Company Valuation

Financial Statements, Ratios & Valuation Principles

Pascale Boyer Barresi, CFAAssociate Director Business Analysis,

Business Development & Licensing, Debiopharm International, Lausanne (Switzerland)

March 2015

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ContentStarting Point◦ Financial Health – overview of financial statements◦ Key Ratios◦ Burn rate◦ Type of company: Private/Public◦ Business Cases

Valuation Principles◦ Foundation of Value◦ Valuation across Time◦ Valuation across the Lifecycle

Valuation Models & Methods - Overview

Which Valuation for Which Company? & ConclusionQ&A

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Starting Point◦ Financial Health – overview of financial statements◦ Key Ratios◦ Burn rate◦ Type of company◦ Case Study

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Financial Health –Overview of Financial StatementsConcept: « Show Me The Money »They show you where a company’s money came from, where it went, and where it is now. There are four main financial statements◦ Income statement shows how much money a company made and spent over a period of

time. ◦ Balance sheet shows what a company owns and what it owes at a fixed point in time. ◦ Cash flow statement shows the exchange of money between a company and the outside

world also over a period of time. ◦ The fourth financial statement, called a “statement of shareholders’ equity,” shows changes

in the interests of the company’s shareholders over time.

Let’s look at each of the first three financial statements in more details.

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Income StatementAn income statement is a report that shows:◦ how much revenue a company earned over a specific time period (usually for a year or some

portion of a year)◦ the costs and expenses associated with earning that revenue ◦ and the literal “bottom line” of the statement is the company’s net earnings or losses. This

tells you how much the company earned or lost over the period. To understand how income statements are set up, think of them as a set of stairs. ◦ You start at the top with the total amount of sales made during the accounting period (often

called “the top line”). ◦ Then you go down, one step at a time. At each step, you make a deduction for certain costs

or other operating expenses associated with earning the revenue. ◦ At the bottom of the stairs, after deducting all of the expenses, you learn how much the

company actually earned or lost during the accounting period. People often call this “the bottom line.”

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Income Statement – Simple ExampleTotal amount of money brought in from sales of products

Amount of money the company spent to produce the goods it sold during the period

Operating expenses – for the support of a company’s operations for a given period that cannot be linked directly to the production of the

products or services being sold (administration, R&D, marketing). Depreciation - wear and tear on production assets (machinery, tools…),

which are used over the long term. The cost of these assets is spread over the years they are used.

Earnings per share or EPS - how much money shareholders wouldreceive for each share of stock they own if the company distributed all of its net income for the period. EPS = net income / number of outstanding

shares of the company

CHF million Statements as of December 31 2013 2014 Growth

2013-2014

Revenue 1’772 1’928 8.8%

Cost of Sales / COGS -194 -200

Gross Profit 1’578 1’728 8.6%

Gross margin 89.0% 89.6%

Research/Development expenses -464 -484 4.3%

R&D in % of sales 26.2% 25.1%

Selling, General & Admin expenses -645 -744 15.3%

SG&A in % of sales 36.4% 38.6%

Operating Income 469 500 6.7%

Operating margin 26.4% 25.9%

Net Income Before Taxes 339 441 30.1%

Provision for Income Taxes -27 -50

Tax rate 8.1% 11.4%

Net Income After Taxes 312 391 25.3%

Net margin 22.4% 20.2%

Number of shares 118.70 119.05

EPS (Earnings per share) 3.35 3.28

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Balance SheetA balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity (like a PICTURE).

Assets:◦ are things that a company owns that have value, meaning they can either be sold or used by

the company to make products that can be sold in the end. ◦ Assets include physical property (plants, equipment, inventory) but also ◦ things that can’t be touched (intangibles) but nevertheless exist and have value, such as

trademarks and patents. ◦ Cash itself is an asset.

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Balance SheetLiabilities◦ are amounts of money that a company owes to others. ◦ all kinds of obligations: money borrowed from a bank, rent for use of a building, money owed

to suppliers, payroll owes to its employees, environmental cleanup costs, taxes owed to the government.

Shareholders’ equity is sometimes called capital or net worth. ◦ It’s the money that would be left if a company sold all of its assets and paid off all of its

liabilities. ◦ This leftover money belongs to the shareholders, or the owners, of the company.

ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY

Like a HOUSE = MORTGAGE + EQUITY

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Balance Sheet Health Typology

Assets

Liabilities

Share holders’ equity

AssetsLiabilities

Shareholders’ equity

Assets

Liabilities

Share holders’ equity

Assets Liabilities

Share holders’ equity

Healthy Normal Unhealthy Crisis

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Long-term liabilities are obligations due more than one year away.

Balance Sheet – Simple ExampleCHF millions –Statements as of December 31 2013 2014

Cash 877 1’195

Short term investments 466 250

Accounts Receivable 470 520

Inventory 61 59

Current Assets 1‘874 2’024

Property, Plant & Equipment 281 399

Intangibles 384 240

Fixed Assets 665 639

TOTAL ASSETS 2’539 2’663

Assets are generally listedbased on how quickly they

will be converted intocash.

Current assets are things a company

expects to convert to cash within 1 year.

Liabilities are generallylisted based on their due dates.

Fixed assets are things a company does not expect to or cannot convert to cash within 1 year. These assets are used to

operate the business.

Current liabilities are obligations a company

expects to pay off withinthe year.

CHF millions –Statements as of December 31 2013 2014

Short Term Debt 427 444

Accounts Payable 698 546

Current Liabilities 1’125 990

Long Term Debt 132 136

Litigation Provision 0 0

TOTAL LIABILITITES 1’257 1’126

SHAREHOLDERS’EQUITY 1’282 1’537

TOTAL LIABILITIES & SHAREHOLDERS’EQUITY 2’539 2’663

Shareholders’ equity is the amountowners invested in the company’s stock

+ company’s earnings since inception(retained earnings) – dividends (portion

of earnings that is distributed).

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Cash Flow StatementCash flow statements report a company’s inflows and outflows of money. Cross comparison: ◦ while an income statement can tell you whether a company made a profit, ◦ a cash flow statement can tell you whether the company generated cash.

A cash flow statement shows changes over time. ◦ It uses and reorders the information from a company’s balance sheet and income statement. ◦ The bottom line of the cash flow statement shows the net increase or decrease in cash for the period.

