Econ Pro Valuation Methods - General recap and pitfalls. October 1, 2010

Transcription

1 Econ Pro Valuation Methods - General recap and pitfalls October 1,

2 Agenda Valuation Dimensions & Applications Valuation Methods Market method Cost method Income method Income method for Intangible assets Pitfalls Concluding Remarks 2

3 Valuation Dimensions 3

4 Valuation Dimensions & Applications VALUATION TAX PURPOSES FINANCIAL REPORTING CIVIL LAW Merger & Acquisitions Corporate planning Business Restructuring Intangible Property Valuation Purchase Price Allocation Annual Impairment Fair value valuation Forensic and investigative accounting Litigation Support / fairness opinion Shareholder and partner agreements Striking employee option prices Employee buy-outs Merger & Acquisitions, IPO s, spinoff s 4

5 Valuation Valuation Guidelines VALUATION TAX PURPOSES FINANCIAL REPORTING CIVIL LAW Tax Law OECD guidelines Case Law GAAP, s: IFRS USGAAP Other Discussion papers of various institutions such as IVSC, AICPA, IASB Expert knowledge Bank regulations common sense 5

6 Valuation Stakeholders VALUATION TAX PURPOSES FINANCIAL REPORTING CIVIL LAW Tax authorities Tax paying entity Reporting Entity Financial regulatory authorities: SEC (US), (FSA (UK), AMF, (France), AFM (NL), BaFin (Germany), etc. (potential) Shareholders, Banks, Investors, Financial Analysts Involved parties: employer, employee, Company, shareholder, individual, buyer, seller,,... 6

7 Valuation Methods Overview 7

8 Common Valuation Methods Challenges: Forward looking (DCF) depends on forecasting Depends on WACC assumptions and continuing value MARKET APPROACH INCOME APPROACH COST APPROACH Recent market transactions Rule of thumb Challenges: Comparable must be comparable or adjusted accordingly. Price paid are typically multidimensional Quality of the answer depends on the quality of the sample Discounted Cash Flow Relief from Royalty Multi-period excessearnings method (MEEM) Incremental Cash Flow Method Option valuation Monte Carlo simulation Challenges: Input required often not available, for ex. standard deviation Complex Historical Costs Reproduction cost Methods Replacement Cost Method Challenges: Difficult to identify relevant historical costs Important drivers of cost could be omitted, for ex. Market conditions and RD Efficiency For IP: cost to create the intellectual property is often not the same as the IP value 8

9 Value of a Business Equation BUSINESS ENTERPRISE MONETARY ASSETS + TANGIBLE ASSETS = = + INTANGIBLE ASSETS VALUE OF EQUITY + VALUE OF LONG TERM DEBT 9

10 Risk and Return Assets NON LIQUID NARROW MARKET INTANGIBLE ASSETS TANGIBLE ASSETS RECEIVABLES INVENTORY LIQUID VERSATILE CASH LOW INVESTMENT RETURN REQUIREMENT HIGH 10

11 Value of a Business Equation BUSINESS ENTERPRISE MONETARY ASSETS + TANGIBLE ASSETS = = + INTANGIBLE ASSETS VALUE OF EQUITY + VALUE OF LONG TERM DEBT 11

12 Market Method 12

13 Market Method Prices from previous transactions provide empirical evidence for the value of an asset Determines fair value by reference to the transaction prices of valuation multiples implicit in the transaction price of identical or similar assets / businesses Valuation Multiple is determined by dividing the transaction price paid for by a financial or non-financial parameter Adjustments are required to the transaction prices to reflect the differentiating characteristics. For ex. with business multiple adjustments are often needed for excess cash, non operating assets, leases, employee stock options, pensions. In some cases more than one valuation multiple is used, the valuer must apply judgement in assessing which resulting values to place the most reliance on 13

14 Market Method Multiples BUSINESS VALUATION ASSETS / OTHER EBITDA Profit Before Tax Revenue / Sales Price-earning-growth (PEG) ratio s (value multiple / exp. EBITA Growth rate) Non financial (Operational) Data, rule of thumb Web site hits Number of subscribers Number of customers Price of a matching market comparable asset (commodity) Turnover generated by the (intangible) asset Profit contribution after deduction of certain costs, such as marketing Non financial (Operational) Data, rule of thumb Customers (value of customer list) Tons of pollutants allowed (value of emission right) Other factors influencing subject asset 14

