valuation for beginners - check mate! part 1
DESCRIPTION
Part 1 of Valuation for Beginners. A presentation which gives you extensive insight in valuation techniques, like discounted cash flow models, weighted average cost of capital, accounting, operational cash flows and all other aspects of valuation. See also: Valuation for Beginners - Check Mate Again! > Part 2 Author: Eva Hukshorn, EFactorTRANSCRIPT
Valuation for Beginners – check mate
Authors: Eva Hukshorn, Hein Verloop, ABN AMRO / RBS
Agenda
Session 1: • Introduction • Introduction to value • Basic accounting • Discounted Cash Flow valuation
Session 2: • Multiples valuation • Leveraged Buy Out valuation • Capita Selecta • Conclusion
1 Introduction
4
Goal: provide insight in M&A banking
• In this course we will provide you some insight in Mergers & Acquisitions, particularly in valuation and valuation techniques:
– Discounted Cash Flow (DCF) valuation – Multiples valuation
– Comparable Company Analysis (CCA) – Comparable Transaction Analysis (CTA)
– Leveraged Buyout (LBO) valuation – Other techniques: share price, premia, etc.
• In the next session we will also touch upon items you regularly come across in legal documentation and SPAs, such as: enterprise value, working capital and net debt adjustments, closing accounts
• We have built our story around a hypothetic case and will often refer to ‘real life’ situations and experiences
5
As a teaser, we begin where we aim to end… …understanding multiple valuation techniques
Indicative and preliminary valuation range of EUR 1.9 billion to EUR 2.1 billion at this early stage of due diligence
EV EV/EBITDA 2006
1.8b - 2.2b 9.5x - 11.5x
1.9b - 2.1b 10.0x - 11.0x
1.8b - 2.3n 9.4x - 12.2x
1.5b - 1.7b 7.9x - 9.0x
Indicative, preliminary valuation range
1,400 1,600 1,800 2,000 2,200 2,400
CCA
DCF
LBO
CTA
In EUR million
6
Topics of this session
• Introduction to value
• Case study that covers the following topics: – Basic accounting / balance sheet mechanics – Basic P&L mechanics – Basic cash flow mechanics – Beyond accounting: towards economics – Introduction to DCF valuation - valuation terminology – Free cash flow – Discounting and discount rate (WACC) – Net present value – Perpetuity / Terminal value – Concepts: Enterprise value / value of operations / equity value etc.
2 Introduction to value
8
Introduction to value
Historical cost around EUR 2.0 million
Economic value around EUR 1.8 million
Replacement cost around EUR 1.5 million
Market value around EUR 5.5 million
Value of an asset (or company) is determined subjectively; to A it might be worth more than to B
9
Why valuation?
Distinction between price and value:
• Price is driven by: – Demand – Supply
• Value of a company is driven by: – Growth & prospects – Profitability – Capital intensity – Risk – Leverage – Tax
Gap Subjective (M&A, synergies)
• Price ≠ value
10
How to determine the value of a firm
• Generally the valuation of a company is calculated as follows:
Value of the shares (Equity) + Value of interest bearing liabilities (Debt) - Value of cash and cash like items “net debt and other adjustments” +/- Value of non operating assets and liabilities = Enterprise Value (EV)
• In a DCF valuation we reverse these steps
– Based on the DCF analysis we know the Enterprise Value (in this context EV is also referred to as the Value of Operations)
– Subsequently, we make the same steps as displayed above, but then in reverse order, to calculate the value of the shares:
Enterprise Value (Value of Operations) - Value of interest bearing liabilities (Debt) + Value of cash and cash like items “net debt and other adjustments” +/- Value of non operating assets and liabilities = Value of the shares (Equity)
11
How to determine the value of a firm (cont’d)
• Crucial in any valuation analysis in the judgement on what value items (assets and liabilities) are ‘operating’ and which ones are ‘non-operating’
– Operating assets are assets a company controls: business activities under direct managerial control – For example: a manufacturing plant, machinery, equipment
– Non-operating assets relate to investments in activities not under direct managerial control. The majority of the non-operating items is usually non-core – For example: investments in associates, derivatives, assets held for sale
• DCF valuation relates to the valuing the operating activities (the Value of Operations)
• In order to make a proper judgement on whether an activity is operating or non-operating, we first of all need to have a better understanding of accounting
• Therefore, we will now move towards a case in which we will demonstrate how to tackle this
12
DCF valuation approach
i.e. we need some basic understanding of accounting
To understand cash flows, we also need to understand the profit & loss statement and the balance sheet
To understand Free Cash Flows, we need to understand cash flows
In order to derive to a DCF, we need to develop an understanding about discounting (WACC) and about Free Cash Flows
We will apply a ‘bottom-up’ approach is assessing DCF
13
Case assignment
• Imagine you would have quit the law practice and started your own little enterprise. You would have been the new CEO of the coolest hotdog stand (hotdog kraam) at the Dam square by now…
3 Basic accounting
15
Case assignment I: Balance sheet
• First thing to do is: – Incorporate a BV, put EUR 18,000 in as equity and arrange EUR 6,000 with a bank – What does the balance sheet look like on 1 December?
