Finance 7311

1
Finance 7311

• Lecture 6
• Business Valuation

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What is Being Valued?

• Equity
• Minority Interest
• Controlling Interest
• Assets
• In effect a controlling interest?
• Whose management is being valued?

3
Approaches to Valuation

• Cost
• Market
• Cash Flow

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Cost

• Book Value
• Book Value of Equity (Assets) Shares O/S
• Not really value
• Reflects historical value of transactions only

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Cost

• Modified Book Value
• Obtain appraisals
• Create adjusted balance sheet
• Write up/down assets
• Record other side in equity
• Still doesnt reflect going concern value
• A company is more than a collection of things a
  set of systems which uses the things to create
  value

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Cost, continued

• Cost to Replicate
• What would it cost to recreate the company
• Takes into account the fact that a company is
  worth more than the sum of the parts
• Still does not reflect going concern value

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Cost, continued

• Liquidation Value
• Parts assumed to be worth more than sum ? worth
  more dead than alive
• Should be net of taxes trans. Costs
• Depends on amount of time to sell fire sale ?
  lower value

8
Market

• How does the market value similar assets
• Market and DCF are interrelated
• Both look to the market
• Also called multiple or market multiple
  approach

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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

10
Market

• How does Market Value Similar Assets?
• Ex Real Estate - how does market value similar
  houses
• What does similar mean?
• Same geographic location
• Same age
• Similar size
• Similar features
• Same quality

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Common Multiples

• Financial Multiples
• Earnings (P/E) ? Equity
• Revenues ? normally Equity
• Cash Flows ? Equity or Firm
• Book Value ? Equity or Firm
• Industry Multiples
• Beds/Rooms (Hospitals, hotels)
• Customer (e-tailers)
• Cases sold (Beverage distribution)
• Subscribers (Cable, newspapers, internet)
• Any performance measure

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Sample of comparable companies

• Same Industry (SIC /NAIC code)
• Yahoo Finance Quicken
• Go through descriptions to narrow list
• Earnings or cash flow companies with positive
• Growth history and potential stage
• Size

13
Market Multiple Steps

• 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

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Multiple Fundamentals Ex.

• Consider Dividend Discount Model
• P D1/(R g)
• Let D EPS x (1-r), where r retention ratio
• P EPS(1-r)/(R g) Now, divide by EPS
• P/E (1 r)/(R g)
• P/E f(reinvestment, risk, growth)

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P/E Multiple

• Price per share / EPS
• An equity value
• Which earnings?
• Current
• Trailing 4 quarters
• Annual in most recent F/S
• Forecast or leading
• Accounting impacts

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P/E Multiple

• Quality
• Reinvestment
• Growth
• Risk
• Operating
• Financial (financial leverage)
• Beta captures both

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Price / Sales

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

21
Price / Sales Quality

• Suppose we want to consider P/Sales
• Recall P EPS(1-r)/(R g)
• Divide both sides by sales
• P/Sales EPS/SPS x (1-r)/(R-g)
• P/Sales f(net margin, reinvestment, risk,
  growth)

22
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

23
Price / Cash Flow

• May be either an equity or a firm value
• Which cash flow?
• EBITDA (Usually firm value Enterprise Value)
• Net Income Non-cash items (equity value)
• FCF (firm or equity depending on definition)
• Quality
• Growth
• Reinvestment (maybe)
• Risk

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Price / Book (Equity)

• Price per share divided by book value per share
• What investor is willing to pay for a 1 of book
  value of equity
• Determinants of QUALITY
• ROE (Return on book value of equity)
• Risk (amount of financial leverage)
• Reinvestment needs

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Price / Book (Firm)

• Market value of debt equity divided by book
  value of assets ( D E)
• What investor is willing to pay for a 1 of book
  value of assets
• Determinants of QUALITY
• ROA (Return on book value of assets)
• ROIC (Assets and capital similar)
• Reinvestment needs

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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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Enterprise Value/EBITDA

• Enterprise Value Market value equity debt
• EBITDA EBIT depreciation and amortization

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Market Multiple, example

• Amtek ?
• P/E (Comp 21.7) 18
• (Lower growth than comparable firms more
  financial risk than comparable firms)
• MV firm/EBIT(1-t) (Comp 22.5) 20
• (Lower sales growth no information about
  reinvestment needs assuming business risk is
  same)

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Market Multiple, example

• Amtek Assumed Multiples, cont.
• MV /BV- equity (Comp 2.6) 2.25
• (More financial risk dont have ROE)
• MV /BV-firm (Comp 2.2) 2.1
• (No information on reinvestment needs dont have
  ROIC or ROA)

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Market Multiple, ex.

• P/E 18 x 66.1 1190 32.82 36.25/share
• MV firm/EBIT(1-t) 20 x 112.3 (.78) 1751.1
  471 1281 32.82 39.03/share
• MV equity/BV equity 2.25 x 335.1 754 32.82
  22.97 / share

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Market Multiple, ex.

• MV firm/BV firm 2.1 x 805.9 1692 471 1221
  32.82 37.22
• Somewhere between 23 and 39
• Really between 36 and 39

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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)

33
Discounted Cash Flow

• ? NWC
• Consistent with sales assumptions
• Maintain constant of sales
• Capital Spending
• Consistent with growth assumptions?
• Long-run equal to depreciation (no real)
• g x net fixed assets

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Discounted Cash Flow

• Mechanics
• Project out cash flows until stable
• Calculate Terminal 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 (5-7.5?)

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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
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Terminal Value

• Assume Company is stable/mature
• Use P/E approach P/Es taken from comparable
  publicly traded firms
• Use DCF approach w/ constant/no growth

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Discounted Cash Flow
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EXAMPLE NO GROWTH
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No Growth Example, cont.

• Firm Value 874.50
• Value of Debt 250
• ? Value of Equity 874.5 250 624.5 40
  shares O/S 15.61/share

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EXAMPLE 5 GROWTH
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5 Growth Example, cont.

• Firm Value 1045.3
• Value of Debt 250
• ? Value of Equity 1045.3 250 795.3 40
  shares O/S 19.88/share

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EXAMPLE Market Multiple Terminal Value
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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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Benefits to Control

• Appoint Management
• Declare dividends
• Acquire/Liquidate Assets
• Approve major transactions
• Issue What is Effect on Value?
• What is source of value?
• Can you manage better?

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Minority Interest

• Publicly traded share prices represent
  marketable, minority interest values
• Would not adjust unreasonable amounts
• Issue What is likely benefit stream to interest
  being valued?

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Small, 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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Small 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