Overview of Corporate Valuation Techniques

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Overview of the session

Introduction

Discounted Cash Flow (DCF)

Trading Multiples (or market multiples)

Comparable deals

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Valuation skills are critical in most of Morgan’s businesses

M&A

Investment Banking

Equity Capital Markets

Principal investing

Equity derivatives

Global Credit

Asset Management

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Probing for evidence of analytical skills is a primary interview objective

Investment banking involves a great deal of modeling, forecasting, and valuation work

Investment bank interviewers typically ask questions about valuation techniques or finance transactions

– e.g. “You are advising a large technology company on an acquisition of a smaller niche technology company. What are the issues you would consider in valuing it? How would you estimate its value?”

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General themes of this session

There is not one right way to value a firm

– Consultants almost always evaluates DCF, trading values, and comparable transactions

– Other techniques are appropriate in selected situations (dividend discount model, leveraged value, liquidation value)

– Understanding differences between various valuation techniques is often critical to the appropriate decision

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Overview of the session

Introduction

Discounted Cash Flow (DCF) Value based on estimated future cash flows of a company discounted by a rate that reflects the risk of its business and capital structure

Trading Multiples (or market multiples)

Comparable deals

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Discounted cash flow analysis has three key components

Forecasted free cash flows– Cash flows before debt service or distributions to shareholders

Terminal value– Estimate of future value at “stable state”

Cost of capital – Represents current return requirements of debt and equity holders– Reflects target capital structure on a market weighted basis

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Projecting cash flows requires in-depth understanding of the business

Industry outlook

– Anticipated industry growth

– Major opportunities/risks

Competitive position

– Pricing flexibility

– Possible market share changes

– Cost structure

Reinvestment needs

– Working capital

– Required capital expenditures

– Discretionary investments

Expansion opportunities

– New product/stores/format

– Development costs

– Economies of scale

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Defining free cash flow

Free cash flow is the cash that remains after all necessary reinvestments have been made

Free cash flow is measured prior to any debt service (interest and debt repayment), but after taxes

Free cash flow therefore is the amount of cash that can be distributed to shareholders and creditors

Free cash flow is typically defined as:

Operating Profit

- Taxes (Cash)

= Net Operating Profit After Tax (NOPAT)

- Capital expenditures

+ Depreciation

+ Amortization of goodwill

- Change in net working investment 1

+/- All other items (that affect cash flow)

= Free cash flow

1 Inventory plus receivables less payables and accruals (net change; usually a use of funds)

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The terminal value must also be estimated in a DCF valuation

Terminal Value is the portion of a company’s total value that can be attributed to cash flows expected in the period beyond the specific forecast period

The terminal value period is the time from the end of the specific forecast period to infinity

Terminal value should be estimated when the forecast reaches “steady state”– Long-term assumptions have stabilized– Little added value to forecasting more years– Usually around ten years

The terminal value is equivalent to making infinite year-by-year forecasts

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Perpetuity model

Price multiples (i.e., P/E ratios, EBIT multiples, market value/book value, etc.)

Liquidation value – for projects with a limited life which will not generate cash flows forever

Different methods of determining a terminal value

___FCF___(1 + WACC)

FCF (1+g) (1 + WACC)²

FCF (1+g)² (1 + WACC)³

Terminalvalue += + + . . .+

FCF WACC - g=

FCF (1+g) (1 + WACC) n

n-1

g = growth rate in perpetuityWACC = weighted average cost of capitalFCF = free cash flow in terminal value

year (year after last projected period)

Where . . .

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The discount rate applied to free cash flows reflects several key factors

Cost of equity

Cost of debt

Target capital structure

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The cost of equity is the major component of the discount rate

The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation)

J.P. Morgan, McKinsey and PwC always estimate the cost of equity using the capital asset pricing model (“CAPM”)– Risk-free rate based on government securities– A market-wide equity risk premium adjusted for the specific risk of the

investment under consideration

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The CAPM has several components

Cost of equity = Risk free rate + (Beta xEquity riskpremium)

Long-term return onequity investment intoday’s market

=

Long-term risk-freerate of return (beta=0)

+

Adjustment forcorrelation tostock marketreturns

x

Appropriate “extra”return above risk freerate

= 10-year U.S.Treasury bond

+ Predicted betasfrom BARRA

x Estimated usingvarious techniques

For market average = 5.75% + ( 1.00 x 4.00% )

