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Valuation Measurement and Value Creation

Valuation Measurement and Value Creation. 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

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Valuation Measurement and Value Creation

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  1. Valuation Measurement andValue Creation

  2. 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?

  3. Business Valuation Techniques • 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)

  4. 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

  5. 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 +... • If growth is constant (g2 = g3 = . . . = g) , the valuation formula reduces to: Ve = Div1/(r - g) • Some estimation problems: • firms may not (currently) pay dividends • dividend payments may be “managed” (e.g., for stability)

  6. Dividends: The Stability Factor Dividend changes: Publicly traded U.S. Firms Factors that influence dividends: • Desire for stability • Future investment needs • Tax factors • Signaling prerogatives Source: A. Damodaran, Investment Valuation, Wiley, 1997

  7. Discounted Free Cash Flow Equity (FCFE) Approach (“Direct” Method) • Buying equity of firm is buying future stream of free cash flows (available, 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. Exp. - Increase in WC - Princ. Payments • Problem: Calculating cash flows related to debt (interest/ principal) & other obligations is often difficult!

  8. 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.e. firm has significant “growth opportunities”)

  9. 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

  10. 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, or • Value of “operating assets” or “Total Enterprise Value” (TEV)

  11. 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)

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

  13. 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 - tax rate) + Depreciation and amortization (non cash items) - Capital Expenditures - Increase in Working Capital • What is working capital? Non-cash current assets - non-interest bearing current liabilities (e.g. A/P & accrued liab.)

  14. Working Capital vs. Permanent Financing Short- term liabilities Short-term assets Working capital Permanent Capital Operating assets Permanent Capital Long-term assets Uninvested 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

  15. FCFF vs. Accounting Cash Flows Cash Flow Statement, Hudson’s Bay, ($millions, FYE Jan 1999) Cash flow from operations Net Income $ 40 Non-cash expenses $ 169 Changes in WC ($116) Cash provided (used) by investments Additions to P,P & E ($719) Cash provided (used) by financing Additions (reductions) to debt $ 259 Additions (reductions) to equity $ 356 Dividends ($ 53) Overall Net Cash Flows ($ 64) Income Statement, Hudson’s Bay ($millions, FYE Jan 1999) Sales $7,075 Cost of Goods Sold $6,719 EBITDA $ 356 Depreciation $ 169 EBIT $ 187 Interest Expense $ 97 Income Taxes $ 50 Net Income $ 40 Dividends $ 53 Hudson’s Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561)

  16. 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

  17. 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 • tax rate is 40% • firm expects to generate 220,000 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?

  18. An Example, continued • Let us look first at how the EBIT is distributed to the various claimants: EBIT $220,000 Interest (20,000) $200,000*10% EBT $200,000 tax (80,000) 40% rate EAT $120,000 Div. to common $120,000 Note: The dividend to equity equals 15% of equity capital

  19. An Example, continued • The firm here generates a cash flow that is just enough to deliver the returns required by the different claimants. • i.e. the NPV of the firms projects = 0 • Another way to see this: • WACC = 0.2 * 10% * (1 – 0.4) + 0.8 * 15% = 13.2% • Pre-tax WACC = 13.2% / (1 – 0.4) = 22% • EBIT / capital is also 22%, so NPV of future projects for this firm is zero • From “first principles”, the value of the firm should equal the invested capital, or $1,000,000

  20. An Example, continued • Now consider FCFF valuation of this firm • FCFF = EBIT * (1-t) = $220,000 * (1 – 0.4) = $132,000 • Value = 132,000 / 0.132 = $1,000,000 • 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 = $140,000 • Value = $140,000 / 0.14 = $1,000,000 • Key: account for tax benefit, but only once (no double counting)!

