Introduction to Valuation and Financial Analysis

1
Introduction to Valuation and Financial Analysis

• FINA 6211
• Prof. J. Allen

2
Fundamentals

• Time value of money
• Value creation
• ability to generate cash flow from operations
  (CFFO)
• Compensation for bearing risk

3
Key Measures

• Key areas
• Business Performance
• Profitability, growth, rates of return
• Earnings Quality
• Cash flow generation, asset replacement rates
• Asset Control and Velocity
• Asset utilization, working capital management
• Financial Leverage
• Valuation
• market values relative to operating metrics

4
Business Performance
5
Asset Control Velocity
6
Asset Control Velocity (contd)

• Cash Conversion Cycle
• Average Collection Pd. Days in Inventory
  Payment Deferral Pd.
• Ex. What is the cash conversion cycle for a
  company with sales of 3,600, cost of sales of
  2,400, receivables of 300, average inventory of
  400 and payables of 120?

7
Financial Leverage
8
Valuation
9
Performance Analysis

• Financial metrics
• Compare across time
• Compare to benchmark firms (size industry
  match)
• Adjustments should be made for
• Timing of reporting periods
• Accounting differences (e.g. leases, inventory
  valuation, franchising, etc.)

10
Weaknesses of Ratio Analysis

• Weaknesses
• Static measurement window dressing (e.g.
  balance sheet)
• Off balance sheet financing / issues found in
  footnotes
• One-time events or non-recurring items
• Validity of data
• May not be indicative of key shifts in industry
  or actions of competitors that will drive future
  performance

11
Operating Leverage

• Operating leverage is the fixed cost component in
  a firms total cost structure.
• Degree of operating leverage (DOL)? flow measure
  
• ? in EBITDA / ? in Sales
• Not necessarily a direct relationship between op.
  leverage and fixed assets (PPE)
• Difficult to measure accurately since fixed and
  variable costs are not reported

12
Qualitative Measures

• Management quality
• How can an analyst make this assessment?
• Accounting risk
• Revenue recognition
• Depreciation methods
• Inventory pricing
• Off-balance sheet transactions
• Industry position does the firm have
  competitive advantage whereby they can
• Keep competition out?
• Set prices and/or maintain above average margins?

13
Approaches to Valuation

• Compare to similar transactions (multiples)
• Compare to public valuations (multiples)
• Fundamental - discounted cash flow (DCF)
• The best method to use depends on the context
  of the decision and available data more than
  one method is often used
• Imprecision is part of the game also where
  solid analysis adds the most value
• Analyses are generally very sensitive to key
  assumptions
• Avoid shortcuts several million deserves your
  analysis

14
Transaction Comparisons

• Multiples of
• Earnings (EBITDA, EBIT)
• Cash flow
• Revenues
• Assets
• Revenue and asset-based comparisons should be
  avoided if at all possible
• Revenues often have no relation to cash flow
• Book value of assets is a weak basis, at best, of
  market value

15
/- of Earnings and Cash Multiples

• Why transaction multiples?
• Based on (hopefully) similar and recent
  transactions
• Easy to calculate and communicate
• Commonly reported
• Note that the transaction amount generated from
  any type of sophisticated analysis can ultimately
  be expressed as a multiple of cash flow, e.g.
  EBITDA, EBIT, revenue, etc.

16
/- of Multiples (contd)

• Disadvantages of transaction multiples
• Basis is a single period in time ignores growth
  and longevity of cash flows
• Direct comparisons are difficult due to context
  differences, motivations behind a sale, asset
  composition, etc.
• Subject to significant swings in value (e.g. 5x
  to 5.5x)
• Subjectivity of appropriate multiple
• Did buyers in prior deals over or underpay?
• Should be used as a reference point, not as the
  sole basis for determining value

17
Public Market Comparables

• Issues
• Differences between public and private firms
• Control
• Illiquidity
• Governance
• Size
• Subject to market sentiment reliance on
  accuracy of current public market value
• Multiples are recommended more by advisors than
  in situations where a buyers capital is at stake

18
Less Utilized Approaches

• Liquidation value sum of the piecemeal sale of
  the company less debt
• Often has little relevance to the value as a
  going concern
• Replacement cost value equals expected
  replacement cost of assets
• Tangible assets only unrelated to cash
  generated by firm

