CORPORATE VALUATION. Introduction to Valuations 1

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1 CORPORATE VALUATION Introduction to Valuations 1 Dividend Discount Model (DDM) 1-3 Discounted Cash Flows (DCF) 4-5 Comparable Transaction (Acquisition) Analysis 6-8 Sum of Parts 9 Residual Income Method Private Equity Valuation Approaches

2 Introduction to Valuations Definition Valuation is the process of determining the value of an asset or company. There are many techniques for valuation, and it is often partially objective and partially subjective. Knowing what business is worth and what determines its value is prerequisite for intelligent decision making. Business valuation is the process of determining the economic value of a business or company. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and divorce proceedings. Often times, owners will turn to professional business valuators for an objective estimate of the business value. Dividend Discount Model (DDM) A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. The dividend discount model (DDM) is a method for assessing the present value of a stock based on the growth rate of dividends. Value of Stock = ((Dividend per share/(discount Rate- dividend growth rate)) This procedure has many variations, and it doesn't work for companies that don't pay out dividends. For example one variation is the supernormal dividend growth model which takes into account a period of high growth followed by a lower, constant growth period. The principal behind the model is the net present value of the cash flows. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio). 2

3 Example: The dividend discount model (DDM) seeks to estimate the current value of a given stock on the basis of the spread between projected dividend growth and the associated discount rate. The DDM calculates this present value in the following manner: In the DDM, a present stock value that is higher than a stock's market value indicates that the stock is undervalued and that it is a good time to purchase shares. To illustrate, suppose stock XYZ declares a dividend of two dollars per share and is currently valued at $125 in the market. Based on the stock's dividend history, a broker determines a dividend growth rate for the stock of five percent per year and a discount rate of seven percent. The present stock value is calculated as follows: Present Stock Value = $2.00 per share / (0.07 discount 0.05 dividend growth) = $2.00 / 0.02 = $100 With a calculated present value of $100 against a market value of $125, stock XYZ is undervalued in this instance and represents an opportunity to purchase for future value. Why It Matters: The DDM is a tool used by many investors and analysts as an aim to choosing stocks. The greatest disadvantage of the DDM is that it is inapplicable to companies which do not pay dividends. 3

4 Discounted Cash Flow (DCF) It can be hard to understand how stock analysts come up with fair value for companies, or why their target estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flows(dcf). However, you don't have to rely on the word of analysts. With some preparation and the right tools, you can value a company's stock yourself using this method. This tutorial will show you how, taking you step-by-step through a discounted cash flow analysis of a fictional company. In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as discounted" cash flow because cash in the future is worth less than cash today. For example, let's say someone asked you to choose between receiving $100 today and receiving $100 in a year. Chances are you would take the money today, knowing that you could invest that $100 now and have more than $100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth $100 dollars today - or the discounted value is $100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company's value. There are several tried and true approaches to discounted cash flow analysis, including the dividend discount model (DDM) approach and the cash flow to firm approach. In this tutorial, we will use the free cash flow equity approach commonly used by Wall Street analysts to determine the "fair value" of companies. As an investor, you have a lot to gain from mastering DCF analysis. For starters, it can serve as a reality check to the fair value prices found in brokers' reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All of this will give you an appreciation for what drives share value, and that means you can put a more realistic price tag on the company's stock. 4

5 To demonstrate how this valuation method works, this tutorial will take you step-by-step through a DCF analysis of a fictional company called The Widget Company. Let's begin by looking at how to determine the forecast period for your analysis and how to forecast revenue growth. COMPARABLE TRANSACTIONS (ACQUISITION) ANALYSIS Comparable transactions analysis is based upon a comparison of the subject company to similar companies involved in actual merger and acquisition transactions. Duff & Phelps used multiple databases and conducted key word searches to identify transactions involving companies in the nutritional supplement and health food industries, and conducted searches for transactions involving the selected group of comparable public companies that Duff & Phelps used for its comparable public company analysis described above. Duff & Phelps identified six transactions involving targets that were comparable to the GFA business in terms of business model, markets served, size, financial performance, or a combination thereof. Duff & Phelps noted, however, that only one of the targets in the selected group of transactions Horizon Organic Holdings Corp., which was acquired by Dean Foods Co. in October 2003 had a revenue growth profile that was similar to that of the GFA business. Target Company LTM Revenue ($ in millions) LTM Revenue Growth% Horizon Organic Holding $ Corp. Spectrum Organic Products Inc. Silhouette Brands, Inc NA International Multifoods NA Corp. Quest Food Ingredients NA NA Burt s Bees Inc NA NA LTM EBITA Margin% 5

