vi oiv international business valuation n-e … · 04-12-2017 · vi oiv international business...

VI OIV International Business ValuationConference

Milan, 4 december 2017 1

BUSINESS VALUATION: THE KEY PROBLEM PRACTICE AREA

BUSINESS VALUATION: A PAN-EUROPEAN PERSPECTIVE

Mauro Bini

The key problem practice area is attributable to the effects of conditionality on valuation

Definition of CONDITIONAL (Merriam-Webster):

1. Subject to; implying, or dependent upon, a condition.

2. Expressing, containing, or implying a supposition.

3. a: true only for certain values of the variables or symbols involved.

b. stating the case when one or more random variables are fixed or one or

more events are known.


Five topics where conditionality is relevant

• Distressed Firms Valuation

• Prospective Financial Information (PFI)

• Discount rates

• Early Stage Company Valuation

• Volatility of valuation tools




• Discount rates




Distressed firm Valuation: conditionality

• Equity and Debt don’t have a linear payoff. They are conditional to:

• Enterprise Value

• Volatility of Enterprise Value

• Forced sale discount

• Expected values of equity and debt (going concern) are NOT equal to

their payoffs at the expected enterprise value


An example


Equity value (going concern = 10,5) > Expected Enterprise Value (100) – Face value of Net debt (100) Expected Enterprise value (going concern = 100) > Net Debt (going concern) = 89,5 >

Enterprise Value (forced sale = 70)

GOING CONCERN

Scenario Probability Enterprise Value Net Debt Equity value Enterprise Value Net Debt Equity value

1 2,50% 180 100 80 4,5 2,5 2

2 15% 130 100 30 19,5 15 4,5

3 20% 120 100 20 24 20 4

4 25% 100 100 0 25 25 0

5 20% 80 80 0 16 16 0

6 15% 70 70 0 10,5 10,5 0

7 2,50% 20 20 0 0,5 0,5 0

100 89,5 10,5

LIQUIDATION (25% discount)

75 75 0 75 75 0

Payoffs Probability- weighted Payoffs

Expected Values

More risk = less debt value


GOING CONCERN

Scenario Probability Enterprise Value Net Debt Equity value Enterprise Value Net Debt Equity value

1 2,50% 180 100 80 4,5 2,5 2

2 15% 170 100 70 25,5 15 10,5

3 20% 163 100 63 32,6 20 12,6

4 25% 100 100 0 25 25 0

5 20% 40 40 0 8 8 0

6 15% 30 30 0 4,5 4,5 0

7 2,50% 0 0 0 0 0 0

100 75 25

LIQUIDATION (25% discount)

75 75 75 75 0

Payoffs Probability- weighted Payoffs

Expected Values

Risk adverse Lender prefers liquidation

Higher volatility = lower debt value; higher (potential) equity value

Distressed Firm and Capital Increase


GOING CONCERN

Scenario Probability Enterprise Value Capital Increase Net Debt Equity value

1 2,50% 180 14,5 85,5 94,5

2 15% 170 14,5 85,5 84,5

3 20% 163 14,5 85,5 77,5

4 25% 100 14,5 85,5 14,5

5 20% 40 14,5 40 0

6 15% 30 14,5 30 0

7 2,50% 0 14,5 0 0

Scenario Enterprise Value Net Debt Equity value

1 4,5 2,1 2,4 0,4 2,0

2 25,5 12,8 12,7 1,9 10,8

3 32,6 17,1 15,5 2,3 13,2

4 25,0 21,4 3,6 0,5 3,1

5 8,0 8,0 0 0,0 0

6 4,5 4,5 0 0,0 0

7 0 0 0 0,0 0

Expected values 100 66 34 5 29

Payoffs

Probability- weighted Payoffs OLD Equity

(15%)

NEW Equity

(85%)

37,5% pr.

66 > 75 – 14,534 < 25 + 14,5

Five topics where the conditionality is relevant



• Discount rates




Prospective Financial Information (PFI)

• FINANCIAL FORECAST-

A financial forecast is based on the responsible party’s assumptions reflecting

the conditions it expects to exist and the course of action it expects to take

• FINANCIAL PROJECTION –

A financial projection is based on the responsible party’s assumptions

reflecting conditions it expects would exist and the course of action it expects

would be taken, given one or more hypothetical assumptions


Discount Rate Adjustment Technique (DRAT)

• The discount rate adjustment technique uses contractual or promised or

most likely cash flows. Those cash flows are conditional upon the

occurrence of specific events (for exampe contractual or promised cash

flows for a bond are conditional on the event of no default by the debtor).

• The contractual or promised or most likely cash flows are discounted at a

rate that corresponds to an observed market rate.