Division into 3 main parts:◦ operating activities◦ investing activities

◦ financing activities

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Cash Flow Statement – Simple ExampleCHF millions –Statements as of December 31 2013 2014

Net Profit 397 390

Depreciation & Amortization 64 36

Changes in Working Capital -37 370

Cash From Operating Activities 424 316

Acquisition/Sale of short and long term deposits -92 216

Capital Expenditures -133 -128

Acquisition/Sale of intangibles and financial assets -8 -23

Acquisition of companies or assets -58 -43

Cash From Investing Activities -294 23

Dividend payment 0 0

Convertible bond buyback 0 0

Stock buyback -116 -35

Cash From Financing Activities -21 -5

Free cash flow (CFO - CapEx) 291 188

Change in Cash 210 318Link with the Balance Sheet: Please look at the difference between the cash position in the balance sheet in 2014 and 2013: 1195-877= 318

CFO The 1st section of the cash flow statement reconciles the net income (as shownon the income statement) to the actual cash the company received from or used in its operating activities. It adjusts net income for any non-cash items (like depreciation) and for any cash thatwas used/provided by operating assets and liabilities (WC).

CFI The 2nd part of a cash flow statement shows the cash flow from all investingactivities, which generally include purchases or sales of long-term assets (capex) as well as investment securities.

CFF The 3rd part of a cash flow statement shows the cash flow from all financingactivities. Typical sources of cash flow include cash raised by selling stocks, borrowing. Likewise, paying back a bank loan would show up as a use of cash flow.

FCF Free cash flow is the REAL cash generation and calculated as CFO-Capex-Dividends

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Key TakeawaysIncome

Statement

Balance Sheet

Cash Flow Statement

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… but don’t forget the FootnotesThe footnotes to financial statements are packed with information. It is important to read them in order to avoid negative surprises… Here are some of the highlights: ◦ More details about specific positions in IS, BS or CFS. Example: inventory is sometimes detailed into raw

materials, work-in-process goods and completely finished goods.◦ Significant accounting policies and practices – Companies are required to disclose the accounting policies. ◦ Income taxes – The footnotes provide detailed information about the company’s current and deferred income

taxes. ◦ Pension plans and other retirement programs – The notes contain specific information about the assets and

costs of these programs, and indicate whether and by how much the plans are over- or under-funded.◦ Stock option plans – The notes also contain information about stock options granted to officers and

employees, including the method of accounting for stock-based compensation.

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Key RatiosRatios are essential to follow the trends over the life of the company and the relationships between specific items in the financial statements. Several types of ratios depending on the final objective:

Inte

rnal

Liq

uidi

ty • Estimation of the ability of the company to pay its short term debt and current liabilities over the next 12 months

Ope

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ce • Show the operating margins and the returns on invested capital Fi

nanc

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isk • Help value

the financial burden linked to debts and interest coverage

Qua

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of E

arni

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signal ratios leading to detection of accounting gimmicks

Valu

atio

n • Link the stock price (for public companies) to key elements in the financial statements

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Key Ratios - LiquidityRatios Formula Interpretation

Current Ratio Current AssetsCurrent Liabilities Company’s ability to pay its debt over the next 12 months. It has to be over 1.

Cash Ratio Cash+ Marketable SecuritiesCurrent Liabilities Indicator of short-term liquidity. It has to be over 0.5.

Quick Ratio Cash + Marketable Securities+ ReceivablesCurrent Liabilities Ability to use its quick assets to pay its current liabilities. It has to be over 1.

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Key Ratios – Liquidity - CCCRatios Formula Interpretation

Cash Conversion Cycle (#days)

Receivables Collection + Inventory Processing

– Payables Payment

Expression of time (in days) that it takes to purchase raw materials for production, convert them in goods, sell them and collect the money. The shorter, the better.

Receivable Collection 365Receivables turnover #days required to collect the money from clients.

Receivables Turnover Net salesAverage receivables over the last 2 years

Measures a business' ability to efficiently collect its receivables. Higher ratios mean that companies are collecting their receivables more frequently throughout the year.

Inventory Processing 365Inventory turnover #days of stay of the inventory.

Inventory Turnover COGSAverage inventory over the last 2 years

Measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys and also shows investors how liquid a company's inventory is.

Payables Payment 365Payables turnover #days after which the company is paying its providers.

Payables Turnover COGSAverage payables over 2 years

Indication on how quickly a company pays off its vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a business. A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. A high turnover ratio can be used to negotiate favorable credit terms in the future.

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Key Ratios – Operating PerformanceRatios Formula Interpretation

Gross Margin Gross ProfitNet Sales Higher is better.

Operating Margin (EBIT) Operating IncomeNet Sales Higher is better.

R&D Expenses in % of sales R&D ExpensesNet Sales Expression in % of sales what is spent in R&D.

Marketing Expenses in % of sales Marketing ExpensesNet Sales Expression in % of sales what is spent in Marketing.

General & Admin Expenses in % of sales

General & Admin ExpensesNet Sales Expression in % of sales what is spent in General & Administration.

Return on Equity (ROE) Net IncomeShareholders’ equity

Shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are desirable.

Return on Invested Capital (ROIC) NOPATShareholders’ equity+ LT debt Looks at operating return free of the effects of capital structure.

Enterprise Value Added (EVA) EVA = NOPAT – (Capital*Cost of Capital) Will show the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).

Working capital Current Assets – Current LiabilitiesIt is the money leftover if a company paid its current liabilities (that is, its debts due within one year of the date of the balance sheet) from its current assets.

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Key Ratios – DuPont ROERatios Formula Interpretation

Return on Equity (ROE) Net IncomeShareholders’equity

Shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are desirable.

=

Net Margin Net IncomeNet Sales This model was developed to analyze ROE and the effects different

business performance measures have on this ratio. So investors are looking to analyze what is causing the current ROE. For instance, if investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.Once the problem area is found, management can attempt to correct it or address it with shareholders.

x

Total Asset Turnover Net SalesAverage Total Assets

x

Financial Leverage Average Total AssetsShareholders’equity

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Key Ratios – Financial RiskRatios Formula Interpretation

Gearing Total Debt-CashShareholders’ equity

Show how encumbered a company is with debt. Depending on the industry, a gearing ratio of 15% = prudent, anything over 100% = risky or 'highly geared'.

Debt-to-Equity Ratio Total LiabilitiesShareholders’ Equity

It means that the company has CHF XX of debt to every CHF 1 shareholders invest in the company.

Interest Coverage Operating Profit or EBIT or EBITDAInterest Expenses

Company's ability to meet its debt obligations. Warning sign when interest coverage falls below 2.5x.

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Key Ratios – Quality of EarningsRatios Formula Interpretation

Return on Total Capital Pre-tax income + Interest expenseTotal Assets - Current liabilities

Interest expense is added back to pretax income to remove the effect of financial leverage. The higher the better.

Cash Realization Ratio Operating CashflowNet Income

Measure of how close a firm’s net income is being realized in cash. Has to be over 1.

Productive Asset Reinvestment Ratio

Capital ExpendituresDepreciation

Company’s commitment to maintaining its level of investment in capital assets Has to be over 1.

Tax Rate %to be compared to the average

Provision for Income TaxesPre-tax Income

High quality earnings companies tend to report tax rates at or above the average reported tax rate for all companies.

