C1: Valuing Businesses – the Role of the Actuary

2004 Finance & Investment Conference27-29 June, Royal Windsor Hotel, Brussels

Our Working Party

The purpose of our paper was to educate actuaries about corporate valuation and look for areas where actuaries can add value. Our working party consisted of:

Eight actuaries mostly pensionsOne corporate financier/accountantMBA on corporate valuation

What is Value?

The market price of a business as demonstrated by a transaction. Reasons to calculate value:

Investing in the stock marketValuing unquoted securitiesCorporate planningStaff incentivesMergers and acquisitions

Efficient Market Hypothesis (“EMH”)

Where tradable our model should usually come up with the same value as the market price of a business as demonstrated by its market capitalization. However sometimes EMH will not strictly apply:

Illiquid marketsUnquoted securitiesSmaller companiesHeavily dependant on judgments

Our Measure of Value

Starting point is the market price of the business to any investor.

We can then allow for:Additional value due to synergiesStrategic premiums as per synergiesOther i.e. deal costs etc..Value of equity onlyMay value whole business and then split in equity/debt

Finance Theory

Discounted cash flow (“DCF”) value is the correct way to value any asset (including a business). Common usage inside/outside professionVarious methods for valuing a business:

Enterprise DCF Model Equity DCF Model Adjusted Present Value Economic Value Added

Discount rate to use (from CAPM): Risk Free Rate + [Equity Risk Premium x Beta of Equity]

Other valuation techniques

Short hand methods are often used such as a

multiple of an accounting metric. The metrics can

include: Earnings before Interest and Tax (“EBIT”) EBITA EBITDA

Effectively a proxy for a DCF with an implicit growth and

discount rate assumption

Other valuation techniques

Other ‘short hand metrics’ include. Price to sales ratios:

Young companies where market share is important

Indirect cash flow measures: Number of subscribers for mobile phone companies

Price/earnings ratios: Often used as a “first pass” filtering mechanism

Measures of capital employed: EV/Assets, EV/Capital Employer, Price to Book Ratio

Short Hand Metrics

What is wrong with short hand metrics? Just as complex as DCF modelling:

Adjustments made to EBITDA

Lack of clarity and credibility: Lots of implicit assumptions Arbitrary and too much discretion Value dependant on growth rate assumption

Is the multiple 8 or 9? Huge difference in value and no way to tell which

Evidence from Market Participants

What are people actually doing to calculate the value of a business? Equity analysts:

Occasionally simple DCF models Peer group comparison on simple metrics (e.g. P/E) Qualitative issues have a very high weight

Corporate entities: More likely to use DCF model More value – management, synergies, strategic value More information and less time constraints

Evidence from Market Participants

What are people actually doing to calculate the value of a business? Management consultants:

SIAS Paper – often use DCF models More often use earnings/capital employed by business Focused on corporate efficiency

Investment banks: Most corporate purchasers use an investment bank in a deal Blended approach of various metrics to give a valuation range

Peer group comparisons, DCF model, IRR model

Evidence from Market Participants

What are people actually doing to calculate the value of a business? Private equity houses:

Very sceptical on DCF models IRR model and cash to cash multiples No expansion of multiple

Summary: Most participants believe DCF is the correct method But due to perceived weaknesses in the DCF model they do

not use it

Weaknesses in DCF Models

If everyone thinks it is the right model why does no one actually use it? Choosing the discount :

WACC seems to be lower than that applied in practice Could be to do with specific risk versus CAPM?

Other assumptions: Difficult to obtain any reliable data especially unbiased

Extraordinary items/catastrophes Generally no allowance for extreme events “Extraordinary” items occur nearly every year

Weaknesses in DCF Models

If everyone thinks it is the right model why does no one actually use it? Time horizon:

Some investors have a short time horizon Large proportion of value is ‘exit price’

Practical issues: Information requirements Assumptions and correlations

Time and Cost versus Value Added If a simple metric provides the same answer why bother?

Role of the Actuary

Complex modelling using the DCF technique should be playing to actuarial strengths.

Some hurdles to overcome: Little current involvement Lack of credibility Non-business minded calculator freaks? Not up to speed on Financial Economics

Role of the Actuary

Complex modelling using the DCF technique should be playing to actuarial strengths.

If we can overcome problems of DCF then significant opportunities:

Impact of management strategies Risk measurement and management Aligning shareholders and managers interests

Actuarial Solutions

Choice of discount is the major issue and one in which there is likely to be most debate between the Financial Economists and the market participants.Does specific risk matter?Suggest that the choice of discount rate is left to the client:

Stochastic DCF model can show the volatility of the cash flows This gives a guide as to whether the historic Beta might still be

appropriate Can show results on a variety of discount rates

Actuarial Solutions

Other areas much more actuarially simple.Other assumptions:

Building up a set of realistic and mutually compatible assumptions

Some areas actuaries lack experience (e.g. oil price) Correlations between variables

Extraordinary items and catastrophes: An insurance problem therefore actuaries ideally suited Use RAMP framework to identify risks

Actuarial Solutions

Other areas much more actuarially simple.Time horizon:

Our long term DCF can add value for short term investors: Can calculate all metrics (e.g. IRR and Cash to Cash) required Range of results and the risk profile of these metrics

Practical issues: Models are complex to create and thus expensive However not expensive in the context of deal related fees Timescales may be more problematic

The Actuarial Approach

How would the actuary go about creating a DCF model of a business?Break business down into manageable units:

Similar to approach for an insurance company or pension fund valuation

Head office plus operating businesses would be usualConstruct a model of each business unit:

What are the key drivers of the cash flows? E.g. sales, cost of sales, wages, overheads, tax Project forward each of these variables (consistently) Ensure correlations are accounted for

The Actuarial Approach

How would the actuary go about creating a DCF model of a business?Catastrophes and special events:

Risk analysis to identify possibilities Either:

Allow for insurance premiums to remove costs Model risk with insurance techniques

Convert to a stochastic approach: We have a base line - now need to make variables dynamic Models such as Wilkie for some variables Other variables there will be no standard stochastic model

The Actuarial Approach

How would the actuary go about creating a DCF model of a business?Applying the discount rate:

See previous discussion

Is this too complex?: Simple metrics are not simple And complexity contains hidden judgments Start with a simple model to gauge broad price Make more accurate as deal progresses

Advantages of the Actuarial Approach

The two key advantages of the actuarial approach are:Transparency:

All assumptions are explicit rather than hidden Client has control over assumptions Discount rate is the key parameter – range of results

Risk identification: Catastrophes and special events are allowed for More accurate picture of business risk A risk management tool

Advantages of the Actuarial Approach

Other potential advantages of the actuarial approach include:Sensitivity analysisIdentification of key driversAccurate model of business can be used for:

Testing proposed changes Assessing the changing value of the business over time A more accurate assessment of remuneration

Conclusions

DCF modeling is the correct way to value businesses but is rarely used in practice because they are usually incorrectly applied.Actuaries are comfortable with DCF modelingActuaries should be able to solve the problemsActuaries can add value through DCF modelingHowever there are perception problems