Corporate Valuation

Keith M. Howe Scholl Professor of Finance DePaul University Summer 2009

Valuation Approaches

I.

Discounted cash flow (DCF) analysis

II.

  

Relative valuation analysis

comparable companies analysis equity valuation using P/E multiples enterprise valuation using EBITDA multiples

Discounted cash flow (DCF) analysis

Basic idea : find the present value of the expected future cash flows over the asset’s life and discount at cost of capital (required rate).

Value  N   CF  t Where: CF t =Cash flow in period t r = discount rate Notes: 1.

2.

Discount rate is an opportunity cost.

CF = Rev - Costs - Taxes - Investment = (Rev - Costs) (1 - T c ) + (T c * Dep) - Investment

Discounted cash flow (DCF) analysis

A DCF model has three parts:



Explicit forecast period



Cash flows are after-tax incremental cash flows



Continuing value or terminal period



Perpetuity



FCF, NOPLAT, NOPAT



Constant growth



Multiples



Discount rate



Discount rates can be determined a number of different ways (e.g., CAPM, Gordon growth model, APT, etc), but the expected free cash flows are discounted at the rate that reflects the risk of the cash flows.

4

Discounted cash flow (DCF) analysis Continuing Value

V

O



t N

  1 ( 1

CF

t



r

)

t



PV

(

CFs beyond t



N

)

PV of forecasted CFs Continuing Value (CV)

Discounted cash flow (DCF) analysis Two general approaches are taken:

For the continuing value (or terminal value) component, simplifying assumptions are made about future CFs (e.g., g=3% in perpetuity) or future valuation alignment based on market multiples.

Two general approaches: 1) Constant growth rate of CFs.

2) Market-based multiples

Discounted cash flow (DCF) analysis

Forecasting Continuing Value CFs

Forecasted Cash Flows g = ?

0 1 2 Explicit forecast 3 4 Time 5 Assumed growth path

Discounted cash flow (DCF) analysis

1) Constant growth approach:

CV t = FCF t+1 WACC - g • Over what period will the firm earn abnormal returns?

• What is the relation between the period of competitive advantage and the continuing value formula?

Discounted cash flow (DCF) analysis

2) Multiples Approach:

CV t = EV t * EBITDA Peers EBITDA Where: EV = enterprise value EBITDA = earning before interest, tax, depreciation and amortization • Aligns DCF value with market pricing for the industry

Discounted cash flow (DCF) analysis

Example: Discounted Free Cash flow

Year Free Cash flow 2008 2009 2010 2011 250 260 280 300 Terminal Value 3,000 Value of Operations Less: Value of Debt Equity Value Price per share Discount Present Factor (10%) Value 0.9091

0.8264

0.7513

0.6830

0.6830

227.28

214.86

210.36

204.90

2,049.00

2,906.40

(600.00)

$2,306.40

$4.16

Discounted cash flow (DCF) analysis

Required Rates for DCF Method

   

r =D

1

/P

0

+ g r = r

f

+ β (r

m

Gordon’s Model - r

f

) CAPM r = r

f

+ β

1

(r

1

- r

f

) + β

2

(r

2

- r

f

) +… Arbitrage Pricing Theory Fama-French model (size, BV/MV)

Discounted cash flow (DCF) analysis

Weighted average cost of capital (WACC) WACC = R D (1-T) * D/V + R E * E/V

Where: R D (1-T) = after-tax cost of debt (current) R E = cost of equity (CAPM) D/V, E/V = debt and equity proportions (market-value based)

Discounted cash flow (DCF) analysis

Market Forces Value Drivers Competitive Nature Required Investment Market Demand Profitability Investment Corporate Value Competitive Position Cost Advantage Product Differentiation Growth Risk

Discounted cash flow (DCF) analysis

Forecasting CF Performance 1. Develop the forecast period

•

How long will it take to reach an mature, equilibrium stage?

(often 10 years is used)

2. Define strategic perspective

•

Tell the story - give the context

(For example, demand will peak in 4-5 years and then decline as competitors enter the market. Margins will decline following the period.)

Discounted cash flow (DCF) analysis

Forecasting CF Performance 3. Period of competitive advantage

(ROIC > WACC) •

Providing superior value to consumers thru better service, a

• •

differentiated product.