  21. 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

  22. 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, capital expenditures, working capital given as a percentage of sales • Discount FCFF at the firm’s WACC (kc) FCFF1+ FCFF2 + . . . + FCFFt VALUE1 = 1+kc (1+kc)2 (1+kc)t

  23. 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 - g

  24. Stage 2 Valuation Present value of Stage 2 cash flows (Terminal Value or TV): 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 FCFFt * (1+g) 1 TV = x Kc - g (1+kc)t

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

  26. Discounted FCFF Example (cont’d) FCFF = EBIT*(1-t) + Dep - CapEx - Increase in WC Year 1 FCFF = 40*(1 - 0.4) + 4 - 6 - 2 = 20 Year 2 FCFF = 50*(1 - 0.4) + 5 - 7 - 3 = 25 Year 3 FCFF = 60*(1 - 0.4) + 6 - 8 - 4 = 30

  27. Discounted FCFF Example (cont’d) 20 25 30 30*(1+g) 30*(1+g)2 | | | | | | t=0 1 2 3 4 5 P = Vfirm 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

  28. Discounted FCFF Example (cont’d) TEV = 20/(1.10) + 25/(1.10)2 + 30/(1.10)3 + [30*(1.03)/(0.10 - 0.03)]/(1.10)3 = 18.2 + 20.7 + 22.5 + 331.7 = 393.0 TEV + Cash (unused assets) = Vfirm ==> Vfirm = TEV =393.0 Vfirm = Vdebt + Vequity ==> Vequity = Vfirm - Vdebt Vequity = 393.0 - 100.0 = 293.0

  29. 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, then the price of the firm (P) should be such that: P / EPS1 = “P/E multiple” • Rearranging, P = “P/E multiple” x EPS1

  30. Relative Valuation - Example • ABC Company: • Next year’s forecasted EPS = $1.50 • Comparable company: XYZ corporation • Next year’s forecasted EPS = $0.80 • Current share price = $20 • PE ratio = 20 / 0.80 = 25 • If ABC and XYZ are comparable, they should trade at same PE • Implied price of ABC = 25 * 1.50 = $37.5 • Note: Analyst prefer “forward looking” ratios but “backward looking” ratios are more readily available • Key: Make comparisons “apples with apples”

  31. P/E Ratios and the DDM • Recall the constant growth DDM model; assume payout ratio is PO% • D1 = PO * EPS1 • P/E ratios capture the inherent growth prospects of the firm and the risks embedded in discount rate P = D1 ke - g P= PO *EPS1 ke - g P = PO EPS1 ke - g P/E Motto: Growth is Good, Risk is Rotten

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

  33. TEV / EBITDA Approach • TEV = MVequity + MVdebt - cash • EBITDA: earnings before taxes, interest, 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, then the TEV for the firm should be such that: TEV / EBITDA1 = “EV/EBITDA multiple”

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

  35. EV/EBITDA Valuation - Example • ABC Company: • Next year’s forecasted EBITDA = $50 million • Shares outstanding = 20 million; value of debt = $50 million; cash = $0 • Comparable company: XYZ corporation • Next year’s forecasted EBITDA = $40 million • Current share price = $20; shares outstanding = 10 million; value of debt = $100 million; cash = $0 • EV = 20* 10 + 100 – 0 = $300 million • EV/EBITDA ratio = 300 / 40 = 7.5 • If ABC and XYZ are comparable, they should trade at same EV/EBITDA • Implied EV for ABC = 7.5 * 50 = 375 million • Value of equity = 375 + 0 – 50 = $325 million • Price per share = 325/20 = $16.25

  36. 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, for example, price to earnings?

  37. 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, EBITDA, sales, etc.) • 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

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

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

  40. Some Valuation “Myths” • Since valuation models are quantitative, valuation is objective • models are quantitative, inputs are subjective • A well-researched, well-done model is timeless • values will change as new information is revealed • A good valuation provides a precise estimate of value • a valuation by necessity involves many assumptions • The more quantitative a model, the better the valuation • 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 market is generally wrong • 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 Source: A. Damodaran, “Investment Valuation: Tools and Techniques for Determining The Value of Any Asset”

  41. 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.

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

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

  44. Valuation References Copeland, Koller and Murrin,1994, Valuation: Measuring and Managing the Value of Companies(Wiley) Damodaran,1996, Investment Valuation (Wiley); http://www.stern.nyu.edu/~adamodar/ Pratt, Reilly and Schweihs, 1996, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Irwin) Benninga and Sarig, 1997, Corporate Finance: A Valuation Approach (McGraw Hill) http://finance.wharton.upenn.edu/~benninga/home.html Stewart, 1991, 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)

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