Transcript Valuation methods - Ross School of Business

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Valuation methods
An overview
©2001 M. P. Narayanan
University of Michigan
Methodologies
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 Comparable multiples
 P/E multiple
 Market to Book multiple
 Price to Revenue multiple
 Enterprise value to EBIT multiple
 Discounted Cash Flow (DCF)
 NPV, IRR, or EVA based Methods
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WACC method
APV method
CF to Equity method
©2001 M. P. Narayanan
University of Michigan
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Valuation: P/E multiple
 If valuation is being done for an IPO or a takeover,
 Value of firm = Average Transaction P/E multiple  EPS of
firm
 Average Transaction multiple is the average multiple of recent
transactions (IPO or takeover as the case may be)
 If valuation is being done to estimate firm value
 Value of firm = Average P/E multiple in industry  EPS of firm
 This method can be used when
 firms in the industry are profitable (have positive earnings)
 firms in the industry have similar growth (more likely for
“mature” industries)
 firms in the industry have similar capital structure
©2001 M. P. Narayanan
University of Michigan
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Valuation: Price to book multiple
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 The application of this method is similar to that of the
P/E multiple method.
 Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each dollar of
equity invested.
 This method can be used for
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companies in the manufacturing sector which have significant
capital requirements.
companies which are not in technical default (negative book
value of equity)
©2001 M. P. Narayanan
University of Michigan
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Valuation: Value to EBITDA
multiple
 This multiple measures the enterprise value, that is
the value of the business operations (as opposed to
the value of the equity).
 In calculating enterprise value, only the operational
value of the business is included.
 Value from investment activities, such as investment in
treasury bills or bonds, or investment in stocks of other
companies, is excluded.
 The following economic value balance sheet clarifies
the notion of enterprise value.
©2001 M. P. Narayanan
University of Michigan
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Enterprise Value
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Economic Value Balance Sheet
PV of future cash from business
operations
$1500
Cash
$200
Debt
Marketable securities
$150
Equity
$1850
$650
$1200
$1850
Enterprise Value
©2001 M. P. Narayanan
University of Michigan
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Value to EBITDA multiple: Example
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 Suppose you wish to value a target company using the
following data:
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Enterprise Value to EBITDA (business operations only)
multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2,
10.5, 10.3.
Recent EBITDA of target company = $20 million
Cash in hand of target company = $5 million
Marketable securities held by target company = $45 million
Interest rate received on marketable securities = 6%.
Sum of long-term and short-term debt held by target = $75
million
©2001 M. P. Narayanan
University of Michigan
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Value to EBITDA multiple: Example
 Average (Value/ EBITDA) of recent transactions
 (10.1+9.8+9.2+10.5+10.3)/5 = 9.98
 Interest income from marketable securities
 0.06  45 = $2.7 million
 EBITDA – Interest income from marketable securities
 20 – 2.7 = $17.3 million
 Estimated enterprise value of the target
 9.98  17.3 = $172.65 million
 Add cash plus marketable securities
 172.65 + 5 + 45 = $222.65 million
 Subtract debt to find equity value: 222.65 – 75 = $147.65
million.
©2001 M. P. Narayanan
University of Michigan
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Valuation: Value to EBITDA
multiple
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 Since this method measures enterprise value it
accounts for different
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capital structures
cash and security holdings
 By evaluating cash flows prior to discretionary capital
investments, this method provides a better estimate of
value.
 Appropriate for valuing companies with large debt
burden: while earnings might be negative, EBIT is
likely to be positive.
 Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.
©2001 M. P. Narayanan
University of Michigan
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Heuristic methods: drawbacks
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 While heuristic methods are simple, all of them share
several common disadvantages:
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they do not accurately reflect the synergies that may be
generated in a takeover.
they assume that the market valuations are accurate. For
example, in an overvalued market, we might overvalue the
firm under consideration.
They assume that the firm being valued is similar to the
median or average firm in the industry.
They require that firms use uniform accounting practices.