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Burn Rate◦ For loss-making companies, it is useful to know how much time they could survive with the available

cash.◦ Burn rate:

◦ The rate at which a new company uses up its capital to finance itself before generating positive cash flow from operations. In other words, it's a measure of negative cash flow.

◦ Burn rate is usually quoted in terms of cash spent per month, per quarter or per year. ◦ Formula:

Cash & Cash Equivalents (+ Marketable Securities) Operating Cash Flow + Capital Expenditures

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Burn Rate – ExampleFiscal Period: 2014Period End Date: 30.06.2014Period Length: 6 MonthsUpdate Date: 30.06.2014Accounting Standard: U.S. GAAPOriginally Reported Unit: ThousandsReporting Currency: CHFSource Interim Report

Operating Activities -44'897Cash from Operating Activities -44'897Maturities of LT Investments 130'000 Purchase/Sale of Intangibles -33ST Financial Assets -90'000LT Financial Assets --Purchase/Sale of PPE net -562Investments in Tangibles --Investments in Intangibles --Cash from Investing Activities 39'405 Dividends PaidExercise of Stock Options 17'513 Repayment of Capital Lease --Cash from Financing Activities 17'513Foreign Exchange Effects -31Net Change in Cash 11'989 Net Cash - Beginning Balance 118'897 Net Cash - Ending Balance 130'887

◦ Company: Basilea◦ Country: Switzerland◦ Industry: Biotech – Antibiotics & Antifungals◦ Financial Statement: Cash Flow Statement for 6 months

◦ Cash Burn = CFO + Capital Expenditures = -44’897 + (-562) = -45’459 for 6 months◦ Cash Burn per month = -45’459 / 6 = -7’577 per month◦ Available cash end of June 2014: CHF 130’887◦ Number of «survival months»: 130’887 / 7’577 = 17.3

◦ Conclusion: Basilea has cash for 17.3 months of ongoing activities (at the sameburn rate).

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Public vs. Private Company –5 key differences

Public Company Private Company

Size… the cost of being public

High costs of running a public company (larger operations, staff, compliance costs to be publicly listed...)

Small size equals more risk. Risk levels and premiums are higher for smaller companies. A small size can reduce growth prospects because there is less access to capital to fund expansion.

Overlap of shareholdersand management

Pressure from, and reporting to, external investors (the shareholders) can slow down the pace at which decisions get made.

Shareholders are generally involved in the management of the company. In many startups, the shareholders are often the founders. This aligns shareholder and management goals.

Shorter and longer-term strategies

A publicly listed company is under pressure to have consistent growth rates and earnings as it directly relates to its stock price performance. The smallest change can affect this performance.

Private companies are mostly invested into with the longer-term in mind. VCs often enter with a three to five-year plan before exiting. This means management can work towards that five-year plan, theoretically with more reward, and less immediate pressure.

Quality and depth of management

Theoretically more attractive as salary and benefits are higher.More depth in management but could be detrimental to performance and lead to bureaucratic organizations.

Theoretically less attractive to high-quality management candidates because it can’t match the salary or benefits of a larger business. Startups generally have less management depth than a public company

Quality of financial information

Public companies have to meet requirements for submitting financial reports which they often produce quarterly. These reports have to be of a high quality, and contain sufficient detail, to please external shareholders.

Private companies have lower quality – and most likely less detailed – financial information than public companies, if at all.

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Business CasesDo you already have working groups?

1. Ratios Computation by Groups◦ Roche◦ Straumann

2. Burn Rate Calculation over time by Groups◦ Evolva◦ Newron

1. Please choose 1 company to work on2. Go into the Business Cases File and take the Excel

file with the chosen company name3. Perform all the key ratios calculation (use the

template at the end of the worksheet)4. Comment on the financial health of these

companies

1. Please choose 1 company to work on2. Go into the Business Cases File and take the Excel

file with the chosen company name3. Perform all the burn rate calculation for all time

periods4. Comment on the burn rate

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ValuationPrinciples

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Valuation Principles◦ Foundation of Value

◦ Asset◦ Public Company◦ Private Company

◦ Valuation across Time◦ Valuation across the Lifecycle

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Foundation of Value◦ «The fundamentals of valuation are straightforward but the challenges we face in valuing companies

shift as firms move through the lifecycle». A. Damodaran◦ Intrinsic value of an asset = present value of expected cash flows (CF) over its life, discounted to reflect

both the time value of money and the riskiness of the cash flows.

◦ Where:◦ E(CFt) is the expected cash flow in period t◦ r is the risk-adjusted discount rate◦ N is the life of the asset

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝑉𝑉𝐴𝐴 = �𝑡𝑡=1

𝑡𝑡=𝑁𝑁𝐸𝐸(𝐶𝐶𝐶𝐶𝑡𝑡)

(1 + 𝑟𝑟)𝑡𝑡

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A Word about Terminal Value◦ The previous formula is fine for assets with finite life but a company has a «going concern» principle.

Said differently, it will keep on generating cash flows forever.◦ We need to use what we call a Terminal Value

◦ However, the terminal value concept can be used ONLY when the firm becomes a mature business.

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐵𝐵𝑉𝑉𝐴𝐴𝐵𝐵𝐵𝐵𝑉𝑉𝐴𝐴𝐴𝐴 = �𝑡𝑡=1

𝑡𝑡=𝑁𝑁𝐸𝐸(𝐶𝐶𝐶𝐶𝑡𝑡)

(1 + 𝑟𝑟)𝑡𝑡+

𝐸𝐸(𝐶𝐶𝐶𝐶𝑁𝑁+1)(𝑟𝑟 − 𝑔𝑔𝑛𝑛) (1 + 𝑟𝑟)𝑁𝑁

This terminal value willcapture the value of all cash flows (in order to consider the perpetuallife of the company).

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A Word about Discount RateOne of the most critical input is in choosing the correct (best guess) discount rate to apply.

The discount rate should capture the risk of the business. We use higher discount rates on riskier business cash flows and lower discount rates on safer business cash flows.

In this section we consider the risk for a business (and not the risk for an equity investment).

In order to do so, we need to calculate the WACC, the weighted average cost of capital.