15 Market Method Pro s and Cons Can provide a reliable measure of fair value in a homogeneous market, however such markets are rare Captures incremental value created over cost and is generally more reliable than the income approach when comparable transactions are present Frequently inseparable from a related asset and therefore difficult to identify comparable transactions to determine fair value Due to uniqueness of (intangible) asset(s) no active markets exist Can be distorted by transaction specific facts of which outside parties are not aware 15

16 Cost Method 16

17 Cost Method An investor will pay no more for an asset than the cost to purchase or construct an asset of equal utility COST METHODS HISTORICAL COST REPRODUCTION COST REPLACEMENT COST Cost of purchase Cost to construct an exact duplicate Cost to construct Equivalent Utility Using same materials production standards, design Using modern materials, production standard, design *** Principle cost approach **** 17

18 Cost Method From cost to value = Reproduction Cost Curable functional and technological obsolescence = Replacement Cost Incurable functional and technological obsolescence Physical deterioration Economic obsolescence (external) = Value of asset (used) 18

19 Cost Method Examples where cost method is used Tangibles Equipment Vehicles Computer Hardware Intangibles Software with the same or similar service capacity Construction of a web site Building up of a Workforce Customer relationships 19

20 Cost Method Pro s and Cons Calculating the cost of replacing an asset provides a ceiling or maximum for the fair value a rational purchaser would not pay more for an asset than he would need to pay to replace it. Useful when measuring a unique internally developed asset that is used in conjunction with generating the cash flow of an enabling asset, e.g. billing software and customer relationships Not suitable for valuing assets for which there are no assets with equivalent service potential, e.g. Brand or publishing titles Cost approach may not reflect value created through development of the asset, e.g. discovery of unique technology Diversity in practice in its application, approach dependent upon facts and circumstances 20

21 Income Method 21

22 Common Valuation Methods MARKET APPROACH INCOME APPROACH COST APPROACH Recent market transactions Rule of thumb Discounted Cash Flow Relief from Royalty Multi-period excessearnings method (MEEM) Incremental Cash Flow Method Option valuation Monte Carlo simulation Historical Costs Reproduction cost Methods Replacement Cost Method 22

23 Discounted Cash Flow (DCF) General term for valuation of future cash flows, main method for valuation of an enterprise IP valuation methods, Relief from Royalty, Multi-period excessearnings method (MEEM) and Incremental Cash Flow Method, all use DCF Often combined with scenario analysis: optimistic, neutral and pessimistic scenario For business valuation continuing value has to be determined, for intangible asset valuation a useful life period has to be determined Formula 23

24 Discounted Cash Flow (DCF) Examples WACC 10% Growth 5% 5% 5% 5% 5% 5% 5% 5% 5% Year Continuing Value FCF ,551 DCF NPV 1,342 WACC 20% Growth 5% 5% 5% 5% 5% 5% 5% 5% 5% Year Continuing Value FCF ,551 DCF NPV 742 WACC 40% Growth 50% 75% 100% 75% 50% 10% 10% 10% 10% Year Continuing Value FCF ,378 1,516 1,668 1,834 2,018 20,177 DCF NPV 1,847 24

25 Discount Rate / WACC An appropriate discount rate should be utilised based on the risk profile of underlying asset. WACC represents the best indication for a discount rate: WACC = r e x E E + D + r d x (1 t) D E + D Risk-free rate, market-risk premium and underlying index used for beta regression should correspond Determinants of the WACC calculation should be derived from peer group Apply interest rate from hypothetical buyer Always take the perspective of a market participant! 25

26 Concept of tax amortisation benefit ACQUISITION OF AN ASSET ASSET DEAL SHARE DEAL Creates new tax basis Old book values are carried forward Tax basis unchanged Deal structure and tax basis should not impact fair value Difference in tax basis is reflected in computation of deferred taxes 26