• Second thing to do is: – Purchase inventory (worst, broodjes, mosterd) for 1,650 hot dogs during December (cost price EUR
0.50 per hotdog) – Take into account that although you have to pay cash for your purchase, you will only receive your
order in one month time – What does the balance sheet on 1 January look like immediately after you made your order and
paid?
16
Case assignment I: Balance sheet
Oprichtingsbalans
Assets EUR Liabilities & Equity EUR
Totaal Totaal
17
Case assignment I: Balance sheet
Oprichtingsbalans
Assets EUR Liabilities & Equity EUR
Kraam 0 Eigen vermogen 18,000
Voorraad 0 Bankschuld 6,000
Nog te ontvangen 0
Kas 24,000 Nog te voldoen 0
Totaal 24,000 Totaal 24,000
18
Case assignment I: Balance sheet
Per: 01/01
Assets EUR Liabilities & Equity EUR
Kraam 20,000 Eigen vermogen 18,000
Voorraad 0 Bankschuld 6,000
Nog te ontvangen 825
Kas 3,175 Nog te voldoen 0
Totaal 24,000 Totaal 24,000
19
Case assignment II: Profit and loss
• Assume the following for the first year of operations:
• Prepare the profit and loss statement of your first year in business
Number of hotdogs sold 33,000
Consumer price EUR 1,50
Purchased broodjes, worst & mosterd equivalent of 34,980 hotdogs
Cost of ingredients per hotdog EUR 0.50
SG&A (Other costs) EUR 17,100
Depreciation EUR 2,000
Interest rate over EUR 6,000 6%
Tax rate 25.5%
20
Case assignment II: Profit and loss
• Prepare the P&L in the following format:
Sales
– COGS
Gross Profit
– SG&A
Operating result (EBIT)
– Interest
Profit Before Tax (PBT)
– Tax
Net Income
Note: COGS = Cost of Goods Sold SG&A = Selling, General & Administrative expenses (i.e. Salaries)
Depreciation is to be included in COGS
21
Case assignment II: Profit and loss
Profit and loss
EUR
Sales 49,500
COGS -18,500
Gross profit 31,000
SG&A -17,100
EBIT 13,900
Interest -360
PBT 13,540
Tax -3,453
Net income 10,087 Note: We assume we pay out 70% of our profit as a dividend, which equals to EUR 7,061, i.e. the remainder (EUR 3,026) will be transferred to
Retained Earnings
22
Cash Flow
• In addition to preparing an income statement, a company must prepare a cash flow statement – The cash flow statement is like your bank statement. It shows how cash came in and went out – A cash flow statement simply describes the flows of cash into and out to different accounts over the
course of one year
• To understand cash flow, we will start to assess the cash account on the balance sheet. Almost every account on the balance sheet is linked to cash
• In order to prepare the cash account, we need to make some closing statements
23
Closing statements
• We need to calculate our ending inventory:
• The ending inventory stands at EUR 990 per 31 Dec 2007
Ending inventory calculation
# hotdogs purchased 34,980
# hotdogs sold 33,000
Results 1,980
Inkoopprijs van 1 hotdog 0.50 x
Inkoopprijs vd voorraad 990
24
Closing statements (2)
• As you know, we need to pay our inventory one month in advance, i.e. in December we already need to pay for our stock in January
• Given the current favorable market circumstances, we assume a 5% increase in sales growth for 2008 • As a consequence, we assume a similar development in our inventory:
• Nog te ontvangen bedragen stands at EUR 866 per 31 Dec
Sales growth in 2008 5%
Inventory 1st month 2007 1,650
5% increase 83 +
Inventory 1st month 2008 1,733
Inkoopprijs van 1 hotdog 0.50 x
Nog te ontvangen 866
25
Cash account
• Below we have portrayed an overview of all cash expenses since incorporation:
Beginning cash 24,000
Sales 49,500
Kraam -20,000
COGS -16,500
SG&A -17,100
Interest -360
Tax -3,453
Dividend -7,061
Maintenance -2,000
Paydown of debt -1,000
Voorraad -990
Nog te ontvangen -866
Ending cash 4,170
26
Case assignment III: Cash Flow
