review of valuation methods

Advanced Corporate Finance Spring 2011

Review Of Valuation Methods

Brandon Julio

Advanced Corporate Finance. Spring 2011 – Brandon Julio 2

Plan of Attack

•

Important Assumptions

•

Traditional DCF vs. Risk-Neutral Valuation

•

Valuation Using Adjusted Present Value.

•

Comparing APV and WACC.

•

Discounted Cash Flow Valuation Methods.–

Capital Cash Flow.

–

Equity Cash Flow.


Plan of Attack (cont.)

•

Valuation by Multiples.

•

Valuation of Private Companies.

•

Appendix: Computing Asset Betas and Equity Betas.


Overview of Assumptions

$

$

Corporate Project

Financial Market

Investment

Corporate Manager

Risky Future Cash Flows

Risky Future Cash Flows

Investor

Let Manager Invest For Me?

Invest Directly On My Own?

• Investors are “rational”.

• Managers are “rational”.

• Financial Markets are “efficient”.

• Managers objective function:

Maximize shareholder wealth.


Two Approaches to Valuing Cash Flows

Risky Cash Flows

1

t

Risk Adjusted

E CFV

r

1

t

Risk Free

E CF Risk AdjustmentV

r

*

1t

Risk Free

E CFV

r

Adjust discount rate for risk.

Adjust cash flows for risk.


Example

•

Consider a project that pays an uncertain cash flow in one year. The project pays £120 million in a ‘good’

state of

the world and £60 million in the ‘bad’

state of the world. Suppose we know the probability of the good state is 0.70 and the appropriate risk-adjusted discount rate is 12%. Assume the risk-free rate is 4%. Then:

07.91£)12.01(

102£102£)60)(£70.01()120(£70.0)(

V

CFE

This is the traditional DCF approach


Example, cont.

•

Alternatively, we could approach this in a different way. Suppose we don’t know the right risk-adjusted discount rate. Can we adjust the cash flows and discount by the risk-

free rate to get the same value?

VV

CFE

)12.01(102£07.91£

)04.01(71.94£*

71.94£)60)(£579.01()120(£579.0)(*

Notice that I have solved for a different set of probabilities that sets the value equal to the risk-adjusted value.

This is the risk-neutral approach to valuation


Objective for Today: DCF Methods

•

We know how to value a 100% equity financed project.

•

Now we want to take financing into account. Recall financing matters through: –

Tax shields

–

Costs of financial distress–

Bankruptcy costs

–

Agency Costs

•

There are different techniques in the valuation world. Much more than the ones we will cover in this course. –

We want to review the basics of WACC, APV, Discounted Cash Flows (DCF), Equity Cash Flows (ECF), Capital Cash Flows (CCF) and Multiples/Comparables. Next time: Real Options.


Two Different Methods

Two different methods for valuation with financing:

•

WACC (Weighted Average Cost of Capital).

•

APV (Adjusted Present Value).

Valuation Using APV


The Adjusted Present Value Method

•

An alternative approach to the WACC is to compute the Adjusted Present Value (APV).

•

The two simple steps involved in computing the APV are:–

Step 1: Value of the project as if all-equity financed: use the after-tax cash flows and discount them at the cost of capital. Remember that for an all-equity firm the cost of capital equals the cost of equity.

–

Step 2: Add the present value of the tax shield (TS) generated by the project.

APV

NPVall equity

+ PV(TS)

•

APV is also known as valuation by components.


The Adjusted Present Value Method

•

This is simply MM Proposition I with taxes in action.

APV = VL

= VU

+ PV[TS]

•

We do this to separate the value of running the business from the value created by financing.

•

Doing this allows us to identify the sources of value and to

discount different risks appropriately.

•

The APV method uses the value additivity

principle to evaluate the contribution of both cash flows and increased debt tax shields. It can easily be adapted to include other financing side effects.


Important Caveat

•

In principle, financing should affect the value of a potential

project only if

the ability to use certain financing depends

directly on the decision to take the project.

•

Otherwise, if the firm can use the financing regardless of the investment decision, the value of the financing is not incremental to the project and should be ignored.

•

It follows that the tax benefits of debt (as well as the associated costs) should be attributed to a project only if the project

increases the debt capacity

of the firm.


