Finance 7325

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Finance 7325

• Business Valuation

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What is Being Valued?

• Equity
• Minority v. Controlling Interest
• Equity Value Firm Value - Debt
• Assets (Firm)
• In effect a controlling interest?
• Whose management is being valued?

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Purposes of Valuation

• Strategic Planning evaluating strategies
• Any equity financing stage
• Mezzanine/venture financing
• Initial Public Offerings
• Merger or sale
• Other
• Estate Planning
• Partnership formation/dissolution

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Approaches to Valuation

• Cost
• Market Multiples (Comparables)
• Cash Flow (NPV Adjusted Present Value)
• Venture Capital

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Cost (Asset Based)

• Book Value
• Book Value of Equity (Assets) Shares O/S
• Not really value
• Reflects historical value of transactions only
• Modified Book Value
• Obtain appraisals
• Still doesnt reflect going concern value

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Cost (Asset Based)

• Entrepreneurial Ventures
• This approach usually would NOT be appropriate
• Why?
• These are GROWTH companies, and hence most of
  their value is reflected in future transactions,
  not those already recorded
• Relevant for bankers and liquidation or BR

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Market Multiples - Comparables(Relative
Valuation Approach)

• Looking to Market for Valuation
• How does Market Value Similar Assets
• Ex Real Estate - how does market value similar
  houses
• Two Issues
• Which Multiples should be used?
• What does similar or comparable mean?

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Market Multiple Approach

• Gives a relative value as opposed to an
  intrinsic value
• Reflects current mood of market
• If market over or undervalues comparable firms,
  this approach will over or undervalue your firm
• Its simplicity can lead to its abuse

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Market Multiples

• (Price per Share) / (Economic Measure per share)
  ? Value of Equity
• Value of firm / Economic Measure ? Value of
  Firm

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Accounting Based Multiples

• Earnings (P/E) ? Equity
• Revenues ? normally Equity
• Cash Flows ? Equity or Firm
• Enterprise Value/EBITDA is most common
• NI Deprec.
• Book Value ? Equity or Firm (also called
  market/book)

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Industry Multiples

• Examples
• Beds/Rooms (Hospitals, hotels)
• Customers (e-tailers)
• Million Barrels of Oil ounces of gold
• Cases sold (Beverage distribution)
• Subscribers (Cable, newspapers, internet
  cellular)
• Any performance measure
• Industry specific multiples more predictive of
  value

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Market Multiple Issues

• Defined consistently and measured consistently
  across firms
• Understand cross-sectional distribution of
  multiples across sector and market
• Understand fundamental determinants of multiple
• Find right firms for comparison

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Defined Consistently

• Consider P/E ratio Earnings definition
• Price Price per share
• Earnings
• Current earnings (from most recent F/S)
• Trailing (last four quarters)
• Forward (expected in next financial year)
• Diluted - W/WO extraordinary items

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Distributional Characteristics

• Price/earnings ratios cannot be negative
• Constrained below by 0 unconstrained above
• Skewed to the right median more representative
  than the average average too high
• Outliers ? can have very high P/E when E is close
  to 0
• Throw out negative earnings, or use aggregate
  earnings and equity

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Multiple Determinants

• What are the fundamentals that determine a
  multiple? (Also known as quality)
• Normally, one or more of the following
• Growth
• Risk (stability)
• Profitability (margins)
• Reinvestment
• Entrepreneurial firms liquidity lack of
  marketability

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Determinants of Quality Accounting Multiples

• Earnings
• Growth
• Stability (Risk)
• Reinvestment needs
• Revenues
• Net or operating margin
• Growth
• Stability (Risk)
• Reinvestment needs

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Quality Accounting Multiples

• Cash Flows
• Growth
• Stability
• Reinvestment needs
• Risk

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Quality Industry Multiples

• Profit margin (subscribers customers)
• Cost to obtain (oil reserves customers)
• Cost to retain (subscribers customers)
• Cost to service

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Multiple Fundamentals Ex.

• Consider Dividend Discount Model (Constant growth
  model using D instead of CF)
• P D1/(R g) Let D EPS x (1-r), where r
  retention ratio
• P EPS(1-r)/(R g)

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Multiple Fundamentals Ex.

• P/EPS (1-r)/(R g)
• P/EPS f(reinvestment (r), risk (R), growth
  (g)), as stated

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Multiple Fundamentals Ex.

• Suppose we want to consider P/Sales
• Divide by Sales
• P/Sales EPS/Sales x (1-r)/(R-g)
• P/Sales f(net margin, reinvestment, risk,
  growth), as stated.