Expected Present Value Tecnhnique (EPVT)

• The Expected Present value technique uses probability- weighted average

cash flows. Because the cash flows are probability weighted, the resulting

expected cash flow is not conditional upon the occurrence of any specified

event (as are the cash flow in the discount rate adjustment technique).

• The discount rate corresponds to an expected rate of return (i.e. CAPM,

etc.)

• The market rate (DRAT) likely will be higher than the expected rate of

return. The difference is the specific risk premium.


An example: from PFI ……


Years 1 2 3 4 5

Revenue 150 170 190 210 230

Ebit 10 15 20 24 28

UFCF 8 16 19 23 27

Product A

Revenue 100 105 110 115 120

Ebit 9 10 11 11 12

UFCF 8 10 11 11 12

Product B NEW PRODUCT

Revenue 50 65 80 95 110

Ebit 1 5 9 13 16

UFCF 0 6 8 12 15

……..to an inconsistent Valuation


CAPM WACC = 10%; g product A = 0% g Product B = 2%

Years 1 2 3 4 5 TV

UFCF A 8 10 11 11 12 12

Discount rate 10%

Discount Factor 0,909 0,826 0,751 0,683 0,621

PV(UFCF) 7,3 8,3 8,3 7,5 7,5

g 0%

PV(TV) 74,5

Value Product A 113,3

UFCF B 0 6 8 12 15 15,3

Discount rate 10%

Discount Factor 0,909 0,826 0,751 0,683 0,621

PV(UFCF) 0 5,0 6,0 8,2 9,3

g 2%

PV(TV) 118,8

Value Product B 147,2

Total Value 260,5

The consistent approach


Years 1 2 3 4 5

Revenue 150 170 190 210 230

Ebit 10 15 20 24 28

UFCF 8 16 19 23 27

Product A

Revenue 100 105 110 115 120

Ebit 9 10 11 11 12

UFCF 8 10 11 11 12

Product B NEW PRODUCT

Revenue 50 65 80 95 110

Ebit 1 5 9 13 16

UFCF 0 6 8 12 15


UFCF PRODUCT B are conditionalUFCF PRODUCT A are expectedTOTAL UFCF are mixed

UFCF PRODUCT B

Years 1 2 3 4 5

MOST LIKELY HIGH CASE 50% 0 6 8 12 15

BASE CASE 30% 0 1 2 3 4

LOW CASE 20% 0 1 1 2 2

Expected Cash flows 0 3,5 4,8 7,3 9,1

UFCF PRODUCT A

Years 1 2 3 4 5

HIGH CASE 15% 9 12 13 13 14

MOST LIKELY BASE CASE 70% 8 10 11 11 12

LOW CASE 15% 7 8 9 9 10

Expected Cash flows 8 10 11 11 12

Expected rate of return


Existing Market New Market

Existing Product

LOWEST

RISK

INCREASED

RISK

New Product

INCREASED

RISK

HIGHEST

RISK

Systematic risk

EPVT


PRODUCT B

Years 1 2 3 4 5 TV

Most Likely 50% 0 6 8 12 15

Medium 30% 0 1 2 3 4

Low 20% 0 1 1 2 2

Expected Cash flows 0 3,5 4,8 7,3 9,1 9,3

Discount rate 13%

Discount Factor 0,885 0,783 0,693 0,613 0,543

PV(UFCF) 0,0 2,7 3,3 4,5 4,9

g 2%

PV(TV) 45,8

Value Product B 61,3 -58%

Value Product A 113,3

Total value 174,6 -33%

WACC PRODUCT B = 13%; EXPECTED CASH FLOWS

DRAT and specific risk premium


ENTERPRISE VALUE (DRAT)

Years 1 2 3 4 5 TV

UFCF 8 16 19 23 27 27,3

Discount rate 13,7%

Discount Factor 0,880 0,774 0,681 0,599 0,527

PV(UFCF) 7,0 12,4 12,9 13,8 14,2

g 1,1%

PV(TV) 114,3

Total Value 174,6

COMPANY SPECIFIC RISK PREMIUM =13,7% - 10% = 3,7%

PRODUCT B (DRAT)

Years 1 2 3 4 5 TV

UFCF B most likely 0 6 8 12 15 15,3

Discount rate 18,5%

Discount Factor 0,844 0,712 0,601 0,507 0,428

PV(UFCF) 0,0 4,3 4,8 6,1 6,4

g 2%

PV(TV) 39,7

Total Value 61,3

PRODUCT B SPECIFIC RISK PREMIUM = 18,5% - 13% = 5,5%

PFI: conclusions

1) We spend relatively more time and effort debating the CAPM/WACC and

their components, and relatively less time and effort assessing the risks of

the estimated future cash flows that we are discounting

2) The valuation professional should not presume management is biased;

however, the valuation professional should not accept and rely on less-

than-persuasive evidence because the valuation professional believes

management is unbiased

3) «Most Likely» is not necessarily equals to «Expected (probability

weighted)»