• The crux of the cash flow statement is to separate cash flows from operating activities from the other cash flows
• Moreover, we need to filter out non-cash items such as depreciation
• The cash flow statement distinguishes between three types of cash flows: – Cash flow from operations – Cash flow from investing activities – Cash flow from financing activities
27
Case assignment III: Cash Flow
• The cash flow statement can have the following structure:
• Assignment III: Prepare the cash flow statement
EBIT + Depreciation
Operating cashflow before changes in WC + Changes in working capital = Cash flows from operating activities (A)
+ Cash flows from investing activities (B)
+ Cash flows from financing activities (C)
= Net increase in cash (A + B + C) + Cash at 1 January 2007 + YE cash
28
Case assignment III: Cash Flow
EBIT 13,900 + Depreciation 2,000 = Operating cashflow before changes in WC 15,900
Change in inventory -990 Change in receivables -41 Change in payables 0 Income tax expense -3,453 Cash from operating activities 11,416
Acquisition of PPE -2,000 Cash from investing activities -2,000
Paydown of debt -1,000 Interest expense -360 Dividend paid -7,061 Cash from financing activities -8,421
= Net increase in cash (A + B + C) 995 + Cash at 1 January 2007 3,175 = YE cash 4,170
29
Case assignment IV: Closing balance sheet
• Now that we have prepared the cash statement we can also finalize the closing balance sheet • Prepare the closing balance sheet for 2007
Balans na jr 1: 12/31
Assets EUR Liabilities & Equity EUR
Kraam 20,000 Eigen vermogen 21,026
Voorraad 990 Bankschuld 5,000
Nog te ontvangen 866
Kas 4,170 Nog te voldoen 0
Totaal 26,026 Totaal 26,026
4 Beyond accounting: to economics
31
Beyond accounting
• For a proper valuation exercise we are in need of economics rather than accounting metrics – Accounting data can be directly retrieved from the annual accounts – In order to retrieve economic values, we need to transform the accounting items to economic items,
i.e. we ought to distinguish between operating and non-operating items as essentially we are in search of the value of operations
Accounting = backward looking
Economics (valuation) = forward looking
32
Balance sheet: accounting vs. economic
Balance sheet
Assets Liabilities & Equity
Operating fixed assets
20,000 Operating current liabilities
0
Operating current assets
1,856 Debt 5,000
Non-operating assets
0 Equity 21,026
Cash 4,170
26,026 26,026
Valuation steps
Determine economic value of all operating assets / liabilities
Determine economic value of all non-operating assets / liabilities
Determine value of cash
Determine value of debt
Determine value of EQUITY
Accounting ≠ Economic
33
Balance sheet: accounting vs. economic
Balance sheet
Assets Liabilities & Equity
Operating fixed assets
20,000 Operating current liabilities
0
Operating current assets
1,856 Debt 5,000
Non-operating assets
0 Equity 21,026
Cash 4,170
26,026 26,026
Valuation steps
Determine economic value of all operating assets / liabilities
Determine economic value of all non-operating assets / liabilities
Determine value of cash
Determine value of debt
Determine value of EQUITY
Accounting ≠ Economic
34
Income statement: accounting vs. economic
Adjustments • COGS sometimes include
depreciation (= non cash)
• SG&A usually includes depreciation and amortisation
Standard P&L
Sales – COGS
Gross Profit – SG&A
Operating result (EBIT) – Interest
Profit Before Tax (PBT) – Tax
Net profit
Make sure to split cash and non-cash items
Adjusted P&L
Sales – COGS (ex depreciation)
Gross Profit – SG&A (ex depreciation)
EBITDA – Depreciation
EBITA – Amortisation
EBIT – Interest
Profit before tax (PBT) – Tax
Net profit
Note the introduction of ‘EBITDA’!