= 9.75%

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The cost of equity and debt are blended together based on a target capital structure

The target reflects the company’s rating objective– Firms generally try to minimize the cost of capital through the

appropriate use of leverage

The percentage weighting of debt and equity is usually based on the market value of a firm’s equity and net debt position– Most firms are at their target capital structure– Adjustments should be made for seasonal or cyclical swings, as well

as for firms moving toward a target

Using a weighted average cost of capital assumes that all investments are funded with an equal mix of equity and debt

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The cost of equity and debt are blended together based on a target capital structure

[ (D/(D+E)) x (kd (1-t)) ] + [ (E/(D+E)) x ke ]

EXAMPLE

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The three elements are pulled together to derive a value

The forecasted free cash flows and the terminal value are discounted by the weighted average cost of capital

The present value of these cash flows is an estimate of Firm Value, i.e. the value of the entire enterprise

The value of claims held by debt holders and preferred stock holders must be deducted to arrive at an estimate of Equity Value

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Overview of the session

Introduction

Discounted Cash Flow (DCF)

Trading Multiples (or market multiples) Estimate of the value at which a firm should publicly trade in today’s market based on the multiples of similar firms

Comparable deals

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Multiples analysis looks to the market for guidance on value

Multiples are ratios of total value to certain operating metrics such as earnings or cash flow

An example is the widely-used P/E ratio– Quoted market price = $24– Earnings per share = $2.00– P/E = 12 x

Multiples are useful because they allow us to normalize for differences in size

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Multiples analysis can be broken down into a 7-step process

1. Identify the peer group

2. Select appropriate multiples

3. Perform financial analysis on peers and establish values for ratios

4. Calculate summary multiples for peer group

5. Apply summary multiples to TargetCo’s forecasted results, derive values

6. Adjust implied values for debt & cash, establish equity value range

7. Assess position of TargetCo within value range

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The basics of trading multiples

Understand the company you are valuing

Understand its industry factors

Develop as similar a peer group as possible– Quantitative factors– Qualitative

Check for data errors– Whether done by hand, or using an automatic model which pulls in

data and generates multiples, always check for mistakes

Review several multiples– Different multiples are important for different industries

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Trading multiples that are typically used

Multiple Comment

Firm value/op. Profit1 3 Generally most accurate multiple to use

Firm value/op. profit DA 2 3 Used if amortization of goodwill or acquisition-related depreciation is significant

Firm value/ EBIT or EBITDA Similar to op. profit multiples (watch out for interestincome)

Market value/ trailing net income P/E ratio – affected by one time charges

Market value/FY14 net income Forward looking – actively used by Wall Streetanalysts

Market value/FY2 net income Forward looking – Firms with near-term losses

Market value/ next 12mos. Net inc.5 Forward looking – avoids problems with differentfiscal years

Market value / cash earnings GAAP EPS + amortization of acquisition-relatedgoodwill & intangibles – growing in use; shouldbecome more popular

Firm value/sales Generally not very accurate or appropriate (exceptfor start-up/small add-on acquisitions)

Market value/book value Most appropriate for financial institutions

Industry specific Price per subscriber/ barrel/pop., etc.

1 Operating profit before interest and taxes2 Operating profit before interest, taxes, depreciation and amortization of goodwill3 EBIT is often substituted for operating profit. This substitution does not create a problem unless interest income is significant4 Net income projected by brokerage firms for the current fiscal year5 Calculated using estimates for fiscal year one (current year) and fiscal year two

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Why trading values can differ from DCF

Market may view the firms’ outlook differently (different implied forecast)

Discounts– Lack of liquidity– IPO/Spin-off– Conglomerate

Supply/demand imbalance

Difference in capital structure

Company doesn’t distribute all of its free cash flow to shareholders

Option value

Acquisition speculation

Event risk

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Overview of the session

Introduction

Discounted Cash Flow (DCF)

Trading Multiples (or Market Multiples)

Comparable deals - Estimate value based on what buyers have paid for 100% of similar firms in the past

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Comparable deals analysis is usually problematic

Often a limited number of transactions

Dated information – Stock market has changed– Business has changed– Financing has changed– Bidders have changed

Missing data– Earnings usually unavailable on subsidiary transactions

Hard-to-find data

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Why bother with comparable transactions?

