financial valuation of companies

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Dominique THEVENINDominique THEVENIN Financial valuation of companies Financial valuation of companies 2009 2009

Financial Valuation of companiesFinancial Valuation of companies

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Financial Valuation of companiesFinancial Valuation of companies

Objectives of the course: Unterstand the commonly used techniques in

valuation of companies

Be able to estimate a spread of values of a company

Pr Dr Dominique Thévenin

Associate Professor

Grenoble Ecole de Management

[email protected]

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SummarySummary

1. Asset Pricing: general rules 2. Patrimonial valuation methods 3. Analogy valuation methods 4. Discounted methods 5. WACC issues and statistical approach of CAPM 6. Specific cases: techno companies, convertible

bonds

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SummarySummary

Course documents Slides, Exercices and small cases, Cases

Required tools Simple calculator, or PC Excel Linear regression, statistics Boursorama, yahoo finance, google finance Bloomberg, www.infancials.com,

Course Book Bryley & Meyers ( en) Vernimen (Fr)

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1. General rules about asset pricing1. General rules about asset pricing

Financial ressourcesFinancial ressourcesFinancial ressourcesFinancial ressources

operationsoperationsoperationsoperations

investmentinvestmentinvestmentinvestment

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1.1 Overview on interest rates1.1 Overview on interest rates

Interest rate Expected inflation Report of consumption Time (liquidity) Risk premium

Short horizon interest rate Decided by Central Banks In the context of monetary policy

Long Horizon interest rate Market rate cointegrated with short rates

2% 2% (2010 €)(2010 €)3% ( past average)3% ( past average)

1-2% (5-15 years)1-2% (5-15 years)0% - 4 -6%0% - 4 -6%

2% 2% (2010 €)(2010 €)3% ( past average)3% ( past average)

1-2% (5-15 years)1-2% (5-15 years)0% - 4 -6%0% - 4 -6%

1% € 2007-2010,1% € 2007-2010,0,25% yen, $, 0,25% yen, $, 20102010

1% € 2007-2010,1% € 2007-2010,0,25% yen, $, 0,25% yen, $, 20102010

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1.2. Overview: asset pricing1.2. Overview: asset pricing

Value of an asset = transaction price = price that the owner estimates to be enough. that the investor should pay when buying this asset,

P° What you pay = what you get = sum of the future cash flows that you receive as long as

you hold this asset = Discounted future cash flows

Certain or safe cash flows: bonds P°= present value of future cash flows @ right risk rate

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Overview: asset pricingOverview: asset pricing

Uncertain cash flows: Speculative pricing : discounted expected cash flows

Interest rate = adjusted to the risk of the asset

P° moves in response to rates fluctuations and cash flow revisions

Real assets P° sensitive to expected selling price, rents, and interest

rates

Stocks P° sensitive to dividends, profits, selling price and interest

rates

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Overview of asset pricing: bonds Overview of asset pricing: bonds valuationvaluation

The bondholder receives fixed subsequent payoffs. Exemple : 500 € in fine bond @ 3%, maturity 10 years. What is the value of this bond if market rate is ?

5% 8% 12% 2% 1%

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1.3 Valuation of a company1.3 Valuation of a company

Firm = set of assets holded by shareholders Shares are assets themselves

Value of a company = value of all of its assets = Debt Value + Equity value Creditors = money suppliers = stakeholders. Thus the

good issue is the value of Equities. Equity Value = Assets value – Debt Value

Direct valuation: valuate equities from dividends or profits

Indirect valuation: valuate assets and substract the debt

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Valuation of a companyValuation of a company

Assets oh the company = set of projects, investments in process, (no growth situation)

growth opportunities ( few are disclosed)

Value of the assets = PV of the future cash flows of all the projects

+ PV of growth opportunities

Discounted at the weighted cost of capital

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Main methods to valuateMain methods to valuate

Book value, or patrimony approach Financial statements provide information about patrimony

information about past profitability

Information about competitors

Analogy approach Duplicate the valuation from similar firms

Financial or discounted approach The value of an asset or a security = present value of

expected cash flows = sum of discounted expected cash flows. ( part 3)

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2. Book value approach2. Book value approach

A1: value of equities = book value of equities Simple: just read it in the financial statements !