Low cost provider Barriers to entry - patents, government policy 4. Develop financial forecast based on the strategic perspective

• • •

Begin with revenue forecast.

Develop the income and balance sheet forecasts.

Then calculate CFs and key value drivers.

Discounted cash flow (DCF) analysis

Forecasting CF Performance 5. Develop performance scenarios

(best and worst cases) •

Sets of plausible assumptions.

6. Check consistency and alignment with industry structure

•

Entry barriers, technology, strategic issues

How to Display a DCF- Based Model Assumptions Example:

Revenue % Growth EBITDA % of Sales EBIT % of Sales Net Income % of Sales FCF Real Asset Growth % CFROI %

2000A

$8,872.8

32.1% 2,689.1

30.3% 2,256.9

25.4% 1,782.1

20.1% 2,768.50

33.8% 19.6% Actuals 2001A 2002A

$7,090.6

(20.1%) $5,438.4

(23.3%) 568.9

8.0% 122.7

2.3% 20.7

0.3% (507.7) (7.2%) 620.30

7.1% 3.9%

(402.7) (7.4%) (118.7) (2.2%) 120.60

(1.5%) 1.1% Research Estimates CSFB Estimates 2003E

$6,345.9

16.7% 1,179.4

18.6%

2004E `

$7,511.5

18.4% 1,656.9

22.1% 417.9

6.6% 755.5

10.1%

2005E 2006E

$8,413.0

12.0% 2,271.6

27.0% 1,262.0

15.0% $9,254.3

10.0% 2,591.2

28.0% 1,480.7

16.0% 419.8

6.6% 1,212.50

8.7% 5.2%

615.3

8.2% 1,755.40

12.8% 6.2%

1,010.6

12.0% 2,268.50

12.2% 7.1%

1,159.7

12.5% 2,444.30

11.2% 6.9% 2007E

$10,179.7

10.0% 2,952.1

29.0% 1,730.6

17.0% 1,318.4

13.0% 2,860.30

10.8% 6.9% Here we develop a base case model from Wall Street Research and CSFB projections

Discounted Cash Flow Valuation

($ in millions)

EBITDA

Less: D&A EBIT Less: Cash Taxes Unlevered Net Income Plus: D&A Less: Capital Expenditures Less: Change in Working Capital

Unlevered Free Cash Flow

(1) 2004E not included in calculating NPV of cash flows.

($ in millions)

DISCOUNT RATE

11.25%

2004E (1) $35.0

(7.9) $27.1

(8.6) $18.5

7.9

(11.6) (1.8)

$13.0

2005E $50.0

(7.8) $42.2

(9.9) $32.3

7.8

(23.4) 0.0

$16.7

2006E $52.1

(7.8) $44.3

(10.5) $33.7

7.8

(8.0) (0.8)

$32.7

11.75% 12.25%

5.5x

$107 178 $285 8.2x

5.7x

0.1% $106 174 $280 8.0x

5.6x

0.6% $104 170 $275 7.8x

5.5x

1.0%

EBITDA TERMINAL VALUE 6.0x

6.5x

$107 194 $302 8.6x

6.0x

0.9% $106 190 $296 8.4x

5.9x

1.4% $104 186 $290 8.3x

5.8x

1.9% $107 210 $318 9.1x

6.4x

1.7% $106 206 $312 8.9x

6.2x

2.1% $104 201 $306 8.7x

6.1x

2.6%

2007E $53.1

(7.8) $45.3

(11.4) $33.9

7.8

(8.0) (0.3)

$33.3

2008E $54.1

(8.0) $46.1

(12.3) $33.8

8.0

(8.0) (0.3)

$33.5

2009E $55.2

(8.1) $47.0

(13.1) $33.9

8.1

(8.0) (0.3)

$33.8

Present Value of Free Cash Flow Present Value of Terminal Value

Enterprise Value

Implied EV / 2004E EBITDA Implied EV / 2005E EBITDA Implied Perpetuity Growth Rate Present Value of Free Cash Flow Present Value of Terminal Value

Enterprise Value

Implied EV / 2004E EBITDA Implied EV / 2005E EBITDA Implied Perpetuity Growth Rate Present Value of Free Cash Flow Present Value of Terminal Value

Enterprise Value

Implied EV / 2004E EBITDA Implied EV / 2005E EBITDA Implied Perpetuity Growth Rate 18

Scenario analysis

critically review your assumptions on the following variables



Broad economic conditions:

economic conditions?

