Post on 28-Dec-2015
transcript
C1: Valuing Businesses – the Role of the Actuary
2004 Finance & Investment Conference27-29 June, Royal Windsor Hotel, Brussels
Our Working Party
The purpose of our paper was to educate actuaries about corporate valuation and look for areas where actuaries can add value. Our working party consisted of:
Eight actuaries mostly pensionsOne corporate financier/accountantMBA on corporate valuation
What is Value?
The market price of a business as demonstrated by a transaction. Reasons to calculate value:
Investing in the stock marketValuing unquoted securitiesCorporate planningStaff incentivesMergers and acquisitions
Efficient Market Hypothesis (“EMH”)
Where tradable our model should usually come up with the same value as the market price of a business as demonstrated by its market capitalization. However sometimes EMH will not strictly apply:
Illiquid marketsUnquoted securitiesSmaller companiesHeavily dependant on judgments
Our Measure of Value
Starting point is the market price of the business to any investor.
We can then allow for:Additional value due to synergiesStrategic premiums as per synergiesOther i.e. deal costs etc..Value of equity onlyMay value whole business and then split in equity/debt
Finance Theory
Discounted cash flow (“DCF”) value is the correct way to value any asset (including a business). Common usage inside/outside professionVarious methods for valuing a business:
Enterprise DCF Model Equity DCF Model Adjusted Present Value Economic Value Added
Discount rate to use (from CAPM): Risk Free Rate + [Equity Risk Premium x Beta of Equity]
Other valuation techniques
Short hand methods are often used such as a
multiple of an accounting metric. The metrics can
include: Earnings before Interest and Tax (“EBIT”) EBITA EBITDA
Effectively a proxy for a DCF with an implicit growth and
discount rate assumption
Other valuation techniques
Other ‘short hand metrics’ include. Price to sales ratios:
Young companies where market share is important
Indirect cash flow measures: Number of subscribers for mobile phone companies
Price/earnings ratios: Often used as a “first pass” filtering mechanism
Measures of capital employed: EV/Assets, EV/Capital Employer, Price to Book Ratio
Short Hand Metrics
What is wrong with short hand metrics? Just as complex as DCF modelling:
Adjustments made to EBITDA
Lack of clarity and credibility: Lots of implicit assumptions Arbitrary and too much discretion Value dependant on growth rate assumption
Is the multiple 8 or 9? Huge difference in value and no way to tell which
Evidence from Market Participants
What are people actually doing to calculate the value of a business? Equity analysts:
Occasionally simple DCF models Peer group comparison on simple metrics (e.g. P/E) Qualitative issues have a very high weight
Corporate entities: More likely to use DCF model More value – management, synergies, strategic value More information and less time constraints
Evidence from Market Participants
What are people actually doing to calculate the value of a business? Management consultants:
SIAS Paper – often use DCF models More often use earnings/capital employed by business Focused on corporate efficiency
Investment banks: Most corporate purchasers use an investment bank in a deal Blended approach of various metrics to give a valuation range
Peer group comparisons, DCF model, IRR model
Evidence from Market Participants
What are people actually doing to calculate the value of a business? Private equity houses:
Very sceptical on DCF models IRR model and cash to cash multiples No expansion of multiple
Summary: Most participants believe DCF is the correct method But due to perceived weaknesses in the DCF model they do
not use it
Weaknesses in DCF Models
If everyone thinks it is the right model why does no one actually use it? Choosing the discount :
WACC seems to be lower than that applied in practice Could be to do with specific risk versus CAPM?
Other assumptions: Difficult to obtain any reliable data especially unbiased
Extraordinary items/catastrophes Generally no allowance for extreme events “Extraordinary” items occur nearly every year
Weaknesses in DCF Models
If everyone thinks it is the right model why does no one actually use it? Time horizon:
Some investors have a short time horizon Large proportion of value is ‘exit price’
Practical issues: Information requirements Assumptions and correlations
Time and Cost versus Value Added If a simple metric provides the same answer why bother?
Role of the Actuary
Complex modelling using the DCF technique should be playing to actuarial strengths.
Some hurdles to overcome: Little current involvement Lack of credibility Non-business minded calculator freaks? Not up to speed on Financial Economics
Role of the Actuary
Complex modelling using the DCF technique should be playing to actuarial strengths.
If we can overcome problems of DCF then significant opportunities:
Impact of management strategies Risk measurement and management Aligning shareholders and managers interests
Actuarial Solutions
Choice of discount is the major issue and one in which there is likely to be most debate between the Financial Economists and the market participants.Does specific risk matter?Suggest that the choice of discount rate is left to the client:
Stochastic DCF model can show the volatility of the cash flows This gives a guide as to whether the historic Beta might still be
appropriate Can show results on a variety of discount rates
Actuarial Solutions
Other areas much more actuarially simple.Other assumptions:
Building up a set of realistic and mutually compatible assumptions
Some areas actuaries lack experience (e.g. oil price) Correlations between variables
Extraordinary items and catastrophes: An insurance problem therefore actuaries ideally suited Use RAMP framework to identify risks
Actuarial Solutions
Other areas much more actuarially simple.Time horizon:
Our long term DCF can add value for short term investors: Can calculate all metrics (e.g. IRR and Cash to Cash) required Range of results and the risk profile of these metrics
Practical issues: Models are complex to create and thus expensive However not expensive in the context of deal related fees Timescales may be more problematic
The Actuarial Approach
How would the actuary go about creating a DCF model of a business?Break business down into manageable units:
Similar to approach for an insurance company or pension fund valuation
Head office plus operating businesses would be usualConstruct a model of each business unit:
What are the key drivers of the cash flows? E.g. sales, cost of sales, wages, overheads, tax Project forward each of these variables (consistently) Ensure correlations are accounted for
The Actuarial Approach
How would the actuary go about creating a DCF model of a business?Catastrophes and special events:
Risk analysis to identify possibilities Either:
Allow for insurance premiums to remove costs Model risk with insurance techniques
Convert to a stochastic approach: We have a base line - now need to make variables dynamic Models such as Wilkie for some variables Other variables there will be no standard stochastic model
The Actuarial Approach
How would the actuary go about creating a DCF model of a business?Applying the discount rate:
See previous discussion
Is this too complex?: Simple metrics are not simple And complexity contains hidden judgments Start with a simple model to gauge broad price Make more accurate as deal progresses
Advantages of the Actuarial Approach
The two key advantages of the actuarial approach are:Transparency:
All assumptions are explicit rather than hidden Client has control over assumptions Discount rate is the key parameter – range of results
Risk identification: Catastrophes and special events are allowed for More accurate picture of business risk A risk management tool
Advantages of the Actuarial Approach
Other potential advantages of the actuarial approach include:Sensitivity analysisIdentification of key driversAccurate model of business can be used for:
Testing proposed changes Assessing the changing value of the business over time A more accurate assessment of remuneration
Conclusions
DCF modeling is the correct way to value businesses but is rarely used in practice because they are usually incorrectly applied.Actuaries are comfortable with DCF modelingActuaries should be able to solve the problemsActuaries can add value through DCF modelingHowever there are perception problems