6 Using the transaction price to estimate the enterprise value of the target companies, Duff & Phelps calculated multiples of enterprise value relative to selected financial metrics (EBITA and revenue) for each of the targets. Table of Contents The following table presents a summary of the valuation multiples for the targets in the identified merger and acquisition transactions. Date Target Acquirer Target EV/ LTM Rev. Jun- 03 Horizon Organic Holding Corp. Target EV/ LTM EBITA Dean Foods Co. 1.46x 34.3x Aug- 05 Spectrum Organic Products Inc. The Hain Celestial Group Inc. 0.85x 36.6x July- 04 Silhouette Brands, Inc. Dreyer s Grand Ice Cream Holdings Inc. 0.89x NA Mar- 04 Mar- 04 International Multifoods Corp. Quest Food Ingredients JM Smucker Co. 0.96x NA Kerry Group plc 1.73x NA Sep- 03 Burt s Bees Inc. AEA Investors LLC 5.00x NA Note: EV = Enterprise Value; NA = Not Available Duff & Phelps noted that the LTM revenue growth rate for the GFA business was 35.9%, which was higher than that of any of the target companies for which there was data available. Duff & Phelps calculated an implied enterprise value for the GFA business of $710 million by applying the EV / LTM EBITA multiple of 34.3x for Horizon Organic Holding Corp the target with the highest revenue growth among those targets with data available to the LTM EBITA of $20.7 million for the GFA business. Duff & Phelps noted that due to the fact that the GFA business has substantially higher profit margins than the target companies for which data was available, it was not appropriate to apply a revenue multiple derived from the valuations of the target companies to obtain a value estimate for the GFA business. Management agrees with Duff & Phelps s assessment, based on management s judgment and standards generally accepted in the 6

7 financial community. Duff & Phelps also noted that due to the lack of adequate financial detail pertaining to the identified comparable transactions, the enterprise value for the GFA business indicated by this analysis was much less precise than the ranges implied by the discounted cash flow analysis or the comparable public company analysis. Therefore, Duff & Phelps used the comparable transaction analysis as an additional data point and check on the other valuation methodologies. Duff & Phelps concluded, however, that the enterprise value for the GFA business implied by the comparable transactions analysis exceeded the $465 million enterprise value for the GFA business implied by the consideration to be paid by us pursuant to the merger agreement. SUM-OF-THE-PARTS ANALYSIS Sum-of-the-parts ("SOTP") or "break-up" analysis provides a range of values for a company's equity by summing the value of its individual business segments to arrive at the total enterprise value (EV). Equity value is then calculated by deducting net debt and other non-operating adjustments. For a company with different business segments, each segment is valued using ranges of trading and transaction multiples appropriate for that particular segment. Relevant multiples used for valuation, depending on the individual segment's growth and profitability, may include revenue, EBITDA, EBIT, and net income. A DCF analysis for certain segments may also be a useful tool when forecasted segment results are available or estimable. 7