Business Discount Rate = WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt * Weight of Debt)

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A Word about Discount Rate

Cost of Equity:

Cost of Debt:

Business Discount Rate = WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt * Weight of Debt)

𝐶𝐶𝑜𝑜𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝑉𝑉𝐵𝐵𝐴𝐴𝐸𝐸 = 𝐸𝐸𝐸𝐸𝐸𝐸𝑉𝑉𝐸𝐸𝐴𝐴𝑉𝑉𝐸𝐸 𝑅𝑅𝑉𝑉𝐴𝐴𝑉𝑉𝑟𝑟𝐵𝐵 = 𝑅𝑅𝐵𝐵𝐴𝐴𝑅𝑅𝑜𝑜𝑟𝑟𝑉𝑉𝑉𝑉 𝑟𝑟𝑉𝑉𝐴𝐴𝑉𝑉 + 𝛽𝛽𝐼𝐼𝑛𝑛𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝐼𝐼𝐼𝐼𝑛𝑛𝑡𝑡 (𝐸𝐸𝐸𝐸𝑉𝑉𝐵𝐵𝐴𝐴𝐸𝐸 𝑅𝑅𝐵𝐵𝐴𝐴𝑅𝑅 𝑃𝑃𝑟𝑟𝑉𝑉𝑃𝑃𝐵𝐵𝑉𝑉𝑃𝑃)

In order to have historical equity risk premiums, please look at the Excel file namedHistorical_Equity_Risk_Premiums_Damodaran.xlsx

In order to calculate beta for public companies, please look at the Excel file namedCalculate-Beta-with-Excel_Roche_Evolva_Straumann_Newron.xlsx

𝐶𝐶𝑜𝑜𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐷𝐷𝑉𝑉𝐷𝐷𝐴𝐴 = (𝑅𝑅𝐵𝐵𝐴𝐴𝑅𝑅𝑜𝑜𝑟𝑟𝑉𝑉𝑉𝑉 𝑟𝑟𝑉𝑉𝐴𝐴𝑉𝑉 + 𝐷𝐷𝑉𝑉𝑜𝑜𝑉𝑉𝑉𝑉𝑉𝑉𝐴𝐴 𝑆𝑆𝐸𝐸𝑟𝑟𝑉𝑉𝑉𝑉𝐸𝐸) ∗ (1 −𝑀𝑀𝑉𝑉𝑟𝑟𝑔𝑔𝐵𝐵𝐵𝐵𝑉𝑉𝑉𝑉 𝑇𝑇𝑉𝑉𝐸𝐸 𝑅𝑅𝑉𝑉𝐴𝐴𝑉𝑉)

What we call the «Tax Shield» as interest expensescan be deduced from income taxes

In order to calculate the default spread for public companies, wewill have to compute the interest coverage ratio. Then please look at the Word file namedInterestCoverageRatios_Ratings_DefaultsSpreads_2015.doc

Quicker method: Interest expenses / (LT Debt + ST Debt)

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Asset

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Value of an Asset - ExampleIt is exactly what we did yesterday with Project Valuation.

Remember:◦ Projects without risk - NPV◦ Projects with risks - rNPV

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Public Company

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Value of a Business - ExampleRemember the formula:

We need some inputs:◦ Cash flows (CF)◦ Perpetual growth of these cash flows (going concern principle – for mature business)◦ Discount rate (WACC)

Example: Roche

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐵𝐵𝑉𝑉𝐴𝐴𝐵𝐵𝐵𝐵𝑉𝑉𝐴𝐴𝐴𝐴 = �𝑡𝑡=1

𝑡𝑡=𝑁𝑁𝐸𝐸(𝐶𝐶𝐶𝐶𝑡𝑡)

(1 + 𝑟𝑟)𝑡𝑡+

𝐸𝐸(𝐶𝐶𝐶𝐶𝑁𝑁+1)(𝑟𝑟 − 𝑔𝑔𝑛𝑛) (1 + 𝑟𝑟)𝑁𝑁

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Value of a Business - RocheCash flows:◦ Item: FCFF = Operating profit after tax – Capex – Depreciation*.◦ Time period: 2015-2019 (Thomson Reuters Consensus Estimates available)◦ Data (CHFb):

◦ 2015: 16.48◦ 2016: 17.65◦ 2017: 19.09◦ 2018: 20.83◦ 2019: 21.89

Perpetual growth (Swiss GDP growth): 1.89%

*Normally you should include the changes in working capital but for simplification reasons wechose no to include this item in the calculation.

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Value of a Business - RocheDiscount rate:◦ Cost of Equity

◦ Risk free rate (Switzerland): 0.04% (as of February 12th 2015)◦ Link: http://www.snb.ch/fr/iabout/stat/statpub/zidea/id/current_interest_exchange_rates◦ Beta: 1.045◦ Equity risk premium (over the last 10 years): 4.60% ◦ Cost of Equity = 0.04% + 1.045*4.60% = 4.85%

◦ Cost of Debt◦ Long term debt + Short term debt = 19’347 + 6’367 = 25’714◦ Interest expenses = 926 => theoretical interests rate = 3.60%◦ Marginal tax rate: Income taxes/Pre-tax income = 2980/12515 = 23.8%◦ Cost of Debt = (3.60%)*(1-23.8%) = 2.74%

◦ Cost of Capital (Liabilities: 56’055 Equity: 19’586 Total: 75’641)◦ (25.89% * 4.85%) + (74.11% * 2.74%) = 1.26% + 2.03% = 3.29%

38

Value of a Business - Roche

Biaised by low interestrates

Discount rate (Cost of Capital) 3.29%

Perpetual growth 1.00%

t 0 1 2 3 4CHFb 2015 2016 2017 2018 2019EBIT 16.5 17.7 19.1 20.8 21.9

Average tax rate 22.2% 22.2% 22.2% 22.2% 22.2%EBIT after tax 12.8 13.8 14.9 16.2 17.0

Average Capex in % of EBIT 20.9% 20.9% 20.9% 20.9% 20.9%Capex estimate 3.4 3.7 4.0 4.3 4.6

Average Depreciation in % of EBIT 13.2% 13.2% 13.2% 13.2% 13.2%Depreciation estimate 2.2 2.3 2.5 2.7 2.9 Free cash flow to the firm 7.2 7.7 8.3 9.1 9.6 Discount rate factor 1.00 0.97 0.94 0.91 Terminal ValueDiscounted EBIT (CHFb) 7.21 7.50 7.84 8.27 395.79Company Value of Roche (CHFb) 426.6Market Capitalization (CHFb) (Value of Equity Only) 210.2as of February 2015

Estimates fromThomsonOne

Average tax rate calculatedfrom 2006 to 2014

Average capex calculatedfrom 2006 to 2014

Average depreciationcalculated from 2006 to

2014

Free cash flow to the firm= Operating profit after tax- Capex- Depreciation

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐵𝐵𝑉𝑉𝐴𝐴𝐵𝐵𝐵𝐵𝑉𝑉𝐴𝐴𝐴𝐴

= �𝑡𝑡=1

𝑡𝑡=𝑁𝑁𝐸𝐸(𝐶𝐶𝐶𝐶𝑡𝑡)

(1 + 𝑟𝑟)𝑡𝑡+

𝐸𝐸(𝐶𝐶𝐶𝐶𝑁𝑁+1)(𝑟𝑟 − 𝑔𝑔𝑛𝑛) (1 + 𝑟𝑟)𝑁𝑁

39

Business Case 1Use the Excel file for Roche from the example and modify the cost of capital in order to see the sensitivity of this input.