Assets are valuated according rules and regulations. Continental Europe focuses on safety principle, with historical costs: does not reflect their market value. Far from

reality.

Distinguish some liabilities from equities is not trivial Convertible bonds ? Options on stocks ?

Consolidated datas are not always safe

IFRS regulation improves the valuation of listed companies

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2.1. Book value approach2.1. Book value approach

A2: net reevaluated assets : Valuate every asset in the balance sheet at its market value

Are all assets liquid ?

Are all assets profitable ? (useless assets)

Does every asset fully reflect future earnings ? Brands, licences, specific assets ?

Some elements do not exist in assets and financial statements Know how, human capital, specific assets, growth

opportunities

On the other side: dissimuated liabilities

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2.1. Book value approach2.1. Book value approach

Listed companies: IFRS Assets and liabilities are valuated at their « fair value »

A2 approach Only some untangible assets are valuated at the fair value:

acquired brands and licences, financial investments, etc.

Goodwills are controversy

IFRS are sometimes contrevorsy, but the induced valuations are closer to market valuations

Nevertheless, the difference between market and book values are large

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2. Book value approach2. Book value approach

A3: the goodwills:

Idea: valuate assets that accounting systems are not able to do, but generate profits.

Untangible assets, know how, human ressources,…

These additionnal value = Goodwill.

But methodologies suggest hazardous formulas:

No cash, no discount, no risk and no expectations!

The Goodwill valuation approach has no backgroud

But Goodwill exists : ex post, GW = Price of a firm – Book Value…

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Example: HermesExample: Hermes

31/12/2010 sept-11INVESTED ASSETS 1627 25512BOOK EQUITIES 2150 MARKET CAP 26035NET DEBT -523 -523

2010/2011SALES 2631EBITDA 897NET INCOME 518

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Example: RenaultExample: Renault

31/12/2010 sept-11INVESTED ASSETS 42419 27474BOOK EQUITIES 22235 MARKET CAP 7290NET DEBT 20184 20184

2010/2011SALES 40404EBITDA 3835NET INCOME 3860

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3. the « multiples »3. the « multiples »

Underlying idea: markets evaluate identical firms at the same price.

Consider the PER: Market price /net income Price Earning Ratio indicates how many times of annual profit you

pay a company PER Air liquide = 18 the price of the share = 18 times its annual

net profit The current net profit is commonly seen as the main

reference to measure the profitability of a company. the PER shows the expected growth of the profits PER 6-8 = low growth PER 10 = maturity PER > 20 = growing company

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The multiplesThe multiples

Consider now the links between economic variables of the firm: income, sales, net assets, book value Net profit = Sales x net margin in% Sales = invested assets x turn over speed

Links between 1 economic variable and the market price are established A « multiple » = market price / economic variable

there are links between market valuation and most economic variables. Multiples are very closed among an industry, because

companies run the same business model

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multiplesmultiples

But the debt will infer. Thus separate these indicators Market cap / net income, variables related to equities,

Enteprise value / variable limited to economic variables

Where Enteprise value = market cap + debt

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multiplesmultiples

Equities assets

Common PER= MarkCap/net incomeP :B = Markcap / book value of equities

Q Tobin = Ev / book value of assets

industry P:D : market cap / dividend

P:S = Ev / salesP:EBITDA = Ev / EBITDAP:EBIT =Ev / EBIT

Ev commonly means market value of assets = market cap + debt

P:S, P:EBIT are often computed on market cap and not Ev . Please pay out

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examplesexamples

DEC 2008 sept-09

company book value market cap P:B perBNP 53 56 1,06 12,4SOC GEN 36 30 0,83 29CREDIT AGRICOLE 41 29 0,71 25,5AIR LIQUIDE 7 20 2,86 18PEUGEOT 13 5 0,38 NARENAULT 19 9 0,47 NAACCOR 3,3 8,3 2,52 30,6VIVENDI 23 24 1,04 9,25LVMH 13 34 2,62 18,3GOOGLE in EUROS 20 100 5,00 35

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The multiplesThe multiples

The use of the multiples if non listed company Look for listed similar companies on a market Compute main multiples Duplicate the multiple to unlisted companies, or analyse the

place of a company among its competors Advantages

simple, easy Cons

Difficult to build samples of similar companies What else if no earnings… What else if the maket price is very volatile Book datas are delayed in regards to market datas

