixed assets and net working capital are growing at the rate g n Formally, FCFF n+1 = EBIT n (1 t c ) (1 + g n ) Invested Capital n+1 (boy) g n where boy stands for beginning of year, and Invested Capital n+1 (boy) = Net Capex n+1 (boy) + + Non-Cash NWC n+1 (boy) When the growth rate from year n 1 to n is g n then FCFF n+1 = FCFF n (1 + g n ) When g n = 0 then FCFF n+1 = FCFF n = EBIT n (1 t c ) Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 11 / 36

12 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Growth Rate and ROIC The growth rate can be estimated as g n = ROIC n (1 Payout Ratio n ) = ROIC n Plowback Ratio n where the payout ratio is the ratio of dividends to EPS The return on invested capital (ROIC) is defined as ROIC n = EBIT n (1 t c ) Invested Capital n (boy) where Invested capital = B + S Book Value of Non-Operating Assets ROIC can also be calculated in terms of sales margin and the turnover of invested capital as ROIC n = EBIT n (1 t c ) Sales n Sales n Invested Capital n (boy) Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 12 / 36

13 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Enterprise Value and Equity Value Enterprise Value Reloaded and Equity Value Taking into account terminal value, EV becomes EV = n t=1 where TV n = FCFF n+1 / (R WACC g n ) The equity value of a firm is Alternatively, FCFF t (1 + R WACC ) t + TV n (1 + R WACC ) n Equity Value = Firm Value Market Value of Debt Equity Value = EV + Market Value of Non-Operating Assets Market Value of Debt Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 13 / 36

14 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Free Cash Flow to Equity Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 14 / 36

15 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Free Cash Flow to Equity An Alternative: Free Cash Flow to Equity Alternative methods for calculating cash flows rely on cash flows available to shareholders after paying taxes, debt service and capex Dividends Free Cash Flow to Equity (FCFE) FCFE is defined as FCFE = Net Income + Depreciation Capex Change in Non-Cash NWC+ + New Debt Issued Debt Repayments For both alternatives the relevant discount rate is the cost of equity, and the PV of cash flows is the equity value Both lead to the same conclusion if Dividends = FCFE; or Dividends < FCFE, and the excess cash is invested in zero-npv projects Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 15 / 36

16 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Free Cash Flow to Equity Advantages of FCFF FCFF is the most widely used methodology for DCF calculations as FCFF is an unlevered cash flow because it is prior to debt payments it is consistent with a constant target debt-equity ratio, thereby with WACC calculation The difference between FCFF and FCFE can be understood, assuming perpetual cash flows, from Firm Value = t=1 FCFF t (1 + R WACC ) t Equity Value = Firm Value Market Value of Debt = = t=1 FCFE t (1 + R S ) t Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 16 / 36

17 Measuring Performance: Economic Value Added Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 17 / 36

18 Measuring Performance: Economic Value Added Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 18 / 36

19 Measuring Performance: Economic Value Added Capital budgeting is like looking through the windshield while driving a car. You need to know what lies farther down the road to calculate a net present value. Performance measurement is like looking into the rearview mirror. You find out where you have been. Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 19 / 36

20 Measuring Performance: Economic Value Added Example: Economic Value Added (1) Example Many years ago, Henry Bodenheimer started Bodie s Blimps, one of the largest high-speed blimp manufacturers. Because growth was so rapid, Henry put most of his effort into capital budgeting. He forecast cash flows for various projects and discounted them at the cost of capital appropriate to the beta of the blimp business. However, these projects have grown rapidly, in some cases becoming whole divisions. He now needs to evaluate the performance of these divisions to reward his division managers. How does he perform the appropriate analysis? Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 20 / 36

21 Measuring Performance: Economic Value Added Example: Economic Value Added (2) Example (cont d) Henry first measured the performance of his various divisions by return on invested capital (ROIC). For example, if a division had after-tax earnings of e 1,000 and invested capital of e 10,000, the ROIC would be e1, 000 ROIC = e10, 000 = 10% He calculated the ROIC for each division, paying a bonus to each of his division managers based on the size that division s ROIC. Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 21 / 36

22 Measuring Performance: Economic Value Added Example: Economic Value Added (3) Example (cont d) While ROIC was generally effective in motivating his managers, there were a number of situations where it appeared that ROA was counterproductive. Sharon Smith s division had after-tax earnings of e 2,000,000 on an invested capital base of e 2,000,000 (ROIC= 100%), and the R WACC of the division was 20%. Henry suggested a project to Smith that would earn e 1,000,000 per year on an investment of e 2,000,000. This was clearly an attractive project with an ROIC= 50%. However, Smith did everything she could to kill the project. As Henry later figured out, Smith was rational to do so. If the project were accepted, the division s ROIC would become ROIC = e2, 000, e1, 000, 000 e2, 000, e2, 000, 000 = 75%, leading to lower division ROIC and lower bonus for Smith. Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 22 / 36