©2001 M. P. Narayanan
University of Michigan
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Valuation: DCF method
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 Here we follow the discounted cash flow (DCF)
technique we used in capital budgeting:
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Estimate expected cash flows considering the synergy in a
takeover
Discount it at the appropriate cost of capital
©2001 M. P. Narayanan
University of Michigan
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DCF methods: Starting data
 Free Cash Flow (FCF) of the firm
 Cost of debt of firm
 Cost of equity of firm
 Target debt ratio (debt to total value) of the firm.
©2001 M. P. Narayanan
University of Michigan
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Template for Free Cash Flow
“Income Statement”
Working capital
0
Year
Revenue
Costs
Depreciation of equipment
Profit/Loss from asset sales
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation
Profit/Loss from asset sales
Operating cash flow
Change in working capital
Capital Expenditure
Salvage of assets
Free cash flow
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Noncash item
Noncash item
Adjustment for
for non-cash
Capital items
University of Michigan
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Template for Free Cash Flow
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 The goal of the template is to estimate cash flows, not profits.
 Template is made up of three parts.
An “Income Statement”
 Adjustments for non-cash items included in the “Income
statement” to calculate taxes
 Adjustments for Capital items, such as capital expenditures,
working capital, salvage, etc.
 The “Income Statement” portion differs from the usual income
statement because it ignores interest. This is because, interest,
the cost of debt, is included in the cost of capital and including it
in the cash flow would be double counting.
 Sign convention: Inflows are positive, outflows are negative.
Items are entered with the appropriate sign to avoid confusion.
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©2001 M. P. Narayanan
University of Michigan
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Template for Free Cash Flow
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 There are four categories of items in our “Income Statement”.
While the first three items occur most of the time, the last one is
likely to be less frequent.
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Revenue items
Cost items
Depreciation items
Profit from asset sales
 Adjustments for non-cash items is to simply add all non-cash
items subtracted earlier (e.g. depreciation) and subtract all noncash items added earlier (e.g. gain from salvage).
 There are two type of capital items
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Fixed capital (also called Capital Expenditure (Cap-Ex), or Property,
Plant, and Equipment (PP&E))
Working capital
©2001 M. P. Narayanan
University of Michigan
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Template for Free Cash Flow
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 It is important to recover both at the end of a finite-lived project.
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Salvage the market value property plant and equipment
Recover the working capital left in the project (assume full recovery)
©2001 M. P. Narayanan
University of Michigan
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Template for Free Cash Flow
Taxab le income = Revenue - Costs - Depreciation + Profit from asset sales
NOPAT = Taxab le income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
Add the noncash items you sub tracted earlier and sub tract the noncash items you added earlier.
©2001 M. P. Narayanan
University of Michigan
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Estimating Horizon
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 For a finite stream, it is usually either the life of the
product or the life of the equipment used to
manufacture it.
 Since a company is assumed to have infinite life:
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Estimate FCF on a yearly basis for about 5  10 years.
After that, calculate a “Terminal Value”, which is the ongoing
value of the firm.
 Terminal value is calculated one of two ways:
 Estimate a long-term growth and use the constant growth
perpetuity model.
 Use a Enterprise value to EBIT multiple, or some such
multiple
©2001 M. P. Narayanan
University of Michigan
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Costs of debt and equity
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 Cost of debt can be approximated by the yield to
maturity of the debt.
 If it is not directly available, check the bond rating of
the company and find the YTM of similar rated bonds.
 Cost of equity
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CAPM
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Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the
assumption that market is efficient, this is the required re.
©2001 M. P. Narayanan
University of Michigan
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Model of a Firm
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Value from
Operations
Enterprise value
Value from
investments
Value generated
Equal if debt
is fairly priced
FIRM
Value to Equity
DEBT and
other
liabilities
©2001 M. P. Narayanan
EQUITY
University of Michigan
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Value of equity
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 Value of equity
= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities
©2001 M. P. Narayanan
University of Michigan
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