19
Discounted Cash Flow

• The value of any financial asset is the present
  value of its future cash flows
• e.g. Treasury or corporate bonds priced to the
  penny
• Since DCF is multi-period, several assumptions
  are required this is the nature of finance
• One cannot predict the future with certainty
• Variance is smaller in industries where cash flow
  is highly predictable or there is a long history
  to serve as a basis
• Techniques must be used to increase confidence in
  the valuation, e.g. scenario and sensitivity
  analysis

20
Key Assumptions

• DCF is based on cash flow estimates in future
  periods and the discount rate
• Estimates of future cash flows should be
• Defendable and reasonably conservative (buyer vs.
  seller)
• Based on the underlying fundamentals of the
  business and industry
• Forecasted in detail over a short horizon with
  future cash flows estimated using a conservative
  terminal value calculation, e.g. inflation rate
• Note that the length of the forecast should not
  affect the value of the firm

21
Free Cash Flow from Operations (FCFFO)

• Total after-tax cash flow generated by the
  company that is available to both shareholders
  and creditors
• Before financing and therefore unaffected by
  capital structure
• Does not include cash from non-operating sources.
  Non-operating cash flows, however, may affect
  the overall value of a company

22
Enterprise Value

• Enterprise value
• Present value of a companys free cash flow from
  operations
• Present value of after-tax non-operating cash
  flows
• Excess cash (greater than required to operate)
• Excess marketable securities

23
Net Income to FCFFO

• Start with Net Income
• add increase in deferred taxes (equals
  adjusted or cash taxes)
• add amortization or impairment expenses (no tax
  adjustment)
• Adjusted Net Income
• add net interest expense after taxes (x by 1
  t)
• add rent/lease expense after taxes if included
  in WACC (x by 1 t)
• less non-operating income after taxes (x by 1
  t)
• less gain on sale of assets (x by 1 t)
• Net Operating Profit less adjusted taxes
  (NOPLAT)
• add depreciation expense
• less increase ( decrease) in non-interest
  bearing working capital
• less capital expenditures and new investment in
  goodwill
• less increase ( decrease) in other assets, net
  of other liabilities
• plus foreign currency translation gains (-
  losses)
• Free Cash Flow from Operations

24
Forecasting Guidelines

• Companies rarely outperform their peers for long
  periods of time growth rates decline as
  industries mature
• Company performance often varies widely from
  industry averages
• Economic fundamentals always play a role in
  forecasts but the effect varies by industry
  cyclicality in forecasting is difficult, but is
  much more accurate in DCF than other approaches

25
Implications of Leverage

• Advantages to debt
• Interest on debt is tax deductible
• Adds managerial discipline
• Debt is always cheaper than equity
• Disadvantages to debt
• Costs of bankruptcy or financial distress
  increases risk
• Agency costs between debtholders and shareholders
• Loss of future flexibility

26
Adjusted Present value (APV)

• Variation on standard DCF
• No need to estimate capital structure discount
  the cash flow estimates at the required return to
  equity
• Add the present value of the tax shields obtained
  from debt
• Shows where value comes from e.g. operations
  vs. tax shields on debt
• Automatically incorporates changes in capital
  structure over time

27
Residual Value

• The residual is the present value of all cash
  flows beyond the forecast period.
• A significant portion of asset value is often
  tied up in the terminal (or residual) value.
• Growth assumption is key
• Appeal to conservative estimate
• Effect is reduced because cash flows in the
  future are discounted at an increasing rate
• Expected inflation rate at minimum unless
  declines are expected

28
Adjustments

• Control premium
• VERY Subjective depends on extent of power held
  by those in control
• Up to 40 percent found in studies of public
  companies (perhaps overpayment vs. rational)
• Illiquidity/lack of marketability discount
  (relative to public firms)

29
Adjustments (contd)

• Subtractions or adjustments should be made for
  the following
• Off-balance sheet liabilities (e.g. guaranteed
  debt in unconsolidated subsidiaries)
• Unfunded pension liabilities shortfall between
  plan assets and the projected benefit obligation
  (PBO)
• Unusual capital or refurbishment costs not in
  forecast
• Expected cost of other pending liabilities e.g.
  potential legal judgments

30
Minimizing Subjectivity

• Sensitivity analysis what happens to the value
  if key assumptions change?
• Discount rate
• Growth rates
• Capital requirements
• Economic fluctuations
• Source of information?
• Post audit prior decisions to determine if
  systematic errors occurred

31
Introduction to Valuation and Financial Analysis

• FINA 6211
• Prof. J. Allen