What can you say?

40

Business Case 2Use Straumann and do the same. In the same file as the Roche example: Roche_ValuationExample, you createanother worksheet (copy & paste & change the inputs).

Below some key inputs for your calculations:◦ EBIT estimates CHFm (2015-2019): 165 / 191 / 214 / 232 / 270◦ Perpetual growth (same as Roche): 1.00% (Swiss GDP)◦ Cost of equity:

◦ Risk free rate: 0.04%◦ Beta: 1.594◦ Equity risk premium: 4.60%◦ Cost of equity = …

◦ Cost of debt:◦ Long term debt + Short term debt = 203 + 0 = 203◦ Interest expenses = 3.7 => theoretical interest rate = 3.7 / 203 = 1.8%◦ Marginal tax rate = 15.8% (19/120)◦ Cost of debt = …

◦ Cost of capital (Liabilities: 388 Equity: 631 Total: 1020)◦ Calculation: …

41

Business Case 2 - correctionUse Straumann and do the same. In the same file as the Roche example: Roche_ValuationExample, you createanother worksheet (copy & paste & change the inputs).

Below some key inputs for your calculations:◦ EBIT estimates CHFm (2015-2019): 165 / 191 / 214 / 232 / 270◦ Perpetual growth (same as Roche): 1.00% (Swiss GDP)◦ Cost of equity:

◦ Risk free rate: 0.04%◦ Beta: 1.594◦ Equity risk premium: 4.60%◦ Cost of equity = 0.04% + (1.594*4.60%) = 7.37%

◦ Cost of debt:◦ Long term debt + Short term debt = 203 + 0 = 203◦ Interest expenses = 3.7 => theoretical interest rate = 3.7 / 203 = 1.8%◦ Marginal tax rate = 15.8% (19/120)◦ Cost of debt = 1.8% * (1-15.8%) = 1.52%

◦ Cost of capital (Liabilities: 388 Equity: 631 Total: 1020)◦ Calculation: (61.86%*7.37%) + (38.14%*1.52%) = 5.14 %

42

Business Case 2 - Straumann - correctionDiscount rate (Cost of Capital) 5.14%

Perpetual growth 1.00%

t 0 1 2 3 4CHFm 2015 2016 2017 2018 2019EBIT 165 191 214 232 270Average tax rate 23.0% 23.0% 23.0% 23.0% 23.0%EBIT after tax 127.1 147.1 164.8 178.6 207.9

Average Capex in % of EBIT 28.7% 28.7% 28.7% 28.7% 28.7%

Capex estimate 47.4 54.8 61.4 66.6 77.5 Average Depreciation in % of EBIT 28.6% 28.6% 28.6% 28.6% 28.6%

Depreciation estimate 47.2 54.6 61.2 66.4 77.2

Free cash flow to the firm 32.5 37.6 42.2 45.7 53.2

Discount rate factor 1.00 0.95 0.90 0.86 Terminal ValueDiscounted EBIT (CHFm) 32.51 35.79 38.14 39.32 1'105.42Company Value of Straumann(CHFm) 1'251

Market Capitalization (CHFm) (Value of Equity Only) 4'209 as of March 2015

43

Private Company

44

And How Can We Value a PrivateCompany?All the points we saw in the previous slides were fully dedicated to public companies for which a lot of financial data is available (financial statements, stock prices,….).

For private companies, there is a lack of data, especially stock prices, beta,…

How can we value this type of company?◦ Benchmark construction◦ Estimating the cost of equity, debt and capital◦ Estimating the cash flows

But after taking that into account, the methods are the same. We just need to make someadjustments:◦ Illiquidity discount as a private business cannot be easily bought and sold◦ Control premium if the buyer is acquiring more than 50%

45

Private Company – Cost of EquityRemember?

2 methods to calculate the beta:◦ Comparable firms betas

◦ Collect a group of publicly traded companies in the same line of business◦ Estimate the average beta for the publicly traded comparable firms and use it to calculate the cost of equity for the private firm

◦ Accounting betas◦ Collect the accounting earnings for the private company for as long as there is history◦ Collect the accounting earnings for the stock exchange benchmark that is relevant (S&P 500) for the same period◦ Regress the changes in earnings for the private company against the benchmark◦ The slope of the regression is the accounting beta◦ Limitations: small number of observations, sometimes lack of history, accountants tend to smooth earnings

◦ Do not forget to adjust the beta (representing the market risk) to represent the total risk:Total Risk Beta = Market Risk Beta / Correlation factor (r) with the market

𝐶𝐶𝑜𝑜𝐴𝐴𝐴𝐴 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝑉𝑉𝐵𝐵𝐴𝐴𝐸𝐸 = 𝐸𝐸𝐸𝐸𝐸𝐸𝑉𝑉𝐸𝐸𝐴𝐴𝑉𝑉𝐸𝐸 𝑅𝑅𝑉𝑉𝐴𝐴𝑉𝑉𝑟𝑟𝐵𝐵 = 𝑅𝑅𝐵𝐵𝐴𝐴𝑅𝑅𝑜𝑜𝑟𝑟𝑉𝑉𝑉𝑉 𝑟𝑟𝑉𝑉𝐴𝐴𝑉𝑉 + 𝛽𝛽𝐼𝐼𝑛𝑛𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝐼𝐼𝐼𝐼𝑛𝑛𝑡𝑡 (𝐸𝐸𝐸𝐸𝑉𝑉𝐵𝐵𝐴𝐴𝐸𝐸 𝑅𝑅𝐵𝐵𝐴𝐴𝑅𝑅 𝑃𝑃𝑟𝑟𝑉𝑉𝑃𝑃𝐵𝐵𝑉𝑉𝑃𝑃)

46

Private Company – Cost of DebtThe debt of private companies is not publicly available to investors, and therefore it is not rated.

There are 3 solutions to estimate the cost of debt:◦ Assume that the private company can borrow at the same rate as similar firms (in terms of size) in the

industry; ◦ Estimate an appropriate bond rating for the company based upon financial ratios;◦ Use the simple formula: Interest expenses / Total debt

Then you’ll have to compute the after-tax cost of debt by multiplying the cost of debt by (1-tax rate).

47

Private Company – Cost of CapitalAfter the computation of the cost of equity and the cost of debt, we need to determine the weight of each component: equity & debt.

We can choose to use the industry average debt ratio or the optimal debt ratio for the firmconsidered.

