Value Based Management

1
Business Valuation
2
Outline of a Business Analysis and Valuation

• Define the problem
• General economic conditions
• Industry analysis
• Companys position within the industry
• Company financial analysis
• Historical
• Forecast
• Preliminary valuation
• Premiums/discounts

3
Defining the Valuation Problem

• Valuation date
• Purpose
• Definition of value
• Claim (level of value)

4
Business Valuation Definitions of Value

• Fair Market Value
• The fair market value of an asset is generally
  defined as the cash price at which the asset
  would change hands between a willing buyer and a
  willing seller, if the asset were offered for
  sale on the open market for a reasonable period
  of time, and both the buyer and the seller were
  adequately informed of the relevant facts with
  neither being under any compulsion to act.

5
Business Valuation Definitions of Value

• Investment Value
• The investment value is the value of the asset
  to a specific owner or prospective owner.
  Accordingly, this type of value considers the
  owners or prospective owners knowledge,
  abilities, expectations of risks, earning
  potential, and other factors.

6
Business Valuation Definitions of Value

• Fair Value
• The term fair value is used to refer to a
  court-determined value provided for under the
  laws of some states. In those states, if a
  corporation agrees to a merger, sale, or other
  action and the minority stockholders believe they
  will not get adequate consideration for their
  stock, those stockholders have the right to have
  their shares appraised and get fair value in cash.

7
Valuation Premises

• The value of a business is equal to the present
  value of the future benefits of ownership.
• Value is not always a single number.
• Value is specific to a point in time.

8
The Fair Market Value Balance Sheet
Current Liabilities (excluding current long-term
debt)
Current Assets
Net Working Capital
Long-Term Debt
Property, Plant, and Equipment
Value of Total Capital
Business Value
Intangible Assets
Stockholders Equity
Goodwill and Going Concern
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General Economic Conditions

• What is the current state of the economy?
• What are the general economic prospects?
• How are they likely to affect the firm in the
  future?

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Industry AnalysisMichael Porters Five Factors
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Value Created through Acquisition Synergies
Unique Synergy
Universal (Industry) Synergy
Potential Premium
Cost Savings
Revenue Gains
Offensive/ Defensive
Transaction Costs
Savings/ Gains

• Operating Improvements
• Administrative Cost Savings
• Marketing Synergy

• Operating Synergy
• Contracting Synergy
• Securing Existing Markets
• Growth in New Markets
• Keeping Competitors Out

Stand-Alone Value
Strategic Value
Numerous Bidders
Few Bidders
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12

• Preliminary Business Valuation

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Valuation Methodologies

• Cost approaches
• Replacement cost
• Adjusted book value or sum of assets
• Market approaches
• Comparable multiple and transaction analyses
• Income approach
• Discounted cash flow

14
Cost ApproachesReplacement Cost Analysis

• The cost of duplicating the assets in their
  present form.
• Reflects asset type and condition at a particular
  point in time.
• Generally used for insurance purposes.
• Does not reflect the earnings/cash flow
  generating capacity of the business.
• Useful for a buy versus build analysis.

15
Cost ApproachesAdjusted Book Value (Sum of
Assets)

• The value of individual assets and liabilities
  are restated to reflect their market value.
• Typical adjustments include those for
• Inventory under-valuation (LIFO)
• Bad debt reserves
• Market value of PPE
• Patents and franchises
• Investments in affiliates
• Low-cost debt securities
• Tax loss carry-forwards

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Cost ApproachesAdjusted Book Value (Sum of
Assets)

• Useful for valuing holding companies whose main
  assets are publicly traded or other investment
  securities.
• Less applicable for operating businesses
• Total value is usually greater than the sum of
  the asset values
• Difference between total value and the sum of the
  asset values is called the going concern value.
• Useful in valuing operating companies where
• Going concern value is negative
• Liquidation is being considered

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Market Approaches Introduction

• Two general approaches
• Comparable Multiples Analysis
• Comparable Transactions Analysis
• Identify publicly-traded companies engaged in
  similar business activities with risk/return
  characteristics similar to those at the subject
  company.
• Infer value from the prices of the securities at
  these publicly-traded firms.