APV: Basic Steps

•

Step 1: Value free cash flows as if the firm were 100% equity

financed.

–

Calculate free cash flows (we are estimating enterprise value).–

Unlever

the equity beta and calculate the return on equity if the firm had

no debt using an asset pricing model.–

Discount the cash flows with the unlevered cost of capital.

–

Do a terminal value calculation.

•

Step 2: Value the tax shields separately.–

Calculate expected interest shields.

–

Discount the tax shields at the “appropriate”

rate.–

Do a terminal value calculation for the tax shields related to the terminal value of cash flows.

•

Let’s go through each of these steps in detail.


Step 1: Valuing the Cash Flows

•

Free Cash Flows are exactly what you need.–

Get the FCF from running the business as an all-equity firm.

–

FCF = EBIT(1-

tC

) + Change in Deferred Taxes + Depreciation – Increase in NWC –

CAPX + Other.

•

We start with EBIT because this is what is available to be paid to the owners –

regardless of the existing debt/equity mix . We

don’t want the tax consequences of capital structure to matter.

•

It is important to remember that getting the correct free cash flow estimates will usually have a much larger impact on the final value than obtaining the correct discount rate.

•

We typically have a forecast horizon of 5 years. Be careful with cyclical industries and young growth firms.


Some Remarks About Free Cash Flows

•

Be careful with non-cash expenses and income.–

For example, deferred taxes.

Should be added back since it is a non-cash expense. This is tax that we owe, but do not presently have to pay.

•

Bottom Line: –

Non-cash expenses should be summed-up to the FCF.

–

Non-cash income should be subtracted from the FCF.


Which Discount Rate?

•

You need the rate that would be appropriate to discount the firm’s cash flows if the firm were 100% equity financed.

•

This rate is the expected return on equity if the firm were 100% equity financed.

•

To get it, you need to:–

Find comparables, i.e., publicly traded firms in same business.

–

Employ an asset pricing model (usually CAPM) to translate risk exposures into expected returns.

–

Estimate their expected return on equity if they were 100% equity financed, by unlevering

the equity betas.


Which Discount Rate? (cont.)

•

Unlever each comp’s E

to estimate its asset beta (more on this later)

•

D

and E

are historical market values. If no market value for D, use book value.

•

In D only include interest bearing debt.–

Exclude Account Payables and Pension Liabilities.

–

Include interest bearing short-term and long-term debt.

•

Deduct Excess Cash (only) from debt.

•

Bottom Line: Beta is not perfect, but it is the best we have.


Which Discount Rate? (cont.)

•

Use the comps’

A

to estimate the project’s A

(e.g. average).

•

Use the estimated A

to calculate the all-equity cost of capital rA

rA

= rf + A

* Market Risk Premium

•

Here is an obvious place where judgment is required. How do you pick the risk-free rate and the excess return on the market?–

Short-term or long-term for rf

? →Same horizon as the investment.

–

There are plenty of estimates of risk premium of market over Treasury Bonds.

•

Use rA

to discount the project’s FCF.


Estimates of the Equity Risk Premium

•

Historical Equity Risk Premium–

There are plenty of estimates of risk premium of market over Treasury Bonds. Historically 6%.

–

Ibbotson & Associates (2000): Realized average risk premium over treasuries in 1999 was 9.32%.

•

Implied Equity Risk Premium–

Fama

& French (2001): Risk premium implied by fundamentals

and stock prices over the 1872-2000 time period was between 2.55% and 4.32%.

–

Kaplan and Ruback

(1996): Risk premium implied by sample of MBOs

was 7.8%

•

Equity Risk Premium –

Survey Estimates–

Graham and Harvey (2001) survey of CFOs: 10-year risk premium ranges between 3.6% and 4.7%.

–

Welch (2001) survey of finance professors: 1-year risk premium averaged 3.4%, 30-year premium averaged 5.5%.


Detour on the Discount Rate

•

Best check on the discount rate:–

Sensitivity Analysis.

–

Re-do valuation with other discount rates (always!).

•

Getting “fancy”

with the discount rate is a low payoff activity.–

Using “term structure”

(different risk-free rates for each period)

adds very little.–

Using Fama-French (three-factor or four-factor) model instead of CAPM makes no difference.

–

Instead better to calibrate. –

How do we proceed with calibration?