35
Valuation terminology
• EV = Value of the total company → value generated by the ‘core’ operations of a Company → value of
operations • Equity value = EV + all cash & non-operating items - all claims by non-residual claimants
(net debt) • Net debt = All claims by non-residual claimants - cash • Debt = Interest bearing (bank) debt
Debt to equity holders Bonds (convertibles) Debt in pension plans Debt in operating leases ESOP / MSOP programmes
• Working capital = All operating current assets minus operating liabilities • Excess cash = Cash that can be used to lower Debt, i.e. cash that is not required for the day-to-
day operations of the business • Synergies
– Cost synergies – Revenue synergies – Financing synergies
5 Discounting and discount techniques
37
Discounted Cash Flow (DCF)
• D = Discounting – Time value – Risk
• CF = Cash Flow – Focus on cash generation from operating the company minus investments to sustain and grow the
company – In addition: do not take into account non-cash costs
Operating fixed assets
Operating Working capital
Non-operating assets & liabilities
Equity
Debt
Free Cash Flows (operating flows)
Non-operating flows
Financing flows
38
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
39
DCF overview
Notes: 1) including non-operating investments 2) including underfunded pension plans
Enterprise value is the equivalent of Value of Operations
MV of interest-
bearing debt
MV of minority interests
Corporate value
MV of financial
fixed assets1
Value of Operations
Free Cash Flow
WACC
Terminal value
Equity value
MV of other financial liabilities2
MV preferred equity
Excess cash & marketable
securities 1
3+4
6
5
2
7
7
7
7
7
7
= input = output
B/S
P&L
Cash Flow
Accounting
40
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
41
Operating Free Cash Flow
• FCF is the difference between all revenues and sources of cash resulting from the strategy and all cash expenses and investments necessary to implement the strategy
• Free cash flow (FCF) is cash that is not required to fund the firm and can be used at management's discretion beyond continuing the existing operating strategy
• For example: FCF can be used to service debt or make payouts to shareholders (FCF is available to all claimants and providers of capital)
42
How to derive Free Cash Flows?
• Preparing the Free Cash Flow (FCF) is somewhat similar to preparing the cash flow statement • Main difference: financing flows should be left out
EBIT
+ Depreciation
+ Amortisation
+ Sustaining capital expenditure
Cash flow before interest and taxes (CBIT)
– Cash taxes
Cash flow before new investments (CBNI)
– Expansion capital expenditure
± Change in working capital
Free Cash Flow from operations
Costs, no expenses: prevent ‘double counting’
43
Background on ‘new’ items in the FCF
• Capital expenditure (CAPEX) – Sustaining CAPEX, i.e. maintenance of existing (fixed) assets: maintenance of the kraam – Expansion CAPEX, i.e. investment in new assets that will serve to grow and expand the business,
e.g. enlargement of the kraam – Both type of investment will result in higher
depreciation levels
44
Background on ‘new’ items in the FCF (cont’d)
• Cash taxes – Cash taxes represent an adjustment to
taxes payable (from the P&L): taxes that relate to non-operating activities (e.g. financing) are added to (resp. subtracted from) taxes payable
• Case Assignment V: Prepare the Free Cash Flow statement for 2007
Cash taxes
2008
PBT 13,540
Rate 25.5%
Taxes 3,453
Net interest 360
Rate 25.5%
Taxes 92
CBIT 13,900
Implied cash tax rate 25.5%
Cash taxes 3,545
1
3
2
45
Case assignment V: Free Cash Flow
Free Cash Flow statement
2008
Revenues
EBIT
+ Depreciation
– Sustaining investments in tangible assets
CBIT
Cash taxes
CBNI
Expansion capex
Working capital investments
FCF
46
Case assignment V: Free Cash Flow
Free Cash Flow statement
2008
Revenues 49,500
EBIT 13,900
+ Depreciation 2,000
– Sustaining investments in tangible assets -2,000
CBIT 13,900
Cash taxes -3,545
CBNI 10,356
Expansion capex 0
Working capital investments -1,031
FCF 9,324
47
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
48
Case assignment V: Forecasting
• Forecasts are crucial for a proper valuation exercise – Essentially, we need to forecast the Free Cash Flows and discount them back to today to calculate
the present value of operations – In order to come up with a forecasted Free Cash Flow, we first need to prepare a forecasted P&L,
balance sheet and cash flow statement
49
Profit & loss account Standard model Consider
Revenue growth % growth GDP, market growth, inflation, volume vs. price, price pressure, product mix, acquisitions/disposals
Gross margin % of revenues price pressure, efficiency, product mix, raw material costs
Operating costs growth % growth sales growth, variable vs. fixed costs, inflation, wage costs, efficiency
Depreciation % of opening tangible fixed assets
accounting policy change, large investments (current & historic)
Amortisation % of opening intangible fixed assets
goodwill: linear write-off and no additions
Forecasting financial statements
50
Profit & loss account Standard model Consider
Dividend pay-out ratio % of net earnings before extraordinaries
percentage of earnings or stable DPS growth
Preferred interim dividends % of preferred share capital outstanding
Preferred interim dividend % of preferred dividends
Interest on debt interest rate maturity of debt, default spread
Interest on cash interest rate current market rate
Forecasting financial statements
51
Forecasting financial statements
Balance sheet Standard model Consider
Stock days days of incr. revenues efficiency of working capital, seasonality
Trade debtors days days of incr. revenues efficiency of working capital, country mix, seasonality, annual average
Other debtors % of incr. revenues timing, annual average, constituents
Operating cash % of incr. revenues idem stock days, industry average
Trade creditors days days of total incr. costs idem trade debtors
Other creditors % of incr. revenues idem other debtors
Cash flow statement
Capital expenditure (expansion and sustaining)
% of incr. resp total revenues large investments, maintenance vs. expenditure
52
Case assignment V: Forecasting
• As you have just noticed, forecasting is an exercise that requires us to make certain assumptions on the development of our company: – We assume revenue growth with 5% in the first two years and thereafter with 3% – Moreover, we assume that COGS and SG&A as a percentage of revenues remain constant (i.e.