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Example 2006Example 2006

Strong differences even in the same industry!PEUGEOT RENAULT VW Porsche GM en M$ BMW TOYOTA M€

SALES 56267 41338 95268 6575 162610 46656 149221EBITDAEBIT 1940 1323 2792 872 -982 3774 14806NET INCOME 1029 3367 1120 779 -8921 2242 9733CARS in 1000 1995 2543 5193 88 9200 1425 7974book EQUITIES 14406 19661 23647 2525 15636 16973 79091DEBT 8992 8448 61261 326 241251 29509 61524book Assets 23398 28109 84908 2851 256887 46482 140615

Ev : S 0,34 0,83 0,90 2,35 1,59 1,27 1,61Ev : EBIT 9,75 25,94 30,77 17,73 -263,71 15,66 16,20Q tobin 0,81 1,22 1,01 5,42 1,01 1,27 1,71P:B 0,69 1,32 1,04 6,00 1,13 1,74 2,25P E R 9,64 7,68 22,01 19,43 -1,99 13,21 18,32mark cap / cars in € 4973 10174 4747 172017 1925 20777 22364

mark cap 9 922 25 872 24 649 15 138 17 709 29 607 178 334Ev 18 914 34 320 85 910 15 464 258 960 59 116 239 858

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4. Discounted approaches4. Discounted approaches

Value of equities = value of assets – value of debt.

Assets = sum of investment projects

Assets value = present value of future economic cash flows, discounted @ the cost of capital.

Infer equities

Value of equities = present value of the future cash flows to shareholders

equities value = (economic cash flow – cash flow to bondholders) discounted @ the cost of equities

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4. Discounted approach4. Discounted approach

Exemple: a company produces cheese and generate a stable and infinite EBITDA = 20 M. The balance sheet shows 50 M debt at 6% interest. Income tax = 30%, and shareholders require a 9% return.

1. Estimate the value of its equities, 2. Estimate the WACC and the value of its assets

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4.1. The DCF method4.1. The DCF method

DCF = Discounted Cash Flows. Translate strategy into a stream of future economic cash

flows.

Discount @ wacc

DCF gives the value of assets

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4.1.DCF4.1.DCF

« free cash flow » table Economic cash flow including

operating flows after tax (NOPAT + depréciations) + Delta Net Working Capital - investment required to maintain operations possible No interest or debt flows (except if you compute cash

flow to shareholder) Techniques

Assume depreciations = investment (roll over) Cash flow every year as long as the visibility is correct Troncate the subsequent flows at the end: « terminal price

»Assume a multipleOr assume a long term growth rate

Discount the free cash flows value of assets

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4.1. DCF4.1. DCF

Advantages Translate a strategy into datas

Specific DCF if diversified company. Then consolidate. ( SOTP = sum of the part)

Cons Few visibility over long period

DCF is very sensitive to the « terminal price »

Requires to know the WACC

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Example: MemscapExample: Memscap

Memscap: high tech company at Grenoble. IPO: january 2001 valuated by Société Générale

Owen Subsequent DCF are published:

2001 2002 2003 2004 2005 2006 2007 2008 2009sales 17,5 79,5 131 245 344 464 604 767 959cost of salesEBITTaxdepreciationsfluctuation NWCacquisitions 6,8 8,8Free Cash Flow -17,3 -25,1 19,3 44,9 62,7 81 105,3 133 175

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4.2.Discounted approaches:4.2.Discounted approaches:dividends or fundamental approachdividends or fundamental approach

Price of a stock = present value of the cash flows to shareholders Dividends and capital gains: D1 and (P1-P0) if cash flo to

shareholders are restricted to dividends

If D1 and P1 are estimated, the required return to shareholders wellknown,

R

PDP

1

110 R

PDP

1

221

nn

n

tt

t

R

P

R

DP

)1()1(10

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4.2. dividends4.2. dividends

= present value of inifinite dividend stream If you introduce a long term growth rate: Gordon-Shapiro

model.