27 Income Method Intangible assets 27

28 Intangible Assets Intellectual Property Intellectual property is essentially worthless unless it can create, maintain or increase future cash flow Principles Understand potential use of IP is essential Prospective value: function of future earnings Point in time Market dictates rate of return Significant judgment often required as risks are often unique Hindsight generally inadmissible 28

29 Intangible Assets Categories RIGHTS Franchises Receiving Contract Providing Contracts RELATIONSHIPS Assembled Workforce Customer Relationships Distributor Relationships UNDEFINED INTANGIBLES Going Concern Value Goodwill INTELLECTUAL PROPERTY Proprietary Technology Trade Secrets Patents Trademarks Copyrights Software Mark Works Right of Publicity 29

30 Common Valuation Methods MARKET APPROACH INCOME APPROACH COST APPROACH Recent market transactions Rule of thumb Discounted Cash Flow Relief from Royalty Multi-period excessearnings method (MEEM) Incremental Cash Flow Method Option valuation Monte Carlo simulation Historical Costs Reproduction cost Methods Replacement Cost Method 30

31 Relief from Royalty Method Top down approach determine market royalty rate for comparable asset Multiply with applicable revenues Subtract tax expenses Calculate the present value of royalty savings Compute the tax amortisation benefit See chart for trademark example 31

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33 Relief from Royalty Method Pro s and Con s Dependent on the comparability of the subject asset to market based royalty agreements Market based agreements may or may not disclose sufficient information to evaluate the royalty rate It is intended to reflect the profit that a licensor and licensee would require for their respective efforts and use of other assets Should be evaluated in the context of the subject business to ensure there is sufficient income to support the royalty rate 33

34 Multi-period excess-earnings method (MEEM) How to measure: Derive future cash flows for subject intangible asset Apply contributory asset charges, possible contributory asset charges: Working Capital Machinery & Equipment, Land and buildings (PPE) Assembled workforce Other intangible assets Subtract tax expenses Calculate present value of future cash flows Compute the tax amortisation benefit 34

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36 Multi-period excess-earnings method Pro s and Con s The MEEM is dependent upon the ability to prepare reasonable expected cash flows. Suffers from inability to recognise ALL relevant going concern components in the contributory assets charges. All of the excess income is attributed to an amortisable intangible asset and/or goodwill. In the event of multiple intangible assets, excess income needs to be allocated amongst the intangible assets. Future assets are also considered in estimating the excess income. 36

37 Incremental Cash Flow Method Stratification of business total cash flows to measure Economic Benefit from IP How to measure? Derive pre-tax incremental cash flow of subject intangible asset Subtract tax expense Consider incremental contributory asset charges Calculate the present value of incremental cash flows Compute the tax amortisation benefit 37

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39 Incremental Cash Flow Method Pro s and Con s Provides a direct measure of the economic benefit provided by the asset Cost savings and premium pricing are more readily measurable, however incremental market share becomes more subjective Assumptions may only be available within the subject entity and may be difficult to identify for market participants The application of contributory asset charges is dependent upon the nature of the increment. For example premium pricing would not require a contributory asset charge for PP&E, but a working capital charge would be appropriate. 39

40 Pitfalls 40

41 Pitfall Limitations of the application of DCF, ex financial projections, sensitivity to discount rate, sensitivity to terminal value / useful life Presentation of Fairness Opinions Incorrect selection and use of comparables, ex. historical transactions, royalty rates, other Incorrect use of Price Premiums and discounts, ex. control premium, discount for lack of marketability Ignoring existence of non-earning or excess assets Wrong tax assumptions No sensitivity testing 41

42 Concluding Remarks 42

43 Concluding remarks Issue is generally not which model, but how used: WACC (discounts & premium, beta, tax regime) Relevant Business Plan Synergies (market participants vs. buyer specific) Avoid double counting of cash flows Tax Amortization Benefit (tax rate, duration) Determination of useful life Stand-alone valuation vs. portfolio approach Reasonability checks employed Level of professional skepticism applied to inputs Use of subjective assumptions/judgments 43

44 Thank you 44