2008 levels) • Prepare the P&L for 2009 - 2012
53
Forecasting the P&L
• Revenues growth by more than EUR 8,000 to almost EUR 58,000 in 2011
• What can you say about the profitability of the company going forward?
P&L 2007 2008F 2009F 2010F 2011F
Revenues 49,500 51,975 54,574 56,211 57,897Growth 5.0% 5.0% 3.0% 3.0%
COGS -16,500 -17,325 -18,191 -18,737 -19,299As a % of revenues 33.3% 33.3% 33.3% 33.3% 33.3%
Gross Profit 33,000 34,650 36,383 37,474 38,598Gross margin 66.7% 66.7% 66.7% 66.7% 66.7%
SG&A -17,100 -17,955 -18,853 -19,418 -20,001As a % of revenues 34.5% 34.5% 34.5% 34.5% 34.5%
EBITDA 15,900 16,695 17,530 18,056 18,597EBITDA margin 32.1% 32.1% 32.1% 32.1% 32.1%
Depreciation -2,000 -2,000 -2,000 -2,000 -2,000As a % of revenues 4.0% 3.8% 3.7% 3.6% 3.5%
EBIT 13,900 14,695 15,530 16,056 16,597EBIT margin 28.1% 28.3% 28.5% 28.6% 28.7%
Interest (@ 6%) -360 -300 -240 -180 -120
PBT 13,540 14,395 15,290 15,876 16,47727.4% 27.7% 28.0% 28.2% 28.5%
Tax -3,453 -3,671 -3,899 -4,048 -4,202Tax rate 25.5% 25.5% 25.5% 25.5% 25.5%
Net Profit 10,087 10,724 11,391 11,827 12,276Profit margin 20.4% 20.6% 20.9% 21.0% 21.2%
Dividend (i.e. bonus for employee) -7,061 -7,507 -7,974 -8,279 -8,593Dividend ratio 70.0% 70.0% 70.0% 70.0% 70.0%
Retained earnings 3,026 3,217 3,417 3,548 3,683
2008 2009F 2010F 2011F 2012F
54
Forecasting the balance sheet
• In our case, forecasting of the balance sheet requires little assumptions – We assume that Inventory and Receivables both remain at a constant percentage of revenues
• All other BS items are a consequence of other decisions we have made at an earlier stage in our case: – Depreciation equals the maintenance investment in our kraam, i.e. fixed assets remain constant – Equity is adapted automatically: the retained earnings from the P&L flow into Equity – Debt is paid down yearly in six years and subsequently decreases with EUR 1,000 per year
Cash = last year’s cash + the net increase in cash (from CF)
55
Balance sheet
Forecasting the balance sheet
Balance sheet 2007 2008F 2009F 2010F 2011F
AssetsKraam 20,000 20,000 20,000 20,000 20,000As a % of revenues 40.4% 38.5% 36.6% 35.6% 34.5%
Inventory 990 1,040 1,091 1,124 1,158As a % of revenues 2.0% 2.0% 2.0% 2.0% 2.0%Receivables 866 910 955 984 1,013As a % of revenues 1.8% 1.8% 1.8% 1.8% 1.8%Cash 4,170 6,294 8,614 11,101 13,720 As a % of revenues 8.4% 12.1% 15.8% 19.7% 23.7%
Total assets 26,026 28,243 30,661 33,209 35,892
Liabilities & EquityEquity 21,026 24,243 27,661 31,209 34,892
Debt 5,000 4,000 3,000 2,000 1,000
Payables 0 0 0 0 0As a % of revenues 0.0% 0.0% 0.0% 0.0% 0.0%
Total liabilities & Equity 26,026 28,243 30,661 33,209 35,892
2008 2009F 2010F 2011F 2012F
56
Case assignment VI: Forecasting cash flows
• With the information presented (P&L and balance sheet) at hand now prepare the cash flow statement for 2009 - 2012
• Subsequently, prepare the Free Cash Flow statement for the period 2009 - 2012
57
Cash flow statement
Forecasting cash flows
Cash Flow 2007 2008F 2009F 2010F 2011F
EBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Operating cashflow before changes in WC 15,900 16,695 17,530 18,056 18,597
Change in inventory -990 -50 -52 -33 -34Change in receivables -41 -43 -45 -29 -30Change in payables 0 0 0 0 0Income tax expense -3,453 -3,671 -3,899 -4,048 -4,202Cash from operating activities 11,416 12,931 13,533 13,946 14,332
Acquisition of PPE -2,000 -2,000 -2,000 -2,000 -2,000Cash from investing activities -2,000 -2,000 -2,000 -2,000 -2,000