Dividend and growth rate are not independant

Growth rate has to be < return rate

Reverse the model and get Required return = dividend yield + growth rate

Fundamental and Gordon Shapiro models have a weak explainatory power:

< 40% in US stocks

60% in France

gR

DP

1

0

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Limits of Gordon Shapiro model Valid with mature companies

Irrelevant with growing companies Troncate the model into growing period and

maturity

ROE often irrelevant (delayed) to estimate g with( way 2)

Irrelevant if the dividend policy is unstable

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3 ways to estimate the growth rate? Try to translate the strategy into sustenable long terme

growth rate Link payout ( Dividend / Earnings) = b, and growth

(1-b) * Earnings are retained and invested Ceteris paribus,

the book equities increase by (1-b)*ROEEarnings and Dividends increase by (1-b)*ROE

g = (1-b)*ROE g is the requested growth to get the same ROE

Observe subsequent dividends over time, and run an exponential regression t / t-1

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Exercice: look at a listed company Compute b, ROE,

infer growth rate,

Compute dividend yield

Infer the cost of equities

Download the dividends over the past 10 years

Regress and infer g

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4.3. growth and stock price4.3. growth and stock price

Growth of sales and earnings should show a long term link g = 0: b = 100%, dividends = earnings. P0= earnings / r

PER = 1/r, or r = 1/PER If g>0: additionnal cash flows and earnings Price moves

up PER moves up r = 15% g = 0% b=100% PER = 6.67 R = 15% g =10% b=40% ROE =16.66% PER = 8 r = 15% g =10% b=50% ROE =20% PER = 10

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French market 2006: average PER = 16 (13 in 1993) PER were historicaly high 1998-2002. Earnings had to grow ! Dec 2009: <10

Growing company : PER > 20 - 25

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4.4 Discounted approach: Bates 4.4 Discounted approach: Bates ModelModel

PERb g A

k gA PERn0

1 1

( )( )

. Ag

k

n

n

( )

( )

1

1

Mix DCF + PER approaches Firm is growing at g over n years, and retained earnings (1-b)

are constant over time.

PERn reflects moderate growth.

PER0 can be estimated as follows:

Value of equities = PER0 x Net Income0

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BatesBates

Advantages Valid for growing companies

Simple

Possible to run Bates with a multiple of NOPAT, and gives the value of assets

Limits Positive Net income is required

Constant % dividend payout ( possible to input b=0%)

Requires to know the cost of equities

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Bates: example GoogleBates: example Google

Google sept 2011 Cost of equities 10,3% ( beta 1, rf 1,8%, market 8,5%)

Net income 2010/2011 = 9013 M$

Market cap = 174 000 M$ PER°=19,3

b = 0 assumed for a long time

Forecasts = PER 2013 = 10,8

implicit growth rate = 47% over 2 years.

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Conclusion about valuation methodsConclusion about valuation methods

Patrimonial approaches reflect the past Correct if real assets Avoid a priori Goodwills

Financial approaches are founded on expectations. They price growth opportunities. It ensures volatility when expectations are revised. Sensitive methods to hypothesis

Strong links with strategy Financial approaches requires to estimate first the cost of

equities, and/or the cost of capital ! Strong links with capital structure

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5. Discount rate5. Discount rate

Discounted methods (part 4) require to know the discount rate

Cost of equities, or

WACC.

Cost of equities and WACC depend on the D/E leverage ratio

D/E ratio includes the market values and not the book values

Risk of « circular » estimation of discount rate

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5.1 Cost of equities and CAPM5.1 Cost of equities and CAPM

Stock return = risk free + risk premium Stock risk = systematic risk + specific risk

Systematic risk = risk generated by the stock market on our stock

Specific risk = risk that can be eliminated by diversification of the portfolio owned by the shareholder

Only systematic risk is paid to shareholder This risk = Market risk smoothed or incréased by the

sensitivity of the stock in response to the market fluctuation

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5.1 CAPM5.1 CAPM

Thus we get the derived equation of CAPM approach

Where beta = sensitivity of stock / market = cov (stock, market)/market variance

*)( fmfi rrrRE

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5.1 CAPM5.1 CAPM

How to estimate the cost of equities of a listed company ?