Detour on the Discount Rate (cont.)

Three Basic Steps on Calibration

•

Value Company as it is.–

Use current forecasts.

–

Find the discount rates.

•

Is estimated value close to the market value?–

No? Try to understand why.

–

Make adjustments to get the market value.

•

Apply discount rate/growth rate to:–

Other companies/investments.

–

Check whether assumptions seem sensible in other valuations.


Terminal Values

There are generally two ways to proceed to compute TV

•

Take cash flow (that presumably you already calculated earlier) and do a perpetuity calculation.

•

Assume that you can sell the firm using a simple rule involving P/E’s –

i.e. price will equal x

times earnings.


Terminal Values: Perpetuity Calculation

•

If you do a perpetuity calculation you probably will use the last free cash flow and divide it by rA

- g.

–

Terminal FCF in Last Year T. The main issue is to determine the FCF in steady-state situation.

Careful with high-growing companies, cyclical industries.

–

Get FCFT

and then apply formula:

–

Where do we get g?

Careful here: valuation is typically very sensitive to this.

TFCF (1 )TV =A

gr g


Terminal Values: Perpetuity Calculation (cont.)

•

To get PV(TV), need to discount back: PV(TV) = TV / (1 + rA

)T

•

Make sure FCFn

used to get TV reflects g:–

Adjust capital expenditures and depreciation.

•

Bottom Line: Are depreciation, NWC and other flows you have in the cash flow estimate consistent with the g that you choose?


Terminal Values: Multiples of Earnings

•

If you use a multiple of earnings to calculate the sale price, then you need to calculate earnings –

not free cash flows.

•

Where do you get the multiple from?

–

Another place where you can manipulate the answer. –

Presumably you pick the multiple using comparable firms.

–

More on Valuation with Multiples later.


Step 2: Add PV[Tax Shield of Debt]

•

Need to account for the debt tax shields, including any associated with the terminal value and discount these at the appropriate interest rate.

•

These deductions depend on the interest payments and the tax rate. Often the interest payments will appear on the financial statements. If so use them.–

If only the debt levels appear you need to translate them into implied levels of interest payments.


What Interest Rate Do We Use to Discount TS?

•

The choice of the discount rate depends on the risk. What is the risk of the tax shield? We don’t actually know…

•

In general the tax shield will have its own risk, which will depend also on the probability that the government will change its tax policy, and similar issues.

•

Estimating the risk of the tax shield would be very cumbersome (and not worthwhile), thus typically we choose among two assumptions: the risk of the tax shield is equal to the risk of the debt

or the risk of the assets.

–

Since these are assumptions there is no absolute right or wrong answer. However, one may claim that one criteria will probably be closer the truth, depending on circumstances.


A Suggestion

•

If debt is predetermined or has a low level, risk of tax shields similar to risk of repayments to debtholders; so rD

is correct discount rate.

•

If high level of debt (e.g. LBOs), or if level of debt varies with firm value, then riskiness of tax shields similar to that of operating assets and tax shields should be discounted at rA


•

For example, in the article by Kaplan and Ruback, several LBOs are considered. The level of debt is very high.

•

When leverage is 80-90% of the value of the firm, the risk of the debt is close to the risk of the assets.

•

Then we might as well assume that the risk of the tax shield is also equal to the risk of the assets for firms with very high leverage.


•

Whatever assumption you make about the risk of the tax shield, you have to take care to be consistent throughout the valuation.

•

In particular, remember that the assumption you make about the risk of the tax shield also affects the equation you will use to

lever and unlever the beta.


Two Possible Scenarios SCENARIO 1 – Using rA

•

Debt in the future is not fixed. –

Debt and interest expense are tied to FCF.

•

Model when big changes in capital structure, –

LBOs

(more highly leveraged transactions).

–

Bankruptcy.

•

In those cases, the ability to use tax shields has more systematic risk than the ability to pay debt.

•

Intt

comes from debt repayment schedule and interest rates.

1 2 T2 T

Int Int IntTS = Tax Rate * ...(1 ) (1 ) (1 )A A Ar r r


Two Possible Scenarios (cont.)

SCENARIO 2 – Using rD

•

You expect a predictable, stable and low level of debt.

•

Ability to use tax shield has the same systematic risk as the ability to pay debt. Generally in less highly leveraged situations.