Paydown of debt -1,000 -1,000 -1,000 -1,000 -1,000Interest expense -360 -300 -240 -180 -120Dividend paid -7,061 -7,507 -7,974 -8,279 -8,593Cash from financing activities -8,421 -8,807 -9,214 -9,459 -9,713
Net increase in cash 995 2,124 2,320 2,487 2,619
Cash at 1 January 3,175 4,170 6,294 8,614 11,101
YE cash 4,170 6,294 8,614 11,101 13,720
2008 2009F 2010F 2011F 2012F
58
Forecasting cash flows
Free cash flow statement
Free Cash Flow 2007 2008F 2009F 2010F 2011F
Revenues 49,500 51,975 54,574 56,211 57,897EBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Sustaining investments in tangible assets -2,000 -2,000 -2,000 -2,000 -2,000CBIT 13,900 14,695 15,530 16,056 16,597Cash taxes -3,545 -3,747 -3,960 -4,094 -4,232CBNI 10,356 10,948 11,570 11,961 12,365Expansion capex 0 0 0 0 0Working capital investments -1,031 -93 -97 -61 -63FCF 9,324 10,855 11,472 11,900 12,302
2008 2009F 2109F 2011F 2012F
59
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
60
Discounting
• Discounting cash flows is what someone is willing to pay today in order to receive an anticipated cash flow in future years
• Hence, the future cash flows must be discounted in order to express their present values in order to properly determine the value of a company
• Future cash flows are discounted at a certain rate over time at a rate (also called: “rate of return”), that reflects the perceived riskiness of the cash flows
• The applied discount rate reflects two things: – The time value of money – A risk premium
• We will now take a closer look at both items
Essentially, discounting is all about two things: time and risk
61
Discounting - time value of money
• Congratulations!!! You have just won EUR 1,000 in the Staatsloterij!
• You have the unconventional luxury of two payment options: – Receive EUR 1,000 now – Receive EUR 1,000 in a year from now
• Does EUR 1,000 today have the same value as EUR 1,000 one year from now?
62
Discounting - time value of money
• If you choose option A, receiving EUR 1,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. Your future value will be EUR 1,000 plus any interest acquired over the year
• For option B, you don't have time on your side, and the payment received in one year would be your future value e.g EUR 1,000
Present value
Future value
t = 0 t = 1 years
Option A
Option B
EUR 1,000
EUR 1,000 - interest
EUR 1,000 + interest
EUR 1,000
The time value of money demonstrates that, all things being equal, it is better to have the money now rather than later
63
Discounting – risk premium
• In addition to the time value, the discount rate reflects a risk premium that represents the extra return investors demand, because they want to be compensated for the risk that the cash flow might not materialize after all
• An example: Time value
t = 0 t = 1
Cash in hand 100 100 106
Annual saving return 6%
Time value + risk
Incorporating risk
Cash in hand 100 100 110
Profit XY 10%
64
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
65
Discount rates
• Let’s go back to the previous example:
• The discount rates respectively are:
– i.e. 6%
– i.e. 10%
Time value
t = 0 t = 1
Cash in hand 100 100 106
Annual saving return 6%
Time value + risk
Incorporating risk
Cash in hand 100 100 110
Profit XY 10%
1 x 100% 100
106 -
1 x 100% 100
110 -
66
Discount rates: Case assignment
• What would be the present value of EUR 1,000 you will receive in one year from now, given a discount rate of 6%?
• What would be the present value of EUR 1,000 you will receive in two years from now, given a discount rate of 6%?
• What would be the present value of EUR 1,000 you will receive in three years from now, given a discount rate of 6%?