How sensitive is the forecast to the 

Competitive structure of the industry:

How competitive and concentrated is the industry? What impact will this have?



Internal capabilities of the company :

products on time and manufacture them within the expected range of costs?

Can the company develop its 

Financing capabilities of the company:

changes in its plan? How?

Can the company finance the

Discounted cash flow (DCF) analysis

Pros



Widely accepted



Provides a generally reliable and sophisticated approach to valuation by accounting for:

 

Profitability Growth

  

Capital investment/intensity Capital structure Risk and opportunity cost Cons



Generally not easy to calculate



Grounded by assumptions



Gives only an absolute valuation, which in isolation is not telling



Loaded with assumptions

20

Note on Cash Flow Analysis

We can use free cash flows to find: a) Enterprise Value b) Value of Equity

21

Note on Cash Flow Analysis

Matching CFs and discount rates in DCF analysis Project or Firm Valuation (Debt Plus Equity Claim) Equity Valuation Steps Step 1

: Estimate the amount and timing of future cash flows Project (firm) free cash flow (i.e.,

PFCF = FFCF

) Equity free cash flow (

EFCF

)

Step 2

: Estimate a risk appropriate discount rate

Step 3

: Discount the cash flows Combine debt and equity discount rate (weighted average cost of capital -

WACC

) Equity required rate of returm (

cost of equity

) Calculate the PV(FCF) using the WACC to estimate

V (Firm)

Calculate the PV(EFCF) using the equity discount rate to estimate

V(Equity) Note that we have the same value of equity and the value of project (firm) from using project and equity valuation methods

22

Less: Less: Less: Add: Less: Less: Definitions: Project (firm) free cash flow Sales Cost EBITDA Depreciation EBIT Tax @ 40% Unlevered Net Income Depreciation CAPEX NWC Increase Free Cash Flows

to the firm

##### ##### ##### ##### ##### ##### ##### ##### ##### #####

Definitions: Equity free cash flow Less: Less: Less: Less: Add: Less: Less: Sales Cost EBITDA Depreciation EBIT Interest expense Levered net income before taxes Tax @ 40% Levered net income or Net Income* Depreciation CAPEX NWC Increase Cash Flows

to equity

*Note that Net Income + Interest (1-t) = EBIT (1-t) ##### ##### ##### ##### ##### ##### ##### ##### ##### ##### ##### #####

Cash Flow Outline Firm Valuation Method Subtract taxes

(tax rate X EBIT) Unlevered Net Income Plus Depreciation, Less Capital Expenditure, Less Working Capital Change

Firm Free Cash Flow

Discount at WACC

EBIT Equity Valuation Method Subtract Interest Expense

Net Income before Taxes

Subtract taxes

(Tax rate X Net income before taxes) Plus Depreciation, Less Capital Expenditure, Less Working Capital Change

Equity Free Cash Flow

Discount at Cost of Equity

Example:

Sample data

        

Cost of Equity (Rs) = 12% Cost of Debt (Rd) = 8% Tax rate = 40% Earnings before Interest and taxes (EBIT) = $40 million Depreciation = $15 million Capital Expenditures = $15 million The EBIT is perpetual (mature firm) Target debt-to-value ratio (D/V) = 40% Current value of debt is $105.26 million Using free cash flows to find:

 

Enterprise Value Value of Equity

Firm Valuation Method Firm Free Cash Flow WACC

 EBIT(1  T)  Depreciati on  Capital Expenditur es - Change in NWC  $40(1  0.4)  $15  $15  0  $24 million  R d (1  T)D/V  R S * E/V  .08