48

Private Company – Estimating the Cash FlowsBe aware of:◦ Shorter history – less information available over an extended time period◦ Different accounting standards – look at all suspicious numbers or larges differences or unexpected

growth◦ Mixing personal and business expenses – in small businesses, personal expenses could be reported as

business expenses as well as salaries can be reported as dividends for the founder…

Adaptation:◦ Restate earnings & cash flows (compare the figures with publicly traded firms in the same industry)◦ Exclude all personal expenses◦ Estimate reasonable salaries

49

Private Company – Illiquidity DiscountWhen?◦ Only when a private business is sold to another private individual because it is associated with the fact

that a private business cannot be easily bought and sold.

How much? Decision criteria:◦ Type of assets owned by the company (the more liquid the assets, the lower the discount)◦ Size of the company (the larger the company, the lower the discount)◦ Health of the company (the healthier the company, the lower the discount)◦ Cash flow generating capacity (the higher the capacity, the lower the discount)◦ Size of the block (the smaller the block of ownership, the lower the discount)

Never◦ If a private business is sold to a publicly traded company, there should be no illiquidity discount (as the

stock in the acquirer is traded). However, there will be a premium as the public company will be able to take better advantage of the private firm’s strengths.

The average* illiquidity

discount isbetween

30 and 35%

* According to several studies done by Maher, Moroney and more recently Silber.

50

Private Company – Control PremiumThe value of the control premium that will be paid to acquire a block of equity will depend on:◦ The probability that control of firm will change (and replace the current management)◦ The value of gaining control of the company (increase in value that can be derived from changes in the

way the company is managed and run)

Criteria:◦ Legal restrictions on takeover (the stricter the legislation, the smaller the premium)◦ Market attitudes towards control changes (the more skeptical, the smaller the premium)◦ Size of stock holding controlled by the current management (the greater, the smaller the premium)

51

Private Company Case StudyExample: Boehringer Ingelheim.

Look at the annual report in your files. You will find all the necessary inputs for the valuation.

Key benchmarks & other inputs you could need are in the Excel file namedBoehringerIngelheim_PrivateCompanyValuation.xlsx

Use the tab named Exercise and don’t look at the solution.

52

Valuation across Time

53

Valuation across TimeThe 3 basic inputs into every valuation…◦ Risk-free rate◦ Equity risk premium◦ Overall economic growth

… can be volatile in some cases, making it difficult to value any company.

54

Valuation across Time – Risk-free RatesComment Issues

Risk-free rates A small definition: it is the rate of return you can expect to make on an investment with a guaranteedreturn (no default risk).

Tied to the time horizon.Normally we use government long-term bonds but some governments are not default-free andmay sometimes not issue debt that can be usedas benchmark.Risk-free rate can today be abnormally high or low relative to fundamentals or history.

55

Valuation across Time – Equity RiskPremium

Comment Issues

Equity riskpremium

A small definition. It is the additional return that we assume investors demand for investing in risky assets (equities) as a class, relative to the risk-free rate.

Economic shocks can change equity riskpremiums significantly. The premium has to beestimated over a long period of time includingcrises and recessions.

56

Valuation across Time – Macroeconomicenvironment

Comment Issues

Macroeconomicenvironment

Since instability in the economyfeeds into volatility in companyearnings and cash flows, it is easierto value companies in mature economies, where inflation and real growth are stable. In this case, changes come from company-specific inputs.

In unstable economies, it could be challengingto calculate company valuations as the macroeconomic environment can dramaticallychange value for all firms.3 general macroeconomic inputs influence value:• Growth in the real economy

(impact on all companies but largest effect for cyclical firms)

• Expected inflation (look at the pricing power of the company and itsability to pass through the higher costs to the customer)

• Exchange rates

57

Valuation acrossLifecycle

58

Valuation across the Lifecycle

Source: The Dark Side of Valuation, A. Damodaran, 2nd edition (2013), p. 8.

Same inputs for all businesses.

Challenges in making the estimates canvary significantly across firms.

Time spent in each phase can varywidely across firms. Think about Google vs. Coca-Cola…

or Young Growth

59

Valuation across the Lifecycle –Young companiesValuation challenges:◦ Few or no existing assets◦ All the value comes from expectations about future growth (market potential? Profitability?)◦ No clues about the potential margins and returns that could be generated◦ Little historical data◦ Difficulties to develop risk measures◦ The valuation will depend on the type of investor performing it as different equity investors can have

different claims on the cash flows

How to solve the issues?◦ Make realistic assumption for each input◦ Use more than one scenario in order to have a valuation range

60

Valuation across the Lifecycle –Growth companiesValuation challenges:◦ How the currently reported revenue growth will scale up? => the rhythm of growth slowing when the

company gets bigger as well as its revenue base…◦ How profit margins will evolve over time as revenue grow?◦ What are the reinvestment assumptions? And what would be the average return for these

reinvestments?◦ How will risk evolve in the future as revenue and profit change?

How to solve the issues?◦ Estimate competitive advantages and analyze the market served – how is the company positioned?◦ Analyze more mature competitors to see their evolution in revenue growth, margins and risk.◦ Use the cost of capital as benchmark for return on (re)investment.

61

Valuation across the Lifecycle –Mature companiesValuation challenges:◦ Changes in efficiency can have a large impact on earnings and cash-flow.◦ External growth (acquisitions,…) can be difficult to predict but is often used by companies to re-create a

growth potential.◦ Financial restructuring can lead to changes in equity/debt mix depending on the cost of each

component of the cost of capital.

How to solve the issues?◦ Integrate all publicly disclosed programs in the forecasts used for valuation.◦ Use multiple scenarii to anticipate the impact of a equity/debt mix change.

62

Valuation across the Lifecycle –Declining companiesValuation challenges:◦ Dealing with decline requires a lot of assumptions.◦ Anticipation of restructuring with asset swaps and asset sales that will impact valuation.◦ How much cash will be derived from the sale and where will it be reinvested?◦ Change in debt liabilities, very often increase leading sometimes to distressed situations.◦ Impossible to adopt a growth-oriented view of the future and assuming that cash flows will grow

forever.

How to solve the issues?◦ Make several assumptions and scenarii.◦ Use a business model for a declining company (in the same way we do for startups) in order to see

which strategy is sustainable.

63

Lifecycle View of Valuation

Source: http://aswathdamodaran.blogspot.ch/2014/11/twitter-bar-mitzvah-is-social-media.html

This chart is summarizing the key points and questions to ask when performing a company valuation at each stage of the development of a firm.

What are the key questions?

Which are the most important metrics?

Do we have to believe in a story or innumbers?

What are the value drivers?

What could be the dangers the companywill face?