67
Discount rates: Case assignment
• Discount rate: 6%
• Calculation:
• whereby is the discount factor
Discount factor: 1 / (1 + discount rate)t where t = {1,2,…,T}
Now 1 2 3 Years
943.39 1,000.00
889.99 1,000.00
839.62 1,000.00
( ) 3 , 2 , 1 06 . 0 1
000 , 1
+
( ) 3 , 2 , 1 06 . 0 1
1
+
68
Discount rate = Cost of capital
• The discount rate is also referred to as the cost of capital • In other words, the cost of capital represents the cost for time and risk. Or, to put it differently: the
required return all capital providers demand
• For example: – As a shareholder of Philips you require an annual return of 10% on your shares (equity) – As a lending bank to Philips, RBS requires a 6% annual interest rate
• Altogether, the Cost of Capital (Kc) represents the blend of all required return to capital providers – Equity: Ke (Cost of Equity) – Debt: Kd (Cost of Debt) Weighted Average Cost of Capital (WACC)
69
Weighted Average Cost of Capital (cont’d)
• Obviously, you wouldn’t be able to tell the WACC as we have not yet provided the total market value of equity and debt of the company
• So, let’s suppose Philips is financed with: – EUR 2,000 in equity – EUR 1,500 in debt
• We already provided: – All equity holders demand an annual return of 10% (i.e. Ke = 10%) – All debt providers demand an annual interest of 6% (i.e. Kd = 6%)
• Hence, what would be the WACC for Philips? – A. 7.1% – B. 7.5% – C. 8.3%
70
Weighted Average Cost of Capital (cont’d)
• Answer C would be the correct one!
• Calculation occurs as follows:
• In formula terms:
KdDebtEquity
DebtKeDebtEquity
EquityWACC !+
+!+
=
( ) ( )%9.7%5
500,1000,2500,1%10
500,1000,2000,2WACC =!
++!
+= 6% 8.3%
71
Weighted Average Cost of Capital (cont’d)
• In the calculation, there is one crucial item we still would need to incorporate:
Indeed: TAXES! • Bear in mind that there is a tax shield (tax advantage) on the cost of debt • This changes our WACC formula to:
)T1(KdDebtEquity
DebtKeDebtEquity
EquityWACC !""+
+"+
=
Whereby T equals to the corporate tax rate (25.5% in The Netherlands)
72
A closer look at the cost of equity (Ke)
• As we have explained, the cost of equity equals the required return of equity investors (10% at Philips)
• The required return by equity investors can in fact be decomposed in two parts: – The so called ‘risk free’ return – The return that is specifically related to the Philips stock and the market (i.e. the AEX index)
Ke = risk free return + risk bearing return
73
A closer look at the cost of equity (Ke)
• The risk free rate (Rf) represents a ‘floor’, i.e. a return that is virtually without risk and that anyone can make. Usually, the risk free rate equals the yield to a 10yr Government Bond (currently around 4.3%)
3m 6m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 30y 0
0.02
0.04
3.9
4.0
4.1
4.2
4.3
4.4
4.5
Current Previous
74
A closer look at the cost of equity (Ke)
• The market always has a Beta of 1, it is the ‘benchmark’
• The return that is specifically related to the Philips stock and the market (i.e. the AEX index) is in fact bearing risk
• We need to measure the risk/return of the Philips share relative to the market (the AEX index)
• In order to calculate this rate, we need three items: – The deviation of the risk of the Philips stock vis-à-vis the risk of the market (called Beta) – The expected return of the Market (Rm) – The risk free rate (Rf) of 4.3%
• We now get to the following formula:
( )RfRm !"#
= also referred to as Market Risk Premium (MRP)
75
A closer look at the cost of equity (Ke)
• The Beta of a stock is usually higher or lower than the market – The Beta is higher when a share is more risky (volatile) than the market for a certain period of time
(e.g. 5 yrs). To compensate for the additional risk, such shares will ‘demand’ higher returns (e.g. cyclical or volatile industries, such as semiconductors)
– Conversely, the Beta is lower when a share incorporates less risk (less volatility) than the market. Consequently, required returns are lower (e.g. stable sectors like utilities)
76
A closer look at the cost of equity (Ke)
• In the end, the Cost of Equity (Ke) still equals the sum of the risk free returns and risk-bearing returns that can be summarised in the following formula:
• Graphical version:
( )RfRmRfKe !"+= #
E9R)
rf
Market risk(beta)
( )RfRmRfKe !"+= #
77
Case assignment: Calculate the Ke
• With the aforementioned information in mind, calculate the Ke for our hot dog kraam at the Dam square:
• Please assume the following: – Risk Free Rate of Return 4.50% – Market Rate of Return 10.50% – Company’s Beta 1.02
• The Cost of Equity (Ke) will be: 4.50% + 1.02*(10.50% - 4.50%) = 10.62%
78
Case assignment: Calculate the WACC
• With the aforementioned information in mind, calculate the WACC for our hot dog kraam at the Dam square:
• Please assume the following: – Debt to Equity ratio = 0.33* – Cost of Equity = 10.62% – Pre-tax cost of debt = 6% – Tax rate = 25.5%
• The WACC will be:
– WACC = 0.75*10.62% + 0.25*6%*(1-25.5%) = 9.1%
• What does this imply for any future investments you are planning to make?
