more on valuating

8/10/2019 More on Valuating

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2001 M. P. Narayanan University of Michigan

Valuation methods

An overview


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Methodologies

Comparable multiplesP/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

WACC method

APV method

CF to Equity method


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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 offirm

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 valueValue 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 formatureindustries)

firms in the industry have similar capital structure


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Valuation: Price to book multiple

The application of this method is similar to that of theP/E multiple method.

Since the book value of equity is essentially the

amount of equity capital invested in the firm, thismethod measures the market value of each dollar ofequity invested.

This method can be used forcompanies in the manufacturing sector which have significantcapital requirements.

companies which are not in technical default (negative bookvalue of equity)


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Valuation: Value to EBITDA

multiple

This multiple measures the enterpr is e value, that isthe value of the business operations (as opposed tothe value of the equity).

In calculating enterprise value, only the operationalvalue of the business is included.

Value from investment activities, such as investment intreasury bills or bonds, or investment in stocks of othercompanies, is excluded.

The following economic value balance sheet clarifiesthe notion of enterprise value.


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Enterprise Value

Economic Value Balance Sheet

PV of future cash from business

operations$1500

Cash $200 Debt $650

Marketable securities $150 Equity $1200

$1850 $1850

Enterprise Value


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Value to EBITDA multiple: Example

Suppose you wish to value a target company using thefollowing data:

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 = $75million


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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 millionEBITDA Interest income from marketable securities

20 2.7 = $17.3 million

Estimated enterprise value of the target

9.98

17.3 = $172.65 millionAdd cash plus marketable securities

172.65 + 5 + 45 = $222.65 million

Subtract debt to find equity value: 222.6575 = $147.65million.


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Valuation: Value to EBITDA

multiple

Since this method measures enterprise value itaccounts for different

capital structures

cash and security holdings

By evaluating cash flows prior to discretionary capitalinvestments, this method provides a better estimate ofvalue.

Appropriate for valuing companies with large debtburden: while earnings might be negative, EBIT islikely to be positive.

Gives a measure of cash flows that can be used tosupport debt payments in leveraged companies.


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Valuation: DCF method

Here we follow the discounted cash flow (DCF)technique we used in capital budgeting:

Estimate expected cash flows considering the synergy in atakeover

Discount it at the appropriate cost of capital


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Template for Free Cash Flow

IncomeSta

tement

Working capital

Year 0 1 2

Revenue

Costs

Depreciation of equipment Noncash itemProfit/Loss from asset sales Noncash item

Taxable income

Tax

Net oper proft after tax (NOPAT)

Depreciation Adjustment for

Profit/Loss from asset sales for non-cash

Operating cash flowChange in working capital

Capital Expenditure Capital items

Salvage of assets

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 Incomestatementto calculate taxes

Adjustments for Capital items, such as capital expenditures,working capital, salvage, etc.

The Income Statementportion differs from the usual incomestatement because it ignores interest. This is because, interest,the cost of debt, is included in the cost of capital and including itin 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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There are four categories of items in our Income Statement.While the first three items occur most of the time, the last one islikely to be less frequent.

Revenue items

Cost itemsDepreciation items

Profit from asset sales

Adjustments for non-cash items is to simply add all non-cashitems subtracted earlier (e.g. depreciation) and subtract all non-

cash items added earlier (e.g. gain from salvage).There are two type of capital items

Fixed capital (also called Capital Expenditure (Cap-Ex), or Property,Plant, and Equipment (PP&E))

Working capital


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It is important to recover both at the end of a finite-lived project.

Salvage the market value property plant and equipment

Recover the working capital left in the project (assume full recovery)


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Taxable income = Revenue - Costs - Depreciation + Profit from asset sales

NOPAT = Taxable 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 subtracted earlier and subtract the noncash items you added earlier.


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Estimating Horizon

For a finite stream, it is usually either the life of theproduct or the life of the equipment used tomanufacture it.

Since a company is assumed to have infinite life:Estimate FCF on a yearly basis for about 5 10 years.After that, calculate a Terminal Value, which is the ongoingvalue of the firm.

Terminal value is calculated one of two ways:

Estimate a long-term growth and use the constant growthperpetuity model.

Use a Enterprise value to EBIT multiple, or some suchmultiple


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Costs of debt and equity

Cost of debt can be approximated by the yield tomaturity 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 equityCAPM

Findbeand calculate required r

e.

Use Gordon-growth model and find expected re. Under the

assumption that market is efficient, this is the required re.


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Model of a Firm

Value fromOperations

FIRM

DEBT andother

liabilitiesEQUITY

Value generated

Value to Equity

Equal if debtis fairly priced

Value frominvestments

Enterprise value


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Value of equity

Value of equity

= Enterprise value

+ Value of cash and investments

- Value of debt and other liabilities

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