* .4

* (1  .4)  .12

* .6

 .0912

or 9.12%

Enterprise Value (EV) Value of Equity

 Free Cash Flow WACC  $24 million .0912

 $263.16

million  Enterprise Value  Debt  263.16

 105.26

 $157.9

million

Equity Valuation Method Interest Payments Cash Flows to Equity

 8% * 105.26

 $8.42

million  [EBIT  Interest]( 1  T)  Depreciati  CAPEX  Change in NWC on  [40  8.42](1  .4)  15  15  0  $18.947

million

Equity Value Enterprise Value

 Cash Flows to Equity Cost of Equity  $18.947

million .12

 $157.9

million  Equity Value  Debt  $157.35

 $105.26

 $263.16

million

Relative valuation analysis

General thoughts on relative valuations



Most valuations on Wall Street use multiples



Multiples reflect current market perceptions



Relative valuations require fewer explicit assumptions and are easier to use



Relative valuations often find a more receptive audience (easier to understand as there are fewer assumptions)

29

Relative valuation analysis

Equity valuation using P/E multiples Pros

   Most commonly used and accepted multiple with sell side research Easy to calculate (simply need to ensure you match time periods, trailing, current, future) Takes into account profitability

Cons

       • • Cannot use if companies do not have accounting earnings Are GAAP earnings a good measure of cash flow?

Adjustments for normalized earnings?

• Ignores Economic Profitability A company could be buying earnings Completely ignores capital structure Debt not included in the value of the firm Interest costs and tax shield are ignored Ignores future growth opportunities Ignores capital intensity and investment

Although widely accepted, P/E has serious drawbacks.

Example: P/E multiples

(

P

)

E peers



Multiple of comparable firms EPS subjectfir m

 (

P

)

peers E



Price of subject firm

Relative valuation analysis

Equity valuation using P/E multiples Example

 Comparable firm example (Automotive): Toyota Motor Corp P/E Ratio 13.2

DaimlerChrysler AG 10.5

General Motors Corp 6.6

Ford Motor Company Average 16.0

11.575

Relative valuation analysis

Equity valuation using P/E multiples Example (con’t) Private Company:

  EPS = $2.50

P = 2.50 x 11.575 = $28.94 Estimate

Traded Company:

GM P/E=6.6

 What can we say about GM? Price too low?

 Need to look at accounting methods, risk, growth rates, and payout to see if comparable.

Display Example: A Valuation Perspective

20.0x

15.0x

10.0x

5.0x

0.0x

18.3x

JEC 16.0x

16.0x

TANGO TTEK

P/E 2004E

15.8x

FLR 14.0x

CBI 13.3x

Median 15.8x

6.9x

GVA URS

From our analysis what can you tell me about our company?

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Display Example: Relative Valuation - Correct Time Periods P/E - 2004E

20.0X

15.0X

18.1x

18.0x

17.8x

17.5x

17.1x

14.9x

16.4x

15.6x

15.3x

15.1x

14.0x

13.2x

10.0X

5.0X

0.0X

APD AIRL ARG PX LNDE BOC AIRL ARG PX APD LNDE BOC Source: I/B/E/S Estimate.

10.0x

8.0x

6.0x

4.0x

2.0x

0.0x

8.7x

PX

EV / 2004E EBITDA

8.2x

7.7x

7.3x

ARG APD AIRL 6.0x

BOC 4.8x

LNDE

PX’s trading multiples are consistent with the market’s expectations for future performance.

35

Relative valuation analysis

Enterprise valuation using EBITDA multiples Pros

     Second most commonly used and accepted multiple on Wall Street Easy to calculate (but need to ensure you match time periods, trailing, current, future) Takes into account profitability EBITDA generally a good proxy for cash Takes into account capital structure • Includes debt in the value of the firm (should use net debt) • Includes Interest as part of cash flow

Cons

  Ignores Economic Profitability Ignores capital intensity and investment

The EBITDA multiple is a “cleaner” multiple, however it still misses the hurdle rate and investment required into the business.

Implementing a Multiples Approach

 

Define the multiple

There are different definitions for the same multiple (current, trailing, forward).

  

It is integral to look at the entire distribution of the multiple

Understand the differences between the mean, median and standard deviation Understand why the outlier are outliers (question relevance of the multiple and the companies inclusion in the peer group)  

Understand the fundamentals of the multiple

What are the strengths and weaknesses of the multiple?

 

Choosing a peer group for Relative Valuation Methods

Why are you trying to determine value?