•

For permanent debt with the same risk as interest:

TS = Permanent Debt * Tax Rate = t * D

1 2 T2 T

Int Int IntTS = Tax Rate * ...(1 ) (1 ) (1 )D D Dr r r


Just to Check Things Are Clear

•

Remark 1: If debt is predetermined (D is constant) and has a low level, risk of tax shield equal to risk of payments to debt holders; so rD

is the correct discount rate.

•

Remark 2: If high level of debt or if level of debt varies with firm value (D/V is constant), then the risk of the tax shield is

similar to that of operating assets and tax shields should be discounted at rA

.

•

Remark 3: Some firms have high leverage or maintain a target leverage ratio while maintaining an investment grade rating on their debt. For these firms, the correct discount rate is probably closer to rD.


How Leverage Affects the Betas?

•

Whatever assumption you make about the risk of the tax shield, you have to take care to be consistent throughout the valuation. –

In particular, remember that the assumption you make about the risk of the tax shield also affects the equation you will use to

lever

and unlever

the beta.

•

If the risk of the tax shield is equal to the risk of the debt

(D is constant), then such equation is:

•

If instead the risk of the tax shield is equal to the risk of the assets (D/V

is constant), then such equation is:

C

C C

(1 )(1 ) (1 )A D E

D t EE D t E D t

A D ED E

E D E D


What About the TS Associated with the TV?

•

If you do a perpetuity calculation for the TV and the firm is expected to have some debt then this matters!–

Remember that you have to add any debt tax shields on NPV that accrue beyond the terminal date.

•

There are “many”

ways to compute the terminal value of the tax shields.–

Again you do not have to get fancy. Common sense matters!

–

They are obviously short-cuts. The main thing is to recognize that you are going to get some tax shields beyond

T and then do

something sensible.

•

Let’s see 2 different ways…


What About the TS Associated with the TV?

1.

If D stabilizes at a permanent (and low) level, DT.

2.

If (D/V) stabilizes at some level, γ

(DT

= γ

* VT

):

TC DtTSTV *)(

grrDtTSTV

A

DTC

**)(


Comments on Step 2 (cont.)

•

For many projects, neither D nor D/V is expected to be stable.–

Need to be careful and creative.

–

Firms on average tend to rebalance leverage towards a target, but they do so slowly (at an average rate of 30% per year).

•

For instance, LBO debt levels are expected to decline.

•

In general you can estimate debt levels using:–

Repayment schedule if one is available.

–

Financial forecasting.

and discount by a rate between rD

and rA

.


Extending the APV Method

•

You could also take care of the costs to financing that come from financial distress, any issue costs, etc. Once again you find the present value and subtract it.

•

You could also add the PV of the costs of financial distress. How?–

Write scenarios and include costs of distress in bad scenarios.

–

Often people omit PV(costs of distress) because it is difficult to quantify.

APV vs. WACC


Pros and Cons of APV

•

Pros:–

Implicit assumptions are very clear. No contamination.

–

Works even if debt is not permanent.–

Is very easy if the level

of future debt is known.

–

Clearer: Puts the spot light on what is creating value. Beautiful! Easier to track down where value comes from.

–

Assists in the decision of how to structure financing for projects.–

More flexible: Just add other effects as separate terms.

•

Cons:–

Requires explicitly calculating future debt levels.

–

It is increasingly used, but still less well known than WACC.


Pros and Cons of WACC

Pros:–

Most widely used.

–

The inputs are easy to get.

–

If you have a precise debt to value policy, then it is easy and relative accurate.

But this seems to be highly restrictive.

–

Less computations needed. It is very simple tool.

Only when project is similar to rest of the firm.


Pros and Cons of WACC (cont.)

Cons:–

Mixes up the effects of assets and liabilities.

Errors/approximations in effect of liabilities contaminate the whole valuation.

Does not reveal where the value is coming from.

–

Not very flexible. Cannot easily allow for changes in:

Other effects of financing (e.g., costs of distress, issue costs)

Non-constant debt ratios

Changes in tax rates


Practical Implications

•

In principle we can always use either WACC or APV. As long as you follow all the steps and you are careful in making the same assumptions you should obtain (approximately) the same solution.