• Discount rates




0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

80,0

31/01/2007 31/01/2008 31/01/2009 31/01/2010 31/01/2011 31/01/2012 31/01/2013 31/01/2014 31/01/2015 31/01/2016 31/01/2017

CBOE Market Volatility Index Euro STOXX 50 Volatility

22Milan, 4 december 2017

Uncertainty decreases to pre-crisis levels

9,710,4

15,3

20,7

Euro Stoxx 50 Volatility Index

CBOE VIX

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

7,00%

8,00%

9,00%

10,00%

11,00%

12,00%

gen-07 gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 gen-14 gen-15 gen-16 gen-17


The relationship between ERP (implicit in Stoxx600) and Risk-free rate

Coe1Y Moving Average = ERP + Rf

IRS 10Y1Y Moving Average

5,38%

0,81%

ERP

4,57%

In Euro

Date 24/11/2017 31/12/2017 31/12/2018 31/12/2019

Years 0 0,10 1,10 2,10 TV

EPS - Stoxx 600 23,49 25,57 27,80

DIV ps - Stoxx 600 12,57 13,40 14,32

Pay-out ratio 53,5% 52,4% 51,5%

Coe - Stoxx 600 5,38% = 0,81% + 4,57%

Implied g - Stoxx 600 1,64%

Discount Factor 0,99 0,94 0,90

PV(DIV) 12,50 12,65 12,83

TV 389,24

PV(TV) 348,65

Price as of 24/11/2017 386,63

Implied g 1,64%

b rate = 1 - Pay-out FY3 48,5%

ROE Growth Opportunity 3,38% < Coe = 5,38%


The effect of lower Coe in the valuation

NPVGrowth Opportunity < 0 ??

It is conditionl to Coe

2017 2018 2019

EPS - Stoxx 600 23,49 25,57 27,8

Δ%EPS 8,85% 8,72%

b rate = 1- pay out 46,5% 47,6% 48,5%

ROE (Implied) = Δ%EPS / bt-1 19,05% 18,32%

The long term relationship between ERP (implicit in Stoxx 600) and Risk-free rate


0,00%

2,00%

4,00%

6,00%

8,00%

10,00%

12,00%

14,00%

16,00%

Media IRS 10Y = 4,21%

Δ = Media ERP Stoxx600 = 4,60%

Media coe = 8,81% = 4,21% + 4,60%


Duff & Phelps: ERP and Risk-free rate guidance

Current Guidance for US Equity Markets,as of 5 September 2017

Risk-free rate = 3,50%ERP = 5,00%Coe = 3,50% + 5,00% = 8,50%

In Euro

Date 24/11/2017 31/12/2017 31/12/2018 31/12/2019

Years 0 0,10 1,10 2,10 TV

EPS - Stoxx 600 23,49 25,57 27,80

DIV ps - Stoxx 600 12,57 13,40 14,32

Pay-out ratio 53,5% 52,4% 51,5%

Coe - Stoxx 600 8,81%

Implied g - Stoxx 600 5,21%

Discount Factor 0,99 0,91 0,84

PV(DIV) 12,46 12,21 11,99

TV 417,90

PV(TV) 349,96

Price as of 24/11/2017 386,6

Implied g 5,21%

b rate = 1 - Pay-out FY3 48,5%

ROE Growth Opportunity 10,73% > Coe = 8,81%

= 4,21% + 4,60% (Long Term Average Risk-free and ERP

implied in Stoxx 600)


… the effect of normalizing the Coe’s parameters

NPVGrowth Opportunity > 0



• Discount rates




29

Early Stage Company Classification

REVENUESSTAGE

IDEA&PLAN/

PROJECT

EXPENSE

HISTORY

Established Financial

History[6] BUYOUT [/IPO] Complete

Mantainance

Level

None[1] BUSINESS IDEA Incomplete Limited

None[3] START-UP Complete Significant

Some revenues but loss

generating[4] EXPANSION Complete Significant

Higher revenues; might

break even[5] ROUND FIN. Complete Maximum

None[2] SEED Complete Significant

KEY MILESTONES

PRODUCT DEVELOPMENT

Product Ready

None

Key milestones met;

product near completion

Product Ready

Add. milestones met

Product Ready

Under way

EARLY STAGE

COMPANIES

MATURE (/LISTED)

COMPANIES

Milan, 4 december 2017

30

Early Stage Companies Definition

In general, early-stage companies can be defined as demonstrating any or all of the below factors:

1. Yet to meet key technological or commercial milestones;

2. No revenues or little revenues in comparison to market potential;

3. Negative profitability and cash flows, or low in comparison to market potential;

4. Little certainty as to future revenues and profitability projection.


No listed

comparable

Difficult Cash Flow Estimate

Extremely Difficult Terminal Value Estimate

31

Common issue in Early Stage Company Valuation

VALUATION METHODS

ACCOUNTING FOR RISK

Comp. Transaction Multiples

DCF

Guideline Comps. Multiples

Transactions exists,

but:

• Multiple is more

function of the acquirers’

potential than the target

characteristics;

• Limited available information and limited multiple choice

because of target’s negative performance.