Note: If D/E = 1/3, then D/(D+E) = 1/(1+3) = 0.25
79
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
80
Case assignment: Discount the Free Cash Flows
• Now we have calculated the Free Cash Flows and derived a discount rate (a WACC of 9.1%), we can actually start to discount our cash flows
• Assignment: discount the FCFs (2008 - 2011) of our Kraam and calculate the Present Values of the annual cash flows
• In doing so bear in mind what we have mentioned previously:
Discount factor: 1 / (1 + discount rate)t where t = {1,2,…,T}
81
Case assignment: Discount the Free Cash Flows
• The result would be as follows:
• Key question: What is the value of our operations?
Free Cash Flow 2007 2008F 2009F 2010F 2011F
Revenues 49,500 51,975 54,574 56,211 57,897EBIT 13,900 14,695 15,530 16,056 16,597Depreciation 2,000 2,000 2,000 2,000 2,000Sustaining investments in tangible assets -2,000 -2,000 -2,000 -2,000 -2,000CBIT 13,900 14,695 15,530 16,056 16,597Cash taxes -3,545 -3,747 -3,960 -4,094 -4,232CBNI 10,356 10,948 11,570 11,961 12,365Expansion capex 0 0 0 0 0Working capital investments -1,031 -93 -97 -61 -63FCF 9,324 10,855 11,472 11,900 12,302
Cost of capital (WACC) 9.1% 9.1% 9.1% 9.1%Discount factor 0.917 0.841 0.771 0.707
PV of FCF 9,953 9,644 9,172 8,694
82
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
83
Terminal value: let’s first get back to our last question • Q: What is the value of our operations?
• A: The value of our operations equals the sum of: – The sum of the PV of the Free Cash Flows generated from 2008 - 2011 (portrayed above) – The sum of the PV of the Free Cash Flows generated from 2012 - ∞ (also known as: Terminal
Value)
Free cash flow 2007 2008F 2009F 2010F 2011F
FCF 9,324 10,855 11,472 11,900 12,302
Cost of capital (WACC) 0.0 9.1% 9.1% 9.1% 9.1%
Discount factor 0.917 0.841 0.771 0.707
PV of FCF 9,953 9,644 9,172 8,694
84
The concept of Terminal Value
• Forecasting until infinity is a harsh exercise, therefore we use a shortcut: – We split the forecasted periods in two sections:
– The explicit forecast period (generally 5 to 10 years from now) – The terminal value period (year 11 → ∞)
• Terminal Value equals the value of all Free Cash Flows after the period explicit forecast period
• Crucial assumption for the Terminal Value is that Free Cash Flows are constant
85
Terminal value
50%
60%
30%
50%
40%
70%
The concept of Terminal Value (cont’d)
Explicit forecast period Terminal Value
2007
∞ 2011
2015
2013
2007
2007 ∞
∞
86
The concept of Terminal Value (cont’d)
• What in your opinion would be a valid assessment of Terminal Value? – A. Model in an endless number of Free Cash Flows and discount them back – B. Model 100 years of Free Cash Flows and discount them back – C. Something else
87
The concept of Terminal Value (cont’d)
• Option A would be calculated as follows:
i.e. mathematically a perpetuity Whereby ‘g’ represents the growth of Free Cash Flows
• g > 0 implies constant growth • g = 0 a constant state
• Make sure not to mix up the concepts of ‘growth’ and ‘value creation’ – Growth does not automatically lead to value creation!
gWACCFCF
!T
88
2. Forecasting
4. Discount rates
Overview DCF approach
1. Determine operating Free Cash Flows
3. Discounting
5. Discount the Free Cash Flows
6. Shortcut to determine Terminal Value
7. All other valuable items
89
A recap of all topics covered today
Notes: 1) including non-operating investments 2) including underfunded pension plans
Enterprise value is the equivalent of Value of Operations
= input = output
MV of interest-
bearing debt
MV of minority interests
Corporate value
MV of financial
fixed assets1
Value of Operations
Free Cash Flow
WACC
Terminal value
Equity value
MV of other financial liabilities2
MV preferred equity
Excess cash & marketable
securities
B/S
P&L
Cash Flow
Accounting
7 Wrap up
91
Let’s see whether we gained some more insight
Indicative and preliminary valuation range of EUR 1.9 billion to EUR 2.1 billion at this early stage of due diligence
EV EV/EBITDA 2006
1.8b - 2.2b 9.5x - 11.5x
1.9b - 2.1b 10.0x - 11.0x
1.8b - 2.3n 9.4x - 12.2x
1.5b - 1.7b 7.9x - 9.0x
Indicative, preliminary valuation range
1,400 1,600 1,800 2,000 2,200 2,400
CCA
DCF
LBO
CTA
In EUR million