Important part of “deal-speak”

Our clients typically want to know deal history

Our competition will certainly provide this– Premium needed in the past to win bidding– Valuation techniques used by buyers– List of likely buyers– Bidding strategies

Industry-specific multiples can be important

Often necessary information for Board of Directors, fairness opinions, etc.

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Example of a comparable deals list

Transaction multiples

Dateannc Target Target business

Totalfirm

value Debt

Totalequityvalue Sales EBIT EBITDA

Equityvalue/LTM

net income

6/99 JustLike You Inc. Widgets 400 (100) 300 1.18 11.8 9.0 18.6

12/98 HighGrowth Corp. Widgets for internet 150 NA 1.67 16.7 12.8 NA

7/98 MuchBigger Co. Widgets and other stuff 3,500 (500) 3,000 1.09 10.9 8.4 17.2

1/98 FarEast Inc. Widgets for emerging market 50 NA 5.00 NA NA NA

9/97 SomeData Co. Widgets 250 NA 1.22 NA NA NA

5/97 LotsaGoodwill Inc. Widgets 900 (300) 600 1.15 14.4 8.8 25.0

6/96 BadComp Co. Cement and Widgets 400 NA 0.71 10.2 7.1 NA

8/95 HiddenAsset Inc. Widgets and gold mine 600 (100) 500 2.00 15.4 13.5 26.0

2/94 BadData Plc Widgets for Europe 750 (350) 400 1.15 23.0 11.5 139.5

7/89 OverPaid Corp. Widgets for Hollywood 1,200 (200) 1,000 1.54 15.4 11.8 26.0

7/84 OldDeal Co. Widgets 700 (50) 650 0.91 .91 7.0 14.4

Average 1.60 14.01 10.0 38.1

Median 1.18 14.4 9.0 25.0

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Valuing target based on transaction multiples

$ millionsSales EBIT EBITDA Net Income

Data for target $290 $28.2 $36.2 $17.2

Multiples based on:

Average 1.60 14.1 10.0 38.1Median 1.18 14.1 9.0 25.0JustlLike You inc. 1.18 11.8 9.0 18.6

Value based on:

Average multiples $465 $398 $362 $655Median multiples 342 406 326 430Just like you 342 333 326 320

Average multiples

Median multiples

JustLikeYou Inc.

Valuation Summary

362 655

430

320 342

326

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When can transaction values differ from DCF

Cost of capital differences– Buyer may have a lower cost of capital

High level of synergies– Revenue enhancements– Cost savings

Cross-border– Differences in capital costs, tax rules, repatriation levels, etc.

Differences in view of the future – Buyer may have a dramatically different view of the future than the

market• Other strategic reasons

- Buy vs. build- Platform for other investments - Defensive acquisitions

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Conclusion

There is not one right way to value a firm– Morgan almost always evaluates DCF, trading values, and

comparable transactions

Understanding differences between various valuation techniques if often critical to the appropriate decision

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Preliminary analysis is summarized for the client by indicating a value range

$80 $97

$55 $69

$97 $101

$88 $92

$61 $73

50 60 70 80 90 100 110

Share price as of [date]

Total equity valueUS$ millions

Comparable trading

analysis

– Base case

– Aggressive case

– Conservative case

Discounted cash flow

analysis

Comparable transaction

analysis

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Summary of valuation methodologies

Analysis of purchase prices of selected transactions

Can be difficult to draw conclusions due to dissimilarities in transactions

May provide insights into acquisition strategy of potential competing buyers/industry peers

Includes control premium

Selected transaction multiples analysis

Discounted cash flow (“DCF”) analysis

Preferred measure of intrinsic value

Present value of free cash flows to debt and equity holders

Incorporates both short-term and long-term expected performance

Risk in cash flows and capital structure captured by discount rate

Free cash flow incorporates future requirements to reinvest in working capital and fixed assets

Provides ability to separate sources of value– Business by business– Standalone value vs. synergies

Selected trading multiples analysis

Analysis of how selected companies trade relative to business being valued

Applied using historical and prospective multiples

Key multiples include [price/earnings] and [firm value/EBITDA]

Does not include a control premium