•

In practice, however, one of the two will be much simpler to use depending on the situation.–

For complex, changing or highly leveraged capital structure (i.e. LBOs) APV is much better.

–

Otherwise, it does not matter much which method you use.

•

Lets consider two cases:–

Debt is rebalanced.

–

Debt is predetermined.


Practical Implications (cont.)

•

If debt is rebalanced (i.e. the firm has a target debt/asset ratio):–

Computing WACC is much easier.

–

APV is much more complex since you do NOT know D.–

Bottom Line: In this case of rebalanced debt use WACC.

•

If debt is predetermined (i.e. firm knows the evolution of D):–

APV is easy to compute by discounting future expected interest payments.

–

WACC instead has a problem, because if the debt is not rebalanced then D/V changes over time and so does WACC.

–

Bottom Line: In this case of predetermined debt use APV.


Two Remarks

•

Remark 1: In principle, you can always forecast D/V values, compute a different WACC for each year and discount back by using a different WACC every year. This is a headache!

•

Remark 2: For non-constant debt-ratios, could use different WACC for each year but this is heavy and defeats the purpose.

Discounted Cash Flow Valuation Methods


Three Cash Flow Valuation Methods

•

The three methods differ in their measure of cash flows and the discount rate applied to those cash flows.

•

The names for the three methods correspond to the type of cash flow that is used in the valuation:

–

Capital Cash Flow (CCF) –

Provides Enterprise Value.–

Free Cash Flow (FCF) –

Provides Enterprise Value.

–

Equity Cash Flow (ECF) –

Provides Equity Value.

•

The three methods provide consistent valuations when applied correctly.


FCF and CCF

•

CCF method includes the benefits of the tax shields as cash flows.–

The more the tax advantages, the higher the capital cash flow.

–

The discount rate for this method is the return on assets.

•

FCF method includes the tax benefits of deductible interest payments in the discount rate as it uses WACC –

The more the tax advantages, the lower the discount rate.

–

Because the tax advantages of debt are included in the discount rate, the cash flows do not include the tax benefits of debt.

•

The difference between the FCF and the CCF is in the Interest Tax Shield:

Capital Cash Flow = FCF + Interest Tax Shield


CCF and APV

•

Note that the expression of the CCF is close and resembles to the APV expression we studied before.

•

In fact, when we use rA as the discount rate of both terms:

•

Thus, APV = NPV(CCF) discounted at rA

. It is also called “Compressed APV”.

FCF FCF ITS CCFAPV C D

A A A A A

t r Dr r r r r


CCF and APV (cont.)

•

CCF uses actual taxes (projected tax payments).

•

Hence, you should always compute it starting from Net Income because Net Income is already net of actual taxes.

•

CCF from a net income version:–

CCF = Net-after tax income (NI) + Interest Expense (I) + Dep

–

Capx

–

Change in NWC + Other


When Should We Use CCF?

•

CCF valuation is generally useful for:

–

Highly Leveraged Transactions.

–

Firms in Financial Distress.

–

Bankruptcy.

•

In these cases we would have discounted the tax shield with rA

•

However, we recommend using APV instead of CCF. Why?


Equity Cash Flow

•

ECF measures the cash flow available to stockholders after payment to debt holders are deducted from operating cash flows.

•

Payment to debt holders are sometimes called “Debt Cash Flows”

(DCF), and they include interest and principal

payments.

ECF = CCF –

DCF

•

As DCF are paid out of operating cash flows before equity cash flows, debt cash flows are safer than equity cash flows.

•

ECF are riskier than cash flow measures that combine DCF and ECF. And riskier cash flows have higher discount rates.


Equity Cash Flow (cont.)

•

ECF are calculated by subtracting taxes, interest and debt repayments from operating cash flows and adding debt additions.

ECF = Net Income + Dep

–

Capx

–

Change in NWC + Other + Change in Debt

•

Notice that Increases in Debt help to finance increases in capital expenditures and net working capital.

•

Alternatively, ECF can be calculated as CCF less DCF.

•

The discount rate used in the ECF is the return on equity and the value we obtain is the equity value of the firm.


Equity Cash Flow (cont.)

•

ECF is extremely useful for:

–

Valuing financial institutions. Very difficult to use APV or WACC in banks. Why?

Debt is part of the business of most financial institutions.

Very difficult to have an “all equity bank”.


