Market vs Intrinsic Value

Market Value

Determined by the consensus of market

participants

Observed in the market

Intrinsic value

Present value of expected future cash flows

Not observed

Estimated using valuation methods

Investment Decisions

If MV = IV; fairly valued (Hold?)

If MV < IV; undervalued (Buy?)

If MV > IV; overvalued (Sell?)

Valuation Methods

Valuation Methods

Relative Valuation

Multiples

DCF

Dividend Discount

FCF Discount

Assets Value

Liquidation Value

Replacement Value

Asset Based Valuation

Valuation at adjusted net worth

Adjusted net worth = adjusted assets –adjusted liabilities

Adjustments are in respect of market values

Not commonly used other than as a cushion for other valuation or in a liquidation or winding up

Cash/earnings generating capabilities are ignored

Dividend Based Valuation

Constant Dividend Growth Model

Constant Dividend Growth Model

Supernormal Dividend Growth

Supernormal Dividend Growth

Supernormal Dividend Growth

Supernormal Dividend Growth

Valuation – Discounted FCF

Key Components of DCF valuation

Forecasting unlevered Free Cash Flow

Discount Rate - WACC

Forecasting Terminal Value

Computing Enterprise Value (EV) and deriving

Equity Value

Free Cash Flow

FCF is the cash flow available to all the

capital providers of a company after all the

operating expenses, taxes and capital

investments (both WC and fixed)

EBIT – Taxes = NOPAT

NOPAT + NCE – CapEx – Inc WC = FCF

WACC

WACC represents the required rate of return to all forms of capital providers

Cost of Equity – CAPM and Beta Ke = Rf + ß (Rm – Rf)

ßLevered = ßUnlevered x [1+ D(1-t)/E)

Cost of Debt – Post tax YTM

Cost of Equity > Cost of Debt

Don’t penalise equity heavy companies with high WACC as low debt reflects ability to leverage in the future

Terminal Value Terminal value captures the firm’s value

for the time beyond the explicit period, which can be theoretically extended into perpetuity

Ideally at least 1/4 of DCF value should be captured by the explicit forecast period

Popular methods

Liquidation/Salvage value (multiple of BV)

‘Exit multiple’ (multiple of NI/ EBITDA/ EBIT

Perpetuity Capitalisation of final FCF (static or growth)

Enterprise Value

EV = OA + NOA(incl. Cash) OA = PV of FFCF

EV = DFCF + NOA(incl. Cash)

EV = Market Cap + PS + NCI + Debt

Market Cap + PS + NCI + Debt

= DFCF + NOA(incl. Cash)

Market Cap = DFCF+ NOA – PS – NCI – Net Debt

Common DCF Errors

Inappropriate forecasts Short forecast horizon

Hockey sticks – Rapid trend changes

Internal inconsistencies (Contradictory assumptions - Expanded output and reduced Cap-Ex)

Aggressive or conservative: How many good things have to happen simultaneously

Terminal Value manipulation

Improper cost of capital

Non operating assets

Discounting discounted cash flow

SOTP Valuation

Sum Of The Parts (SOTP) valuation is a

methodology used to arrive at the total

value of an entity by valuing each

segment of the business separately and

adding the segment values to arrive at

the value of the total entity

Case Study

Case Observations

TSE – Observations Margins are under pressure – declining margins

Revenue growth but with declining margins

Cash rich in spite of healthy dividend payments

YVC – Observations Good operating margin (~20%)

Margins maintained with sales growth

Margin improvements may be due to operating leverage

PPE appears to be very old (low depreciation)

Heavy cap-ex during the last few years

Except the spike from 1999 to 2000, rest of the growth rates are not aggressive

Valuation TSE is going to be a strategic investor, therefore

absolute valuation (DCF) is appropriate.

Comparable P/E Multiple may be done for a comparison

Simple average of P/E multiples

If the valuation is for the whole business based on ‘unlevered’ basis EV/EBIT basis may be used instead of standard P/E multiple

Exit price for Terminal Value

Exit price of TV may be assessed at 10x EBIT which is quite reasonable for an average growth entity.

Even if the acquirer is making a strategic investment (where DCF is preferred) the exit price of TV may be used for negotiation purposes.

Valuation of YVC

Absolute value of $132Mn net of cash is 9x trailing P/E (1999A) and 6x forward P/E (2000F)

Interest income on treasury securities should have been adjusted as non operating income

Control premium to be added on P/E value of $57Mn (@ mkt cap 21.98)

The value of (457Mn + control premium) is still at a good discount to the absolute value of $132Mn

The seller may argue for a higher price on the basis of excellent growth prospects in the future

Compare valuations using P/E and other multiples given on page 15 of the case

Liquidation and Replacement cost

valuation Matters for attention

US Treasury investments can be assumed to have been M2M

Due from US Govt. may have to be discounted due to delay in receipt (consider materiality)

Accounts receivable – consider if further discounting is required (DD matter)

Inventories – usability and relevance, any further provisions? (DD matter)

Deferred assets – may have to be even zeroed

Comments

The current market value appears to be just at the liquidation value. Thus it appears to be under valued

Replacement cost appears higher than equity value based on current market values (based on market multiples)