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Comparable Multiples Analysis

• Infers value from the prices of publicly-traded
  securities at comparable firms.
• P/E, P/Div, P/Rev, P/NAV
• Market/Book
• MVIC/Rev, MVIC/FCF MVIC Market value of
  invested capital (MV debt MV equity)
• Requires extensive analysis of
• Products
• Markets
• Sales growth
• Profit margins

• Geographic scope of operations
• Financial structure
• Financial and Operating Trends
• Quality of Management

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Comparable Multiples Analysis

• Use contemporaneous data
• Adjust the comparable company data for
  depreciation methods, off-balance sheet
  transactions, extraordinary income or expense
  items, non-operating assets etc.
• Achieve consistency between numerator and
  denominator
• Equity value to equity income
• Invested capital value to invested capital income

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Comparable Multiples Analysis

• Interpret the value indications carefully.
• Equity value vs. invested capital value
• Value indications are on a minority basis.
• Publicly-traded equity securities used in a
  multiples analysis typically represent minority
  investments.

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Comparable Transactions Analysis

• Process is similar to comparable multiples
  analysis
• Data reliability is usually lower
• Transaction terms are often difficult to assess
• Value indications are usually on a control basis

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Market ApproachesConcluding Comments

• True comparables are rare
• However, these approaches are often used for
• Estimating risk-adjusted returns
• Benchmark comparison
• even when strong comparables are not available.

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Income ApproachEstimating the Total Value of
the Firm

• The total value of a firm, VF, equals the present
  value of the free (net) cash flows, FCF, that the
  firm is expected to provide investors, discounted
  by the firms weighted average cost of capital,
  WACC.

• The total free cash flows are calculated as
  follows

Sales - Operating Expenses
Earnings Before Interest, Taxes, Dep
Amort (EBITDA) - Depreciation and Amortization
Operating Profit (EBIT) x (1 - Average Tax
Rate) Operating Profits After
Tax Depreciation and Amortization - Capital
Expenditures - Additions to Working Capital
Free Cash Flows
where t is the period in which the
cash flow is received.
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Income ApproachesDiscounted Cash Flow (DCF)
Analysis

• The DCF approach considers the actual benefits
  that investors care about (e.g., cash-equivalent
  value) better than any of the methods discussed
  so far.
• The implementation of the DCF approach can be
  represented as follows
• VF PV(FCFT) PV(TVT) NOA
  3
• where
• V - value of the business
• PV(FCFT) - PV of the total FCF through year T
• PV(TVT) - PV of the terminal value in year T
• NOA - market value of excess or non-operating
  assets

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The Value of a Firm
Just as total assets equals total liabilities
plus shareholders equity in accounting, in
finance
Firm Value Value of Equity Value of Debt
or
VF VE VD
This relation suggests that we can estimate the
value of the firm directly by valuing the assets,
or indirectly by valuing and then summing the
claims on those assets.
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Income Approaches Discounted Cash Flow Analysis
Valuing Free Cash Flows to the Firm

• Lets discuss how we compute each of the
  components of equation 3.
• VF PV(FCFT) PV(TVT) NOA 3

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Calculating PV(FCFT)

• The present value of the free cash flows,
  PV(FCFT), in equation 3 is estimated by using
  the weighted average cost of capital (WACC) to
  discount the projected operating cash flows. The
  operating cash flows in period t are calculated
  as
• NOPATt EBITt(1 - tc)
  6
• FCFT,t NOPATt DEPt - CAPEXt - DWCt
  7
• where
• NOPATt -net operating profits after tax
• EBITt - projected earnings before interest and
  taxes
• tc - corporate tax rate
• CAPEXt - total capital expenditures
• DEPt - tax depreciation and amortization
• DWCt - additions to working capital

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Cash Flow Forecasts

• Cash flow forecasts are typically derived from
  proforma financials.
• Therefore, as with proforma financials, the
  process of forecasting cash flows involves
• making explicit assumptions concerning revenues,
  operating costs, financial market conditions etc.
  and
• modeling the inter-relationships between the
  various line items in the firms financial
  statements.
• Cash flow forecasts will vary depending on
  whether you are calculating Fair Market or
  Investment Value and whether you are valuing a
  Controlling or a Minority interest.