23 Measuring Performance: Economic Value Added Example: Economic Value Added (4) Example (cont d) Henry was later exposed to the economic value added (EVA). a : EVA n = (ROIC n R WACC ) Invested Capital n (boy) Without the new project, the EVA of Smith s division would be EVA = (100% 20%) e2, 000, 000 = e1, 600, 000 while with the new project included, the EVA would jump to EVA = (75% 20%) e4, 000, 000 = e2, 200, 000 If Smith s bonus were based on EVA, she would now have an incentive to accept, not reject, the project. a Stern Stewart & Company have a copyright on economic value added and EVA. Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 23 / 36

24 Measuring Performance: Economic Value Added Some Remarks on EVA EVA differs substantially from ROIC ROIC is a percentage number, while EVA is a monetary value EVA correctly incorporates the fact that a high return on a large division may be better than a very high return on a smaller division (c.f., scaling problem in capital budgeting) Since ROIC Invested Capital = After-Tax Earnings, the EVA formula can be rewritten as EVA n = After-Tax Earnings n R WACC Invested Capital n (boy) Thus EVA can be viewed as earnings after capital costs If the cost of capital is a necessary input to capital budgeting, it should also be a necessary input to performance measurement Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 24 / 36

25 Measuring Performance: Economic Value Added Advantages of EVA EVA can increase investment for firms that are currently underinvesting However, many managers are so focused on on increasing earnings that they take on projects for which profits do not justify the capital outlays They are either unaware of capital costs or they choose to ignore them By using EVA, it is difficult to ignore capital costs It is stark It is either positive or negative EVA analysis makes liquidation easier and more justified EVA generated by the firm exhibits significant correlation with its market value It is an easy way to see how the management works for the shareholders interests Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 25 / 36

26 Measuring Performance: Economic Value Added Disadvantages of EVA EVA has little to offer for capital budgeting It focuses only on current earnings By contrast, NPV analysis uses all future cash flows It may increase the short-sightedness of managers Under EVA a manager will be well rewarded today if earnings are high today The manager has an incentive to run a division with more regard for short-term than long-term value The problem is not with EVA per se but with the use of accounting numbers in general Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 26 / 36

27 Measuring Performance: Economic Value Added Market Value Added Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 27 / 36

28 Measuring Performance: Economic Value Added Market Value Added Market Value Added Market Value Added (MVA) measures the difference between the market value of the firm (equity and debt without non-operating assets) and the amount of invested capital, MVA = Enterprise Value Invested Capital Equivalently, MVA equals the PV of future expected EVAs: MVA = n t=1 EVA t (1 + R WACC ) t MVA measures an accumulated performance: when positive, the market expects a return higher than the cost of capital invested Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 28 / 36

29 Measuring Performance: Economic Value Added Market Value Added Firm Value The firm value can be calculated by using MVA, thus it can also be used for valuation The enterprise value is Then the firm value is EV = Invested Capital + MVA = = Invested Capital + n t=1 EVA t (1 + R WACC ) t FV = EV + Market Value of Non-Operating Assets Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 29 / 36

30 Measuring Performance: Economic Value Added Discounted Cash Flow Valuation v EVA Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 30 / 36

31 Measuring Performance: Economic Value Added Discounted Cash Flow Valuation v EVA EVA v DCF EVA is not a new valuation theory, but a reformulation of the DCF model However, the two approaches may provide different results The firm value obtained by these two methods are identical only under the same assumptions, in particular, when the terminal value is computed as FCFF n+1 R WACC g n versus EVA n+1 R WACC g n and either g = 0 after period n, or g is equal to the growth rate from n to n + 1 DCF cannot be used for performance measurement Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 31 / 36

32 Multiples Outline 1 Discounted Cash Flow Analysis: Free Cash Flow to the Firm Definition of FCFF Enterprise Value and Equity Value Free Cash Flow to Equity 2 Measuring Performance: Economic Value Added Market Value Added Discounted Cash Flow Valuation v EVA 3 Multiples Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 32 / 36

33 Multiples Introduction Comparison of firms is difficult because of different dimensions Multiples are useful for such situations They are relative measures, intuitive, easy to calculate them and provide comparable figures across companies Valuation by multiples allows for measurement of the value of the firm relative to market value However, the choice of the peer group of firms and of the multiples is very subjective Hence, it is a complement to DCF or EVA rather than a substitute Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 33 / 36

34 Multiples Earnings Multiples Price-Earnings Ratio (P/E): P/E = Market Value per Share Earnings per Share (EPS) Perhaps the most commonly used multiple It depends strongly on capital structure EV/EBITDA or EV/EBIT It is capital structure neutral = companies with different debt levels can be easily compared Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 34 / 36

35 Multiples Book Value Multiples Book-to-Market ratio or Price-to-Book ratio (P/B) P/B = Market Value of Equity Book Value of Equity EV/IC Since intangible assets (e.g., patents, brands, etc.) are typically not included into book value, it may not be appropriate for certain firms EV/IC = Enterprise Value Invested Capital A cleaned-up version of P/B Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 35 / 36

36 Multiples Revenue Multiples Price-to-Sales ratio (P/S) P/S = Market Value of Equity Sales Inconsistent as, while sales represent income for both bondholders and shareholders, the numerator only considers equity It is typically calculated for unprofitable companies for which P/E cannot be computed EV/Sales EV/Sales = Enterprise Value Sales More consistent than P/S Sebestyén (ISCTE-IUL) ENTERPRISE VALUATION Corporate Finance 36 / 36