8 Residual Income Method There are many different methods to valuing a company or its stock. One could opt to use a relative valuation approach, comparing multiples and metrics of a firm in relation to other companies within its industry or sector. Another alternative would be value a firm based upon an absolute estimate, such as implementing discounted cash flow modeling or the dividend discount method, in an attempt to place an intrinsic value to said firm. One absolute valuation method which may not be so familiar to most, but is widely used by analysts is the residual income method. In this article we will introduce you to the underlying basics behind the residual income model and how it can be used to place an absolute value on a firm. (The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions. An Introduction to Residual Income When most hear the term residual income, they think of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of equity valuation residual income is the income generated by a firm after accounting for the true cast of its capital. You might be asking, "But don't companies already account for their cost of capital in their interest expense?" Yes and no. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity costs. The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is not a legal requirement like the return to bondholders, in order to attract investors firms must compensate them for the investment risk exposure. In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asserts pricing model. The formula below shows the equity charge equation. Equity charge = Equity capital * Cost of Equity Once we have calculated the equity charge, we only have to subtract it from the firm's net income to come up its residual income. For example, if Company X reported earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required rate of return of 11%, its residual income would be: 8

9 Equity Charge $950,000 x 0.11 = $104,500 Net Income $100,000 Equity Charge -$104,500 Residual Income -$4,500 So as you can see from the above example, using the concept of residual income, although Company X is reporting a profit on its income statement (which it should), once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given level of risk. This finding is the primary driver behind the use of the residual income method. A scenario where a company is profitable on an accounting basis, it may still not be a profitable venture from a shareholder's perspective if it cannot generate residual income. 9

10 Private Equity Valuation Approaches One of the most important elements of the Private Equity (PE) reporting process is the valuation of portfolio investments. This plays a key part in the understanding of investors and other stakeholders of fund performance. Crucial to the perceived quality of this reporting is the independent sign off of these valuations by external auditors. Valuation methodologies PE owned assets generally do not have publicly traded market pricing and as a result there are four commonly used methodologies to generate a portfolio company value. The first three are well established, earnings based analytical tools. These include: Comparable company analysis (peer group analysis) Precedent transaction analysis (deal comps) and; Discounted cash flow analysis (DCF). In addition to the analytics there is a further data point that can provide a further valuation option: the latest price paid. All of these methodologies are well established and understood and for the audit team looking to evidence the investor view, the mechanics behind each can be relatively easily tested. In reality however each methodology has inherent weaknesses that mean that the investors usually do not rely on a single methodology to evidence their views. Comparable company analysis This uses the valuation metrics identified for similar publicly quoted companies as a proxy for the valuation metrics for the PE investment. The key judgment call for the investor is - which companies provide the best quoted comparator multiples? Whether it s differentials in profitability (are margins comparable?), scale (does size offer greater robustness of operations?), geography (how does the diversification of revenue streams compare?), management capability (how deep is the talent pool?), or even volatility (how do historic trends compare?), it is rare that a single quoted business provides an ideal benchmark for valuation purposes. To address this, the investor will often collate a basket of comparatives, which after eliminating outliers from the sample are used to calculate a blended metric. Whilst the selection process is down to commercial judgment, the larger and higher quality the sample set, the higher the reliance the auditor can place on the methodology. 10

11 Precedent transaction analysis As is the case in developing a quoted peer group choosing the basket of peer group of deals to supply another proxy for the earnings metric can also be subjective. True comparability is significantly influenced by factors, such as: transaction timing.the nature of the transaction (was it a beauty contest or a hostile takeover?); and consideration (cash, shares or a combination of both?). Again the larger the relevant sample set the better case the investor can present to support their view. By undertaking each valuation method outlined above, there is typically a broad range of outcomes for the estimate of fair value due to the imperfect nature of the comparables, range of forecasting accuracy and market estimates. From the investor s perspective the final spot value should never be a mechanistic averaging process, despite the fact that this would be easier to audit. Discounted cash flow An alternative to relative valuation techniques such as CCA is offered by discounted cash flow analysis (DCF). It is valued by private equity firms as it is flexible (it can be applied to any stream of cash flows or earnings) and because it produces the closest measure of intrinsic stock value. The key disadvantages of DCF centers around its requirement for detailed cash flow forecasts, the need to estimate the terminal value and an appropriate risk-adjusted discount rate. All of these inputs require substantial subjective judgments to be made, and the resulting value is often sensitive to small changes in these inputs. Due to the high level of subjectivity in selecting inputs for this technique, DCF-based valuations are generally considered by auditors as a cross-check of values generated by market-based valuations and should not be used in isolation of other methodologies. 11