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Calculating PV(FCFT)Determining Corporate Tax
Rate

• Should be forward looking
• Should reflect the rate that will be applied to
  future earnings
• Fair Market Value - Average rate
• Investment Value
• Stand-alone business - Average rate
• Merger - Acquirers marginal rate

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Calculating PV(FCFT)Determining Capital
Expenditures

• CAPEXt in equation 7 includes expenditures for
  RR (repair and replacement/economic depletion)
  and capacity additions.
• Project these two items separately in the pro
  forma analysis.
• RR capital expenditures tend to be relatively
  stable.
• Investments in new capacity must be consistent
  with the growth projections.

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Calculating PV(FCFT)Determining Depreciation

• Depreciation should be based on expected tax
  depreciation schedules.
• Should be calculated for both the existing asset
  base and for future expenditures.

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Calculating PV(FCFT)Determining Additions to
Working Capital

• DWCt is the incremental working capital required
  in year t.
• As a business grows, cash, accounts receivable,
  inventory, and accounts payable also tend to
  grow.
• The historical relation between revenue and
  working capital can be used to estimate this
  percentage.

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Calculating PV(TVT)General

• The present value of the terminal value, PV(TVt)
  in equation 3, is frequently estimated by
  capping the cash flows at the end of a period
  for which detailed projections are produced.
• Businesses are typically long-lived assets.
• Detailed cash flows beyond 5 or 10 years tend to
  be highly uncertain.
• Consequently, analysts usually prepare detailed
  cash flow projections for some finite period and
  then assume some terminal value at the end of
  that period.

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Calculating PV(TVT)

• The constant growth model is typically used to
  estimate the terminal value.
• TVT FCFT(1g)/(WACCT - g) 9
• where
• FCFT operating cash flow in year T
• WACCT - weighted average cost of capital in year
  T
• g - expected growth rate of the free cash flows
• Note that TVT is in year T dollars. It must be
  discounted back to year 0 before it is used in
  equation 3.

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Calculating PV(TVT)Selecting the Terminal Year

• Since the constant growth model assumes that the
  cash flows will grow at rate g forever, you
  should try to prepare detailed cash flow
  projections for a period at least as long as it
  takes the business to stabilize.
• Note that g cannot exceed WACC or the sum of
  expected inflation and the expected real growth
  rate of the economy.

Cash Flows
Year
0
T
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Other approaches to terminal value

• Another method for computing the terminal value
  is to use a multiple approach. Use a multiples
  based on comparable firms
• Price/Earnings
• Price/Cash Flow
• Price/Sales
• Price/Book Value
• Need to take care to ensure that multiples are
  consistent.
• Are you valuing the equity or the entire firm?
• Are the quantities for the comparables computed
  consistently? You may need to make accounting
  adjustments.

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Estimating the Value of Non- Operating Assets
(NOA)

• The approach used to value non-operating assets,
  NOA in equation 3 varies with the type of
  asset.
• Seek professional assistance when necessary.

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The Weighted Average Cost of Capital

• The weighted average cost of capital is
  calculated as follows

Where
rd is the cost of debt
tc is the corporate tax rate
re is the cost of equity
39
Cost of EquityAn Illustration

• An analyst is valuing a privately-held oil
  exploration and production firm on August 10,
  1999. The analyst wants to estimate the cost of
  equity for the firm if it is financed with 30
  debt and 70 equity. Pre-tax earnings from the
  firm will be taxed at an effective rate of 35.
• The analyst must estimate the risk free rate, the
  risk premium, and the beta for the project.
• Risk Free Rate Since the firm has an indefinite
  life, the analyst first looks up the current
  yield on long term Treasury bonds in the WSJ.
  February 2029 bonds are yielding 6.23.

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Cost of EquityAn Illustration (continued)

• In order to estimate the risk premium, the
  analyst obtains the historical annual total
  returns on common stocks and the annual total
  returns on long term Treasury bonds for the 1926
  to 1998 period from the SBBI 1999 Yearbook
  published by Ibbotson Associates.
• The arithmetic average of the yearly differences
  in the annual common stock and Treasury bond
  returns is computed to be 7.40. This number is
  used as an estimate of the market risk premium.