64

Valuation Models & Methods - Overview

Valuation Models & Methods

65

Valuation Models & MethodsValuationModels

IntrinsicValuationModels

Discounted Cash Flows

Stable

2-stage

3-stage

DividendDiscount Model

Stable

2-stage

3-stage

Relative ValuationModels

Comparable Firms &

Multiples

EV/EBIT or EV/EBITDA

EV/Sales

M&A Multiples (former

transactions)

Venture Capital Valuations

Pre- & Post-Money Deal Valuations

Venture Capital Method

Berkus Method

ScorecardMethod

Option Pricing Models

66

Intrinsic ValuationModels

67

Intrinsic Valuation ModelsBasic concept of valuing a firm:

Assets LiabilitiesAssets in place

Growth assets

Debt

EquityCash flows considered are cash

flows from assets prior to any debtpayment but after the firm has

reinvested to create growth assets

Discount rate reflects the cost of raising both debt and equity

financing, in proportion to theiruse

Present value is the value of the entire firm and reflects the value of all claims on the firm

68

Intrinsic Valuation ModelsType of Cash flow used will depend on what you would like to value:◦ The stock price of the public company, then use:

◦ Dividend◦ Free cash flow to equity

◦ The value of the whole company, then use:◦ Free cash flow to the firm

Free cash flow to the firm= Operating profit after tax- Capex- Depreciation

69

Intrinsic Valuation ModelsType of growth pattern used will depend on the company valued:◦ Stable growth: for firms growing at the same rate as the economy (mature firms)◦ 2-stage: for firms with shifting leverage (changing debt/equity mix) and growing at a moderate rate

(mature growth companies)◦ 3-stage: for firms with shifting leverage and high growth (young & high growth companies, could also be

used for anticipating the decline of a company)

70

Intrinsic Valuation ModelsFormulas for each model:

◦ Stable growth:

◦ 2-stage growth:

◦ 3-stage growth:

𝑉𝑉0 =𝐶𝐶𝐶𝐶1

(𝑟𝑟 − 𝑔𝑔𝑛𝑛)

g

t

high growth (g)

stable (gn)𝑉𝑉0 =𝐶𝐶𝐶𝐶0 ∗ 1 + 𝑔𝑔 ∗ 1 − 1 + 𝑔𝑔 𝑛𝑛

1 + 𝑟𝑟 𝑛𝑛

(𝑟𝑟 − 𝑔𝑔) +𝐶𝐶𝐶𝐶𝑛𝑛+1

𝑟𝑟 − 𝑔𝑔𝑛𝑛 ∗ (1 + 𝑟𝑟)𝑛𝑛

g

t

stable (gn)

g

t

high growth (g)

stable (gn)transition𝑉𝑉0 = �

𝐶𝐶𝐶𝐶0 ∗ 1 + 𝑔𝑔 𝑡𝑡

(1 + 𝑟𝑟)𝑡𝑡 + �𝐶𝐶𝐶𝐶𝑡𝑡

(1 + 𝑟𝑟)𝑡𝑡 +𝐶𝐶𝐶𝐶𝑛𝑛+1

𝑟𝑟 − 𝑔𝑔𝑛𝑛 ∗ (1 + 𝑟𝑟)𝑛𝑛

71

Relative ValuationModels

72

Relative Valuation ModelsDiscounted cash flow valuation = find the value of a company given its cash flow, growth and risk characteristics.

vs.

Relative valuation = find the value of a company based on how similar companies are currentlypriced by the market.◦ Find similar companies◦ Use of multiples

Relative valuation is easy to use and intuitive but it is also easy to misuse.

73

Relative Valuation Models3 steps:

Finding comparable companies pricedby the market• Same sector?• Same clients?• Same markets?• …

Scaling marketprices to a commonvariable• EV/Sales• EV/EBITDA• EV/EBIT• …

Adjusting for differences acrossassets• High growth = higher

multiples• Breakthrough innovation

= higher multiples• …

Check multiple consistency across firmsand distribution across

the sector and the market

Understand the fundamentals behind the

multiple

74

Relative Valuation ModelsAdvantages:◦ Less time- and resources-intensive than discounted cash flow valuations◦ Easier to sell (DCF are difficult to explain and contain several inputs)◦ Easy to defend (the relative valuation is determined by a multiple derived from what the market is

paying; DCF contain several assumptions sometimes based on business models and long term economicforecasts)

◦ Market imperative (relative valuation is reflecting the current mood of the market as it measuresrelative and not intrinsic value)

Disadvantages:◦ The average multiple of a group of companies will not reflect the real value of the analyzed firm◦ The market can sometimes over- or under-value companies depending on several factors◦ Lack of transparency in underlying assumptions (vulnerability to manipulation)

75

Relative Valuation Models - ExampleNB: Enterprise Value = Market capitalization + Debt – Cash

We would like to value Boehringer Ingelheim.

We chose to expand the benchmarks for relative valuation in order to include all the othercompanies in the Top 20 Pharma companies.

See Excel file Relative Valuation Example Top 20 Pharma

What did we do?1. Download of Enterprise Values, Sales and EBITDA forecasts in ThomsonOne2. Compute the EV/Sales and EV/EBITDA ratios3. Simple statistical analysis with average, median, standard deviation, standard error, max and min4. Selection of the most consistent ratio to be applied to Boehringer Ingelheim

76

Relative Valuation Models – ExampleWhich one is the most consistent?EV/SALES EV/EBITDA

0

1

2

3

4

5

6

7

8

9

Range 0-1 Range 1-2 Range 2-3 Range 3-4 Range 4-5 Range 5-6 Range 6-7 Range 7-8

Num

ber o

f obs

erva

tions

EV/Sales FY1 - Distribution

0

1

2

3

4

5

6

7

8

9

10

Range 8-10

Range 10-12

Range 12-14

Range 14-16

Range 16-18

Range 20-22

Range 22-24

Range 24-26

Range 26-28

Num

ber o

f obs

erva

tions

EV/EBITDA FY1 - Distribution

Average 3.9Mediane 3.7Standard deviation 1.6Standard error 0.4Minimum 1.3Maximum 7.2

Average 12.7Mediane 12.1Standard deviation 4.1Standard error 0.9Minimum 8.1Maximum 27.5

77

Relative Valuation Models - ExampleThe EV/Sales is the most consistent. There are several reasons for that:◦ Sales are normally recorded when the product is really sold. It is much more difficult to manipulate the

sales figure than any other item on the income statement.◦ EBITDA can be impacted by accounting standards in how specific expenses are recognized. ◦ Expenses can also differ from one company to another because of their own business model.

The next step is to apply the average and median ratio to our forecasted revenues for Boehringer Ingelheim. See the Excel file.

78

Relative Valuation ModelsM&A Multiples◦ Select deals that match the business models, therapeutic areas and size of the company to be valued.◦ Focus on acquisitions as there is a price paid for a whole company which is much more relevant than

any other type of combination.◦ Extract the price paid by the buyer.◦ Search for the sales and EBITDA or EBIT or operating profit of the target company.◦ Compute the multiple.

Always interesting but could be biaised when a therapeutic area is hyped up, like Hepatitis C in 2012-2014 for example.