Therefore it is a good potential candidate for a LBO/MBO

Relative Valuation

Relative Valuation utilises market prices from observed transactions to impute the value of a target investment opportunity

Process

Identification of appropriate comparable firms

Identification of the relevant valuation metric(s)

Computation of valuation metric multiples for the comparable firm(s)

Apply to the target firm (with adjustments for specific attributes)

Multiples

Multiples are driven by

Risk

Growth

Cash generating potential / Profitability

Popular Multiples

P/E; P/EBIDTA

P/BV

P/Sales

P/Cash Flow

EV/EBITDA

Identification of Comparable Firms

- Dimensions of Comparability

Business Product / Service Offerings

Delivery / Distribution Mode

Size Investability

Liquidity

Geography

Profitability

Growth prospects

Capital Structure Financing growth – availability of internally generated

funds

Identification of Valuation Metric

Balance Sheet Metrics Book Value (Net worth)

Net Asset Value

Income Statement Metrics Net Income (EPS)

Yield

Dividend Discount Model (DDM)

The Economic Metrics Revenues

EBITDA / EBIT

Identification of Valuation Metric

- “Hot Button” Profile

Mature – Net Income (EPS), BV

Capital Intensive – EBIT, EBITDA, CEPS, FFO

Thin Margins - EBIT, EBITDA, CEPS, FFO

High Leverage - EBIT, EBITDA, CEPS, FFO

Slow Growth - EBIT, EBITDA, CEPS, FFO

Financially distressed – Revenues, BV, NAV

Emerging – Revenues, EBITDA

Identification of Valuation Metric

- Some sector specific examples

Financial Services, Constructions

Book Value

Utilities

EBIT

Energy, Automobile, Mature Technology

Net Income (EPS)

Grocers, Telecoms, Media

EBITDA, CEPS, FFO

Real Estate

NAV, FFO

Multiple Sectors / Diversified

Net Income

Identification of Valuation Metric

- Some operational metrics

EV / Unit of resource

Natural resources, Metals

EV / Unit of capacity

Logistics, Manufacturing, Real Estate, Retail

EV / Customer

Utilities, Technologies, Cable TV, Telecoms, Financial

Services

Case Study

Screening and initial analysis

Quaker Oats

Just after a very bad acquisition and disposal

New management team

Pepsi Co

Under pressure to push P/E up (31x vs 41x in Coca-Cola)

Many low margin business segments

Target EPS growth 12%-13% (ref. p3 of the case) – need a growth vehicle

Case observations Pepsi Co (Addition by subtraction – ref. Table 1)

Downsizing in terms of revenue and assets – low margin low return segments have been dropped

Increase in ROIC and margins

Higher multiples are attached to quality assets generating higher cash flows

From Pepsi Co., POV this ‘dog’ (OATS) could be turned around to a ‘cash cow’ and may even be spun off later to a private equity

Boot strapping – an entity with high multiples could achieve accretion of value by acquiring low multiple stock

Questions to be answered

Fairness of the deal to the target: Is the price fair and a suitable premium awarded

Is the % control premium comparable to premiums in past comparable transactions? (Historic control premiums in public companies are 20%-40%)

Do the acquisition multiples represent a premium to public company comparable multiples?

Are the acquisition multiples comparable to multiples in past comparable multiples?

Attractiveness of the deal to acquiring shareholders (Accretion vs dilution)

Is the acquisition accretive or dilutive and over what time horizon?

Fairness of the Deal to the Target

Is the control premium comparable?

2.3 PEP shares for each share of Oats

26% premium on Nov 2nd price

Even higher premium on pre

announcement price which is >40%

There is a fair control premium

Fairness of the Deal to the Target Acquisition Multiples

Compare the above multiples with the highest of values

among the 6 comparable companies given in the case

Compare the above multiples with those of Kellogg which

appears to be the most comparable of the 6 comparable

companies given in the case as far as the business segment

is concerned

However in terms of profitability and capital structure

Hershey may be a better comparable

EV / EBITDA 14.156

0.920

EV / Revenue 14.156

5

P/E 97.46

3.35

EBITDA / Revenue 920

5000

2000

= 29.09

= 18.4%

= 15.39

= 2.83

Comparability to comparable transactions (Ref. p.6 of the case)

EBITDA Multiples

Phillip Morris / Nabisco 14.0x

Unilever / Best Foods 13.5x

Kellogg / Keebler 10.3x

Average 12.0x

PEP / Oats transaction is at 15.38x which is at a premium of 26%

Average net income multiple is 27.5x and PEP/Oats transaction is also at similar multiples

Based on the above analysis the offer appears to be fair for the target Oats.

Attractiveness to the acquirer

Synergies Revenue synergies to be: 1 + 1 > 2

Cost synergies: 1 + 1 < 2

PV (Synergies) > Control Premium

PV(Synergies) computation should consider any Cap-ex, if material needed to realize the synergies

Discount rate for synergies

No relationship to COC of PEP or Oats

If probability of synergies is high, even the risk free rate could be used

If the synergies are very aggressive a rate as high as 20% may be used

If the synergies are moderate a rate in between may be used