Risk free is observable at a given date: T-Bonds à 10 years is the most commonly used proxy

Market risk premium: often published in financial newspapers. Average of the market premium over time: 3.5% -

4%. Never use 1/PER of the market

beta is sometimes published in financial newspaper unsafe

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Risk premium over timeRisk premium over time

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5.1 CAPM5.1 CAPM

How to estimate the beta of a listed company Beta = regression coefficient of Ri = a + beta * Rm

Download stock price and stock index, exchange them into returns Week data over 1 year is preferable

Regress Ri on Rm and get the beta coefficient

Run a Student test to decide if your estimation is acceptable Sophisticated econometric tests should be conducted,

due to non stationnary datas Beta reflects the risk of a company, and is not stable over

time, or after M&A

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5.1 CAPM5.1 CAPM

How to estimate the beta of a non listed company Estimate the beta of a listed company Compute market D/E ratio Exchange the beta into the economic beta and duplicate it

to the non listed company,

Valuate the company under all equity financed hypothesis value of assets

Adjust with the debt Some iterations may be required

Avoid to compute the cost of equities and the WACC under book value D/E

)1( )1(0 E

TaxDD

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6. Specific cases. 1. techno firms6. Specific cases. 1. techno firms

Growth opportunities Single cash flow sequence doesn not reflect correctly

Many stages with uncertain cash flow Many stages where decisions can change a project

Decision trees Real options

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Real option as investmentReal option as investment

R&D = valuate with Black and Sholes model Underlying asset = project itself

Maturity = uncertain, unknown

Strike = investment ,

Volatility = the risk of cash flows = substituate with the standard deviation

Options on extension, communication, to give up, to differ, etc

All of this opportunities give more and more value The « true value » is revealed with information

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Black & Sholes modelBlack & Sholes model

)(..)(. 2100 dNePdNPW tRX

f

t

tRP

PLn

df

X

.

2

20

1

tdd 12

W = value of the callP0 = price of underlying assetPx = Stike pricet = maturityrf = risk free interest rateSigma = volatility of the assetN(.) = cumulative normal law

W = value of the callP0 = price of underlying assetPx = Stike pricet = maturityrf = risk free interest rateSigma = volatility of the assetN(.) = cumulative normal law

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6.2 convertible bonds6.2 convertible bonds

Convertible bond = a bond including the right to exchange it to stock @ a given exchange ratio

Stage 1: classical bond ( coupon …) Stage 2: pay back time

No cash, but common stocks, Cash if the value of the stock is low

Advantages to the issuer Interest is tax save No cash to payout if exchange Delays the dilution induced by an equivalent capital

increase

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Convertible bond issue by ABB April 2002 (968 M$) Issuing price : 1000 $ Date : 29 April 2002 expiration: 16 Mai 2007 coupon : 4,625% Reimbursement price: 1000 $ exchange : 87, 7489 actions per 1 bond Exchange period : from 29 April 2002 to 16 May 2007 Stock price ABB: 14,218 CHF (8,77$)

exampleexample

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6.2 convertible bonds6.2 convertible bonds

Advantages to the bondholder Receives fixed interest vs random dividend,

Receives cash if low performance of stocks,

Gets shareholder if high performance

= option to get shareholder

Finance a company Low markets: convertible bonds,

High markets: capital increase

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6.2. valuation of a convertible bond6.2. valuation of a convertible bond

In case of take over, initiator buys most of the shares Convertible bonds may create new shares in the future

Buy convertible bonds

Value of convertible bond under a take over: Arbitrage bond / share according the exchange ratio

+ discounted difference between subsequent dividends and coupons

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6.3. the case of real assets in 6.3. the case of real assets in companiescompanies

Some companies do not hold real assets but rent. Extend to other assets

EBITDA, EBIT, NOPAT, Cash Flow change Multiples change

PV of Cash flow ( DCF) change

WACC ???

Adjust the multiples and DCF, is recommanded

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referencesreferences

Albouy, Décisions financières et création de valeur, Economica 2003 Fr

Sudarsanam: Creating Value from mergers and acquisitions. Prentice Hall 2004 (En)

Ottoo, Valuation of growth opportunities, Garland NY, 2000 (En)

Bryley & Meyers: principles of corporate finance (en) Vernimen (Fr)

financial valuation of companies

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