Pros and Cons of ECF

•

In general, we prefer both APV and WACC to ECF.

•

APV is preferred to the ECF for many of the same reasons that APV is superior to WACC.

–

The use of one discount rate for ECF requires that the firm have

a constant debt to total capital ratio. If the debt to total capital ratio varies over time, we need to calculate a different discount rate

for

the equity for each year.

–

It is much easier to make mistakes using the ECF. In particular, it is critical to include increases in debt in the cash flows, particularly in the terminal value calculation.


Pros and Cons of ECF

•

ECF tend to calculate equity values that are too low.

–

The method values equity as the discounted value of the expected ECF. This is accurate as long as there is no probability that the

equity value will be less than or equal to 0.

–

Expected Debt Payments ≤

Promised Debt Payments.

Valuation Using Multiples


Valuation Using Multiples

•

Valuation by multiples is a fancy name for market prices divided by some measure of performance.

•

It assesses the value based on that of other (publicly-traded) firms:

[Value/Key Characteristic]Ind.Average

* Key Characteristic of Firm

•

Numerator of multiple is typically the total value of the firm.

•

Denominator of multiple is the characteristic that is important for that industry:–

clicks or subscribers for web site

–

paid miles flown for airlines–

number of patents for a hi-tech firm.


Valuation by Multiples: Implicit Assumptions

1.

Comparable companies assumed to have expected cash flows growing at the same rate

and have the same level of

risk

as the company being valued.2.

The value of the company is assumed to vary in direct proportion

with changes in the performance measure; i.e.

if expected EBITDA increases by 8%, expected firm value also increases by 8%.

If these assumptions are valid, valuing by multiples will be more

accurate than the DCF approach because it

incorporates current market expectations of cash flows and discount rates.


Types of Multiples

•

Cash-flow-based Value

multiples:–

MV of firm/Earnings, MV of firm /EBITDA, MV of firm /FCF.

•

Cash-flow-based Price

multiples:–

Price/Earnings (P/E), Price/EBITDA, Price/FCF.

•

Asset-based Value

multiples:–

MV of firm/BV of assets, MV of equity/BV of equity.

•

Industry-specific Value

multiples:–

MV of firm/Hospital Beds, MV of firm/Number of Customers.


Procedure

Hope: Firms in the same business should have similar multiples.

•

Step 1: Identify firms in same business as the firm you wish to value. Be careful not to induce a selection bias.

•

Step 2: Calculate multiple for comparable firms.

•

Step 3: Calculate average for the set of comparable firms. In doing this we are coming up with an estimate of the multiple we wish to use in valuing our firm. Equal-weighting vs. Distance-

weighting.

•

Step 4: Multiply average with the value of the characteristic for the firm you wish to value.

•

Step 5: Often different multiples give you different answers: you need to reflect what is economically reasonable.


Important Remarks

•

When choosing comparable firms you face a trade-off: too many firms requires to select firms that are not truly comparable; too few firms means that your average will reflect idiosyncracies of those firms.

•

For firms with no earnings or limited asset base (e.g. hi-tech),–

Price-to-patents multiples.

–

Price-to-subscribers multiples.–

Or even price-to-Ph.D. multiples!

•

For transactions, can also use multiples for comparable

transactions.–

Similar transaction values.

–

But be aware, everyone might be over/underpaying!


Important Remarks (cont.)

•

For similar public traded companies:–

Use trading multiples.

–

They tell you what market thinks about the value.

•

Multiples based on equity value (or stock price, e.g., P/E) as opposed to total firm value ignore effect of leverage on the cost of equity (or assume the firms have similar leverage) –

Beware if comparables have very different leverage.


Motivation for Multiples?

•

Firms in the same business should have similar multiples.

•

If the firm’s actual FCF is a perpetuity:

MV firm = FCF/(WACC-g) =>

MV firm/FCF = 1/(WACC-g)

•

Comparables will have a similar MV firm/FCF provided they: –

Have the same WACC (requires similar D/(D+E)).

–

And are growing at a similar rate.


Bottom Line on Multiples

•

Multiples complement APV/DCF methodology:–

Check on valuation; market based perspective.

–

Extremely useful when you do not have cash flow projections.

•

EBITDA or cash-flow multiples are preferable to (net) earnings multiples.–

More consistent treatment of leverage.