79

VC Valuation Models

80

VC Valuations – Pre- & Post-Money◦ Pre-money valuation: valuation of a company prior to an

investment or financing. If an investment adds cash to a company, the company will have different valuations before and after the investment.

◦ Post-money valuation: Pre-money valuation + investment

◦ Venture capitalists and angel investors will use a pre-money valuation to determine how much equity to ask for in return for their cash injection to an entrepreneur.

◦ Usually, a company receives many rounds of financing rather than a big lump sum in order to decrease the risk for investors and to motivate entrepreneurs.

◦ Pre- and post-money valuation concepts apply to each round.

◦ Non-dilutive sources of financing: academic grants, government funds, industrial partnerships

◦ Tool to help you compute the dilution: http://venturehacks.wpengine.com/wp-content/uploads/2009/10/Venture-Hacks-Cap-Table.xls

81

VC Valuations – The VC Method◦ This method was created by Harvard Professor Bill Sahlman in 1987 and is one of the most popular

methodologies for valuing pre-money ventures. Here is the basic calculation:

◦ The terminal or harvest value is how much you reasonably expect to sell the company for in the future.

◦ Anticipated ROI is the multiple that you expect the company will produce in return. Anticipated ROI benchmarks depends on the development stage of the company.

◦ The VC Method may produce a more optimistic pre-money valuation (PMV) than other methods because it’s based on future projections, whereas the Scorecard and Berkus Methods (in the next slides) focus more on the current state of affairs. However, just to be safe, it’s wise to use multiple methods to calculate your PMV and ensure the number you use with investors is as sound and realistic as possible.

Company stage AnticipatedROI (multiple)

Seed (lead optimization) 20x

Start-up (preclinical) 10x

First stage (Phase I) 8x

Second stage (Phase II) 6x

Late stage (Phase III) 5x

𝑅𝑅𝑅𝑅𝑅𝑅 =𝑇𝑇𝑉𝑉𝑟𝑟𝑃𝑃𝐵𝐵𝐵𝐵𝑉𝑉𝑉𝑉 𝑜𝑜𝑟𝑟 ℎ𝑉𝑉𝑟𝑟𝑎𝑎𝑉𝑉𝐴𝐴𝐴𝐴 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑃𝑃𝑜𝑜𝐴𝐴𝐴𝐴 − 𝑃𝑃𝑜𝑜𝐵𝐵𝑉𝑉𝐸𝐸 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝐴𝐴𝐵𝐵𝑜𝑜𝐵𝐵

82

VC Valuations – The Berkus MethodOne of the most well-known and widely respected methodologies (especially for technology startups).◦ Uses both qualitative and quantitative factors to calculate a valuation.◦ Was developed in the mid 1990’s by Dave Berkus, an angel investor. He was frustrated by the fact that

most valuation methods relied on an entrepreneur’s projections as a starting point.◦ Methodology based on 5 drivers.◦ Add to Pre-Money Valuation (between USD 0 and 500K) for each driver:

1. Sound Idea (basic value, product risk) 2. Prototype (reducing technology risk) 3. Quality Management Team (reducing execution risk)4. Strategic relationships (reducing market risk and competitive risk)5. Product Rollout or Sales (reducing financial or production risk)

83

VC Valuations – The Scorecard MethodThe Scorecard Method, also called the Bill Payne Method or the Benchmark Method, was developed by angel investor Bill Payne as a way to value a pre-revenue venture by comparing it to other ventures in the same region and business sector.The result is a Pre-money valuation that will be reasonable when compared to similar ventures around you. However, the valuations are only as good as the comps you use, and the process of identifying your multiplier is extremely subjective.

Steps:1. Gather valuations from other pre-revenue companies

in your sector within your geographic region and calculate the average of those valuations.

2. Compare your venture to similar deals done in your area using the following factors.

◦ Average performance = 100%◦ Better performance > 100%◦ Poor performance < 100%

3. Multiply the sum of those factors by the average pre-money valuation that you identified in Step 1.

Value Driver Benchmark Weight

ExampleWeight

ExampleScore

ExampleFactor

Strength of the Management Team 0-40% 30% 150% 0.4500

Size of the Opportunity 0-35% 25% 125% 0.3125

Product/Technology 0-25% 15% 125% 0.1875

Competitive Environment 0-20% 10% 75% 0.0750

Marketing/Sales Channels/Partnerships 0-15% 10% 100% 0.1000

Need for Additional Investment 0-10% 5% 100% 0.0500

Other 0-5% 5% 100% 0.0500

Total 1.225

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VC ValuationsKey points:◦ Don’t use a single method◦ Use a blend of questions, try several methods◦ Customize the method to your own needs and own business model◦ Put yourself in the shoes of the VC (Why would you invest in your company?)

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Option Pricing Models

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Option Pricing ModelsThe option valuation method was developed by Cox in 1979. Another model was developed earlier, in 1973 by Fischer Black and Myron Scholes for the pricing of derivative instruments.

The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the option's expiration date.

The model reduces possibilities of price changes, removes the possibility for arbitrage, assumes a perfectly efficient market, and shortens the duration of the option. The binomial model takes a risk-neutral approach to valuation. It assumes that underlying security prices can only either increase or decrease with time until the option expires worthless.

It is used in 3 cases:◦ Equity Value in Deeply Troubled (or Distressed) Firms◦ Value of Undeveloped Reserves for Natural Resource Firm◦ Value of Patent/License

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Which Valuation for Which Company?

& Conclusion88

Valuation Roadmap & Conclusion

Valuation

AssetrNPV

Option Model

Company

Private

Start-up

VC Model

ScorecardMethod

BerkusMethod

MatureDCF

Relative Valuation

Public

Small

Option Model

Relative Valuation

MediumDCF

Relative Valuation

BigDCF & DDM

Relative Valuation

Here are some common sense guidelines but do not forget to:◦ Use more than one method◦ Use more than one scenario◦ Never end up with one stand-alone number,

prefer a range of numbers◦ Be consistent and realistic in your assumptions◦ Do not hesitate to stress test your assumptions (it

is key to know your flexibility◦ Always compare with what’s currently happening

in your industry and markets

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Q&AFeedback?

90

TestGood Luck!

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Sources◦ Financial Statement Analysis – A Practitioner’s Guide, M. Fridson & F. Alvarez, Wiley Finance, 4th

edition, 2011.◦ Financial Shenanigans – How to Detect Accounting Gimmicks & Fraud in Financial Reports, H. Schilit, 3rd

edition, 2010.◦ Financial Intelligence – A Manager’s Guide to Knowing What the Numbers Really Mean, K. Berman & J.

Knight, Revised Edition, 2014.◦ Ahead of the Curve – A Commonsense Guide to Forecasting Business & Market Cycles, J. Ellis, 2005.◦ The Dark Side of Valuation, A. Damodaran, 2nd edition, FT Press, 2010.

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