Discrete Event

Risk Profile

Going concern

premise?

Broad range

of empirical

measures


Early Stage Companies’ risk profile

32

DISCRETE EVENT

Typical Milestones (e.g. Pharma):

• Discovery;

• Pre-Clinical;

• Early Clinical;

• Confirmatory trials;

• Approval;

• Sales.

𝐼0

𝐼0𝑢

𝐼0d

𝑝

(1 − 𝑝)

∀ 𝑢 > 1; 𝑑 < 10 < p < 1

BINOMIAL OUTCOMES

𝑝 𝐼 > 11 − 𝑝 0 < 𝐼 < 1

Investment

1st Milestone


The VC perspective

33

1. Let’s consider the perspective of a Venture Capital Investor

For each milestone there is a binomial outcome:

1. the investment is worth more than the cash invested (return event with probability p);

2. the investment is worth less than the cash invested (default event with probability 1-p).

Q: Why Required Return of VC are so high?

2. Need a tool to distinguish systematic default risk from idiosyncratic risk

Kemmerer, Rietzschel and Schoenball suggest Creditrisk Analysis of VC Portfolio default rate.

Sample: > 2000 Investments; > 8000 Yearly Observations.


Systematic vs Idiosyncratic risk

34

𝑃𝐷 = 𝑓(𝑋, 𝐾)

Default Probability is estimated through logistic

regression over Macro variables (𝑋 = 𝑥1, … , 𝑥𝑛) and

companies’ industry (K)

SYSTEMATIC RISK (R2)i

𝜆𝑆 =𝑃𝐷𝑆

𝑃𝐷

Idiosyncratic risk is a function of a company stage, and it’s computed as a long-

term average default rate.

In particular, λ coefficient allows a measure of each stage default rate (𝑃𝐷𝑆 )

compared to the average default rate of companies from all stages (𝑃𝐷):

IDIOSYNCRATIC RISK (1-R2)ii

𝑃𝐷𝐶 = 𝜆𝑆 ∙ 𝑃𝐷𝐾𝐸

Company risk is calculated as the product of the

idiosyncratic coefficient of company’s stage (𝜆𝑆) and

the estimate of the default probability (𝑃𝐷𝐾𝐸) for the

company’s industry (K):

COMPANY RISKiii

Avg. Default Probabilities (𝑃𝐷𝑆) 𝜆𝑆 Coefficients


The stage leads to different level of idiosyncratic risk,

thus different required return

35

λs Coefficient Multiplier

Seed 1,37 2,21

Start-up 1,08 1,74

Expansion 0,77 1,24

Replacement Capital 0,75 1,21

Buyout 0,62 1,00

US VC Early Stage

Index

US VC Late &

Expansion Index

23,38% 11,91%

S&P 500 9,66% 2,42 1,23

Russel 1000 9,76% 2,40 1,22

Wilshire 5000 9,62% 2,43 1,24

Multiplier

30Y Pooled Return

3. The presence of different level of idiosyncratic risk leads to different required return

The ratio between VC Early Stage and Late&Expansion returns and listed companies index (S&P 500 or Russell 1000 or Wilshire 5000) return is similar to the lambda multiplier.




• Discount rates



Milan, 4 december 2017 36Milan, 04 december 2017

PE&PBV Multiples, ROE and Beta:

Time Series Coefficient of Variation

37

38,9%

36,7%

31,9%

19,1%

0,0%

5,0%

10,0%

15,0%

20,0%

25,0%

30,0%

35,0%

40,0%

45,0%

PE PBV ROE BETA

CdV

Tim

e S

erie

s [2

007

-20

16

]

Campione: STOXX 600Trimming: 95%N Obs: 450-500


Sample:

PE&PBV Multiples, ROE and Beta:

Cross Section Coefficient of Variation

38

42,5%

45,2%

57,5%

65,4%

42,6%

58,5%

26,6%

28,5%

20,0%

30,0%

40,0%

50,0%

60,0%

70,0%

80,0%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

CdV

Cro

ss S

ectio

n

PE PBV ROE BETA

Campione: STOXX 600Trimming: 95%N Obs: 450-500


Sample:

beta

PE

PBV

Roe

vi oiv international business valuation n-e … · 04-12-2017 · vi oiv international business...

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