Companies with different leverage will have different P/E

multiples, even tough same business risk and growth.

–

Less ability to manipulate

Easier to manipulate net earnings through accountings than EBITDA or cash flow.


Pros and Cons of Multiples

Pros:

–

Incorporates simply a lot of information from other valuations in a simple way.

–

Embodies market consensus about discount rate and growth rate.

–

Free-ride on market’s information.

–

Can provide discipline in valuation process by ensuring that your valuation is in line with other valuations.

–

Sometimes, what you care about is what the market will pay, not the fundamental value.


Pros and Cons of Multiples (cont.)

Cons:

–

Difficult to find true

comparables. Implicitly assumes all comparables are alike in growth rates, cost of capital, and business composition. Hard to find true comparables in real life.

–

Hard to incorporate firm-specific information. Particularly problematic if operating changes are going to be implemented.

–

Relies on accounting measures being comparable too.

–

Differences in accounting practices can affect earnings and equity-based multiples. Therefore better to use FCF and EBITDA multiples.


Pros and Cons of Multiples (cont.)

•

Cons:

–

Book values can vary across firms depending on age of PPE.

–

If market is overpaying, you will too!


Bottom Line On Multiples

•

Because of the many limitations, never rely on just a single multiple or on valuation based only on multiples.

•

Best to use multiples only as a check for the valuation based

on discounted cash-flows.

–

After you have done a throughout

valuation, you can compare your predicted multiples, such

as P/E and market-to-book, to

representative multiples of

similar firms.

–

If your predicted multiples are out of line then

you have to convince yourselves (and your clients) that your

model is

reasonable.


Bottom Line On Multiples (cont.)

•

Because of accounting differences, be careful in using multiples to compare firms across industries, and especially,

across

countries.

•

As a rule of thumb when choosing the basis for multiples, remember that:

–

The higher up the basis is in the income

statement (e.g. sales) the less it is subject to changes in

the accounting method.

–

On the other hand, the less it

reflects differences in operating efficiency across firms (e.g. firm’s pricing policies, production efficiency, etc.).


After Valuation is Done!

•

Three possible answers:–

NPV >> 0

=

GO!!

–

NPV << 0 =

No Go*

–

NPV = 0

= Think More.

•

*Are there future options in project?–

Try to incorporate these in cash flows.

–

Are we overpaying?–

Have we properly accounted for financial / capital structure effects on real cash flows:

changes in incentives?

costs of financial distress?


Takeaways

•

It is important to separate the value created by underlying assets and those coming from financing.

•

APV does this directly and is a very flexible tool. Sometimes it can be difficult because you need to know the future levels of

debt.

•

Both WACC and APV force you to get the asset beta, so you have to be able to do this!

•

If applied correctly, both give the same answer.

•

APV is aesthetically cleaner in terms of the source of the value generation. APV does not mix the valuation of operation with

the effects of financing.


Takeaways (cont.)

•

For APV we need to know the level of debt outstanding each year –

more suitable for LBOs.

•

For WACC we need to know the D/V ratio each year.

•

You should understand the conceptual differences between these two methods and why in principle we prefer APV.

•

Remember there are other cash flows methods you should bear in mind. Go through the examples and be sure you are capable of computing each of the cash flows.

•

Best to use multiples only as a check for the valuation based

on discounted cash-flows.

Example (Be Sure To Go Through It!)

Valuation Of Private Companies


Valuing Private Companies

•

There are three major complications in the case of a private company:

–

We have much less information available.

Estimating Cost of Equity.

Estimating Cost of Debt.

Estimating Cash Flows.

–

Effect of Illiquidity on Value.

–

Control Issues.


I. Less Information: Cost of Equity

The problem with a private company is that there are no past prices to estimate risk parameters (betas).

Two Possible Solutions

1.

Estimate β

of a comparable traded firm.–

Remember to correct for different capital structure.

–

A simple test to see if the group of comparable firms is truly comparable is to estimate a correlation between the revenues or operating income of the comparable firms and the firm being valued.

•

Even after we compute the βA from comparable companies, we do not have a market value of debt and equity to compute leverage.


I. Less Information: Cost of Equity (cont.)

2.