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Multiple of Sales

• CPA Firms
• Medical firms
• Internet firms
• No Earnings
• No Cash Flow
• Most appropriate for acquisition of Customers or
  a Revenue stream

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Multiple of Sales Abuses

• Internet Firms
• No Earnings or cash flow Revenue only positive
  number
• Higher revenues ? higher valuation
• Barter trade ad space (sale purchase)
  multiple of revenue recognizes sale only
• Accounting treatment of e-tailers
• Net sales v. gross
• Solution Multiple of gross margins

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Market Multiple Application

• Select a sample of comparable companies
• Same Industry (SIC, NAIC code)
• Go through descriptions to narrow list
• Earnings or cash flow companies with positive
• Size Stage
• Growth history and potential
• Discount for lack of marketability

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Market Multiple, example
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Market Multiple, example
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Market Multiple, ex.
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Market Multiple, ex.
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Market Multiples Determinants of Quality

• P/E f(Growth, Risk, Reinvestment)
• (Equity value)
• P/Revenues f(Growth, Net or Operating Margin,
  Risk, Reinvestment)
• (Equity value, usually)
• P/CF f(Growth, Risk, Reinvestment?)
• (Equity value or firm value depends on cash flow
  measure)
• P/BK (equity) f(ROE, Risk, Reinvestment)
• (Equity value)
• P/BK (assets) f(ROA or ROIC, Risk,
  Reinvestment)
• (Firm value)

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Discounted Cash Flow

• Cash Flows to Firm
• EBIT
• Non-Cash items (depreciation)
• - Taxes (tax rate x EBIT)
• - ? NWC
• - Capital Spending
• FREE CASH FLOW (FCF)

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Discounted Cash Flow

• ? NWC
• Consistent with sales assumptions
• Maintain constant of sales
• Is current level of NWC optimal???
• Capital Spending
• Consistent with growth assumptions?
• Long-run equal to depreciation or slightly
  greater

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Discounted Cash Flow

• Mechanics
• Project out cash flows until stable
• Calculate Terminal Value (Residual Value)
• Terminal Value Value of perpetual cash flow
  stream TV CF/(R - g)
• Discount Projected CFs TV to present

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Discounted Cash Flow

• Two-Stage Model

CFt
Time
TVt
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DCF, continued

• Discount Rate
• WACC
• Firm being valued (acquired)
• Growth rate should be consistent w/ cash flows
• Example

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WACC

• WACC weighted average cost of capital
• WACC Rd (1-t) (D/V) Re (E/V)
• V D E
• Rd required return on debt (YTM)
• Re required return on equity

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Re

• Capital Asset Pricing Model
• Re Rf B(Rm Rf)
• Beta obtained from sample of comparable
  companies
• Rf risk-free rate use T-bonds
• Rm Rf historical risk premium (6-8?)

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Re, cont.

• Private, high growth companies
• Information asymmetry ? more risk
• Usually smaller
• Lack of marketability
• Add premium to CAPM
• Industry, size, etc.
• Known as Build-up approach

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Discounted Cash Flow
Firm Value
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Terminal Value

• Assume Company is stable/mature
• Use P/E approach, V/EBITDA or other multiple
  multiples taken from comparable publicly traded
  firms
• Use DCF approach w/ constant/no growth

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Discounted Cash Flow

• TERMINAL VALUE

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Growth

• Short-run growth ? high for entrepreneurial firms
• Long-run growth
• Economy growth rate
• Industry growth rate
• Sustainable growth rate (r x ROIC), where r
  (Cap. Spend. dep Change in NWC) / EBIT(1-t)

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Example Part A - D
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Example, cont.

• Firm Value 514.6
• Value of Debt 300
• gt Equity Value 214.6 50
• 4.29/share

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Example Part E
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Example, cont.

• Firm Value 579.7
• Value of Debt 300
• gt Equity Value 279.7 50
• 5.59/share

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Example Part F
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Example, cont.

• Firm Value 671
• Value of Debt 300
• gt Equity Value 371 50
• 7.42/share

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Minority V. Controlling Interest

• Issue Is Ownership of Value?
• EX Suppose you own 10 of company, and company
  is valued at 10,000,000 ?
• Is your interest worth 1,000,000?
• Is the other 90 worth 9,000,000?
• Your interest may be worth less than 10, and the
  controlling more than 90, though the total may
  not exceed 100

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Privately Held Cos

• Excess Compensation
• Owners getting money out of company
• Deficient Compensation
• Owner not taking out enough
• Compensation should reflect economic value of
  services

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Private Businesses, cont.

• Personal expenses in company
• Whether you adjust depends on whether you are
  valuing a controlling interest
• Discount rate higher for smaller cos gt value
  lower