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Cost of EquityAdjusting Beta for Leverage

• Beta is a function of both business risk and
  financial risk.
• It is usually necessary to adjust for leverage
  when using the beta for a publicly-traded
  security as a proxy for beta for an investment.
  The formula that we typically use to adjust beta
  is
• Where
• bl is the beta that you observe for the
  publicly-traded security.
• bu is the unlevered or asset beta.
• VD/VE is the market value of debt divided by the
  market value of equity
• tc is the corporate tax rate

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Cost of EquityAdjusting Beta for Leverage

• The formula on the preceding slide is used to
  unlever the observed beta. This beta would then
  be relevered to reflect the financing for the
  project being considered by using the same
  formula

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Cost of EquityAn Illustration (continued)
The unlevered (asset) beta for the firm can be
estimated using betas for firms that are in the
same business.
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Cost of EquityAn Illustration (continued)

• The unlevered beta must now be relevered to
  reflect the leverage of the project.
• Finally, the cost of equity can be estimated as

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Estimating the Discount RateFMV of a
Controlling Position

• Use debt and equity weights that reflect the
  optimal capital structure.
• Use the average tax rate.

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Estimating the Discount RateFMV or Investment
Value of a Minority Position

• Use debt and equity weights that reflect the
  expected capital structure given the existing
  governance structure.
• Use the average tax rate.

47
Estimating the Discount RateInvestment Value of
a Controlling Position

• Use the capital structure that the investor is
  likely to impose on the firm.
• If a merger is being contemplated use the
  marginal tax rate of the investor, otherwise use
  the average tax rate.

48
Valuing Firms With Multiple Lines of Business

• When valuing a firm with multiple lines of
  business, the cash flow projections should be
  sufficiently detailed to allow for differences
  among the businesses in the growth rates in
  revenue, expenses, etc.
• The discount rate should be a weighted average of
  the discount rates for the individual businesses
  (assuming that the businesses are independent).
  Let TCtotal capital.
• bTot (TCBus1/TCTot)bBus1 (TCBus2/TCTot)
  bBus2 11
• (TCBusN/TCTot)bBusN
• WACCTot (TCBus1/TCTot)WACCBus1
  (TCBus2/TCTot)WACCBus2
• (TCBusN/TCTot)WACCBusN 12

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Calculating Total Equity Value

• Once the total value of the firm has been
  estimated, the value of the equity can be
  calculated by subtracting the value of all other
  claims from the total value.
• VE VF - VD 5
• To implement this approach you have to estimate
  the market value of all other claims to the
  firms cash flows. The methodology that you use
  will depend on the type of claim.

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An Alternative Approach for Estimatingthe Value
of Equity

• The total value of a firms equity, E, equals the
  present value of the cash flows that shareholders
  are expected to receive from the firm, discounted
  by the firms cost of equity.

• The cash flows to shareholders are calculated as
  follows

Sales - Operating Expenses
Earnings Before Interest, Taxes, Dep
Amort (EBITDA) - Depreciation and Amortization
Operating Profit (EBIT) - Interest Expense x
(1 - Average Tax Rate) Net
Income Depreciation and Amortization - Capital
Expenditures - Additions to Working Capital
Proceeds from New Debt Issues - Principal
Repayments Cash Flows to
Shareholders
where t is the period in which the
cash flow is received
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Levels of Value
100 Control
Control Premium
Marketable Minority Interest
Marketability Discount
Closely-Held Minority Interest
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Premiums/Discounts

• Adjust preliminary value estimates for control,
  key people, and/or marketability.
• First make any additional adjustments for
  control, then evaluate key person and
  marketability implications.

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Premiums/DiscountsMarketability/Liquidity

• Differences in marketability can result in a
  substantial variation in the fair market value of
  otherwise equal investments.
• Public versus private firm shareholders.
• An investor is going to require the same rate of
  return for two investments of equal risk.
• Higher transaction costs at a private firm reduce
  the market value of its shares.
• For privately-held businesses, liquidity
  discounts are typically on the order of 30 or
  more.

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Premiums/DiscountsKey People

• The value of some firms is heavily dependent on a
  particular individual or group of individual.
• Discounts are often taken in valuations of such
  firms to reflect the likelihood that a key person
  departs and the expected effect of such a
  departure on the firms cash flows and/or their
  riskiness.