Assume that the private firm will move to the industry average debt ratio. –

The β

for the private firm will then also converge on the industry

average beta.

Might not happen immediately but over the long term.

•

Alternatively you may try to estimate the optimal debt ratio for the company, based upon its operating income and cost of

capital.


I. Less Information: Cost of Debt•

The main problem is that private firms generally do not access public debt markets, and are therefore not rated. –

This problem might also happen with public companies.

•

Most debt on the books is bank debt, and the interest expense on this debt might not reflect the rate at which they can borrow.

•

One possible solution is to assume that the private firms can borrow at the same rate as similar firms in the industry.

•

Alternatively, you can estimate the appropriate bond rating for the company, based upon financial ratios, and use the interest rate related to the estimated bond rating.


I. Less Information: Cost of Debt (cont.)

•

Finally, if the debt on the books of the company is long-term and recent, the cost of debt can be calculated using the interest expense and the debt outstanding.

•

Caveat: If the firm borrowed the money towards the end of the financial year, the interest expenses for the year will not reflect the interest rate on debt.


I. Less Information: Cash Flows

There are special problems associated with estimating cash

flows for a private firm:

•

Shorter History–

Private firms often have been around for much shorter time periods than most publicly traded firms.

There is less historical information available on them.

•

Different Accounting Standards.–

The accounting statements for private firms are often based upon

different accounting standards than public firms, which operate under much tighter constraints on what to report and when to report.


I. Less Information: Cash Flows (cont.)

•

Mix of Personal and Business Expenses.–

In the case of private firms some personal expenses may be reported as business expenses.

•

Separating Salaries from Dividends.–

It is difficult to tell where salaries end and dividends begin in a private firm, since they both end up with the owner.

•

Rules of Thumb –

Dealing With Special Problems.–

Re-state earnings using consistent accounting standards.

–

If any of the expenses are personal, estimate the income without these expenses.

–

Estimate a reasonable salary based upon the services the owner provides the firm.


II. Effect of Illiquidity on Value

•

There is a general agreement that the value of the company should be lower because of illiquidity. –

The problem is by how much? Lots of disagreement!

•

Some recent studies suggest that the liquidity discount is between 20-30% for private firms. –

Adjust subjectively for size.

–

Make the discount smaller for larger firms.

•

Some Facts:–

Discounts should be reduced by:

1.

Roughly 6% for a firm with $100M in revenue.2.

Up to 11% for a company with $1B in revenue.

–

If earnings are negative, increase the discount.


III. Effects of Control

•

Purchasers pay a premium for control positions.–

Many studies show that control block trade at a premium for public companies.

•

This is because once you have control you can improve the company. –

It is almost like a takeover.

•

There is no guideline on how to compute the control premium in DCF.–

You should take into account in your projections what you think you can accomplish with control!

•

Alternatively, you can use transaction multiples. –

However, trying to find comparables both in terms of transaction

and firm is difficult.

Appendix: Computing Asset and Equity Betas


Computing Asset Betas and Equity Betas

How to Measure A

?

•

The value of the levered firm is given by VL

= D + E.

•

Since, VL

= VU + PV(TS), then VU

= D + E -

PV(TS).

•

And therefore:

•

Which we can be re-written as:

U U U

D E PV(TS)V V V

A D E TS

UV D E PV(TS)A D E TS


Computing Asset Betas and Equity Betas (cont.)

•

Now we need to assume something about TS

.

•

Assumption 1: The risk of the tax savings is the same as the risk of the debt that generates it (TS = D

).

•

Then the previous equation becomes:

•

And since VU

= V -

PV(TS), we have:

D - PV(TS) EV - PV(TS) V - PV(TS)

Α D E

U U U

D E PV(TS)V V V

A D E D



•

This formula simplifies under some special cases.

–

If D is constant:

–

If, in addition, the debt is riskless (D

= 0):

D (1 ) EV D V D

CΑ D E

C C

tt t

D1 (1 )E

( )E

C

A

t



•

Assumption 2: The risk of the tax savings is the same as the risk of the existing assets (TS = A

).

•

Then we are left with,

•

And since, VL

=VU

+ PV(TS) we have that:

•

Conclusion: We can compute A

just using the values from the levered firm in the Finance I formula.

U(V PV(TS)) D EA D E

D EV V

Α D E

review of valuation methods

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